UBC Theses and Dissertations

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UBC Theses and Dissertations

Tests of determinants of optimal capital structure Portman, Nicholas Francis 1983

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TESTS  OF  DETERMINANTS  OF  OPTIMAL  CAPITAL  STRUCTURE  by  NICHOLAS B . C o m m . ( H o n s . ) ,  A  THESIS THE  MASTER  FRANCIS  D a l h o u s i e  SUBMITTED  IN  REQUIREMENTS OF  SCIENCE  PORTMAN U n i v e r s i t y ,  PARTIAL FOR  THE  (BUSINESS  1981  FULFILMENT DEGREE  OF  OF  ADMINISTRATION)  i n THE D e p a r t m e n t  We  Of  FACULTY Commerce  a c c e p t to  THE  OF  t h i s  the  And  r e q u i r e d  UNIVERSITY  OF  N i c h o l a s  STUDIES  B u s i n e s s  t h e s i s  A p r i l  ©  GRADUATE  as  A d m i n i s t r a t i o n  c o n f o r m i n g  s t a n d a r d  BRITISH  COLUMBIA  1983  F r a n c i s  P o r t m a n ,  1983  In p r e s e n t i n g  t h i s t h e s i s i n p a r t i a l f u l f i l m e n t of  requirements f o r an advanced degree at the  the  University  o f B r i t i s h Columbia, I agree t h a t the L i b r a r y s h a l l make it  f r e e l y a v a i l a b l e f o r reference  and  study.  I  further  agree t h a t p e r m i s s i o n f o r e x t e n s i v e copying of t h i s t h e s i s f o r s c h o l a r l y purposes may department or by h i s or her  be granted by  the head o f  representatives.  my  It is  understood t h a t copying or p u b l i c a t i o n of t h i s t h e s i s f o r f i n a n c i a l gain  s h a l l not be allowed without my  permission.  Department of The U n i v e r s i t y of B r i t i s h Columbia 1956 Main Mall Vancouver, Canada V6T 1Y3  DE-6  n/fin  written  i i  Abstract This  paper p r o v i d e s  between c a p i t a l A  synopsis  date  the  examination  s t r u c t u r e and  of  the  i s provided.  capital  an  theory A  a number o f  and  model  amounts  of  is  r e l a t e d to operating  bankruptcy  costs.  T e s t s of with  the  The  class,  the  and  for  net  to  to  Capital related  to  h a v e no  long  liquidity,  to act  positively  term debt.  i n f l u e n c e on  preferred  stock  like  posits  and  sales v a r i a b i l i t y ,  and  had  equity.  of  dependent variables  sales,  assets),  and  Dummy  influence on  capital  a  of  number  debt r a t i o s .  were class,  structure.  ratio  negatively  leverage,  and  subordinated  to  sales v a r i a b i l i t y  leverage.  of  inventory  industry  significantly  r e l a t e d to the S i z e and  industry  variables  industry c l a s s , operating  higher  the  secured to unsecured debt, a  f o u n d t o be  financial  context,  independent  variance  assets). the  size,  p r i o r i z e d debt,  r a t i o as  as  to  that  firm  (accounts r e c e i v a b l e ,  preferreds  s t r u c t u r e was  significantly other  for  of  total  leverage  total  check  c o n v e r t i b l e d e b t and  used  leverage,  to  operating  plant,  introduced  leverage,  proportion  l i q u i d i t y measure (cash proxies  and  of the d e b t - t o - e q u i t y  of o p e r a t i n g  firm size,  which  r e l a t e d to l i q u i d i t y ,  characteristics  degree  structure  m o d e l were p e r f o r m e d i n a r e g r e s s i o n  logarithm  variable. were  the  relationship  firm characteristics.  developed  subordinated  negatively  the  e v i d e n c e on c a p i t a l  structure i s positively  relative  of  were f o u n d  F i r m s w h i c h had Convertible  debt  to  issued tended  Table of C o n t e n t s Abstract L i s t of T a b l e s L i s t of F i g u r e s I. CAPITAL STRUCTURE: THEORY AND EVIDENCE TO DATE II. A SIMPLE MODEL OF CAPITAL STRUCTURE I I I . METHODOLOGY AND RESULTS LITERATURE CITED APPENDIX A - LIST OF COMPANIES SAMPLED  6  iv  L i s t of T a b l e s Regression R e s u l t s V a r i a n c e Decomposition Industry Regressions Industry Regressions Continued  V  L i s t of F i g u r e s  1. Expected Normal P l o t , A l l Cases, 1981 & 1976 Data 2. Expected Normal P l o t , Cases 69 & 241 D e l e t e d , 1981 1976 Data 3. Expected Normal P l o t , A l l Cases, 1971 & 1966 Data  49 & 5 0  51  1  I.  CAPITAL STRUCTURE; THEORY AND  In a w o r l d  where c a p i t a l  perfect,  the  financing  have no  increases, for  relative  stockholders  bearing  increased  Hamada  examined  systematic  risk  proposition  held.  have been had estimates of  the  of  Hamada adjusted  firm  returns  systematic each  risk  measured  equity  systematic  risk,  systematic  risk  the  effect  but if  used  financial  returns  not  stock  for  leverage  t o compensate  financial  the  and  leverage  assumed returns  been l e v e r e d , and  (observed of  of  Hamada  2  adjusted  them  then  explained  unlevered 21  MM would  regressed  against  between  the  the  t o what t h e y  adjusted)  l e v e r e d and  that  on  the  estimates  firms.  and  24  The  percent  risk. the  systematic  found  This  financed  equity  and  risk.  measure  industry.  As  1  DATE  both . complete  r i s k y d e b t and  demand h i g h e r  He  risk  are  firm value.  leverage  systematic  returns.  on  equity. He  showed t h a t  of o b s e r v e d  all  the  systematic  results  for  of  markets  amounts o f  effect  EVIDENCE TO  the  t o be  firms they  adjusted  within  to have  increased  h i s observed  deviation  f o r the  that  tended could  of  standard  lower  suggested  firms  risk  face  the  chosen  financial  each  and  of  his  returns, industry,  same l e v e l s to  of  have  more  leverage.  Chi-  1  J o s e p h E. S t i g l i t z , "On t h e I r r e l e v a n c e of C o r p o r a t e P o l i c y , " A m e r i c a n E c o n o m i c R e v i e w , December 1974.  Financial  2  R o b e r t S. Hamada, "The E f f e c t of t h e F i r m ' s C a p i t a l Structure on the Systematic R i s k o f Common S t o c k s , " J o u r n a l o f F i n a n c e , June 1966.  2  squared  t e s t s suggested  that v a r i a t i o n  i n systematic r i s k w i t h i n  r i s k c l a s s e s was l e s s than t h a t i n the whole sample.  T h i s again  suggested  f o r firms  within  similar  each  underlying  industry,  capitalization  but  differing  F i n a l l y , Hamada found  that  industries  f o r the observed  was  less  than f o r the a d j u s t e d ones. measures  have  variability  similar  of  the  of  risk classes.  variance  between  systematic r i s k measures  Between i n d u s t r i e s , systematic  risk  These r e s u l t s tend t o support The  amongst  F-ratio  variability,  systematic  rates  when  compared  risk  to  the  measures of unlevered f i r m s .  the MM h y p o t h e s i s .  i n c l u s i o n of c o r p o r a t e and personal income taxes  t h i s c o n c l u s i o n unchanged f o r the i n d i v i d u a l  firm.  3  leaves  Firms  induce  e q u i t y h o l d e r s t o switch to h o l d i n g bonds by o f f e r i n g them higher yields. loss  These higher y i e l d s compensate e q u i t y h o l d e r s f o r of  positions. rate  tax  savings  tax  to  zero. from  savings  offset  from the s w i t c h . equity  the  reduction  in  their  from  corporate  borrowing  the i n c r e a s e i n p e r s o n a l taxes  Firms w i l l be i n d i f f e r e n t  to issuing  to  T h i s occurs when the i n c r e a s e debt  i n corporate  debt  tax  M.H.  or  equals shield  i s s u e i s o f f s e t by the i n c r e a s e d y i e l d o f f e r e d t o the  suggests  Miller's  that there e x i s t s an o p t i m a l c a p i t a l s t r u c t u r e  f o r a l l f i r m s taken together, but the i n d i v i d u a l f i r m w i l l  3  be  resulting  when the i n c r e a s e i n f i r m value from i s s u i n g debt  i n v e s t o r t o induce him t o s w i t c h drom e q u i t y t o debt. theory  equity  There are some i n v e s t o r s who are taxed at too high a  f o r the  sufficient  from  their  Miller,  find  "Debt and Taxes", J o u r n a l of Finance, May 1977.  3  t h a t  d e b t  s t r u c t u r e  One  argument  c a p i t a l  i n  i n f o r m a t i o n , argument m a n a g e r s .  managers  wrong  A i s  w i t h  of  of  w i l l  o n l y  i s s u e  debt  e q u a l s  the  *  R i c h a r d F i n a n c e ,  5  a n d  Andrew  H.  6  J e r o l d of  B.  F i n a n c e ,  in  d e a d w e i g h t  the in  c a n  l e s s  l o s s e s than  e x p e c t e d be  W a r n e r , 1977.  E .  them  f o r  to  to  make  w h i c h  are  M y e r s ,  K i m ,  " B a n k r u p t c y  of  from  C o s t s :  f i r m more  d i r e c t  or  w i l l  be  Warner  P r i n c i p l e s C h a p t e r  Some  The  on  c o s t s .  by  " T h e o r i e s  v a l u e  u s i n g  e i t h e r  F i n a n c e ,  the  t a k e s  i n c r e a s e s .  as  1981,  t o  p r e s e n t  f i r m  b e n e f i t  f o r t h  T o r o n t o , Han  a  t h e o r y  l e a d  net  b a n k r u p t c y  s e t  J o u r n a l  w i l l  As  c l a s s e d  S t e w a r t I n c . ,  and  s t r u c t u r e  s t r u c t u r e  the  f i r m .  m a r g i n a l  d i s t i n c t i o n  S y n t h e s i s " ,  T h i s  s t o c k h o l d e r s  c a p i t a l  b a n k r u p t c y  and  and  p o s i t i v e  r e s u l t s  of  H i l l ,  of  to  p r o b a b i l i t y  c o s t s  r i s k  m a x i m i z e d .  i n d u c i n g  the  the  May  e l e m e n t  b e i n g  u n t i l  i n f o r m a t i o n  m a x i m i z a t i o n .  T h e s e f i r m  i s  i n t e r e s t  l e a d  I n s i d e r s  5  b u s i n e s s  i n c e n t i v e  to  Chen A  v a l u e  t h e r e b y  o p t i m a l  c o m p r i s i n g  f l o w s  B r e a l e y  S t r u c t u r e :  the  c a n  v a l u e  i n c r e a s e  Mc-Graw  i n  T h i s  debt  B a n k r u p t c y  be  m a n a g e r s ,  c a s h  f i r m  an  p r o v i d e  f i r m ' s  a p p r o p r i a t e  i m p o r t a n t  f u t u r e  to  s i g n a l s  t h a t  an  f i r m  the  c o r r e c t  may  b a n k r u p t  d e b t ,  i n d i r e c t ,  the  c o s t s .  a  e x p e c t e d  more  of  i t  p o t e n t i a l l y  b a n k r u p t c y  v a l u e  the  n a t u r e  f a c e  a s y m m e t r y .  o r d e r  s i g n a l s .  i n c o n s i s t e n t  i n d e e d  i n f o r m a t i o n  e n s u r e  to  do  i n  g i v e n  payments  f i r m s  s i g n a l l i n g  g i v i n g  However,  s i d e  the  By  h o l d s ,  m a t t e r . "  c o n c e r n s  about  p r o f i t a b i l i t y .  not  s u g g e s t s  f i n a n c i a l  s h a r e h o l d e r s  make  t h a t  s t r u c t u r e  engage to  d o e s  of  May  of  C o r p o r a t e  18.  C o r p o r a t e  Debt  1979.  E v i d e n c e " ,  J o u r n a l  4  f o l l o w e d  h e r e .  a c c o u n t i n g ,  t r u s t e e ,  m a n a g e r i a l the  D i r e c t  6  t i m e  I n d i r e c t  l e g a l  the  a s s e t s ,  i d e a l  when  of  ex  d i r e c t l y  of  f o u n d  f o r  c o n t r a s t  t o  c o n c e n t r a t e d  t h a t  of  the  c o s t  e f f e c t s of  the  e x p e c t e d  of  of  of  c o s t s , the  and  c o u r t . l o s s  t i e d  up  of  due  t o  t i m e . b a n k r u p t c y f i r m  of  v a l u e  p r o f i t s , f u n d s  the  m a k i n g  a n t e  of  l e g a l ,  the  c o u r t  a g e n t s  c r e d i t o r s  i s  on  i n c r e a s e s .  8  D.  B.  v a l u e ,  f o r  c o s t s  would  b a n k r u p t c y  on  i n c l u d e  at  r e l e v a n t  the  t i m e  d e c i s i o n s .  b a n k r u p t c y  c o s t s  F o r  the  t o  c o s t s  a r e  not  e x a m i n a t i o n  W a r n e r ,  and  of  e x a m p l e ,  of  $50000,  l i q u i d a t i o n  B a x t e r ,  a s s e t  h i s  O p .  C i t .  of of  s t u d y  f o u n d  " L e v e r a g e , F i n a n c e ,  1967.  t o  $50000,  R i s k  r a t i o  a  of  25.7%, In  7  p u b l i c l y  s u g g e s t e d a s  b a n k r u p t c y  R u i n  r a t i o  b a n k r u p t c i e s ,  d e c l i n e  of  the  1 9 . 9 % .  sample  a l s o  a  s i z e .  was  was  p e r s o n a l  as  f i r m  r e a l i z a t i o n  b a n k r u p t c y  Warner  under  the  c o s t s  c o s t s ,  r e l a t e d  r e a l i z a t i o n s  o v e r  c o s t s  b a n k r u p t c y  n e g a t i v e l y  t o t a l  c o m p a n i e s ,  J o u r n a l  d i r e c t  a r e  a s s e t  B a x t e r ' s  d i r e c t  N e v i n s  t h a t  r e a l i z a t i o n s  r e l a t i v e  J e r o l d  of  f e e s ,  l o s t  c o s t s  f i r m  r a i l r o a d  C a p i t a l " , 8  c o s t  d e c i s i o n  s u g g e s t  a d m i n i s t r a t i v e  w h e r e a s  7  s a l e s ,  e x p e c t e d  ex  a u t h o r s  p e r c e n t a g e  t r a d e d  the  o t h e r  to  o b s e r v a b l e .  Two  B a x t e r  and  a n t e  management  U n f o r t u n a t e l y ,  of  and  r e f e r  b a n k r u p t c y ,  o p p o r t u n i t y  s t r u c t u r e the  the  l o s t  the  c o s t s  p r o f e s s i o n a l  t r u s t e e  e x a m i n a t i o n  c a p i t a l  a n a l y s i s  the  i n c l u d e  p r o c e e d i n g s , An  o t h e r  a s s e s s i n g  by  c o s t s  i n t a n g i b l e  and  s p e n t  d i s b u r s e m e n t s  b a n k r u p t c y  a n d  t h a t  f i r m c o s t s  the  the s i z e  as  a  C o s t  of  5  p e r c e n t 6.6%  of  m a r k e t  f o r  two  the  two  a d d i t i o n  t h e r e  a r e  v e r g e  of  the  debt  and  the  s t r u c t u r e  1  c a p i t a l w h i c h  would  T h e s e  a s s e t  2.7%  w h i c h  d i s t r e s s , of  v a l u e  be  a n d  may  9.1%  and  f o r  the  1.7%  when  w e l l  the  f i n a n c i a l  due  to  be  f i r m  s m a l l ,  i s  on  d i s t r e s s  b o n d h o l d e r  and  m o n i t o r i n g  c o s t s  of  b a n k r u p t c y  and  t r a d i t i o n a l  m i n i m i z e s  and  A r o n s o n  f i r m s  a p p e a l  o p t i m a l  view  the  the  i n c l u d e  s t o c k h o l d e r  a s s o c i a t e d  f i n a n c i a l  t h a t  t h e r e  w e i g h t e d  f i r m s and  and  J o u r n a l  F i n a n c i a l  of  R i c h a r d  B r e a l e y  S c h w a r t z  i n  S u p p o r t  of  F i n a n c e ,  of  and the  M a r c h  and  t h a t  d e v e l o p  o p t i m a l  s e g m e n t s  s t r u c t u r e s  o p e r a t i o n a l  s t r u c t u r e s  a r g u e d  v a r i o u s  c a p i t a l  t h a t  J e n s e n  w o u l d  t o  B e h a v i o r ,  E l i  c o s t s ,  c o s t s  c o s t s  the  w h i c h  f i r m ' s  M . H .  