Florida State University Libraries Electronic Theses, Treatises and Dissertations The Graduate School 2009 Two Essays on Capital Structure Daniel Lawson Follow this and additional works at the FSU Digital Library. For more information, please contact lib-ir@fsu.edu FLORIDA STATE UNIVERSITY COLLEGE OF BUSINESS TWO ESSAYS ON CAPITAL STRUCTURE By DANIEL LAWSON A Dissertation submitted to the Department of Finance in partial fulfillment of the requirements for the degree of Doctor of Philosophy Degree Awarded: Summer Semester, 2009 The members of the committee approve the dissertation of Daniel T. Lawson defended on June 23, 2009. Ang Professor Directing Dissertation ___________________________________ Thomas W.
Zuehlke Outside Committee Member __________________________________ Rebel A. Cole Committee Member __________________________________ Bruce Haslem Committee Member __________________________________ Yingmei Cheng Committee Member Approved: _____________________________________ William Christiansen, Chair, Department of Finance _____________________________________ Caryn L. Beck-Dudley, Dean, College of Business The Graduate School has verified and approved the above named committee members. ii TABLE OF CONTENTS List of Tables.
iv List of Figures. THE ROLE OF OWNER IN CAPITAL STRUCTURE DECISIONS. NEGATIVE EQUITY FIRMS AND LEVERAGE.74 iii LIST OF TABLES Table 1. Descriptive statistics for determinants of capital structure.
Leverage ratios and personal risk tolerance. Wealth exposure and personal commitments. Leverage ratios on traditional capital structure and personal risk tolerance variables. Leverage ratios of unconstrained firms.
The role of collateral and personal guarantees. Collateral versus non-collateral. Negative equity firms, 1970 to 2007. Cash flow and negligible market value of NE firms.
Longevity and demise of NE firms. Survival analysis of NE firms. Cox proportional hazard model estimates for survival of NE firms. Source of funds for NE firms.
Inactive versus active firms by source of funds variables. 57 iv LIST OF FIGURES Figure 1. Percentage of NE firms. Percent of NE and PE firms with negative cash flows.
Percent of NE and PE firms with negative cash flows (out of all firms). Percent of NE and PE firms with negligible market value (<5%). Percent of NE and PE firms with negligible market value (<5%) (out of all firms). Percent of NE and PE firms with negligible market value (<10%).
Percent of NE and PE firms with negligible market value (<10%) (out of all firms). 62 v ABSTRACT The first essay examines the extent to which individual demographic characteristics influence capital structure decisions. I estimate the joint effects of traditional capital structure determinants and manager age, gender, education, business experience, sophistication, and wealth on the capital structure of single-owner corporations. By calculating the marginal contribution of personal risk tolerance, I demonstrate that owner preference contributes meaningfully to the explained variation in capital structure decisions.
The second essay examines the fate of firms that report negative book-value equity between 1970 and 2007. For the full sample of COMPUSTAT from 1970 to 2007, negative-equity firms account for 9.66% of the 246,869 firm-year observations. Upon initially reporting negative equity, these firms remain active in COMPUSTAT, on average, for an additional 6. I examine the taxonomy of these potentially insolvent firms and determine the transition probabilities.
My study also includes an examination into the steady increase in percentage of firms reporting negative equity over the time period, with less than 1% of the firms reporting negative equity in 1970 to more than 10% in 2007, yet the longevity of these firms does not diminish. I analyze sources of funds for these firms to show that distressed firms have a remarkable ability to generate substantial funds through short-term and long-term debt and through the issuance of stock, thereby postponing or avoiding costly bankruptcy. vi INTRODUCTION The first essay examines the extent to which individual demographic characteristics influence capital structure decisions. Traditional capital structure theory is an important part of finance with most of the fundamental theories originating over twenty-five years ago.
1 While there have been a large number of articles on traditional capital structure theory since this time, few fundamental changes have been proposed. An assumption that has remained persistent over time is that owner characteristics do not matter in the firm’s capital structure decision, since the theory implicitly assumes these owners have well diversified personal portfolios (Modigliani and Miller (1958)). I argue that this is not the case for many owners of firms and demonstrate that individual demographic characteristics of owners can help better explain capital structure decisions. Unlike the standard assumptions in portfolio theory, many owners of businesses do not hold a diversified portfolio.
This is particularly true for small firms wherein the owner of the firm tends to serve as manager, resulting in little or no separation of ownership from control. Take for instance, single-owner C and S corporations. While C and S corporations enjoy the benefits of limited liability, the owners of these firms commonly pledge personal as well as business assets as collateral in order to secure requisite financing, and thus the personal assets and business assets tend to be commingled—just as is the case for proprietorships and partnerships. This results in a further reduction in the personal diversification by these owners.
Since business failure can lead to financial loss or ruin at the personal level, individual owner preferences should affect the capital structure of their business. Similarly, families that have a great deal of wealth tied up in their businesses would not be considered to have a diversified portfolio. It is estimated that 80% of businesses in the United States and 95% of businesses world-wide are owned by families (Gersick, Davis, Hampton, and Lansberg (1997) and Litz (1995), respectively). These businesses include sole proprietorships, LLCs, partnerships, and C and S corporations.
