Factors affecting speed of adjustment under different economic conditions. Dynamic capital structure sensitivity analysis
| Published date | 05 October 2015 |
| Date | 05 October 2015 |
| Pages | 165-182 |
| DOI | https://doi.org/10.1108/JCEFTS-08-2014-0015 |
| Author | Muhammad Naveed,Suresh Ramakrishnan,Melati Ahmad Anuar,Maryam Mirzaei |
Factors affecting speed of
adjustment under different
economic conditions
Dynamic capital structure sensitivity
analysis
Muhammad Naveed
Faculty of Management Sciences, Riphah International University,
Islamabad, Pakistan, and
Suresh Ramakrishnan, Melati Ahmad Anuar and
Maryam Mirzaei
Faculty of Management, Universiti Teknologi Malaysia (UTM),
Johor, Malaysia
Abstract
Purpose – This study aims to examine the existence of capital structure dynamics and speed of
adjustment during different economic periods. This study adds to the existing body of literature by
investigating the factors inuencing adjustment process toward target debt in developing economies.
Design/methodology/approach – By employing two-step generalized method of moment (GMM)
and sensitivity analysis, the study highlights critical factors which affect rms’ adjustment mechanism
for target debt.
Findings – Dynamic GMM estimations conrm the substance of past leverage on current debt, which
recognizes the existence of dynamic capital structure. The ndings corroborate that adjustment process
is subject to trade-off between convergence rate and cost of being off-target. The fraction of nancing of
Pakistani rms conrms the pattern of pecking order hypothesis. The outcome of study clearly
validates the signicance of dynamic trade-off modeling for optimal capital structure.
Research limitations/implications – As more data become available, the authors would extend
this study to investigate the sectoral analysis to nd how capital structure dynamics are different across
sectors and how distinctive behavior of each sector differently affects the adjustment process toward
target debt across each sector. In addition, sector-level and macro-economic factors could be
incorporated to examine how external factors affect the rm’s speed of adjustment across
sectors.
Practical implications – The present study provides valuable insights for banking and corporate
sector, mainly in Pakistan. The companies could take into consideration the rm-level factors which
affect the adjustment process toward target debt. Likewise, the borrowing and lending procedures
could be advanced by complying with dynamic mechanism of speed of adjustment. Furthermore, the
ndings of this research provide obstinate grounds for future research.
Originality/value – Both the use of dynamic GMM adjustment model and sensitivity analysis along
with Sargan test validate the health of instruments and values.
Keywords Speed of adjustment, Dynamic capital structure, Generalized method of moment
Paper type Research paper
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Factors
affecting
speed of
adjustment
165
Journalof Chinese Economic and
ForeignTrade Studies
Vol.8 No. 3, 2015
pp.165-182
©Emerald Group Publishing Limited
1754-4408
DOI 10.1108/JCEFTS-08-2014-0015
1. Introduction
Capital structure decisions are of paramount importance for any corporation, as they
create the value of the rms (Voulgaris et al., 2004). Since the path-breaking study of
Modigliani and Miller (1958), a large strand of studies attempted to advance the
understanding of rm level and external factors, which directly or indirectly inuence
the capital structure decisions of the rms (Titman and Wessels, 1988;Rajan and
Zingales, 1995;Baker and Wurgler, 2002;De Jong et al., 2008). The empirical models and
methodologies employed contributed a great deal to understand how the chosen
nancial structure affects the rm’s value. The theoretical developments in the purview
of irrelevancy of capital structure model (MM Model, 1958) have provided grounds for
central governing theories: namely, trade-off theory (Myers, 1977), pecking order theory
(Myers and Majluf, 1984) and agency theory (Jensen and Meckling, 1976).
The static trade-off theory speaks that rms maximize their value when the benets
that stem from debt (the tax shield, the disciplinary role of debt and the fact that debt
suffers less from informational costs than outside equity) equal the marginal cost of debt
(bankruptcy costs and agency costs between shareholders and bondholders). In line
with this theory, rms can optimally achieve its capital structure by balancing the
leverage-related nancial distress costs and debt tax benets (Baxter, 1967;Altman,
1984). Kraus and Litzenberger (1973) argued that benets of the debt nancing in the
form of tax shield are offset by nancial distress costs. Conversely, the increased level of
debt increases the nancial distress and bankruptcy costs. The probability of default on
debt increases when there is increase in the level of debt beyond the optimal level
because the probability of insolvency highly depends on the amount of debt employed
by the rm (Kraus and Litzenberger, 1973;Kim, 1978). Consistent with past literature,
the notion of trade-off theory mainly remained focused on static modeling. Baker and
Wurgler (2002) argued that rms issue new equity when perceived to be overvalued and
repurchase own shares when considered to be undervalued. They concluded that
because rms do not adjust their debt ratios toward the target debt, the effect of market
timing get accumulated and nally drive capital structure of rms. From the
perspectives of market value, managers generally reluctant to issue new shares, as they
feel it may be undervalued. It is because investors tend to perceive that rm issues new
equity only if it is either fairly or over-priced. Such tendency of investors to negatively
react to equity issuance result in management to become reluctant in issue shares
(Myers and Majluf, 1984).
The conception of agency cost also plays an important role in the leverage
mechanism of rm. According to agency cost theory, rms’ can achieve optimal capital
structure by minimizing the cost arising from the conicts between the parties involved
(Jensen, 1986). The employment of debt serves as an important tool to discipline the
management (Harris and Raviv, 1991;Abor, 2008). It is proposed by Ross (1977) that
rm’s management can use debt as a sentiment of condence to investors. The excessive
debt signals the rm’s future value and level of management condence. From the
practical point of view, rms tend to employ excessive debt if they have lower level of
bankruptcy costs. As managers have the privileged information about the value of the
rm, this asymmetrical information may affect the rm’s investment decisions. In
conjunction with this information cost associated with debt and equity nancing, Myers
and Majluf (1984) introduced a nancial hierarchy that is known as pecking order
hypothesis. This theory focuses on asymmetrical information between rms’ insiders
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