of  M a n a g e r i a l  1  and  t o  w i t h  i s  d i s t r e s s  an  o p t i m a l  a v e r a g e  c o s t  of  0  s u g g e s t e d  1  b a n k r u p t c y  9  m a r k e t s ,  t h e  The  b o n d i n g  s u p p o r t  S c h w a r t z  0  of  r a i l r o a d s ,  f i n a n c i a l  f i r m  i n c l u s i o n  to  c a p i t a l .  of  of  c o v e n a n t s .  t e n d s  1  d a t e  b a n k r u p t c y  b a n k r u p t c y .  The  9  to  r e d u c t i o n  debt  o f  t h e  s m a l l e s t  c o s t s  c o n f l i c t s ,  1  at  l a r g e s t . In  1  v a l u e  and  i n  t h e  f a c e  s i m i l a r  W.  H.  C o s t s  E c o n o m i c s , S t e w a r t  J .  R i c h a r d  1967.  of  and  O c t o b e r  M y e r s ,  O p .  A r o n s o n ,  O p t i m a l  be  s t r u c t u r e s  m a r k e t  f o r  f u n d s .  d e v e l o p e d  i n  l i g h t  c h a r a c t e r i s t i c s .  i n d u s t r y  l e v e l s  f r i c t i o n l e s s  c a p i t a l  the  would  M e c k l i n g ,  A g e n c y  C o n c e p t  i n  a s s e t same  w i t h o u t  of  would  have  b u s i n e s s  " T h e o r y  s i m i l a r  r i s k ,  of  O w n e r s h i p  They  the  and  F i r m :  S t r u c t u r e " ,  1976. C i t . , "Some  C a p i t a l  p . 3 9 6 .  S u r r o g a t e S t r u c t u r e " ,  E v i d e n c e J o u r n a l  6  consequently  would  Furthermore, capital  firms  in  to  1928  i n each  industry  industrials. mean  1961.  structures.  and  equity  total  s e e n as  was  a  differring  to  claims.  S c h w a r t z and  1961  or  was  1928  there  within  inter-industry  any  be  ratio  differences  and in  variation  that  in  difference  1928  in  than v a r i a t i o n i n  They d i d  both  examined  mining,  and  more c r u c i a l  firms.  in  eight  f o r a l l sample means.  statistical  c l a s s of  samples of  for differences  Aronson concluded  any  four  utilities,  ANOVA t e s t  assets  sampled  industries  residual claimant,  felt  prior  The  gas  way  they  took t h r e e  i n each y e a r .  to  was  theory,  They  electric  equity  structures  this  They u s e d a one  Common e q u i t y common  test  and  railroads,  the  capital  i n d i f f e r e n t i n d u s t r i e s w o u l d have  effort  industries  were  similar  structures.  In an  firms  exhibit  in  neither financial  find significant  and  1961  for  all  samples. Schwartz structure  and  does  environment. railroads  change For  in  example,  maintained response they  became l e s s l e v e r a g e d .  competition of  Aronson  from o t h e r  forms of  that to  industry  variation  suggested This  was  transport  that  firms  facing higher  reduce t h e i r degree appeared time.  to  them  of that  Unfortunately,  statistically.  Their  l e v e l s of  financial financial they  did  and  structures  e x a m i n a t i o n was  test by  over  the  the time,  increased  susceptiblity  They  implicitly  business risk  leverage.  not  that  in  because of  r a i l r o a d s to v a r i a t i o n in business c y c l e s .  assert  financial  tend  Nonetheless, were s t a b l e this  inspection,  to it  over  hypothesis which  led  7  them t o  conclude  gradually  criticized  argued  that  i n d u s t r i e s , and Regulation similar  capital  structures  and  on s e v e r a l  Aronson  only  of i n d u s t r i e s b i a s e d utilities  may  s t r u c t u r e s w i t h i n each  comparisons  using  many i n t e r  explicitly  sampled  a  risk  of  well  have  industry.  led  but  did  conclusions  S c h w a r t z and A r o n s o n . in equity  groups. Schwartz  and  that  industry  gave  He  same  argued that  ratios in  the  was  response  due  as  significant inter-industry to  management  adjusting  risk  by t h e f i r m , w h i c h d i f f e r e d among i n d u s t r i e s . in intra-industry  indicating  that  of b u s i n e s s  risk.  firms  ANOVA  t h o s e of  structure  differences  t o the the l e v e l of b u s i n e s s  equity  ratios  i n t h e same i n d u s t r y  could face  be  No  such  found,  similar levels  Remmers, S t o n e h i l l , W r i g h t and B e e k h u i s e r (RSWB) f o u n d  D a v i d F S c o t t , J r . , " E v i d e n c e on t h e I m p o r t a n c e S t r u c t u r e " , F i n a n c i a l Management, Summer 1972.  1 2  the  groupings  U s i n g one way results  and He  between the b u s i n e s s r i s k and  financial faced  not  i n d u s t r y d i f f e r e n c e s were s i g n i f i c a n t .  firms,  to  Furthermore,  l a r g e r sample of u n r e g u l a t e d f i r m s ,  c o r r e s p o n d e d t o g r o u p i n g s by b u s i n e s s r i s k . his  four  their results.  o f means b e t w e e n i n d u s t r y  assumed a r e l a t i o n  financial  variation  grounds.  went on t o p e r f o r m t e s t s s i m i l a r t o t h o s e o f  Aronson,  tests,  changed  1 2  f o r e q u a l i t y amongst a l l g r o u p means,  conduct p a i r w i s e  a s k e d how  and A r o n s o n  Schwartz  their choice  capital  Scott  Schwartz  o f r a i l r o a d s and  they t e s t e d  and  financial  i n response t o environmental c h a n g e .  Scott He  that  that  of F i n a n c i a l "  8  S c o t t ' s t e s t was b i a s e d  f o r two r e a s o n s .  by  increasing  two  groups which e x h i b i t e d  unusual  further  In  of sample s i z e a g a i n . of  companies. using  four  extreme  equity  and growth.  in  unsubstantiated.  comprised  this  ratios  because  Unfortunately,  regard:  the  claim  considerably  Scott used 77 f i r m s , with two  samples,  different  each,  and two  and  from  found  that  Scott's.  their  However,  own  of f i v e  industries, ratios they  business  their results.  t e s t s , RSWB attempted t o expand on previous  risk,  i n an i n t e r n a t i o n a l c o n t e x t .  that w i t h i n an i n d u s t r y , firms face hence  variation  correlated. by  industry  of  sales  similar  and earnings  environments, and amongst  T h i s gave them grounds f o r proxying class.  firms a r e  business  risk  They p o s i t e d that s i z e i s a determinant of  s t r u c t u r e because the d i v e r s i f i c a t i o n of product  by l a r g e  firms  reduces  financial  size  They assumed  financial  increase  were  neither  work by l o o k i n g a t c a p i t a l s t r u c t u r e as a f u n c t i o n of both and  issue  industries  industries  e x p l a i n t h e i r comparison procedure, nor provide their  remains  the second i n s t a n c e , RSWB r a i s e the  firms  of  they s t a t e d  RSWB c a l c u l a t e d debt r a t i o s i n the same  larger  In  they s a i d that  the number of i n d u s t r i e s i n the sample, he added  profitability  nothing  First,  1 3  firm  leverage.  risk,  permitting  RSWB p o i n t e d  out  lines  the f i r m  to  that there may be  Lee Remmers, Arthur S t o n e h i l l , Richard Wright and Theo Beekhuisen, "Industry and S i z e as Debt R a t i o Determinants i n Manufacturing I n t e r n a t i o n a l l y " , F i n a n c i a l Management, Summer 1974.  1 3  9  other  reasons  f o r the high c o r r e l a t i o n of i n t r a - g r o u p equity  r a t i o s , such as s i m i l a r technology  and  asset  structures, for  example. RSWB's list.  sample c o n s i s t e d of f i r m s i n the Fortune  A f i r m was i n c l u d e d  industry  which  i n the  sample  500 (1971)  i f i t was  comprised at l e a s t twenty companies.  i n an  They took  sample debt r a t i o s f o r the years 1966, 1970, and 1971, and using an F - t e s t , they means.  They  detected d i d say  no  differences  among  were not a t t r i b u t a b l e t o v a r i a t i o n  e l i m i n a t i o n of these unusual favour  af  accepting  tests led to differences  group  that some i n d u s t r i e s not r e p o r t e d on i n  t h e i r paper d i d have s i g n i f i c a n t l y d i f f e r e n t these  sample  ratios,  i n business  risk.  of  Their  significant,  inter-  In  their  tests  f o r France  were  and Japan,  due  to  there. for size  as  a determinant  of equal numbers, a c c o r d i n g t o t o t a l s a l e s .  In  round  of f i n a n c i a l  of t h i s debate, Scott and M a r t i n  that RSWB's c h o i c e of Fortune  groups  With one e x c e p t i o n ,  the n u l l hypothesis a t the 95% c o n f i d e n c e four  They special  s t r u c t u r e , RSWB s p l i t an i n t e r n a t i o n a l sample i n t o three  they accepted  in  industry  but none i n the U n i t e d S t a t e s , Norway, or the Netherlands.  conditions prevalent  The  international  i n debt r a t i o s f o r i n d u s t r i e s i n France  p o s t u l a t e d that the r e s u l t s  but  i n d u s t r i e s biased t h e i r r e s u l t s  the n u l l h y p o t h e s i s .  the c o n c l u s i o n  debt  level. suggested  500 f i r m s was t o o l i m i t i n g :  i t led  David F. S c o t t , J r . , and John D. M a r t i n , "Industry I n f l u e n c e on F i n a n c i a l S t r u c t u r e " , F i n a n c i a l Management, Spring 1975.  1 4  10  to homogeneity i n the s a m p l e . that  RSWB's  use  of  the  10  Scott and M a r t i n  debt  to  i n a p p r o p r i a t e f o r measuring leverage subsitutability  of p r i o r claims  total  Another  of  the  assets  because of  This  asserted ratio  the  f o r one another.  been p o i n t e d out by Schwartz and Aronson. i s e s p e c i a l l y notable  also  was  degree  of  T h i s had a l s o  substitutability  i n the case of p r e f e r r e d stock and  debt.  c r i t i c i s m s l e v e l l e d a g a i n s t RSWB i s that  their  r e s u l t s may have been erroneous due t o the assumptions necessary for t h e i r t e s t s . variance  Specifically,  across  industries,  the c o n d i t i o n s and  of  normality,  equality  may  have  of been  violated. In t h e i r experiment, Scott and M a r t i n tests and  which  not  non  a  They a s s e r t e d that an "firm  that i s unusually  influential  used  a  point  which  the computation of the  mean debt r a t i o [or e q u i t y r a t i o ] f o r a p a r t i c u l a r they  variance  h i g h l y l e v e r e d or a f i r m  l e v e r e d at a l l may m a t e r i a l l y d i s t o r t  So,  parametric  d i d not r e q u i r e the assumptions of equal  normality.  represents  used  industry".  1 5  non-parametric ANOVA t e s t f o r d i f f e r e n c e s i n  e q u i t y r a t i o s amongst i n d u s t r i e s , where e q u i t y r a t i o was d e f i n e d as common e q u i t y d i v i d e d by t o t a l The  assets.  sample was composed of non-regulated  and M a r t i n  found s i g n i f i c a n t d i f f e r e n c e s among i n d u s t r i e s '  e q u i t y r a t i o s f o r each of the years They  industries.  i n the p e r i o d  a l s o t e s t e d f o r d i f f e r e n c e s based on the ranking  I b i d . , p68.  mean  1967 t o 1972.  r a t i o s , the r e s u l t s of which supported t h e i r p r e v i o u s  1 5  Scott  of e q u i t y findings.  11  They  u s e d  b o t h  e x a m i n a t i o n  of  L i k e  t h e y  RSWB,  a c c o r d i n g  to  in  a s s e t s ,  whereas  They  r a t i o  r e l i a n c e  on  F e r r i c o d e s an  m e a s u r e d  and  s i z e  a v e r a g e  the  most  and  d e v i a t i o n s  1  6  M i c h a e l  F i n a n c i a l F i n a n c e , 1  7  I b i d . ,  t o t a l  of  G .  i n  p633.  1979.  A  They  t o t a l  1  6  i t  s h o u l d  be  the  to  s i m p l i c i t y a  c l a s s ,  b e c a u s e  u s e d  r e f l e c t  i n t o  debt and  the  f i r m ' s  i n d u s t r i e s  u s i n g  b o t h  methods  t o t a l  were  p e r i o d .  The  i n c o m e , s a l e s  W e s l e y  SIC  a s s e t s ,  A v e r a g e s  and New  the  l e v e r a g e .  f e l t  by  s t a n d a r d i z e d  F e r r i  they  j u s t  p r e - t a x  S t r u c t u r e : J u n e  y e a r  on  i n d u s t r y  i m p o r t a n t  and  s a l e s ,  among  t o t a l  7  f i r m s  l i n e s ,  s a l e s .  f i v e  1  g r o u p e d  t o t a l  i s  " c o n c e p t u a l  f u n d s " .  c l a s s e s ,  f i n a n c i a l  l e v e r a g e .  c o m p l e t e l y  e f f e c t  by  r e c e n t  s a l e s ,  more  p r o d u c t  i n d u s t r y  and  i n  J o n e s  of  r a t i o s .  f o c u s s e d  of  upon  w h i c h  t h e i r  s a l e s .  e f f e c t s  l e v e r a g e  e q u i t y e q u a l  s i z e  t o t a l  l e v e r a g e  f i n a n c i a l  to  b o r r o w e d and  the  and  i n  d i f f e r e n c e s  of  was  v a r i a b i l i t y ,  b e c a u s e  a b i l i t y  t e s t  measure  t e s t s  t h r e e  s i g n i f i c a n t  o p e r a t i n g  to  F  s i z e  i n t o  T h e i r  o p e r a t i n g  t h a t  r e l a t e d  f i r m s  t e s t e d  e a r n i n g s  v a r i a b l e ' s  f o r  and  and  between  f o u n d  s i z e  J o n e s  r e a s o n e d  n e g a t i v e l y  SIC  RSWB  r i s k ,  e q u i t y  They  t e s t s .  and  r e f l e c t s  r e l a t i o n  g r o u p e d  a l l  F e r r i b u s i n e s s  the  s i z e .  g r o u p s  n o n - p a r a m e t r i c  by  c o d e s . of  They  a v e r a g e  t o t a l  u s i n g  c o e f f i c i e n t s w e l l  g r o w t h  H.  M e t h o d o l o g i c a l  and  J o n e s ,  b o t h t e s t e d  g r o u p i n g .  