Do Managers Have Capital Structure Targets? Evidence from Corporate Spinoffs

Journal of Applied Corporate Finance, Vol. 17, No. 1, 2005

University of Alberta School of Business Research Paper No. 2013-223

Posted: 26 May 2013 Last revised: 30 May 2013

See all articles by Vikas Mehrotra

Vikas Mehrotra

University of Alberta - Department of Finance and Statistical Analysis

Wayne H. Mikkelson

University of Oregon - Department of Finance

M. Megan Partch

University of Oregon - Department of Finance

Date Written: January 23, 2004

Abstract

The two main theories of capital structure — the tradeoff theory and the pecking order theory — have opposite predictions about the expected relationship between corporate leverage and profitability. According to the tradeoff theory, companies that earn higher profits will use more debt both to shield their income from corporate taxes and to discipline corporate investment policy. In contrast, the pecking order theory predicts that more profitable companies will borrow less mainly because they have less need to borrow.

Corporate spinoffs provide a unique opportunity to investigate the influence of profitability and other asset characteristics on the design of capital structure. In their study of 98 spinoffs over the period 1979-1997, the authors began by investigating the popular argument that managers routinely assign more debt to subsidiaries than parents in order to leave the parents less encumbered — a possibility they reject after finding that the average leverage ratios of the parents and spunoff units were roughly equal. At the same time, the authors reported large differences in the leverage ratios among both parents and spun-off units, and that the variation was explained primarily by differences in three factors: asset tangibility and the level and variability of cash operating profits. Consistent with the tradeoff theory (but not the pecking order), the study found a significantly positive correlation between a post-spinoff company's cash profitability and its assigned debt load, as well as a negative correlation between debt and the variability of operating cash flow.

Suggested Citation

Mehrotra, Vikas and Mikkelson, Wayne H. and Partch, M. Megan, Do Managers Have Capital Structure Targets? Evidence from Corporate Spinoffs (January 23, 2004). Journal of Applied Corporate Finance, Vol. 17, No. 1, 2005; University of Alberta School of Business Research Paper No. 2013-223. Available at SSRN: https://ssrn.com/abstract=2269307

Vikas Mehrotra (Contact Author)

University of Alberta - Department of Finance and Statistical Analysis ( email )

School of Business
University of Alberta
Edmonton, Alberta T6G 2R6
Canada
780-492-2976 (Phone)
780-492-3325 (Fax)

Wayne H. Mikkelson

University of Oregon - Department of Finance ( email )

Lundquist College of Business
1208 University of Oregon
Eugene, OR 97403
United States

M. Megan Partch

University of Oregon - Department of Finance ( email )

Lundquist College of Business
1208 University of Oregon
Eugene, OR 97403
United States

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