Analysis on Shyam-Sunder and Myers, “Testing Static Tradeoff Against Pecking Order Models of Capital Structure”, Jfe 1999
Finance Seminar
Homework #1 Capital Structure
Shyam-Sunder and Myers, “Testing Static Tradeoff Against Pecking Order Models of Capital Structure”, JFE 1999 1. What is the main research question of the paper?
The theory of capital structure has been dominated by the search for optimal capital structure. It predicts reversion of the actual debt ratio towards a target or optimum, and it predicts a cross-sectional relation between average debt ratios and asset risk, profitability, tax status and asset type. The empirical literature seems to confirm these two predictions but they have not checked the statistical power of their tests against alternative hypotheses, say, the pecking order model.
2. What are the main findings? (1) A simple pecking order model explains much more of the time-series variance in actual debt ratios than a target adjustment model based on the static trade-off theory. (2) The pecking order hypothesis can be rejected if actual financing follows the target-adjustment specification.
3. According to the following two equations, how to test the Pecking Order Theory? How to interpret a and bPO ? (1) DEFt = DIVt + Xt + DWt + Rt - Ct (2) DDit = a + bPO DEFit + eit Ct = operating cash flows, after interest and taxes DIVt = dividend payments Xt = capital expenditures DWt = net increase in working capital Rt = current portion of long-term debt at start of period Dt = long-term debt outstanding At = net book assets, including net working capital dt = Dt / At , the book debt ratio
As the pecking order model predicts, when firms need fund, they first consider internal fund, then low risk debt and new equity at last. So the changes in debt ratios are driven by the need for external funds. And DEF just represent the need for external fund. By running the regression on the second equation, we try to find the relationship between debt ratio and need for external fund. The intercept a stands for the debt change when the firm has no deficit or surplus.
Homework #1 Capital Structure
Shyam-Sunder and Myers, “Testing Static Tradeoff Against Pecking Order Models of Capital Structure”, JFE 1999 1. What is the main research question of the paper?
The theory of capital structure has been dominated by the search for optimal capital structure. It predicts reversion of the actual debt ratio towards a target or optimum, and it predicts a cross-sectional relation between average debt ratios and asset risk, profitability, tax status and asset type. The empirical literature seems to confirm these two predictions but they have not checked the statistical power of their tests against alternative hypotheses, say, the pecking order model.
2. What are the main findings? (1) A simple pecking order model explains much more of the time-series variance in actual debt ratios than a target adjustment model based on the static trade-off theory. (2) The pecking order hypothesis can be rejected if actual financing follows the target-adjustment specification.
3. According to the following two equations, how to test the Pecking Order Theory? How to interpret a and bPO ? (1) DEFt = DIVt + Xt + DWt + Rt - Ct (2) DDit = a + bPO DEFit + eit Ct = operating cash flows, after interest and taxes DIVt = dividend payments Xt = capital expenditures DWt = net increase in working capital Rt = current portion of long-term debt at start of period Dt = long-term debt outstanding At = net book assets, including net working capital dt = Dt / At , the book debt ratio
As the pecking order model predicts, when firms need fund, they first consider internal fund, then low risk debt and new equity at last. So the changes in debt ratios are driven by the need for external funds. And DEF just represent the need for external fund. By running the regression on the second equation, we try to find the relationship between debt ratio and need for external fund. The intercept a stands for the debt change when the firm has no deficit or surplus.