computed  a s  u s i n g  as  They a s s e t s  d a t a  from  of  v a r i a t i o n  the  s t a n d a r d  s t a n d a r d i z e d  c a s h  " D e t e r m i n a n t s  A p p r o a c h " ,  J o u r n a l  of of  12  flow growth were used to proxy business r i s k .  To compute  these  measures  of b u s i n e s s r i s k , annual data f o r the most recent f i v e  years was  used.  as  the  ratio  Degree of o p e r a t i n g l e v e r a g e (DOL) of  the  percentage  percentage v a r i a n c e i n s a l e s .  DOL  of f i x e d a s s e t s to t o t a l a s s e t s  variance was  and  in  was  defined  EBIT  to  the  a l s o p r o x i e d by the r a t i o average  fixed  assets  to  t o t a l a s s e t s f o r a f i v e year p e r i o d . In grouped  t h e i r examination of c a p i t a l s t r u c t u r e , F e r r i and f i r m s a c c o r d i n g to debt s t r u c t u r e ,  algorithm.  They  used an asymmetric  t e s t f o r i n d u s t r y e f f e c t s , then used analysis  other  of the c l u s t e r i n g  The d i s c r i m i n a n t t e s t  clustering  uncertainty c o e f f i c i e n t multivariate  hypotheses.  to  discriminant  Unfortunately,  i n t r o d u c e d b i a s i n t o the second  For  this  F e r r i and Jones technique i s not employed i n t h i s Ferri  and  Jones  found  and  reason,  structure  and  size,  industry and  They found SIC codes to g i v e s t r o n g e r r e s u l t s  i n d u s t r y groupings than d i d SIC codes combined Using  the  paper.  o p e r a t i n g l e v e r a g e , but none between debt r a t i o  income v a r i a t i o n .  lines.  test.  some support f o r the e x i s t e n c e of  r e l a t i o n s h i p s between f i n a n c i a l class,  the  i s b i a s e d by the somewhat a r b i t r a r y c h o i c e  of boundaries f o r the groups of f i r m s .  in  a  t o see i f they c o u l d d i s t i n g u i s h between the c l u s t e r s ,  i n examinations of the nature  using  Jones  1976  with  product  d a t a , they found that e i t h e r h i s t o r i c a l or  c u r r e n t data c o u l d be used i n d i s c r i m i n a t i n g e f f e c t i v e l y amongst groups historic  of  debt and  ratios. current  However, data  d i s c r i m i n a t i o n amongst groups.  were  using  1974  necessary  ratios, for  both  effective  They contended that t h i s was  due  13  to  the  differences  periods.  In  to marginal marginal  in  economic  conditions  the expansion of 1976,  f i r m s , whereas i n the  firms  debt was  1974  Operating  when average f i x e d a s s e t s to average t o t a l a s s e t s was  used  hence on  the e l a s t i c i t y of EBIT with respect  f i r m market v a l u e , was defined  volatility product.  Within the  to  systematic  occur  examined i n an e a r l i e r study  by  postulated  costs,  stockholders, of  argument  this  the  hence  common  l e a d s to l a r g e r standard test  and  that  higher  higher  the  stocks. that  homogeneous  higher He  increased  d e v i a t i o n of stock  hypothesis,  Lev  i n d u s t r i e s , f o r the years as  1949  to 1968.  the  noted  estimates  of  total  and  that t h i s  was  financial  leverage  returns.  regressed  He  industry,  the v a r i a b i l i t y  total  c o s t s on s a l e s , f o r the e l e c t r i c u t i l i t y , s t e e l , and  regressions  earnings  f o r f i r m s with lower v a r i a b l e c o s t s per  fixed  analagous to the  data.  on r i s k ,  a r i s k c l a s s , such as a  risk  to  o p e r a t i n g leverage as the r a t i o of f i x e d to  Lev's model  would  higher  To  1976  e f f e c t of the degree of o p e r a t i n g leverage  variable costs.  returns  both  only an e f f e c t i v e d i s c r i m i n a t o r f o r the  He  1 8  in  same  and  The  these  two  1974  s a l e s was  the  these  were unable to f i n a n c e through debt.  as the d i s c r i m i n a t o r , but  Lev.  the  readily available  recession,  leverage d i s c r i m i n a t e d amongst debt c l a s s e s 1976  during  used  operating  o i l producer  the  slope  of  of average v a r i a b l e c o s t s per  Baruch Lev, "On the A s s o c i a t i o n Between Operating Leverage and R i s k " , J o u r n a l of F i n a n c i a l and Q u a n t i t a t i v e A n a l y s i s , September 1974. ~~~  1 8  1 4  u n i t  of  o u t p u t .  f u n c t i o n s b o r n e the  o v e r  o u t ,  the  g e n e r a l ,  a f f e c t e d  o p e r a t i n g i n  i n d u s t r y In and  a  of  book  P a u l  S t u d y " ,  2  0  I b i d . ,  the o i l  by  the  v a l u e s ,  a l r e a d y  f u t u r e  c a s h  J o u r n a l  p 1 3 1 .  C h o i c e  of  F i n a n c e ,  The  low  Rt h a t w h i c h  c o e f f i c i e n t s between  r i s k  c o e f f i c i e n t s  the  on  1959 debt  o n l y of  the and  c a s e the  of  were  l a c k  of  i n  the  f i r m s  t o  t h i n k  i s s u a n c e 1 9 7 0 .  r a t i o  p r o v i d e d  c o v e n a n t s  book  "The  h i s  a s  a v e r a g e  H i s  r e l a t i o n s h i p  h e t e r o g e n e i t y  t e n d  a s s e t s  M a r s h ,  of  and  t i e d  the  one  between  and  to  t h a t  but  a v e r a g e  t h a t  h i s  v a r i a b l e  a l l  t h a t  b e t a  s u g g e s t e d  o n l y  be  used  . 3 8 ,  the  f o c u s s e d  e x p l a i n e d  t r e a s u r e r s  w h i c h  to  then  s t o c k ' s  v a r i a b l e .  .05  the  He  to  i n d u s t r y .  M a r s h  f i r m s  the  not  a r g u e d  v a l u e s ,  c a p i t a l i z e  9  t o  s t u d y ,  p r o x i e d  t h a t  Lev  t e s t s .  was  l e v e l ,  p r o d u c t i o n  a s s u m p t i o n  i n  c o n f i r m e d .  the  B r i t i s h  market  c l o s e l y  1  by  from  the  the  and  d e p e n d e n t  s i n c e  was  found  r e t u r n s  r a n g e d  .05  due  M a r s h  a r g u m e n t s t h a n  was  q u e s t i o n ,  were  p e r i o d .  the  c a s e s .  r e c e n t  e q u i t y  r a t i o s  at  and  i n  r e g r e s s i o n  the  However,  a l l  i n  s t o c k a  c h a n g e s  v a l i d a t i o n  l e v e r a g e  l e v e r a g e  s i g n i f i c a n c e  c r o s s  w h i c h  o p e r a t i n g  r i s k .  n e g a t i v e  of  was  s i g n i f i c a n t  and  by  e s t i m a t e  of  no  p e r i o d ,  in  s t a t i s t i c s ,  d e g r e e  were  sample  v a r i a b l e s  c o s t  s q u a r e d  assumed  d e v i a t i o n  i n d e p e n d e n t v a r i a b l e  the  i n  s t a n d a r d  He  o v e r  terms to  be  of  of  debt  and  owned  by  the  f i r m ,  of  Between May  a s s e t s  E q u i t y  1977.  the  the  and  D e b t :  debt s a m p l e  f o r  book  e q u i t y  f i r m  debt  T a r g e t  w r i t t e n  v a l u e s  f l o w s  9  r e f e r e n c e s  in  t e n d  1  of  and i s  An  the r a t h e r  i n a r e do  terms more not  e x p e c t e d  E m p i r i c a l  15  to a c q u i r e .  2 0  Using  these reasons, he  argued  persuasively  for  the use of book v a l u e s . Marsh  felt  that s i z e would be a f a c t o r i n f l u e n c i n g t a r g e t  debt r a t i o s because of economies of s c a l e i n f l o t a t i o n c o s t s security  issues.  Measures  a s s e t composition of  variation  of  size,  operating  target  ratios  over  p i c k e d up by the h i s t o r i c average debt  depended  upon  the  stock p r i c e s i n such a way ratios  of short and  state that  the  time which had  issuance  effect not  of  of the market and  firms  and  been  ratios.  Marsh found that the c h o i c e between equity  leverage,  were i n c l u d e d to attempt to proxy  in  of  appear  to  debt  historical  have  long term debt and e q u i t y to t o t a l  Furthermore, these t a r g e t l e v e l s were found to be  or  target assets.  functions  of  company s i z e , expected bankruptcy c o s t s and a s s e t s t r u c t u r e . In  imperfect  c a p i t a l markets, with p o s i t i v e bankruptcy  distress costs,  there  arguments  s i z e , asset s t r u c t u r e , i n d u s t r y c l a s s ,  that  appears  to  be  justification  r i s k , bankruptcy c o s t s , d i s t r e s s c o s t s , and affect capital structure.  operating  for  and the  business leverage  16  II. The  A SIMPLE MODEL OF CAPITAL STRUCTURE  objective  model of optimal structure business  of  t h i s section i s to derive a t h e o r e t i c a l  capital  structure.  The  model  posits  capital  as a f u n c t i o n of the l i q u i d i t y of a f i r m ' s a s s e t s , i t risk,  size,  bankruptcy  subordinated and p r i o r i z e d debt  costs,  and  the  levels  of  claims.  The model assumes r i s k n e u t r a l v a l u a t i o n with a p r o b a b i l i t y density  P ( s ) , where s i s d e f i n e d  from s t o s.  t o l i e i n the c l o s e d i n t e r v a l  In an Arrow-Debreu context,  s V= Jjx(s)Q(s)ds,  where Q(s) i s the v e c t o r vector  of s t a t e contingent  cash flows.  This  implies  fo,(s)ds=l/( 1+Rf ) , or  \( l / ( 1+Rf )Q(s)ds=1 .  I  5  i s equivalent  security  which  to s t a t i n g  provides  that  a payoff  the  price  the context of r i s k n e u t r a l v a l u a t i o n ,  as a p r o b a b i l i t y d i s t r i b u t i o n , so t h a t s  (1+Rf)Q(s)=P(s) and  This  provides  ^>(s)ds=1.  of  a  riskless  of 1 i n every s t a t e would be  1 / ( 1 + R i ) , where Rf i s the r a t e of r e t u r n on a In  that  j  s  This  of Arrow-Debreu p r i c e s , and X(s) i s the  riskless  asset.  (l+Rf)Q(s) i s t r e a t e d  17  r X ( s ) P ( s ) d s s  w h i c h  i s  a b o v e .  2  e q u i v a l e n t  r i s k l e s s r i s k y  (1)  the  A r r o w - D e b r e u  p r i c i n g  model  s e t  out  1  Suppose  t h a t  a s s e t ,  f l o w s  the  L ,  p r o j e c t  c a s h  t o  s u c h  w h i c h  from  the  C = X + g ( s - e ) ,  p r o c e e d s as  of  c a s h ,  p r o v i d e s  r i s k y  a  f i n a n c i n g  w h i c h  s t a t e  p r o j e c t ,  e a r n s  a r e  no  c o n t i n g e n t  d e n o t e d  C ,  p l a c e d  r e t u r n , c a s h  be  i n t o  a  and  a  f l o w s .  d e f i n e d  L e t  as  where  s (2)  e = j s P ( s ) d s . s  In  t h i s  the  c a s e ,  s i z e  of  E ( C ) = X ,  the  f i r m  where  X  ( h a v i n g  i s no  a  s c a l e  r e l a t i o n  p a r a m e t e r to  X(s)  r e f l e c t i n g  d e f i n e d  a b o v e ) ,  and % = g % , i s  where  a  p a r a m e t e r  d e f i n i t i o n L e t  of  r e f l e c t i n g  b u s i n e s s  b a n k r u p t c y  B=ag+bX  w i t h  T h i s  c o n s i s t e n t  i s  C h a p t e r c o s t s  2  g  1  1,  a  C o p e l a n d P o l i c y ,  w h i c h w i t h  d i s c u s s i o n and  c o s t s ,  w i l l  be  d e n o t e d  r i s k .  g i v e n B  ,  A  more  p r e c i s e  l a t e r .  have  the  form  ^B/^X=b>0.  d e c r e a s e  F o r  r i s k  b u s i n e s s  J .  A d d i s o n  w i t h  e v i d e n c e  s u g g e s t s  t h a t  i n c r e a s e s  of F r e d  W e s l e y ,  i n  d a t e ,  r e l a t i v e , f i r m  c o n t i n g e n t W e s t o n , Don  t o  M i l l s ,  d i s c u s s e d  p e r c e n t a g e  s i z e .  c l a i m s  a s  F i n a n c i a l O n t a r i o ,  b a n k r u p t c y  F u r t h e r m o r e ,  p r i c i n g , T h e o r y 1979.  see and  in  Thomas  l e t  E .  C o r p o r a t e  18  t=marginal  corporate- tax r a t e ,  outstanding,Vl=the the  F=the  face  value of the l e v e r e d f i r m ,  value Vu=the  of  debt  value  of  unlevered f i r m , Ve=the value of e q u i t y , and Vd=the value of  debt o u t s t a n d i n g . (corporate)  In t h i s c o n t e x t , the s t a t e  tax flows  contingent  after  t o v a r i o u s > s e c u r i t y h o l d e r s are given  below: STATE CONTINGENT CASH FLOWS  STATE  SECURITY L+X+g(s-e)<F  L+X+g(s-e)>F  L+(1-t)(X+g(s-e))-B  BONDS  L+(1-t)(X+g(s-e))-(1-t)F  0  EQUITY  L+(1-t)(X+g(s-e))-B  TOTAL  Define z as being that s t a t e  L+(1-t)(X+g(s-e))+tF f o r which  L+X+g(z-e)=F,  so  that (4) z=(F-L-X)/g+e  The values of debt, e q u i t y , and the l e v e r e d f i r m a r e : =([L+(1-t)(X+g(s-e))-B]P(s)ds  + ^ F P ( s ) d s , or  Vd= 3=  V  S  (5) Vd =L5p(s)ds + ( l - t ) ^ ( X + g ( s - e ) ) P ( s ) d s - B^P(s)ds +F^P(s)ds,and  *  5  J  I  Ve= [ L + ( 1 - t ) ( X + g ( s - e ) ) - ( 1 - t ) F ] j p ( s ) d s , or  s (6)  Ve=(L-(1-t)F)Jp<s)ds  .  * i + (1-t)((X+g(s-e>)P(s)ds,  a n d  19  (7) Vl=L^P(s)ds + (1-t)^(X+g(s-e))P(s)ds + tF^P(s)ds  - BJPUMS,  which i s Ve + Vd.  Since Vu=L^P(s)ds + ( 1 - t ) j ( X + g ( s - e ) ) P ( s ) d s , (7) can be w r i t t e n as 1 s (8)  *  1  Vl=Vu-B\P(s)ds+tF)P(s)ds  which  is  bankruptcy  the  value  of  the  unlevered  firm,  less  c o s t s , p l u s the tax s h i e l d of debt.  Noting that ^z/^)F=l/g, ^z/^L=-l/g,  ^z/&g=-(F-L-X)/g,  ^z/^X=-l/g, and ^Vu/^F=0, i t can be shown that s" ^V1/&F = -B(^z/^F)P(z) s = t^P(s)ds -  + t^P(s)ds -  tFOz/^F)P(z)  [(B+tF)/g]P(z)  T h i s g i v e s the f i r s t order c o n d i t i o n f o r a maximum, s  (9) t ^ P ( s ) d s - [(B+tF)/g]P(z)  The  >Vl/c)F  2  expected  = 0.  second d e r i v a t i v e i s  = -tOz/c)F)P(z) " [ ( B + t F ) / g ] P ' (z) - ( t / g ) P ( z ) 2  = -(2t/g)P(z) - [(B+tF)/g ]P'(z). 2  20  = -(2t/g)P(z) -  [(B+tF)/gZ]P'(z).  T h i s p r o v i d e s the second  order c o n d i t i o n f o r a maximum,  (10) - ( 2 t / g ) P ( z ) - 0 / g ) ( P ' ( z ) ) [ B + t F ] 2  <0.  As an example, assume t h a t s i s d e f i n e d to and  £5, so that P(S)=1/W, where w=s-s.  lie  between  T h i s i s the uniform  s  case,  which s a t i s f i e s the c o n d i t i o n t h a t P ' ( z ) ^ 0 . The  f i r s t , order c o n d i t i o n (9) becomes  t ( s - z ) l / w - [(B+tF)/g]/w = 0 or (11) "s-z - t F / g =B/tg. Substituting  from  (4) i n t o  s - [(F-L-X)/g)+e] (12) F* = -B/2t But  = B/tg, which reduces  to  + (g/2)(s-e) + (L+X)/2.  