Bankruptcy Risk and Optimal Capital Structure

Abstract

This study finds shortcomings in empirical tests of the capital structure irrelevance hypothesis. The alternative hypothesis is that firms choose value maximizing mixes of debt and equity on account of bankruptcy costs and the tax deductibility of interest payments. Based upon the cross‐sectional implications of the tax shelter‐bankruptcy cost hypothesis, an alternative test of the irrelevance hypothesis is performed. The test examines the relationship between failure rates and leverage ratios for 36 lines of business. The results are inconsistent with the irrelevance hypothesis.

Impact of Business Risk on Corporate Capital Structure of Publicly-Listed Nigerian Companies

“…Comprehensive surveyscan be found in Bradley et al (1984), Taggart (1986), Masulis (1988) The bulk of the empirical research on capital structure has focused on the behaviour of firms in the United States and other G-7 states with similar institutional structures andby implication their market values. The major contributors are Taggart (1977), Ferri and Jones (1979), Bowen, et al (1982), Marsh (1982), Bradley et al (1984), Jalilvand and Harris (1984), Castanias (1983), Long and Malitz (1985), Auerbach (1985), Kester (1986), Titman and Wessels (1988), Hodder and Senbet (1990), Chung (1993), Rajan and Zingales (1995), Wald (1999), Shyam-Sunder and Myers (1999), Ozkan (2001)and Bevan and Danbolt (2002).…”

“…Leverage ratios of specific industries were documented by Bowen, et al (1982), Bradley et al (1984), Long and Malitz (1985) and Kester (1986).Their results showed that in line with the traditional pecking order theories, innovative industries, such as Drugs, Electronics and Food industries, have had consistently low leverage ratios by comparison with mature and highly regulated industries such as Utilities and Airlines. Additionally, studies by Bradley, et al (1984), Castanias(1983), Long and Malitz (1985), Kester (1986), Marsh (1982) and Titman andWessels (1988) on the effect of firm-specific factors generally agreed that the use of debt financing is a positive function of fixed assets, non-debt tax shields and growth opportunities. They found a negative correlation between leverage and earnings volatility, advertising expenditures, bankruptcy probability, profitability and the uniqueness of the firm's product.…”

“…Second, it tests the hypothesis that the relationship between business risk and corporate leverage is nonlinear, initially decreasing and eventually rising in the U-shaped manner originally predicted by DeAngelo and Masulis (1980), Castanias (1983) and Kale et al (1991). The intuition underpinning this idea is that in deciding on the appropriate debt-equity ratio that companies should aim to achieve, analysts should consider the "psychology" of investors and its implication for the potential costs of financial distress relative to the firms'market value.…”

Numerical Methods for Differential Games: Capital Structure in an R&D Duopoly

“…The two most popular theories are the tradeoff and the pecking order theories. The tradeoff theory, as represented by Stiglitz (1972) and later Castanias (1983), says there is a tradeoff between the advantage of debt that comes from the tax shield that arises because interest payments are treated as an expense, and the increased probability of financial distress as the level of debt is increased. The pecking order theory, as developed by Myers (1984) and others, argues that firms prefer internal financing whenever possible since outside investors require a premium based on asymmetric information as to the actual financial and operational health of the firm.…”

Financing Theories and Financing Practices: A Case Study of Two Casino Companies

“…Unprofitable companies may want to rely more on equity financing. Empirical studies attempting to find the determinants of capital structure within the trade-off frameworkindude those by Fem and Jones (1979), March (1982), and Castanias (1983. Bradley et al (1984) provided an overall review of the 'IT0 theory and empirical studies.…”