Common Flaws in Empirical Capital Structure Research

Abstract:     
This paper critiques three issues that commonly arise in empirical capital structure research.

1. Capital Structure Proxies: The financial-debt-to-asset ratio is flawed as a measure of leverage, because the converse of financial debt is not equity. This is because most of the opposite of the financial-debt-to-asset ratio is the non-financial-liabilities-to-asset ratio. This problem is easy to remedy- researchers should use a debt-to-capital ratio or a liabilities-to-asset ratio. The converse of either is an equity ratio.

2. Non-linearity: The intrinsic non-linearity of leverage ratios can render standard linear regressions even with perfect independent variables seemingly powerless. Fortunately, researchers can easily test whether variables have a linear or non-linear influence on equity value changes, debt value changes, or leverage ratios.

3. Selection Issues: There are large survivorship biases in the CRSP/Compustat data bases. About 10% of firms appear and 10% disappear in a single year. These birth and death rates are themselves functions of capital structure and other firm characteristics. This selection makes studying long-term capital structure changes diffcult. Unfortunately, this problem is diffcult to remedy.

The paper does not claim that these three issues drive results in the existing literature. It does however claim that they are not so small as to allow ignoring them a priori.

The paper also clarifies some theoretical issues, most of which are not new, but which are suffciently often muddled that a clarification is useful. First the paper distinguishes between capital structure mechanisms and causes. Second, when it comes to causes, it clarifies that there is no dichotomy between the pecking order theory and the trade-off theory. A pecking order arises in a trade-off theory in which issuing more junior securities is relatively more expensive, or possibly prohibitively expensive. A pecking order is not synonymous with adverse selection, financial slack, or a financing pyramid, either.

Keywords: capital structure

JEL Classifications: G32

Working Paper Series