s-e ="s-1/2(s"+s_) =1/2(S-S) =1/2W, so that (12) can be r e w r i t t e  (13) F* = -B/2t and  - F/g  (11) g i v e s  + gw/4  substituting  from  + (L+X)/2 ( 3 ) , the value of the l e v e r e d f i r m i s  maximized when (14) F* = -(ag+bX)/2t + gw/4  +(L+X)/2, which i s e q u i v a l e n t to  (15) F* = [ ( t L + ( l / 2 ) t g w - a g ) + ( t - b ) X ] / 2 t , (16) F* = We  to  {tL+g[(1/2)tw-a]+(t-b)X}/2t.  assume t>>b, and  Equation  which reduces  (l/2)tw<a.  (14) p r o v i d e s  the comparative  statics  results  g i v e n below. (17) ^F*/£)L=l/2>0. Each  dollar  of  liquidity  , L, added, a l l o w s a  fractional  i n c r e a s e i n F. )>0, which i s c o n s i s t e n t with the theory set f o r t h i s Chapter  1.  21  (19) V*/^X  = -b/2t+1/2 = (1/2) (t-b)>0,  s i n c e b<<t by assumption,  again c o n s i s t e n t with theory and  evidence d e s c r i b e d i n Chapter F e r r i and Jones showed  1 . that  the  elasticity  respect t o f i r m s i z e i s g r e a t e r than u n i t y .  of  F*  with  That i s  (dF*/>X)(X/F*)>1 or (20)  \F*/^X>F*/X.  Substituting Using  (19) i n t o  (20) g i v e s  (1/2t)(t-b)>F*/X.  (15) g i v e s  d / 2 t ) ( t - b ) X > (1/2t)[tL+g((1/2)tw-a)] + ( 1 / 2 t ) ( t - b ) X , or ( l / 2 t ) [ t L + g ( ( l / 2 ) t w - a ) ] < 0, or g((1/2)tw-a) < - t L , hence (1/2)tw-a  < - t L < 0,  so that (21)  )F*/9g =  -a/2t + w/4  as i s shown above.  = (1/2t) ( (1/2 ) wt-a )<0  Firms f a c i n g more business r i s k  issue  less  debt, a g a i n supported by the m a t e r i a l presented i n Chapter The the  r e s t of t h i s chapter of the t h e s i s d e a l s with  model,  as  expanding  s e t f o r t h above, t o i n c l u d e two l e v e l s of debt:  s u b o r d i n a t e d and unsubordinated debt.  Denote  value  the  of  1.  senior  debt,  (unsubordinated) debt.  and  Fj  as  Ff  as  the  face  f a c e value of j u n i o r  F u r t h e r , l e t bankruptcy  c o s t s be d e f i n e d  f o r s e n i o r debt as Bf=afg+bfX, and f o r j u n i o r debt as Bj=ajg+bjX The  s t a t e contingent a f t e r  ( c o r p o r a t e ) tax  cash  v a r i o u s s e c u r i t y h o l d e r s are as given below:  flows  to  the  22  STATE CONTINGENT CASH FLOWS  STATE SECURITY  L+X+g(s-e)<Ff  Ff^L+X+g(s-e)<Ff+Fj  SENIOR L+(1-t)(X+g(s-e))-Bf  Fj+Ff^L+X+g(s-e)  Ff  Ff  BONDS  JUNIOR  0  L+(1-t)(X+g(s-e)-(1-t)Ff-Bj  Fj  BONDS  0 L+(l-t)(X+g(s-e)-(l"t)(Ff+Fj)  EQUITY  TOTAL  L+(l-t)(X+g(s-e))-Bf  L+(1-t)(X+g(s-e))+t(Ff+Fj)  L+(1-t)(X+g(s-e))+tFf-BJ  Denoting Vf as the value of s e n i o r debt, V j as the value of junior  debt, x=(Ff-L-X)/g+e, and y=(Ff+Fj-L-X)/g+e, then i t can  be shown that  X  ~  Vf=^[L+(1-t)(X+g(s-e))-Bs]P(s)ds £ x X (22) Vf=-Bf}P(s)ds  S  + F f | p ( s ) d s , or x *  + ( L + ( 1 - t ) ) ^ P ( s ) d s + F f J P ( s ) d s , and  5  X  (23) Vj=Bj^P(s)ds + ( L + ( 1 - t ) ) ^ P ( s ) d s + F j ^ P ( s ) d s - ( 1 - t ) F f \ P ( s ) d s  23  and  s  (24) In  *  Ve=(L+(1-t)) j u + g ( s - e ) ) P ( s ) d s  this  - (1 - t ) ( F f +F j )5P( S ) d s .  case,  s Vu = ^(L+( 1 - t ) ) ( X + g ( s - e ) ) P ( s ) d s ,  Vl=Vu + F f j p ( s ) d s - B f j P ( s ) d s *  so t h a t  + Fj)P(s)ds -  I  -(1-t)FfJp(s)ds  ^  Vl=Vu - B f ( p ( s ) d s  i  Equation equal  - Bj(p(s)ds  *  the value  of the u n l e v e r e d  bankruptcy c o s t s , plus and s e n i o r  + tFfjp(s)ds + tFj^P(s)ds,  *  (25) s t a t e s t h a t  to the value  junior  y  - ( 1 - t ) ( F f + F j ) ^ P ( s ) d s , or  X  (25)  BjJP(s)ds  1 _  T  of the levered  firm i s  firm, l e s s expected  the tax s h i e l d s a s s o c i a t e d  with  debt.  Note t h a t "c)x/^Ff=i/g, 3x/^Fj = 0 , V / ^ F f = l / g , ^ y / 9 F j = l / g , ,  f  ^Vu/^Ff=Vu/r)Fj = 0.  -  ^Vl/^Ff=-(Bf/g)P(x)  + (Bj/g)P(y)  -  \vi/b  + t^P(s)ds  (tFs/g)P(x)  ( t F j / g ) P ( y ) - ( B j / g ) P ( y ) , and  Fj=-(Bj/g)P(y) + t^P(s)ds  - tFjP(y)/g.  Y These g i v e  -  the f i r s t  order  conditions  24  (26) t j p ( s ) d s - ( P ( x ) / g ) ( B f - B j + t F f ) - (P(y)/g) (Bj+tFj) =0, and s  (27) t ^ P ( s ) d s - ( P ( y ) / g ) ( B j + t F j ) = 0 .  The second  order  derivatives are: ^Vl/^Ff =(l/g )P'(x)(-Bf+Bj-tFf) - (l/g )P'(y)(Bj+tFj) 2  2  2  -(2t/g)P(x) ^ V l / d F f Fj=-(1/g )P'(y)(Bj+tFj) - (t/g)P(y) 2  ^ V l / ^ F j = - d / g ) P ' ( y ) ( B j + t F j ) - (2t/g)P(y) 2  2  The  second  order c o n d i t i o n r e q u i r e s that the determinant of  > V1/^ Ff ^ Vl/^)Fft>FJ j 2  2  1  ^VIAFOFJ Substitute  >0.  Vvi/^Fjj/ A=(1/g )P'(x)(-Bf+Bj-tFf), 2  B=(-2t/g)P(x), C = ( - l / g ) P ' ( y ) ( B j + t F j ) , and 2  D=(-t/g)P(y). By s u b s t i t u t i o n , the second order c o n d i t i o n may be r e w r i t t e n (A+B+C)(C+2D)-(C+D)(C+D)>0 (A+B)(C+2D)>DD Again, A=C=0,  i f the uniform and  2BD>DD  case or  i s used,  2B<D  since  P'(x)=P'(y)=0, D<0.  Expanding  i n e q u a l i t y , - ( 4 t / g ) P ( x ) < - ( t / g ) P ( y ) or 4P(x)>P(y), the uniform  so  that  the l a s t  which holds i n  case.  C o n t i n u i n g the uniform case f u r t h e r , equation  (26)  r e w r i t t e n as (28) t ( s - x ) l / w - ( l / g w ( B f - B j + t F f ) - (1/gw)(Bj+tFj) =0.  can be  25  R e c a l l i n g  t h a t  e q u i v a l e n t t F f =  - B f  w h i c h (29)  x = ( F f - L - X ) / g + e  -  t F j  +  -  t ( s - y ) 1 / w  -  X  -  B f / t  (27)  c a n  =0,  = ( l / 2 ) ( L + X + ( l / 2 ) g w )  be  w r i t t e n  as  w h i c h  r e d u c e s  t o  -  ( l / 2 t ) B J .  i t  c a n  ( l / 3 t ) ( B f - 2 B j ) .  s i m u l t a n e o u s l y ,  = ( 1 / 3 ) ( L + X + ( l / 2 ) g w )  +  F o r  e a s e  d e f i n e  of  e q u a l  c o s t s  c o m p a r a t i v e  i m p l i e s  be  =1/3  -  t h a t  l a r g e r  f o r  s t a t i c s  ( l / 3 t ) X  shown  t h a t  M = 1 / 3 ( L + X + ( 1 / 2 ) g w ) .  F f * = F j * = M - B / 3 t ,  b a n k r u p t c y  ~^Ft*/}X  w h i c h  e x p o s i t i o n , then  f o l l o w i n g  (33)  w i t h V f  j u n i o r  and  r e s u l t s  s e n i o r  f o r  (31)  = ( l / 3 ) [ l - ( t / X ) ]  f i r m s  * / ^ ( . ) =^F  Suppose j*/}  (.)  d e b t  and  •  g i v e s  (32):  >0  have  more  of  b o t h  f i r m s  have  more  forms  of  d e b t .  ^Ff*/3L = 1 / 3 > 0 ,  w h i c h  i m p l i e s  t y p e s  of  (35)  have  > F f * / ^ t =  w h i c h  shows  t y p e s  of  m o d e l Now  more  = ( i / 3 ) w  ( w t / 2 ) - a < 0 ,  v o l a t i l i t y (36)  t h a t  l i q u i d  of  b o t h  d e b t .  > F f * / $ g  s i n c e  the  +  e q u a t i o n  B f = B j = B ,  (34)  L  F j *  A s s u m i n g the  +  ( 1 / g w ) ( B j + t F j )  S o l v i n g  t h a t  i s  g [ ( l / 2 ) t w - t ( F f - L - X ) / g ]  2Ff  S i m i l a r l y ,  (31)  (28)  t o  F j * = g w / 2  F j *  s - e = ( 1 / 2 ) w ,  t o  r e d u c e s  (30)  and  of  T h e s e  assume  = ( 1 / 3 t ) [ ( w t / 2 ) - a ] a b o v e .  b o t h  k i n d s  F i r m s of  w i t h  <0 more  c a s h  flow  d e b t .  >0  more  i t s  a / 3 t  shown  l e s s  t h a t  i n  as  B / 3 t  d e b t .  -  h e a v i l y  t a x e d  a r e  c o n s i s t e n t  s i m p l e r t h a t  a l l  f i r m s  have  w i t h  the  more  of  b o t h  p r e d i c t i o n s  of  f o r m . B j = 2 B f .  T h i s  a s s u m p t i o n  i s  not  26  unreasonable, a t l e a s t i n Canadian c o u r t s . maximum  percentage r a t e of the cash or cash e q u i v a l e n t s  unsecured c r e d i t o r s . opportunity take  T r u s t e e s get p a i d  a  p a i d to  E s s e n t i a l l y , the secured c r e d i t o r s have an  t o get t h e i r s e c u r i t y back before  share of the p i e .  courts.  a  the  trustee  T h i s maximum can be o v e r r u l e d  Under t h i s assumption,  (31) and (32) can  be  can  by the  rewritten  as (37)  F j * =(1/3)(L+X+(l/2)gw) - B f / t , and  (38)  F f * =(1/3)(L+X+(l/2)gw).  These give  the f o l l o w i n g comparative s t a t i c s r e s u l t s :  (40) ^)Ff*/^X= 1/3 >0 and (41) V j V ^ X  Larger only  =1/3 - b f / t = ( 1 / 3 ) [ l - ( 3 b f / t ) ] ^ 0 .  firms  are  expected  t o have more s e n i o r debt, but w i l l  i s s u e more j u n i o r debt i f s i s l e s s than  r a t e , or very s m a l l .  This  i s consistent  1/3  of  the tax  with evidence presented  i n Chapter 1. (42) 3.Ff*/)L (43)  = F j * / L =1/3 >0, as b e f o r e .  >f*/<)g =w/6 >0 and  (44) V j / ^ 9  = w  / 6 - a f / t =(l/3t)[(wt/2)-3as]  <0 s i n c e wt/2<as  as shown above. R i s k i e r f i r m s i s s u e more s e n i o r debt and l e s s j u n i o r debt. Riskier  firms  i s s u e more s e n i o r debt and l e s s j u n i o r debt.  (45) Vf*/&t=0 and (46) > j * / c ) t = B f / t so  that  as  the  >0, tax  rate  increases,  there  i n c e n t i v e f o r firms t o issue more j u n i o r debt.  i s an i n c r e a s i n g  27  To examine the e f f e c t s of X,g,t as  a  whole,  the  added t o g e t h e r . costs, is,  the  larger  brackets operating  partial  Under the  and L on c a p i t a l  structure  d e r i v a t i v e s f o r F f * and F j * must be assumption  of  constant  bankruptcy  r e s u l t s are simply twice those given f o r F f * . f i r m s , more l i q u i d  all  issue  leverage  financing.  more  f i r m s , and  debt,  decreases  firms f a c i n g higher  ceteris  the  Furthermore, by adding  paribus.  relative (29)  and  That tax  Increased  reliance (30),  it  shown that the p a r t i a l s of F f * with r e s p e c t to F j * are  on  debt  can  be  identical  to the p a r t i a l s of F j * with respect to F f * . If we  now  examine the p a r t i a l s f o r Bj=2Bf,  (47) ^ ( F f * + F j * ) / ) x =2/3-bs/t = ( 2 / 3 ) [ l - ( 3 b s / 2 t ) ^ 0 .  Size e f f e c t  i s once again l i n k e d to the tax r a t e , and w i l l be p o s i t i v e i f bankruptcy  c o s t s are s m a l l .  (48) \(Ft*+Fj*)/£) L =2/3  >0,  which i s c o n s i s t e n t with  previous  results. (49) ^Ff*+Fj*)/£) g =( l / 3 t ) (wt-3as) <0  Once  again,  as  business  risk  s i n c e tw<3as, as shown abov  increases,  financial  leverage  declines. (50) ^ ( F f * + F j * ) / > t = B f / t  >0.  T h i s i s c o n s i s t e n t with r e s u l t s to date. j u n i o r debt  If the  tax  rate  for  i s p o s i t i v e , then the marginal value of i s s u i n g more  debt d e c l i n e s as the tax r a t e i n c r e a s e s . Business  risk  will  now  be  defined  more  carefully,  as  comprising: (51) Industry r i s k : the r i s k  inherent i n the environment i n which  28  the f i r m i s o p e r a t i n g , and v a r i a b i l i t y and taxes  of earnings before  interes  (EBIT).  The v a r i a n c e of EBIT has two components: (52) S a l e s v a r i a b i l i t y and (53) E l a s t i c i t y of EBIT with r e s p e c t t o s a l e s . To show that VAR(EBIT) has two components, assume Fixed  Costs-Variable  product at p r i c e P.  Costs.  EBIT=Revenue-  Suppose the f i r m s e l l s Q u n i t s of  V a r i a b l e per u n i t  cost  of  production  is  denoted V, while F r e p r e s e n t s f i x e d p r o d u c t i o n c o s t s . VAR(EBIT)=VAR(PQ-VQ-F) =VAR[(P-V)Q] =(P-V)(P-V)VAR(Q) DOL= (P^Q-V>Q) /P}CJ= (P-V) /P These  f i n a l r e s u l t s are c o n s i s t e n t with evidence to date.  The next chapter s e t s out the hypotheses generated by the model, and  the  results  of  the  tests  of  those  hypotheses.  29  III. The  model  influence  METHODOLOGY AND RESULTS  i n chapter two i m p l i e s that a number of f a c t o r s  the c a p i t a l  structure  of  the  firm.  The  null  hypotheses t o be t e s t e d a r e l i s t e d below: H1: from H2:  Liquidity  has  no e f f e c t on the f i r m ' s f i n a n c i n g d e c i s i o n ,  (48). Operating leverage  i s not  related  to  financial  leverage,  from (49) and (53). H3:  Firms i s s u i n g j u n i o r debt do not have l a r g e r  ratios,  from (40),  (41),  (43), and (44).  some firms may have i n c r e a s e d or s e n i o r debt.  H4:  degree  H5:  of  f i n a n c i a l leverage  (47).  Sales v a r i a n c e  i s unrelated  to  financial  structure,  and (52).  H6:  P r e f e r r e d stock has the same i n f l u e n c e on c a p i t a l  as that of common stock, Convertible  structure  below.  t o be d i s c u s s e d  below.  Firms' c a p i t a l s t r u c t u r e s are not a f f e c t e d by  discussed H9:  t o be d i s c u s s e d  time,  t o be  below.  C a p i t a l s t r u c t u r e i s not i n f l u e n c e d by the i n d u s t r y  a f i r m operates, Cross  from  debt has the same e f f e c t on c a p i t a l s t r u c t u r e as  does common stock, H8:  debt-  i s not a f f e c t e d by f i r m  (49)  H7:  that  junior  Doing so would enable them t o have higher  r a t i o s than otherwise.  s i z e , from  The model i m p l i e d  incentives to issue either  to-equity The  debt-to-equity  i n which  from (49) and (51).  sectional  r e g r e s s i o n was used to attempt t o f i t the  model DEBTEQ=A+BiXi, where A i s the i n t e r c e p t term,  Xi  i s the  30  i t h  i n d e p e n d e n t  c o r r e s p o n d i n g v a r i a b l e s  v a r i a b l e ,  to  the  i t h  CMTA=(Cash+  2.  A R T A = A c c o u n t s  3.  I N V T A = I n v e n t o r y /  u s e d  T o t a l  P l a n t /  f o r  r e g r e s s i o n  v a r i a b l e .  c o e f f i c i e n t  The  d e c i s i o n  SIZE=  7.  D O L = E l a s t i c i t y  8.  V A R = S t a n d a r d i z e d  9.  PFDDUM=Dummy  T o t a l  A s s e t s .  A s e t s .  A s e t s . A s e t s .  T h i s  i n c l u d e s  a l l  p h y s i c a l  D e b t / O t h e r  L o n g  Term  D e b t .  A s s e t s . of  E B I T  CONVDUM=Dummy  11.  YRDUM=Dummy  D1-D14=Dummy  f o r  l i s t e d  c o e f f i c i e n t s ,  t o  s h a r e s  c o n v e r t i b l e  sample f o r a b o v e and  s a l e s .  s a l e s .  p r e f e r r e d  f o r  v a r i a b l e s a s  r e s p e c t  of  f o r  v a r i a b l e ,  v a r i a b l e  h y p o t h e s e s  w i t h  v a r i a n c e  v a r i a b l e ,  10.  r e g r e s s i o n  T o t a l  p r o d u c t i o n .  6.  