The preferences and risk tolerance of these owners will play a role in their choice of capital structure. There are also many CEOs and other senior managers that have a great deal of financial wealth tied up in company stock or stock options as well as their largely 1 Some major traditional capital structure theory pieces come from Modigliani and Miller (1958 and 1963), Jensen and Meckling (1976) (agency theory), Akerlof (1970) (asymmetric information), Spence (1973) and Ross (1977) (signaling), Miller (1977) (taxes), Warner (1977) (bankruptcy costs), and Myers and Majluf (1984) and Myers (1984) (pecking-order theory). 1 undiversified human capital. Although many companies may have shareholders that are diversified, the decision makers (top management, controlling families) are not.
The choices these individuals make regarding the firm’s capital structure can have a profound impact on their own personal finances. Personal preferences and the risk tolerance of these individuals play a role in the business decision making. Utilizing data from the Federal Reserve’s 2003 Survey of Small Business Finances (SSBF), I examine the leverage ratios of C and S corporations owned entirely by one individual, taking into account both traditional capital structure determinants and personal risk tolerance. Traditional capital structure considerations include agency theory, asymmetric information, and bankruptcy/distress costs.
Extant literature in corporate finance suggests that these issues are relevant not only to large public corporations but also to privately held businesses (Mills and Schumann (1985), Hutchinson (1996), Berger and Udell (1998), Chittenden, Hall, and Hutchinson (1995), Ang, Cole, and Lin (2000), Romano, Tanewski, and Smyrnios (2000)). Extant literature on individual risk-taking behavior shows that demographic and socioeconomic factors influence individual risk tolerance, e., gender, age, wealth, income, education, personal business experience, and sophistication of the individual. That is, an individual’s ability and willingness to bear risk could be shaped by his or her personal characteristics. It is generally believed that males are more risk tolerant than females and that risk taking tends to decrease with age and increase with education level, higher levels of income, wealth, professional experience, and sophistication.
2 While many of these relationships were discovered in the psychology literature some time ago, there has been a growing body of literature in finance focusing on the relationship between individual manager characteristics and firm performance. Most relevant to this paper include studies that consider the effects of manager characteristics on corporate behavior and 2 For risk taking and gender, see Barsky et al. (1997), Jianakoplos and Bernasek (1998), Donkers, Melenberg, and van Soest (2001), Hartog, Ferrer-i-Carbonell, and Jonker (2002), Hallahan, Faff, and McKenzie (2004), and Eckel and Grossman (2008); as summarized by Borghans, Duckworth, Heckman, and Weel (2008), risk taking tends to increase sharply in adolescence (Steinberg (2004), (2007)) and then throughout adulthood tends to decrease with age (Dohmen et al. This relationship would be represented by an inverted U-shaped curve.
For risk taking and age, see Wallach and Kogan (1961), McInish (1982), Morin and Suarez (1983), Palsson (1996), Hallahan, Faff, and McKenzie (2004), Dohmen et al. (2005); for risk taking and education, see Weiss (1972), Binswanger (1980, 1981), Grable and Lytton (1999), Xiao, Alhabeeb, Hong, and Haynes (2001), Guiso and Paiella (2001), Hallahan, Faff, and McKenzie (2004), Ferrer-i-Carbonell (2005), Anderson et al. 2 performance, such as Graham and Harvey (2001), Bertrand and Schoar (2003) and Ben-David, Graham, and Harvey (2007). Graham and Harvey (2001) examine capital budgeting, cost of capital, and capital structure of firms via cross-sectional survey data on 392 chief financial officers (CFOs), 64% of which are publicly traded.
By assuming that the CFOs act as agents for the Chief Executive Officers (CEOs), Graham and Harvey (2001) examine the relation between the executive’s responses and firm characteristics, including information on CEOs such as management ownership, CEO age, and the education of the CEO (MBA to other). Among their findings, they show that CEOs holding MBA degrees tend to use more sophisticated valuation techniques, while older CEOs favor the payback period as a capital budgeting technique. Graham and Harvey (2001) find little evidence that executives are concerned about asymmetric information, transaction costs, free cash flows, or personal taxes, but do find some support for the pecking- order and trade-off capital structure theories. Bertrand and Schoar (2003) investigate whether individual managers matter by tracking top managers across different firms over time.
Manager fixed effects are found to explain a significant amount of the heterogeneity in investment, financial, and organizational practices of firms. In terms of observable managerial characteristics, Bertrand and Schoar (2003) test the effects of age and education on firm behavior and find that older groups of managers tend to be financially more conservative, while managers with an MBA degree follow more aggressive strategies. In a related paper, Chevalier and Ellison (1999) find that younger mutual fund managers who attended higher quality schools (higher SAT scores) are more risk tolerant in their investment decisions and earn higher rates of returns. A number of recent studies have focused on the overall optimism, or overconfidence, of top executives.
Goel and Thakor (2005) develop a model where agents of a priori unknown ability are being judged relative to each other to determine who wins the race for CEO. 3 They show that overconfident agents who underestimate project risk have a higher probability of being chosen CEO than otherwise identical managers. The rationale stems from the fact that 3 In a prior study, Lazear (2004) argues that while workers are promoted due to meeting or exceeding some standard, the promotion is not based solely on lasting ability, but also on transitory components that may reflect short-term luck. This results in a regression of the mean, creating a “Peter principle” (Peter and Hull (1969).
Lazear (2004) shows that although firms inflate the promotion criterion to offset the regression bias, the effect is never eliminated. Faria (2000) and Fairburn and Malcolmson (2001) explain the “Peter principle” as a byproduct of using promotion to solve a moral hazard problem, where firms choose promotion because workers must live with the consequences of their decision. 3 promotion of managers in firms tends to be tied to past performance, which is correlated to the risk taken by these agents.