GESTIÓN DE RIESGOS

Over the years, a number of theories evolved attempting to explain variations in

corporate financing decisions across firms‟. In their seminal paper, Modigliani and

8_{There is a separate chapter specifically dedicated to literature review of}

the broader capital structure research, including research on

Multinationals. Thus, the review in this chapter mainly pertains to the specific research question of the chapter. Furthermore, this approach minimizes the recycling of the literature.

8 Miller (1958) shows that a firm's choice of capital structure is irrelevant to its intrinsic

value when capital markets are perfect (i.e. zero taxes, no transaction costs, and no

informational advantage). However, in their subsequent paper, in which the zero tax

assumption was relaxed, Modigliani and Miller (1963) made a value proposition, that

firms should use 100% debt financing in a pseudo-perfect market – this was meant to

fully utilize the debt tax shield. In practice, however, many firms show a moderate

amount of leverage, which suggests an existence of certain costs attached to debt

financing, as a result of capital market imperfections. In an imperfect capital market,

managers under optimal contract are expected to deal with the dynamic market forces

to increase value for their shareholders and concurrently meet their financial

obligations to the creditors. Accordingly, the observed capital structure may be

explained by proactive managerial activism in balancing the costs and benefits of debt

in order to fulfil their mandate (i.e optimal contract). Since the “irrelevance”

proposition by Miller and Modigliani (1958)9, the academic community has been vigorously debating the determinants and adjustment dynamics of capital structure.

Although, there is no general consensus on the dynamics of capital structure, prior

evidences have advanced our understanding of the role of firm characteristics in

determining the mix of capital.

Notably, the capital structure literature is dominated by two main competing

theories, the classic trade-off theory and the pecking order theory10. However, market timing hypothesis and inertia propositions have recently entered the literature and

9 _{The “irrelevance” proposition assumes perfect capital markets and zero}

corporate tax. The tax assumption was relaxed in the subsequent paper (Modigliani & Miller, 1963). Ever since, all other assumptions have been relaxed, resulting in the discovery and development of several empirically testable capital structure determinants, theories and hypothesises.

10 _{The pecking order theory, motivated by information asymmetry was}

initially proposed by Donaldson (1961) and later extended by Myers and Majluf (1984).This is the hierarchical financing model, from cheap to expensive financing.

9 have gained considerable attention of both the academics and the practitioners. The

dynamic version of both trade-off and pecking order theories are mainly the dominant

alternative in empirical capital structure research11. The problem with the static trade- off theory is that, it assumes instantaneous readjustment, which implies either zero transaction costs or managers‟ indifference to transaction costs. On the other hand, the

pure pecking order assumes strict adherence to the order of financing, dictated by

issuing costs; from internal capital to debt and finally to equity. These classic versions

of trade-off and pecking order theories are incongruent with the dynamics of both

firm characteristics and the capital markets. The dynamic trade-off model relaxes the

stickiness of static trade-off theory and has combined the key ingredients of both

pecking order12 and trade-off theory, as it allows temporary deviation from the

optimal leverage, the readjustment process is thus determined by both the attributes of

pecking order and trade-off theories.

The dynamic trade-off notion is that, firms do attempt to maintain an optimal (target)

capital structure that balances the costs and benefits associated with different degrees

of leverage, and has an implicit positive effect on expected return on investment. This

view posits that firms counteract disruptions in their optimal capital structure by

rebalancing their leverage ratio back to the optimal level. However, such rebalancing

is done gradually (partially) due to transaction costs imposed by imperfect capital

markets. The dynamic trade-off theory therefore leads us to two central questions;

first what are the costs and benefits of debt financing? Second, what are the costs and

benefits of readjusting to target? If we assume that firms have varying costs and

11_{Among the list are Fama and French (2002), Frank and Goyal (2005),}

Flannery and Ranjan (2006), Hovakimian, Opler, and Titman (2001), Mehotra, Mikkelsen, Partch (2003), and Strebulaev (2004).

12 _{Pecking order and market timing suggests that there is no target}

leverage, which essentially differentiates the trade-off theory from other theories.

10 benefits of both debt financing and adjustment to target, then firms should have

varying debt level and varying speed of adjustment to target. To answer these

questions in a dynamic trade-off framework, prior research weighs the costs and

benefits of debt financing using specific firm-level characteristics. Similarly, the costs

of deviating from target is weighed against the cost of moving towards the target, as

well as the mitigating factors that minimizes external financing costs and therefore

either speed up the adjustment process or tempered the costs of deviation from target.

However, there is a lack of broader consensus as to the theoretical predictions of the

determinants of leverage and factors of adjustment speed. For instance, the prediction

of the trade-off theory is that firms with lower bankruptcy costs or higher tax

advantages should use more debt. Yet, a closer scrutiny of observed leverage reveals

that firms subjected to similar tax policy (i.e. statutory tax rate) may have different

debt level, thus the tax rate alone couldn‟t explain the variation across firms.

Similarly, the proxies used in empirical testing are far from perfect - take bankruptcy

proxy for instance - a probability measure using firm-level characteristics, but recent

events of unexpected bankruptcy of high profile Wall Street firms highlights the

weaknesses of such predictions (i.e. bankruptcy proxy).

Nevertheless, the issue of adjustment to target leverage is central to the understanding

of trade-off theory (Flannery and Hankins, 2007, Frank and Goyal, 2008). But how

fast do firms adjust and why do some firms adjust faster than the others are still under

intense academic debate. The trend in the literature suggests that researchers are

focused on firm-level characteristics as distinguishing determinants of both leverage

and the adjustment process. Yet, empirical evidences for adjustment speed estimates

ranged from 7% to 100%. Perhaps a major area of dissension among the researchers is

11 here is that of the dynamics of the capital markets. Both transaction costs and the

magnitude of those costs are intricate functions of the capital market perception of the

firm and the firm-level characteristics – Both of which vary across firms and over

time.

Consequently, in prior papers, various approaches have been used to detect

heterogeneity across firms, assuming uniform adjustment speed or looking to relative

leverage (i.e. whether the firm is under or over leverage). Roberts and Leary (2005)

shows that rebalancing options influenced adjustment costs and Hovakimian et al

(2001) reported faster adjustment for overleverage firms and those firms that use debt

reduction as preferred rebalancing option, and Flannery and Hankins (2007), noted

the significant effects of size, equity price increase and debt capacity usage on the

speed of adjustment.

At best, the existing literature has provided mixed results on the speed of adjustment

toward target leverage. For example, Flannery and Ranjan (2006) estimate 35.5 for

market leverage and 34.2% for book leverage, Flannery and Hankins (2007) reported

approximately 22% readjustment each year, Fama and French (2002) reported

adjustment speed in a range of 7 to 18%, Huang & Ritter (2007) reported 23.2% for

market leverage and 17% for book leverage, Lemmon et al. (2008) reported 25% for

book leverage, and Roberts (2001) reports adjustment speed close to 100% for certain

industries. My findings in this chapter lies somewhere between prior evidences. The

adjustment speed for DCs depending on the econometric technique has a range of 34

to 53%, 41 to 58% for MNCs (i.e. MNC broadly defined) and 52 to 74% for MNC10

(i.e. MNCs with 10% or > of foreign tax ratio). It is imperative to note that, the speed

at which firms adjust has important implications. If firms adjust rapidly, then

12 observed leverage, and the contrary should be true if firms adjust slowly. From

another perspective, rapid adjustment to target may signify among others, relative

lower transaction costs (such as lower external financing costs), higher costs of

deviating from target, rigid debt contractual agreements or superior financial

flexibility.