The  T o t a l  T o t a l  S U B S E C = S u b o r d i n a t e d  the  the  S e c u r i t i e s ) /  R e c e i v a b l e /  5.  1 2 - 2 5 .  i s  i n d e p e n d e n t  M a r k e t a b l e  NTPTA=Net  a s s e t s  B i  a r e :  1.  4.  and  o u t s t a n d i n g .  d e b t .  y e a r .  i n d u s t r y c a n  t h e s e  be are  c l a s s e s . r e s t a t e d g i v e n  i n  terms  b e l o w .  H1:  B1=0.  H2:  B2=B3=B4=B7=0.  H3:  B5=0.  H4:  B6=0.  H 5 :  B8=0.  H6:  B9=0.  H7:  B10=0.  H8:  B11=0.  H9:  B12=B13=B14=B15=B16=B17=B18=B19=B20=B21=B22=B23=B24=B25=0.  of  31  R a n k i n g  of  m e a n i n g l e s s , in  a  s o  U s i n g  were  i d e n t i t y  H o m o g e n e i t y  amongst  s a m p l e .  s t r u c t u r e  and  i n  Q u a r t e r l y was  t o  be  t h e y  were  or  e a s e  f o r  the  t a p e s u s e d an  q u a r t e r l y  of  SIC  of  would  t e s t s  s t r o n g  a r e  t o  at  work  a  o p t i m a l  t h e n  the  be  g r o u p i n g  and  f o r  i s  However,  u s i n g  i n t o  sample  between c l a s s  some  b i a s  of  c a p i t a l  w i l l  not  be  s t r u c t u r e . and  i n t o  i n v e s t o r s  w h i c h  any  SIC  c o d e s  i d e n t i f i e d .  i d e n t i f i c a t i o n .  w h i c h  no  n e c e s s a r y  w e l l .  management  r e a d i l y  an  a l l .  c a p i t a l  g r o u p  i l l -  i n t o  random  i n d u s t r y  p r o v i d e  an  i n t r o d u c e d  o v e r  Dummy  p r o v i d e d  h o m o g e n e i t y , have  t o  t h o s e  u s e d  i n d u s t r y  t a k e n  then  t o  have  r e l a t i o n s h i p  c l a s s ,  must  were  w i t h i n  b a s i s  been  v a r i a b l e  p a r t i t i o n e d  been  i s  have  i n d u s t r i e s .  l e d  w o u l d  g i v e n  d e t e r m i n i n g  f a l l s  u s e d  in  a  i n d u s t r y  f i r m  i n d u s t r i e s  D a t a  show  i n f o r m a t i o n ,  t h i s  a v a i l a b l e  not  a  r a t i o n a l e , i f  have  i n c l u s i o n  i n  the  f i f t e e n  been  not  t o  i n a p p r o p r i a t e .  the  m e t h o d o l o g y  the  g r o u p i n g s  u s e f u l  p a r t i c u l a r  the  on  of  f e l t  i n d e p e n d e n t  been  have  had  f i r m s  c l a s s  p r e d i c t i n g  i n d u s t r y  p r o v i d e  they  F u r t h e r m o r e , do  u s e f u l  c o u l d  was  an  would  t h e i r  i f  s p e c i f i e d  i n d u s t r i e s  w i t h  w h i c h  i n d u s t r i e s  have  v a r i a b l e s  than  a s  f o u r t e e n  h e n c e  i n d u s t r y  numbers  c o d e s  w o u l d  f o r  dummy  SIC  SIC  s e t t i n g  X - m a t r i x  p r i o r i  If  of  i n f o r m a t i o n  the  the  use  m a t r i x ,  s a m p l i n g a  i n d u s t r y  c r e a t e d  f i f t e e n  c o n d i t i o n e d  i f  the  r e g r e s s i o n  v a r i a b l e s  more  the  s u f f i c i e n t  So  the  d a t a  was  A n n u a l  and  g r o u p i n g s .  sample  of  1982.  a s  an  drawn  B e a r i n g  i n d e p e n d e n t  i n d u s t r y t a p e .  was  w h i c h T h e r e  h a d  from in  the  mind  C o m p u s t a t t h a t  v a r i a b l e , more  were  15  f i r m s  i n d u s t r y were  than  e l e v e n  of  t h e s e  c l a s s  c h o s e n  e n t r i e s  if on  i n d u s t r i e s ,  32  c o n s i s t i n g of 212  companies, i n the sample.  A list  of firms  and  i n d u s t r i e s i s i n c l u d e d i n the appendix. Firms which became bankrupt before February 28, excluded  from the sample.  Observations  dropped from the sample. considerable consider  two  These  unreasonable  firms  noise  could  have  introduced For  f i r m s with p o s i t i v e debt o u t s t a n d i n g ,  but  s l i g h t l y negative  positive  equity.  Their  example, one  e q u i t y , while the other has debt  absolute  sense  of  slightly  r a t i o s would appear at  ends of the r e a l l i n e , whereas i n an  were  f o r which DEBTEQ<0 were  the data.  which has  into  1983,  opposite they  had  almost i d e n t i c a l c a p i t a l s t r u c t u r e s . It  has  been  shown  that  f i r m s approach b a n k r u p t c y . bankruptcy  by  the  would  be  firm's f i n a n c i a l been  To attempt to c o n t r o l f o r impending  i n t r o d u c t i o n of another dummy v a r i a b l e would  r e q u i r e the determination point  22  set  of some  at  some  cutoff  point.  This  cutoff  time before bankruptcy when the  r a t i o s began to d e t e r i o r a t e , which  would  have  when the impending bankruptcy would have begun to have had  an e f f e c t on the f i r m ' s balance be  f i n a n c i a l r a t i o s d e t e r i o r a t e as  arbitrary,  and  a  source  sheet. of b i a s .  become bankrupt before February 28  1983  The  cutoff  point  would  So a l l firms which have were  deleted  from  the  Edward I. Altman, " F i n a n c i a l R a t i o s , D i s c r i m i n a n t Analysis and the P r e d i c t i o n of Corporate Bankruptcy", J o u r n a l of Finance, September, 1978 and William H. Beaver, "Market P r i c e s , F i n a n c i a l R a t i o s , and the P r e d i c t i o n of Failure", J o u r n a l of Accounting Research, Autumn 1968.  2 2  33  sample. In  order  t o ensure  used t w i c e , data was assumed  that  change  over  their  of  inappropriate. then  a  the  from  1981  and  1976.  This  p e r i o d of f i v e y e a r s , f i r m s were able t o structures. 1981  and  i t may w e l l be that i t was  1  both  A  statistical  test  for  1976 data was c o n s i d e r e d t o be  I f a f i r m was a t i t s optimal debt r a t i o i n 1976,  s t r u c t u r e i n 1981. to  taken  capital  independence  a l a r g e enough sample, each f i r m was  at  the same  optimal  capital  YRDUM, a dummy v a r i a b l e , which was set equal  i f the o b s e r v a t i o n was made i n 1976, and 0 otherwise, was  i n c l u d e d as a check f o r the i n f l u e n c e of sample date. All  the v a r i a b l e s used i n these t e s t s were book v a l u e s ,  reported reasons  on the Compustat tapes. given  Book values were used f o r the  i n Chapter 1: t r e a s u r e r s tend t o t h i n k i n terms of  book v a l u e s ; book v a l u e s of debt and tied  to  expected  as  equity  a r e more  closely  the book value of a s s e t s s i n c e they do not c a p i t a l i z e cash  flows from a s s e t s t h a t w i l l  be  acquired  i n the  f u t u r e ; covenants a r e w r i t t e n i n terms of book v a l u e s . Any  noise i n t r o d u c e d by the use of book v a l u e s was assumed  to be random.  No e x p e c t a t i o n of  formulated. determining securities, earnings,  For i n s t a n c e ,  direction  management  s a l e s , or the r e p o r t e d t o minimize or  to portray  income some  book  of  bias  could  be  may choose measures of value  of  marketable  taxes, or maximize accounting desired  level  of  assets  or  Jack C l a r k F r a n c i s , Investments: A n a l y s i s and Management, T h i r d E d i t i o n , McGraw H i l l Book Company, Toronto, 1980.  2 3  34  liabilities.  So there may  2 3  be  incentives  for  management  to  manipulate book v a l u e s . It values  was  beyond the scope of t h i s t h e s i s to c o n s t r u c t market  f o r debt and  equity.  Furthermore, for many of the  a s s e t s , i t would have been extremely d i f f i c u l t values.  were  the  Adequate  would not have values.  only  liquidity  reasonable  proxies  for  market  d e s c r i p t i o n s of these a s s e t s , such as p l a n t ,  been  available  from  which  to  derive  market  A l s o , the uniqueness of c e r t a i n a s s e t s would have made  them e s p e c i a l l y d i f f i c u l t The  to measure market  Indeed, f o r p r a c t i c a l purposes, book v a l u e s of many of  the v a r i a b l e s values.  other  first  to p r i c e , e i t h e r d i r e c t l y or by proxy.  independent v a r i a b l e ,  CMTA,  of the f i r m ' s asset s t r u c t u r e .  was  a  measure  of  F i n a n c i a l leverage  was  expected to i n c r e a s e as a r e s u l t of i n c r e a s e s i n l i q u i d i t y . The  less  liquid  a s s e t s , e s p e c i a l l y NTPTA, may  reverse e f f e c t on l i q u i d i t y , and negative  coefficient.  proxies for costs.  operating  This  also  ARTA,  hence INVTA  leverage, led  to  c o e f f i c i e n t s f o r these v a r i a t e s . were examined to see i f they  be and  since the  have had  associated NTPTA  they  with  were  of  independent.  As  fixed negative  ARTA,INVTA,NTPTA, DOL,  were  a  used as  represent  expectation  a  and is  VAR  shown  below, they are n o n - c o l l i n e a r . SUBSEC debt.  The  coefficient,  was  a  model under  measure posited the  of subordinated that  it  assumption  should of  which were the same f o r both s e n i o r and The  to other have  a  long term positive  small bankruptcy c o s t s subordinated  simpler model p r e d i c t e d that SIZE would  be  debt. positively  35  r e l a t e d  t o  p r e d i c t e d  the  n e g a t i v e , c o s t s .  f i n a n c i a l  c o e f f i c i e n t  d e p e n d i n g P r e v i o u s  the  f i n a n c i a l  more  f i n a n c i a l DOL  the  s h e e t  s t u d i e s  y e a r s  1 , 0 0 0 , 0 0 0  not  j u s t  c h a n g e  e a r n i n g s ,  w h i c h  s a l e s  VAR d i v i d e d  as the  a p p e a r s  was  t a k e n  by  the  The  t h a t  p o p u l a t i o n  a l l o w a n c e c o m p a n i e s .  to  sample  i t t h a n  c o m p l i c a t e d  e i t h e r  f i r m s  of  or  b a n k r u p t c y  p o s i t i v e l y were  model  p o s i t i v e  m a g n i t u d e  be  f o r The  the  r e l a t e d  e x p e c t e d  was  to  to  assume  c a s e s  where  d i f f e r e n c e s  i s  d e f i n i t i o n s  c h o s e n  d a t a ,  and  f i r m s  had  c h a n g e s  i n  C o n s e q u e n t l y , of  EBIT  T h i s  i s  the  b e l o w .  s t a n d a r d  d e v i a t i o n  a g a i n  from  22  a  more  by  the  a v e r a g e f o r  v a r i a t i o n  r e g r e s s i o n  u n d e r e s t i m a t e d  the  b a l a n c e  s a l e s .  of  p e r i o d .  s a l e s ,  D i v i d i n g  no  the  n u m b e r s .  y e a r  was  the  l a r g e  the  q u a r t e r s  Some  s i m p l e  v a r i e d  i n  were  the  to  the  w i t h  in  of  t a x e s  c o e f f i c i e n t  g i v e n  of  v a r i a n c e  v a r i a n c e .  the  sample  s i z e s  sample  of  f i v e  mean  v a r i a n c e  a  l a r g e  r e s u l t s  the  a l l  r e l a t i v e l y  v e r y  r e l e v a n t  be  t h e r e  v a r i a b i l i t y  but  the  o v e r  o b s e r v a t i o n s .  s l o p e  i n  and  a s s o c i a t e d  showed  some  the  a v e r a g e  i n t e r e s t  t a k e n  d a t e  t r e m e n d o u s  to  s i m p l e  b e f o r e  the  measure  sample  S i n c e  f e l t  t o  s a l e s ,  l e d  i n d u s t r i e s . was  t o  in  o v e r  p e r i o d .  be  to  a s  e x c e p t i o n a l  r e d e f i n e d  t h a t  S I Z E  It  t h o s e  DOL  few  m i n i s c u l e  on  to  l a r g e r  s a l e s .  p r i o r  due  a  was  more  r e l a t i v e  e a r n i n g s  e x c e p t i n g  o v e r  measure  i n  r e s u l t a n t  DOL  f o u n d  m e a s u r e d in  c h a n g e  d a t a ,  S I Z E the  so  The  l e v e r a g e . f i r s t  f i v e  The  upon  c h a n g e  p e r c e n t a g e  of  l e v e r a g e ,  was  p e r c e n t a g e  i n  l e v e r a g e .  DOL  of  o v e r  a  t o  50  a c r o s s  s m a l l  s a m p l e s ,  f o r  f i v e  a p p r o p r i a t e sample  l e v e l and  s a l e s  of VAR  a r e  measure  mean  s a l e s  y e a r  made  amongst s t a n d a r d  36  financial  ratios. " 2  PFDDUM  and  CONVDUM were dummy v a r i a b l e s used as checks on  the d e f i n i t i o n of DEBTEQ. were  expected  to  be  The c o e f f i c i e n t s  zero.  of  both  P r e f e r r e d s and c o n v e r t i b l e s were  i n c l u d e d because they can a c t l i k e both debt and convertibles  and  Convertibles are l i k e equity  bondholders  have  securities into residual residual  claimants  a f t e r debtholders The equity  the option  claims.  assets.  by e q u i t y .  and  as  in  turning  that their  stockholders  using  total  Debt-to-equity i t was  debt  to  are until  structure  equity  E q u i t y was t h e sum of common s t o c k ,  convertible  debt.  encompass  less than more  t h a t i t s a t i s f i e s both  capital or  assets  was used r a t h e r  felt  F e r r i and Jones r e c o g n i z e d  measured 2 5  require  have been p a i d .  s i d e s i n t h e d i s p u t e about whether properly  Both  i n t h a t they do not r e c e i v e d i v i d e n d s  d e b t - t o - t o t a l a s s e t s because information.  of  Preferred  dependent v a r i a b l e was d e f i n e d divided  equity.  p r e f e r r e d s a r e l i k e debt i n t h a t they  f i x e d i n t e r e s t payments. convertible  variables  divided  i s more by  preferred  total stock,  T h i s d e f i n i t i o n of DEBTEQ was chosen so  t h a t t h e v a r i a b l e would c o n t a i n as much i n f o r m a t i o n as  possible  about c a p i t a l s t r u c t u r e . Preliminary  regression  runs were examined t o see which of  t h r e e d e f i n i t i o n s of DEBTEQ gave t h e s m a l l e s t the  coefficients  of  PFDDUM  and  CONVDUM.  2ft  R i c h a r d B r e a l e y , and Stewart Myers, Op.  2 5  M.  G.  F e r r i and Wesley H.  t-statistics for The o t h e r  possible  C i t . , pp 586-587.  J o n e s , Op. C i t .  37  d e f i n i t i o n s f o r e q u i t y were common stock, and common stock preferred  stock.  The  chosen d e f i n i t i o n was  most i n f o r m a t i o n about p r e f e r r e d s  and  felt  less  to c o n t a i n  convertibles  and  the  their  r e l a t i o n to c a p i t a l s t r u c t u r e . All This  the non-dummy independent v a r i a b l e s were  was  to  reduce  i n v e r t i n g the X'X is  near  there  the  matrix.  zero,  or  possibility  that  dependent  e r r o r s when  the v a r i a b l e s d i f f e r c o n s i d e r a b l y  the  results  variable  unstandardized  of roundoff  If the determinant of the X'X  i s a s e r i o u s danger of roundoff So  standardized.  was  data  could not  should  be  errors. easily  lead to an  in scale,  2 6  i n t e r p r e t e d , the  standardized.  not  For  example,  i n t e r c e p t term which  i s s i g n i f i c a n t l y negative,  s i n c e t h i s i s not observable  which are going  Because the magnitude of  relatively variates,  concerns.  close i t was  to  felt  that  Preliminary constant violated.  was  independent  that the use of  standardized  independent  i n t e r p r e t a t i o n of the suggested  that  necessary i n a r e g r e s s i o n  the  results. assumption  setting  was  of  being  From a s t a t i s t i c a l p o i n t of view, h e t e r o s c e d a s t i c i t y  was  observed and  of  the r e s i d u a l s i n c r e a s e d with DEBTEQ, and  had  to be c o r r e c t e d .  p r o b a b i l i t y p l o t of r e s i d u a l s was decreasing  DEBTEQ  standardized  results  variance  i n firms  the  v a r i b l e s would a i d i n the  of  matrix  slope.  The  In p a r t i c u l a r ,  the  size  the expected normal  a steep curve of p o s i t i v e  i d e a l expected normal p l o t i s a  and  forty--  John Neter and W i l l i a m Wasserman, A p p l i e d L i n e a r S t a t i s t i c a l Models, R i c h a r d D. Irwin Inc., Homewood, I l l i n o i s , 1974, p34/.  2 6  38  f i v e degree s t r a i g h t l i n e . of  normality,  DEBTEQ  To compensate f o r these  was  transformed.  v a r i a b l e , LNDE, was taken to be the  The  logarithm  violations  new to  dependent  base  e,  of  DEBTEQ. A  decrease  increases has  a  respect  in  e q u i t y both decreases the denominator and  the numerator, so that a change  double  effect.  to e q u i t y .  DEBTEQ  in  The d e r i v a t i v e of the l o g a r i t h m  r a t i o as d e f i n e d , with respect  negative  i f the average e q u i t y t o t o t a l a s s e t s  1/2. An  SIZE  regression  VAR  not  were  showed  sales variance was  with  of the debt-  to p r e f e r r e d stock,  is  r a t i o i s greater  For the sample, the r a t i o was .48.  examination of the  and  policy  i s concave t o the o r i g i n ,  to-equity  that  financing  correlation  highly  that  matrix  correlated  indicated  (.7946).  VAR=.79458(SIZE).  forced  to  zero,  but  An a u x i l i a r y  Average  were not s i g n i f i c a n t l y c o r r e l a t e d . the r e g r e s s i o n  sales  and  The i n t e r c e p t r e s u l t s gave an  i n t e r c e p t term of n i l . T h i s r e g r e s s i o n was h i g h l y with a R-squared s t a t i s t i c  that  significant,  of .63 and a F - r a t i o of 75.19.  A new  v a r i a b l e , NEWVAR, was formed, which e q u a l l e d  VAR-.79548(SIZE),so  as to separate the e f f e c t s of s i z e and s a l e s  variance.  The  regression  r e s u l t s are given  g i v e s the c o e f f i c i e n t s f o r a d i f f e r e n t column 1976  i n Table 1. regression.  corresponds to the output from the f u l l  and 1981.  Each column The  first  set of data from  39  T a b l e  1981 A l l  C a s e s  I  R e g r e s s i o n  1976  r  A l l  R e s u l t s  1971,  DATA  C a s e s  A l l  C a s e s  1966 C a s e s  DATA C a s e s  69,241  38,236  D e l e t e d  D e l e t e d .04  .04  .44  - . 0 4  .46  I n t e r c e p t  -  CMTA  - . 2 2 * * *  - . 2 1 * * *  - . 2 4 * * *  - . 2 4 * * *  - . 2 5 * * *  ARTA  - . 0 7  - . 1 7 * * *  - . 0 7  - . 0 6  - . 0 7  INVTA  - . 1 2  - . 1 7 * * *  -.11  - . 2 2 * *  - . 2 3 * *  NTPTA  - . 3 1 * * *  - . 1 7 *  - . 3 1 * * *  - . 2 3 * *  - . 1 9  1 ^ * * *  . 1 2 * * *  . 1 3 * * *  . 1 2 * * *  SUBSEC  - . 0 4  - . 0 5  -.01  . 1 1 * * *  SIZE  - . 0 2  .03  DOL  - . 0 3  - . 0 6  - . 0 5  NEWVAR  .03  .04  .01  PFDDUM  . 1 3 * * *  . 2 6 * * *  . 1 2 * * *  . 40***  . 3 8 * * *  CONVDUM  .00  .08  .00  .15  .15  YRDUM  - . 0 5  - . 0 7  - . 0 5  .10  .10  D1  - . 5 2 * * *  - . 4 9 * *  - . 6 0 * *  D2  - . 8 3 * * *  _  57***  - . 8 3 * * *  - . 6 9 * * *  - ^ 5 9 * * *  _ 75***  - . 7 4 * * *  - . 3 6  - . 2 7  D4  - *  -  - . 7 3 * * *  - . 7 5 * * *  D5  - . 3 8 *  -'.37*  - . 5 6 * * *  - . 5 6 * * *  D6  - . 6 4 * * *  - . 57***  - . 6 1 * * *  - . 5 6 * * *  - . 4 9 *  - . 5 3 * *  D3  4 8 * * *  .00  - . 0 2  D7  47***  _  54***  _  D9  - * . 8 9 * * *  -".88***  - . 8 9 * * *  - . 8 4 * * *  - .  - . 7 0 * * *  - . 6 8 * * *  - . 6 3 * * *  - . 7 1 * * *  - . 6 2 * *  - . 5 7 * * *  D10  7 3 * * *  - ! 7 4 * * *  D1 1 D1 2 D13  • I N D I C A T E S  . 4 9 *  . 5 2 * *  .39  .31  - . 3 4  - . 3 0  - . 4 6 * * *  BONFERRONI  * * * I N D I C A T E S  .000  BONFERRONI  AT  S I G N I F I C A N C E S I G N I F I C A N C E  .751 .000  .000  S I G N I F I C A N C E  BONFERRONI  1 1  15.745  16.11  .000  • • I N D I C A T E S  .43  .01  .46  14.676  P ( T A I L )  4 7 * * *  .06  - . 4 7 * * *  D14 F - R A T I O  44***  - . 4 5 * *  D8  - .  .10  AT AT  .05 .01  L E V E L L E V E L L E V E L  12.574 .000  40  B o n f e r r o n i j o i n t confidence i n t e r v a l s were used simultaneous essence,  testing  of  the p r o b a b i l i t y  tail  enable  the r e g r e s s i o n c o e f f i c i e n t s .  a s s o c i a t e d with the B o n f e r r o n i  r e q u i r e s t a k i n g the two statistic  all  to  probability  derived  f o r each c o e f f i c i e n t , and d i v i d i n g  In  interval  from  the  t-  that t - s t a t i s t i c  by  the number of r e g r e s s i o n c o e f f i c i e n t s . The  first  hypothesis cannot  be supported:  i t appears  that  f i r m s with more l i q u i d i t y do not have higher debt  ratios.  The  significantly  implies  this  negative  surprising  result.  downturns  in  retained  T h i s may  earnings,  earnings,  hence  cash flows would have If  this  coefficient  coefficient  were  have been due  which  would  CMTA  to firms e x p e r i e n c i n g  have  led  to  decreased  lower e q u i t y , while at the same time  decreased. the  case,  then  one  would  expect  f i r m s would face  growing  would  cash  not be expected  During expansionary  flows,  in  general.  economic  climate  f o r CMTA, s i m i l a r These  results  periods, Retained  to decrease during these  nor would cash be drawn down due to reduced cash flows. if  the  t o be c l o s e r to zero, or l e s s s i g n i f i c a n t , or both,  d u r i n g p e r i o d s of economic growth.  earnings  of  times, To  see  might be i n d u c i n g the negative c e f f i c i e n t  r e g r e s s i o n s were run on 1971  indicate  that  that  the  and  inverse  1966  data.  relationship  between CMTA and LNDE i s permanent. The c o e f f i c i e n t of CMTA may  have been due  to c o l l i n e a r i t y .  However, when a l l the v a r i a b l e s with which CMTA had an value  of  simple c o r r e l a t i o n  of more than  absolute  .20 were d e l e t e d from  41  the  m o d e l ,  the  n e g a t i v e .  F u r t h e r m o r e ,  a l w a y s  among  ( u s i n g  the  was  a l w a y s In  among  c o e f f i c i e n t  a  the BMDP  f i r s t  an  a l l  v a r i a b l e s  p a c k a g e  f u r t h e r or  e f f o r t more  P : 9 R ) ,  r e m a i n e d s u b s e t s  i n c l u d e d and  v a r i a n c e  of  r e q u i r e s  s t a n d a r d i z i n g  P r i n c i p l e  c o m p o n e n t s  down  e i g e n v a l u e s  e i g e n v e c t o r s  are  to  t e s t  s i g n i f i c a n t l y  c o n t e x t ,  i n  CMTA  was  the  r e g r e s s i o n  i t s  c o e f f i c i e n t  c o l l i n e a r i t y ,  e s p e c i a l l y  the  f o r  v a r i a t e s ,  t e c h n i q u e  The  in  CMTA  s i g n  of  n e g a t i v e .  t h r e e  i n t o  f o r  the  d e c o m p o s i t i o n the  a n a l y s i s and then  B e l s l e y ,  was  X - m a t r i x i s  then  u s e d . to  u s e d  T h i s  u n i t to  Kuh  c o l u m n  b r e a k  c o r r e s p o n d i n g  o r t h o g o n a l  d e c o m p o s e d  shown  as  in  the  and  W e l s h  p r o c e d u r e l e n g t h . X - m a t r i x  e i g e n v e c t o r s .  T a b l e  2.  42  Table II - V a r i a n c e  Decomposition  Variance(Bi) Lj  1  2  3  4  5  6  7  8  9  10  1 1  Nj  1 .88  .01  .05  .03  .30  .00  .02  .02  .01  .00  .00  .00  1 .0  1 .32  .02  .12  .17  .27  .00  .09  .02  .07  .00  .03  .05  1 .4  1 .27  .13  .21  .06  .08  .00  .06  .03  .10  .01  .01  . 1 1 1 .5  1 .04  .15  .31  .26  .14  .00  .01  .05  .04  .03  .00  .01  1 .8  1.01  .31  .10  .19  .12  .04  .02  .19  .08  .03  .04  .09  1.9  .95  .08  .05  .06  .01  .03  .03  . 1 1 .04  .02  .02  .06  2.0  .88  .08  .02  .04  .01  .03  .10  .37  .07  .07  .09  .31  2.1  .81  .10  .07  .01  .02  .15  .09  .07  .12  .27  .17  .24  2.3  .77  .01  .03  .15  .01  .02  .42  .02  .34  .09  .06  .07  2.4  .73  .00  .10  .02  .01  .06  .14  .01  .08  .32  .36  .06  2.6  .65  .04  .00  .01  .00  .66  .01  .10  .04  .15  .21  .00  2.9  L j i s the square  root of the j t h e i g e n v a l u e .  Nj i s the j t h c o n d i t i o n index. T h i s i s equal to the square root of the l a r g e s t eigenvalue d i v i d e d by the square root of the j t h eigenvalue.  43  E a c h f i n a l  row  column  i n d e x  on  the  i t h  l a r g e s t h i g h  i n d i c e s  100  i n d i c a t e  i n d e x  i n  one  c o n d i t i o n  Kuh  and  of  an  i n d e x  i s  r o o t  of  and  10,  i s  2 . 9 ,  the  i t h  o t h e r  of  c o l l i n e a r i t y .  m e a s u r e s The  a r e of  l a r g e s t  g i v e s  r o o t  e i g e n v a l u e .  d e p e n d e n c i e s  whereas  w h i c h  the  s q u a r e  w i t h  weak  c o n d i t i o n  of  the  of  a s s o c i a t e d t h a t  the  The  X - v a r i a t e s .  i l l - c o n d i t i o n i n g .  c a s e  g i v e s E a c h  r a t i o  s q u a r e  s u g g e s t 5  the  e i g e n v a l u e . .  t a b l e  o r i g i n a l  i s  the  between  the  the  t o  s e v e r e  t h i s  of  to  e i g e n v a l u e .  index  W e l s h  r e a d  s i d e  e a c h  e i g e n v a l u e  when  c o r r e s p o n d s  r i g h t  to  c o n d i t i o n  B e l s l e y ,  2  w i t h  c o r r e s p o n d s  The  A  T a b l e  a s s o c i a t e d  c o l u m n s  the  of  no  f o u n d 30  to  c o n d i t i o n  i n d i c a t i o n  of  c o l l i n e a r i t y . In of  the  r e s t  v a r i a n c e  of  e i g e n v e c t o r . the  two  or  o r t h o g o n a l  b e i n g  and  about  p o i n t t h a t .80  two  p r o p o r t i o n s  . 3 5 ,  so  c o l u m n s  t h a t of  i n  or  the  same  the  v a r i a n c e -  d i s c r e p e n c i e s s o .  In  i s  i f  row  l i t t l e  X - m a t r i x  a r e  2,  w i t h or  no  two  a r e  to Kuh  l a r g e  or  and  w i t h  more  show  one  i s  up  c o l l i n e a r i t y  o r t h o g o n a l .  i n  T h i s  n o n -  s u g g e s t  t h a t  p r o p o r t i o n s p r o p o r t i o n s  c a s e  c o n d i t i o n  the  v a r i a n c e  w i t h  no  v a r i a n c e  the  l a r g e  of the  then  of  W e l s h  i t h  p o r t i o n  l a r g e ,  the  amount  the  d e c o m p o s i t i o n  t h e r e  any  a  the  by  v a r i a n c e  u s u a l l y  T a b l e  g i v e s  a s s o c i a t e d  the  B e l s l e y ,  i f  i s  way,  the  a s s o c i a t e d  t h e r e  d i a g n o s e d  c o r r e s p o n d i n g  f o r  e n t r y  d e s c r i b e d  X - v a r i a t e s  p r o p o r t i o n s .  c u t o f f  . 5 0 ,  i s  e x p l a i n i n g  X - v a r i a t e s  d e c o m p o s i t i o n  i , j t h  a n o t h e r  p r o p o r t i o n s i s  the  X - v a r i a t e  more  Put  e i g e n v e c t o r  good  t a b l e ,  j t h  e i g e n v e c t o r .  same  i s  the  of  d e c o m p o s i t i o n  a  the  C o l l i n e a r i t y  v a r i a n c e  same  of  i n  w h i c h  index  e x c e e d  the  d a t a ;  - s u p p o r t s  the the  44  contention (52) and  VAR  and  DOL  are  independent as p o s t u l a t e d in  (53).  The and  that  p r o x i e s f o r degree of o p e r a t i n g l e v e r a g e , ARTA,  NTPTA,  a l l have negative  coefficients.  with lower f i n a n c i a l leverage leverage,  so  the  second  for  null  firms  INVTA,  This i s consistent  with  hypothesis  high  is  operating  rejected.  The  i n d i v i d u a l c o e f f i c i e n t s are not a l l s i g n i f i c a n t . The  l a c k of s i g n i f i c a n c e of ARTA and  different  industries  inventories. accounts  having  different  receivable  accounts r e c e i v a b l e and extent  to  which  Write-off  vary  amongst  procedures  industries,  i n v e n t o r y turnover.  for  as  will  Consequently,  the  these v a r i a b l e s measure f i x e d c o s t s w i l l  vary  amongst i n d u s t r i e s . it  to  d i f f e r e n t types of r e c e i v a b l e s and  firms.  will  INVTA c o u l d be due  Plant i s a f i x e d c o s t f o r a l l the f i r m s , so  should be a b e t t e r proxy f o r o p e r a t i n g leverage  than ARTA  or  INVTA. SUBSEC has consistent  with  a s i g n i f i c a n t and the  theory  p o s i t i v e c o e f f i c i e n t , which i s  that  firms which s a t i s f y c e r t a i n  c o n d i t i o n s have higher debt r a t i o s . debt  will  operating  be  used  leverage.  experiment,  depends Tax  on  rates  The taxes, were  extent  to which  junior  bankruptcy c o s t s , not  examined  in  so that the i n f l u e n c e s on SUBSEC cannot be  and this  properly  determined. SUBSEC was and NEWVAR. t-statistic with  The was  regressed a g a i n s t ARTA, INVTA, NTPTA, SIZE, R-squared s t a t i s t i c l e s s than 1.0.  The  was  l e s s than .01,  data was  extremely  only 68 cases being non-zero, so r e g r e s s i o n was  and  DOL, each  skewed,  perhaps an  45  inappropriate  way  to  test  the  relationship  in  question.  Transformations i n d i c a t e d by the expected normal p l o t to c o r r e c t the  error  variance  transformations. observations  were  The  the  f i r s t was  was  0.0,  logarithmic impossible  and  the  or the square root since  second  many  was  of  shown  the  to  be  inappropriate. In Chapter 2,  f i r m s were shown to be  senior or subordinated bankruptcy  costs.  i n d i f f e r e n t to i s s u i n g  debt i f each kind  of  debt  had  similar  However, i f j u n i o r d e b t h o l d e r s faced  bankruptcy c o s t s , j u n i o r debt would  be  issued  if  higher  taxes  were  significantly positive. The the  i n s i g n i f i c a n t c o e f f i c i e n t of SIZE leads to r e j e c t i o n of  f o u r t h n u l l hypothesis,  to-equity  ratios.  positively  Other s t u d i e s c o n s i s t e n t l y found SIZE  related  r e s u l t c o u l d be due Industrial  Tape  to  firms  industry The  some other  financing decision.  of  Quarterly Poor's  400  I t c o u l d be  that  I t may  a l s o be that the s i z e I f there are  s i z e e f f e c t may  be  optimal part  of  effect.  coefficient  for  DOL  is  insignificant,  However, with  the  causing deletion  o u t l i e r s , t h i s v a r i a b l e does become s i g n i f i c a n t at the .10,  be  i s no longer any e f f e c t  industry e f f e c t .  i n d u s t r i e s , then the  to  unexpected  Compustat  large firms.  acceptance of the n u l l h y p o t h e s i s . of  the  This  comprises firms on the Standard and  swamped by the  scales within the  leverage.  reach a c e r t a i n s i z e , there  of s i z e on the e f f e c t was  financial  to sampling b i a s :  I n d u s t r i a l Index, and once  that l a r g e r firms have l a r g e r debt-  using B o n f e r r o n i  confidence  limits.  level  46  The c o e f f i c i e n t of  NEWVAR  i s insignificant,  acceptance of the hypothesis that s a l e s v a r i a n c e to  financial  the model  leverage.  developed  variability  This i s contrary  i n Chapter  2.  f i r m s had i d e n t i c a l  sales  periods.  assume  Further,  of  50,  t o the p r e d i c t i o n of be  that  100, and  150  over  The measures of v a r i a b i l i t y w i l l be the same f o r  same average s a l e s .  The f i r m which grows over  s a l e s which a r e a constant measure  to  d e v i a t i o n s and  the p e r i o d  of v a r i a b i l i t y which would compensate f o r the  t o t a l assets  deviation  of  the r a t i o  (the t o t a l a s s e t s turnover  ratio).  value would be 0 f o r the growth f i r m , and .125 f o r the size  firm.  Unfortunately,  sheet data on a computed  quarterly  Compustat does not provide basis.  However,  on the b a s i s of annual data.  f o r the standard  p o i n t s , had  This  balance was  The c o e f f i c i e n t s f o r a l l regressions.  d e v i a t i o n o f s a l e s turnover was  i n s i g n i f i c a n t , having a t - s t a t i s t i c influential  of  constant  the measure  the v a r i a b l e s were unchanged i n s i g n from p r e v i o u s The c o e f f i c i e n t  has  percentage of s i z e .  s c a l e e f f e c t would be the standard sales  periods.  s i z e of 200 over the  f i r m s , that i s , they have the same standard  One  three  that one f i r m grew over the p e r i o d ,  The second f i r m i s assumed t o have constant  both  sales  For example, suppose two  with t o t a l a s s e t s of 100, 200 and 300 over the three  three p e r i o d s .  to  has no r e l a t i o n  I t may  was measured i m p e r f e c t l y .  leading  of  been d e l e t e d ,  less  than  one.  When  the c o e f f i c i e n t remained  insignificant. The i n s i g n i f i c a n c e of CONVDUM i n the r e g r e s s i o n that  the dependent  indicates  v a r i a b l e i s w e l l s p e c i f i e d with respect t o  47  convertible  debt  acting  like  equity.  However,  PFDDUM  s i g n i f i c a n t l y p o s i t i v e , even though p r e f e r r e d s are a l r e a d y treated  like  equity.  nature of p r e f e r r e d  have  an  preferred dividends,  r e t a i n e d are s u b j e c t the  next  lenders  at  to  period.  p r e f e r that e q u i t y be not  all  However,  after  their  claims  If earnings are more than enough to make  be p a i d to common shareholders  during  and  are only e n t i t l e d to d i v i d e n d s  claims have been s e t t l e d .  upper bound.  that are  in the  dividends.  i n t e r e s t payments and either  being  Perhaps the reason f o r t h i s l i e s  P r e f e r r e d shareholders debtholders'  In  then the excess  or be r e t a i n e d .  first  claim  t h i s context,  i s s u e d s o l e l y i n the  in  the  by  equity  debtholders  d e b t h o l d e r s would  form  of  form of common stock.  i s i s s u e d , so that f i r m s who  must  Earnings  preferreds  I t may  be  f e e l that f u t u r e i n t e r e s t payments are more secure  preferred  is  issue  that when  preferreds  are a b l e to i s s u e more debt. YRDUM i s not  s i g n i f i c a n t , as  Twelve of fourteen The  regression  e f f e c t , which Debt  ratios  there are  i n d u s t r y c o e f f i c i e n t s are  results  are  contradicts are  which  c o n s i s t e n t with an  the  similar  factors  predicted. significant. industry c l a s s  Modigliani-Miller  within  hypothesis.  r i s k c l a s s e s , i n d i c a t i n g that  influence  firms'  capital  structure  decisions. Three  expected  probability  p l o t s are provided  Figures  1, 2 and  sample  with no d e l e t i o n s , with case 241  deleted,  and  241  69 d e l e t e d ,  241  identified  and  3.  normal  These correspond r e s p e c t i v e l y to  respectively.  Case  is  the  in full  with cases in  48  Figure  1  as  residual. residual  the  Case in  o u t l i e r s and  case 69  with the l a r g e s t p o s i t i v e s t a n d a r d i z e d  has  Figures  1  the and  largest 2.  should be d e l e t e d  negative  Cases 69 and  from  the  standardized  241  sample.  are  arguably  When  these  cases are d e l e t e d , the expected normal p l o t of F i g u r e 3 i s c l o s e to  the  straight  ideal,  which  sloped f o r t y - f i v e degree  line.  Case 69 was Kaiser  is a positively  Kaiser  Resources.  Steel, Kaiser  which  has  Resources  bankruptcy i n B r i t i s h Columbia i n 1982. Corp.,  whose  financial  pounds to d o l l a r s . exceptional two  Bankruptcy  occurances,  observations  statements  and  and support  large was  Case  have  holdings  petitioned 241  for  Bowater  been t r a n s l a t e d from  currency  translation  the c o n t e n t i o n  should be d e l e t e d from the  is  in  sample.  that  are these  49  Figure  1 - Expected Normal P l o t , A l l Cases, 1981 & 1976 Data  NORMAL PROBABILITY PLOT OF RESIDUALS + .... + . ... + .. .. + ....-•-.. .. + .... + .... + ....+  2.7  E X P E C T E D N 0 R M A L V A L U E  1 .8  .90  ** 0.0  .90  **  **  •1.8  •2 . 7 •....•....+... .+ .... + .... + .. .. + .. .. + . ...+ -.90 -.30 .30 .90 -1.2 -.60 O.O .60 1.2  1.5  50  Figure  2 - Expected  Normal P l o t , 1981  & 1976  Cases  Data  NORMAL P R O B A B I L I T Y PLOT OF  2.7  E X P E C T E D N 0 R M A L V A L U E  1.8  .90  0.0  . 90  1.8  -2.7  +  69  RESIDUALS  & 241  Deleted,  51  Figure  3 - E x p e c t e d Normal P l o t ,  A l l Cases,  1971 &  Data  NORMAL P R O B A B I L I T Y PLOT OF RESIDUALS ...+....+....+....+....+....+....+....+....+....+....  * 2.7  E X P E C T E D  1.8  +  * *  +  * ** * * * * * *  +  + .  * » * * * * * *  . 9 0 +  +  ** N 0 R M A L V A L U E  0 . 0  ** ** * * * * * * * **  +  . - . 9 0 + .  +  ** * * * * * * * * * ***  . - 1 . 8 +  +  +  * *  * -2.7  +  »  *  •  +  ...+....+....+....+....+....+....+....+....+....+.... -1.5 - . 5 0 . 5 0 1.5 2 . 5 -2.0 - 1 . 0 0 . 0 1.0 2 . 0  1966  52  The the  r e g r e s s i o n r e s u l t s f o r the r e v i s e d sample are given  second  column of Table  1.  In no cases do the s i g n s of the  c o e f f i c i e n t s change, but the DOL the  sign  becomes s i g n i f i c a n t , and  p r e d i c t e d by the model.  The  A  variable  the  s e l e c t i o n technique was  which had the Cp s t a t i s t i c the  of  the  which was  The  subset  closest,  sum  of squares  full  model.  of  variables  that s e l e c t e d as first  mean  intercept. the  The  was  variables  INVTA,  DOL,  18.81. and  twenty-six. Three YRDUM,  were  s i g n s of a l l the c o e f f i c i e n t s  were  for  the  i n s i g n i f i c a n t at the More i m p o r t a n t l y , the  consistent  with  those  of  i n the computer output, f o r a l l subsets  examined, the c o e f f i c i e n t s of a l l the s i g n i f i c a n t Table  the  The Cp s t a t i s t i c f o r  coefficients,  B o n f e r r o n i j o i n t c o n f i d e n c e l e v e l of .05.  Furthermore,  of  equation.  f u l l model had  subset  1.  number  equation had nineteen v a r i a b l e s , i n c l u d i n g  best  Table  for  The expected value of Cp i s the number  v a r i a b l e s i n the reduced chosen  the  S u b t r a c t from t h i s the d i f f e r e n c e between the  v a r i a b l e s i n the s u b s e t .  The  take  square  number of v a r i a b l e s i n the f u l l model l e s s twice the  of  be  from the reduced model  (using a subset of v a r i a b l e s ) to the r e s i d u a l the  to  i n a b s o l u t e terms,  To c a l c u l a t e the Cp s t a t i s t i c , residual  appear  employed t o see i f the  number of v a r i a b l e s i n the subset, was  the best subset. ratio  they  outliers.  model had been c o r r e c t l y s p e c i f i e d .  to  takes  o u t l i e r s d i d introduce a  s l i g h t d i s t o r t i o n of the c o e f f i c i e n t s , but s t a b l e with or without  in  1 had the same s i g n s .  variables  T h i s i s c o n s i s t e n t with the  f i n d i n g s that there i s no c o l l i n e a r i t y  i n the d a t a .  in  earlier  53  Regressions  were  next  run  cases.  The r e s u l t s are given i n  tables  list  the c o e f f i c i e n t s  for Table  each i n d u s t r y , using a l l 3  and  4.  The  f o r each r e g r e s s i o n , f o l l o w e d by a  * i f the c o e f f i c i e n t had a t - s t a t i s t i c which was the .05 l e v e l .  Table  significant  at  54  Table  I I I - Industry  Regressions  D4  D5  D6  D7  D8  -1 .63  -.49  -.15  -.39  .42  .03  -.13  -.19  -.24  -.15*  -.33  -.25  -.29  .24  -.04  .07  .31  .13  -.43  -.70*  -.49  -.21  -.21  .09  -.39  -.14  -.50  -.24  -.30  -.81*  .18  N.A.  D1  D2  INTERCEPT  -.52  -.79  CMTA  -.78  -.09  ARTA  -.97  .24  INVTA  -.47  NTPTA  -1 .00  D3  .22*  .21*  .09  .58*  .61  .46  -.85  -.26  -2.82  -.78  .09  .21  -.01  .03  -.03  -.09  -.03  -.05  -.06  -.05  NEWVAR  -.90  -1.31  4.51  -.03  -.10  -.03  PFDDUM  1.18*  .23  .19  .23  .18  -.83  SUBSEC SIZE DOL  .07  .46*  -.46*  .14* -.09 .12 -.31 .36  .34*  .17  • 19  -.28  .03  -.28*  .1 1  -.25  -.06  .00  .14  .91  .51  .69  .54  .36  F-RATIO DF P(TAIL)  3.60 1 1,4 .1 1  1 .31 11,4 .31  EXPECTED NORMAL PLOT  GOOD  VERY POOR  OK  OK  OK  POOR  POOR  GOOD  OUTLIERS  NO  YES  YES  YES  YES  YES  YES  YES  CASES  16  26  24  36  36  34  48  40  CONVDUM YRDUM R-SQUARED  N.A.:No v a r i a b i l i t y  2.38 11,12 .08  -.20  -.36  .13  .12  -.24  .69  .56  .52  2.77 4.17 1 .42 4.38 2.60 1 1 ,28 1 1 ,36 1 1 ,22 1 1 ,24 10,25 .01 .00 .00 .23 .02  i nthe data.  * Indicates t - s t a t i s t i c  significant  a t .05 l e v e l .  55  Table IV - I n d u s t r y Regressions  D1 1  Continued  D14  D1 5  .69  -.14  .64  -.13  N.A.  -.52*  D1 3  D1 2  D9  D10  INTERCEPT  -.44  -.43  -.73  CMTA  -.53  -.03  -.27  .23*  ARTA  -.42  .25  -.05  .42  .04  .13  -.39  INVTA  -.42  -.12  .45  -.58  .42  .42  -.39  NTPTA  -.62  -.06  -.23  -.44  .05  .35  -.59  .05  .35  .33  -.24  .04  .07  .31  .14  -.25  SUBSEC  .27  .20  -.85  3.12  8.89* -1 .04  SIZE  -1 .74  .21  DOL  -.06  .00  .05  NEWVAR  10.35  .37  -2.02  PFDDUM  •41  .53  -.40  N.A.  .15  .35*  CONVDUM  .04  .14  .57  .10  .21  .01  -.19  -.12  .02  .79*  .83  .62  .67  .92  2.17 11,12 .10  7.77 10,7 .01  YRDUM R-SQUARED  -.25  -1.03*  - 4 . 5 4 * -3.18  -.66 .74  -.72  -.34 -.14 .10  -.27  -.38  .76  .47  3.40 3.12 10,11 11,12 .03 .03 •  1 .77 1 1 ,22 .12  F-RATIO DF P(TAIL)  3.63 11,8 .04  1 .48 11,10 .27  EXPECTED NORMAL PLOT  POOR  VERY POOR  OK  OK  POOR  POOR  OK  OUTLIERS  NO  NO  YES  YES  YES  YES  YES  CASES  20  22  24  18  24  22  34  N.A. means no v a r i a b i l i t y * Indicates t - s t a t i s t i c  i n the data.  significant  a t .05 l e v e l .  56  The  bottom  violate are  row o f t h e t a b l e  the normality  determined  by  shows t h a t most o f t h e r e g r e s s i o n s  assumption, and a  few  have  outliers.  coefficients There  s i g n i f i c a n t c o e f f i c i e n t s , out of a p o s s i b l e signs in  were  total  nineteen  of  165.  of the s i g n i f i c a n t c o e f f i c i e n t s are consistent  Table  1, w i t h  industry.  The  the exception  o f YRDUM  coefficient  i n D12,  f o r SIZE  was  NEWVAR - 4 . 5 4 , i n D12, a n d b o t h were h i g h l y case, t h e normal p r o b a b i l i t y  plot  which  with  the  The those  trucking  8.89, a n d t h a t f o r  significant.  indicated  In this  the presence  of  o u t l i e r s , one w i t h a v e r y l a r g e n e g a t i v e r e s i d u a l , a n d t h e o t h e r with  a  only  very  eleven  large positive residual.  independent  eighteen  cases.  influence  o f o u t l i e r s , The  information  in  generalized least  In  variables the context  be  of  regression  the case  of  t o a l l the industry  determined  so  few  results  D12.  These  regressions,  were  by  only  cases  and t h e  provide  little  results  c a n be  t o each of which a t  one o f t h e f o l l o w i n g c r i t i c i s m s a p p l y : t h e a s s u m p t i o n  constant  error  variance  few o b s e r v a t i o n s ,  the d a t a .  Consequently, l i t t l e  industry  or there  were i n f l u e n t i a l p o i n t s i n  f a i t h can  be  attached  t o the  by i n d u s t r y r e s u l t s .  When r e g r e s s i o n s resultant  of  was v i o l a t e d , t h e s a m p l e c o n s i s t e d o f  relatively  1.  to  Furthermore, there  were r u n w i t h o u t t h e i n d u s t r y  e q u a t i o n was t h a t  shown i n t h e s e c o n d c o l u m n o f T a b l e  C o e f f i c i e n t s were i d e n t i c a l  regressions,  dummies, t h e  in  sign  to  those  of  earlier  a n d ARTA a n d DOL a r e b o t h s i g n i f i c a n t i n B o n f e r r o n i  t e s t s a t t h e .05 l e v e l . In  conclusion,  there  seems t o be an i n d u s t r y  e f f e c t where  57  firms  i n t h e same i n d u s t r y  Liquidity  was  operating  leverage,  leverage  had  found  face  similar  t o be n e g a t i v e l y contrary  a negative  to  plant  such as the inventory to  total  assets  no  relation  to  variance  expectations. financial  did Firms  leverage,  behaved  like  c o n c e p t o f an o p t i m a l  Operating  of EBIT t o s a l e s , o r t h r o u g h  to equity.  or  not a f f e c t c a p i t a l which  r a t i o or  SIZE  the debt-to-equity  issued  ratio. the  the  net  subordinated  was  found  T h i s may  industry  to have  effect.  structure, contratry to  preferred  debt  had  more  w h i c h may be due t o t h e f i x e d a n d r e s i d u a l  n a t u r e of p r e f e r r e d d i v i d e n d s . have  expectations.  Firms which issued  b e e n due t o t h e s a m p l i n g t e c h n i q u e , Sales  r e l a t e d t o the degree of  to t o t a l assets  ratio.  d e b t i s s u e d more d e b t r e l a t i v e have  structures.  e f f e c t on t h e d e p e n d e n t v a r i a b l e , when  measured d i r e c t l y as t h e e l a s t i c i t y proxies  capital  equity. capital  Convertible  debt  was  seen  to  These r e s u l t s t e n d t o s u p p o r t t h e structure.  58  LITERATURE CITED 1.  A l t m a n , Edward I . "Financial Ratios, Discriminant A n a l y s i s and t h e P r e d i c t i o n of C o r p o r a t e B a n k r u p t c y . " J o u r n a l o f F i n a n c e , S e p t e m b e r 1978.  2.  B a x t e r , N e v i n s D. " L e v e r a g e , R i s k of R u i n and t h e Cost Capital." J o u r n a l of F i n a n c e , S e p t e m b e r 1967.  3.  B e a v e r , W i l l i a m H. "Market t h e P r e d i c t i o n of F a i l u r e . " R e s e a r c h , Autumn 1968.  4.  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" J o u r n a l o f F i n a n c e , J u n e 1966.  15.  J e n s e n , M.C.; and M e c k l i n g , W.H. "Theory of the F i r m : M a n a g e r i a l B e h a v i o r , Agency C o s t s and O w n e r s h i p Structure." J o u r n a l of F i n a n c i a l Economics, October  of  1976.  59  16.  Lev, Baruch. "On The A s s o c i a t i o n B e t w e e n O p e r a t i n g Leverage and R i s k . " J o u r n a l of F i n a n c i a l and Q u a n t i t a t i v e A n a l y s i s , S e p t e m b e r 1974.  17.  Marsh, P a u l . "The C h o i c e B e t w e e n E q u i t y a n d D e b t : An E m p i r i c a l Study." J o u r n a l o f F i n a n c e , M a r c h 1982.  18.  M i l l e r , M.H. 1977.  19.  M o d i g l i a n i , F r a n c o ; a n d M i l l e r , M e r t o n H. C a p i t a l , C o r p o r a t e F i n a n c e , and t h e Theory A m e r i c a n E c o n o m i c R e v i e w , J u n e 1958.  20.  Myers, S t e w a r t C , e d . Modern Developments i n F i n a n c i a l Management. H i l l s d a l e , I l l i n o i s : H o l t , R i n e h a r t a n d W i n s t o n , 1976.  21.  N e t e r , J o h n ; a n d Wasserman, W i l l i a m . Applied Linear S t a t i s t i c a l Models. Homewood, I l l i n o i s : R i c h a r d D. I n c . , 1974.  "Debt a n d T a x e s . "  Journal  o f F i n a n c e , May " The C o s t o f of Investment."  Irwin  22.  Remmers, L e e ; S t o n e h i l l , A r t h u r ; W r i g h t , R i c h a r d ; a n d B e e k h u i s e n , Theo. " I n d u s t r y and S i z e a s Debt R a t i o Determinants i n Manufacturing I n t e r n a t i o n a l l y . " F i n a n c i a l Management, Summer 1 9 7 4 .  23.  Schwartz, E l i ; and Aronson, J . R i c h a r d . "Some S u r r o g a t e Evidence i n Support of t h e Concept o f Optimal C a p i t a l Structure." J o u r n a l o f F i n a n c e , M a r c h 1967.  24.  S c o t t , D a v i d F., J r . " E v i d e n c e on t h e I m p o r t a n c e o f Financial Structure." F i n a n c i a l Management, Summer 1972.  25.  S c o t t , D a v i d F., J r . ; a n d M a r t i n , J o h n D. "Industry I n f l u e n c e on F i n a n c i a l S t r u c t u r e . " F i n a n c i a l Management, S p r i n g 1975.  26.  S c o t t , James H., J r . " B a n k r u p t c y , S e c u r e d D e b t , a n d Optimal C a p i t a l Structure:Reply." Journal of Finance, M a r c h 1979.  27.  S m i t h , C l i f f o r d W., J r . ; a n d W a r n e r , J e r o l d B. "On F i n a n c i a l C o n t r a c t i n g : An A n a l y s i s o f Bond C o v e n a n t s . " J o u r n a l o f F i n a n c i a l E c o n o m i c s , 7 ( 1 9 7 9 ) 117-161.  28.  S t a n d a r d and Poor's Compustat S e r v i c e s , I n c . Industrial C o m p u s t a t . New Y o r k : S t a n d a r d a n d P o o r ' s C o m p u s t a t S e r v i c e s , I n c . , 1982.  29.  S t i g l i t z , J o s e p h E. "On t h e I r r e l e v a n c e o f C o r p o r a t e F i n a n c i a l P o l i c y . " American Economic Review, December, 1974.  60  30.  Van H o m e , James C ; D i p c h a n d , c e c i l R.; a n d H a n r a h a n , J . Robert. F i n a n c i a l Management a n d P o l i c y , C a n a d i a n 4 t h e d . S c a r b o r o u g h , O n t a r i o : P r e n t i c e - H a l l o f Canada L t d . , 1977.  31.  W a r n e r , J e r o l d B. " B a n k r u p t c y J o u r n a l o f F i n a n c e , May 1977.  C o s t s : Some E v i d e n c e . "  61  APPENDIX A ~ L I S T OF COMPANIES SAMPLED  the  This appendix l i s t s sample .  t h e i n d u s t r i e s and  firms included in  F o o d and K i n d r e d P r o d u c t s : A n d e r s o n , C l a y t o n & Co.; CPC I n t e r n a t i o n a l I n c . ; C a m p b e l l Soup Co.; C o n s o l i d a t e d F o o d C o r p . ; K e l l o g Co.; N a b i s c o B r a n d s I n c . ; N o r t o n Simon I n c . ; Q u a k e r O a t s Co. T e x t i l e M i l l P r o d u c t s : B e l d i n g Heminway; B u r l i n g t o n I n d u s t r i e s I n c . ; C o l l i n s a n d A i k m a n C o r p . ; Cone M i l l s C o r p . ; Dan R i v e r I n c . ; F i e l d c r e s t M i l l s ; G r a n i t e v i l l e Co.; M. Lowenstein C o r p . ; Reeves B r o t h e r s I n c . ; R i e g e l T e x t i l e Corp.; S p r i n g s I n d u s t r i e s I n c . ; J.P. S t e v e n s I n c . ; West P o i n t - P e p p e r e l l . A p p a r e l l a n d O t h e r F i n i s h e d P r o d u c t s : BTK I n d u s t r i e s I n c . ; B l u e B e l l I n c . ; C l u e t t , P e a b o d y and Co.; H a r t , S c h a f f n e i * artd M a r x Co.; I n t e r c o I n c . ; J o n a t h a n L o g a n I n c . ; L e v i S t r a u s s & Co.; M a n h a t t a n I n d u s t r i e s I n c . ; P h i l l i p s - V a n H e u s e n ; U.S. I n d u s t r i e s ; VF C o r p . ; W a r n a c o I n c . P a p e r and A l l i e d P r o d u c t s : B o i s e C a s c a d e C o r p . ; B y ^ a t e r Corp. L t d . - A D R ; Crown Z e l l e r b a c h ; Diamond I n t e r n a t i o n a l C o r p . ; Domtar I n c . ; F e d e r a l P a p e r B o a r d Co.; F o r t Howard Pape-r; G r e a t N o r t h e r n N a k o o s a C o r p . ; H a m m e r m i l l P a p e r Co.; I n t e r n a t i o n a l P a p e r Co.; K i m b e r l y - C l a r k C o r p . ; Mead C o r p . ; P o t l a c h C o r p . ; S t . R e g i s P a p e r Co.; S c o t t P a p e r Co.; S t o n e C o n t a i n e r C o r p . ; U n i o n Camp C o r p . ; W e s t v a c o C o r p . C h e m i c a l s and A l l i e d P r o d u c t s : A l l i e d C o r p . ; American C y a n a m i d Co.; D i a m o n d Shamrock C o r p . ; Dow C h e m i c a l ; E . I . Du P o n t De Nemours; FMC C o r p . ; W.R. G r a c e & Co.; H e r c u l e s I n c . ; M o n s a n t o Co.; M o r t o n - N o r w i c h P r o d u c t s ; N a t i o n a l D i s t i l l e r s and C h e m i c a l ; O l i n C o r p . ; PPG I n d u s t r i e s I n c . ; P e n n w a l t C o r p . ; Rohm a n d Haas Co.; S t a u f f e r C h e m i c a l Co.; T h i o k o l C o r p . ; U n i o n Carbide Corp. D r u g s : A b b o t t L a b o r a t o r i e s ; A m e r i c a n Home P r o d u c t s C o r p . ; B r i s t o l - M y e r s Co.; I r o q u o i s B r a n d s L t d . ; E l i L i l l y & Co.; Merck a n d Co.; P f i z e r I n c . ; R i c h a r d s o n V i c k s I n c . ; R o r e r G r o u p ; S c h e r i n g - P l o u g h ; G.D. S e a r l e & Co.; S m i t h k l i n e Beckman C o r p . ; S q u i b b C o r p . ; S t e r l i n g D r u g I n c . ; S y n t e x C o r p . ; U p j o h n Co.; Warner-Lambert Co. P e t r o l e u m R e f i n i n g : Amerada H e s s C o r p . ; A s h l a n d O i l I n c . ; A t l a n t i c R i c h f i e l d Co.; B r i t i s h P e t r o l e u m Co. Ltd.-ADR; C i t i e s S e r v i c e Co.; C o a s t a l C o r p . ; E x x o n C o r p . ; G u l f O i l C o r p . ; I m p e r i a l O i l L t d . - C L A; K e r r McGee C o r p . ; L o u i s i a n a L a n d & E x p l o r a t i o n ; M o b i l C o r p . ; Murphy O i l C o r p . ; P h i l l i p s P e t r o l e u m Co.; Q u a k e r S t a t e O i l R e f i n i n g ; R o y a l D u t c h P e t r o l e u m - N Y GLDR 10; S h e l l O i l Co.; S t a n d a r d O i l Co. of C a l i f o r n i a ; S t a n d a r d O i l Co. o f I n d i a n a ; Sun Co. I n c . ; Tenneco I n c . ; Texaco I n c . ; Union  62  O i l Co.  of C a l i f o r n i a ; W i t c o C h e m i c a l Corp.  B l a s t F u r n a c e s - a n d S t e e l W o r k s : Armco I n c . ; A t h l o n e I n d u s t r i e s ; A x i a I n c . ; Bethlehem S t e e l Corp.; Carpenter T e c h n o l o g y ; C o l t I n d u s t r i e s I n c . ; C o p p e r w e l d C o r p . ; C r a n e Co.; I n l a n d S t e e l Co.; I n t e r l a k e I n c . ; K a i s e r S t e e l C o r p . ; K e y s t o n e C o n s t r u c t i o n I n d u s t r i e s I n c . ; LTV C o r p . ; L u k e n s I n c . ; M c L o u t h S t e e l C o r p . ; N a t i o n a l - S t a n d a r d Co.; N o r t h w e s t I n d u s t r i e s ; R e p u b l i c S t e e l C o r p . ; U.S. S t e e l Corp.; W h e e l i n g - P i t t s b u r g Steel. M e t a l w o r k i n g M a c h i n e r y and E q u i p m e n t : A c m e - C l e v e l a n d C o r p . ; B l a c k and D e c k e r M a n u f a c t u r i n g Co.; Brown and S h a r p e M a n u f a c t u r i n g Co.; C h i c a g o P n e u m a t i c T o o l Co.; C i n c i n n a t i M i l l a c r o n I n c . ; E s t e r l i n e Corp.; E x - C e l l - 0 Corp.; G i d d i n g s & L e w i s I n c . ; K e n n a m e t a l I n c . ; M o n a r c h M a c h i n e T o o l Co. G e n e r a l I n d u s t r i a l M a c h i n e r y and E q u i p m e n t : C o o p e r I n d u s t r i e s Inc.; C u r t i s s Wright Corp.; F i g g i e I n t e r n a t i o n a l I n c . ; I n g e r s o l l - R a n d Co.; M i d l a n d - R o s s C o r p . ; New H a m p s h i r e B e a r i n g s ; R e x n o r d I n c . ; S c o t t a n d F e t z e r Co.; S t a - R i t e I n d u s t r i e s ; S u n s t r a n d C o r p ; T i m k e n Co.  Ball  E l e c t r o n i c Computing Equipment: C o m p u t e r v i s i o n Corp.; C o n t r o l Data Corp.; Data G e n e r a l Corp.; D a t a p o i n t Corp.; D i g i t a l E q u i p m e n t ; E l e c t r o n i c A s s o c i a t e s I n c . ; E l e c t r o n i c M e m o r i e s and M a g n e t ; H a z e l t i n e C o r p . ; H e w l e t t - P a c k a r d Co.; H o n e y w e l l I n c . ; S t o r a g e T e c h n o l o g y C o r p . ; Wang L a b o r a t o r i e s - C L B. T r u c k i n g - L o c a l and L o n g D i s t a n c e : C o n s o l i d a t e d F r e i g h t w a y s I n c . ; L e a s e w a y T r a n s p o r t a t i o n C o r p . ; McLean T r u c k i n g Co.; National City Lines; Overnite Transportation; Purolator Inc.; Roadway E x p r e s s I n c . ; T r a n s c o n I n c . - C a l i f o r n i a ; Y e l l o w F r e i g h t System. A i r T r a n s p o r t a t i o n - C e r t i f i e d : American A i r l i n e s I n c . ; Continental A i r Lines Inc.; Delta A i r Lines Inc.; Eastern A i r L i n e s ; N o r t h w e s t A i r l i n e s I n c . ; Pan A m e r i c a n W o r l d A i r w a y s ; T i g e r I n t e r n a t i o n a l ; Trans World Corp.; United A i r L i n e s I n c . ; U.S. A i r I n c . ; Western A i r L i n e s I n c . ; World Airways I n c . R e t a i l - Department S t o r e s : A l l i e d S t o r e s ; A s s o c i a t e d Dry Goods C o r p . ; C a r t e r H a w l e y H a l e S t o r e s ; F e d e r a t e d D e p a r t m e n t S t o r e s I n c . ; R.H. Macy and Co.; M a r s h a l l F i e l d & Co.; May D e p a r t m e n t S t o r e s Co.; J.W. Mays I n c . ; M e r c a n t i l e S t o r e s Co.; J.C. Penny Co.; S e a r s , Roebuck & Co. R e t a i l - Grocery Stores: A.J. Bayless Markets Inc.; Borman's I n c . ; D i l l o n C o m p a n i e s ; G e n e r a l H o s t C o r p . ; G r e a t A t l e n t i c and P a c i f i c Tea Co.; J e w e l C o m p a n i e s I n c . ; K r o g e r Co.; L u c k y S t o r e s I n c . ; Munford I n c . ; P e t r o l a n e I n c . ; Safeway S t o r e s I n c . ; S o u t h l a n d C o r p . ; ' S t a r S u p e r m a r k e t s ; S t o p & Shop C o m p a n i e s ; Supermarkets G e n e r a l Corp.; Thorofare Markets; Winn-Dixie S t o r e s Inc.  

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