Understanding the Roles of the Market-to-Book Ratio and Profitability in Corporate Financing Decisions

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1 Understanding the Roles of the Market-to-Book Ratio and Profitability in Corporate Financing Decisions Long Chen Department of Finance Michigan State University (517) Xinlei Zhao Department of Finance Kent State University (330) First version: April, 2003 This version: February, 2004 Abstract It is well documented that the market-to-book ratio and profitability are two key capital structure determinants. However, because the related empirical evidence can be explained by both the tradeoff theory and the costly external financing theory (which includes both the pecking order theory and the market timing hypothesis), a large controversy remains in the finance literature regarding the economic interpretation of these variables. This study focuses on scenarios where the two theories have drastically different or even opposite predictions about these variables. In each case, we find strong evidence in support of the costly external financing theory but inconsistent with the tradeoff theory. We conclude that firms with higher marketto-book ratios are more likely to issue equity not because they intend to downwardly adjust their target leverage ratios, but because they face lower external financing costs. Similarly, firms with higher profitability are more likely to issue debt, not because they intend to move toward their target leverage ratios, but because they face lower debt financing costs. These conclusions remain firm with extensive robustness checks, alternative variable measures, and different sample choices. JEL Classification: G32 Key Words: Capital structure, tradeoff theory, pecking order theory, market timing hypothesis, market-to-book ratio, profit, external financing costs, bankruptcy risk. We are grateful to Raj Aggarwal, Laurence Booth, Murillo Campello, Charles Headlock, Murray Frank, Jun-Koo Kang, Naveen Khanna, Kai Li, John Thornton, Sheridan Titman, Ivo Welch, and seminar participants at Michigan State University for their very helpful comments. We are responsible for all remaining errors.

2 1 Introduction The market-to-book ratio and profitability assume prominent roles in corporate financing decisions. It is well known that firms with higher market-to-book ratios or profitability have lower leverage ratios. When resorting to external financing, those with higher market-to-book ratios are more likely to issue equity, while those with higher profitability are more likely to issue debt. Despite general agreement on these empirical regularities, the literature has witnessed an increasingly heated debate on the economic interpretations of these two factors. This controversy arises because these patterns can be alternatively explained by two competing schools of thought in the capital structure literature. The first school, namely the tradeoff theory, states that firms choose the optimal capital structure by balancing the tax and incentive benefits of debt financing and expected bankruptcy costs. 1 According to this theory, firms with higher market-to-book ratios also have higher growth opportunities (e.g., Hovakimian, Opler, and Titman (2001)), and they intend to keep lower current target leverage ratios in order to mitigate the underinvestment problem when future opportunities arise (Myers (1977)). They are thus more likely to issue equity when they realize new investment opportunities and downwardly adjust their target leverage ratios. In addition, due to transaction costs (Fischer, Heinkel, and Zechner (1989)), firms with higher profitability will passively accumulate internal funds and are, on average, under-levered, which explains the negative relationship between profitability and leverage ratios. When they resort to external financing, they are more likely to issue debt in an effort to move toward their target ratios (Hovakimian et al. (2001)). As a result, profitability cannot explain the post-financing leverage ratio because the passive role of profitability has been corrected (Hovakimian, Hovakimian, and Tehranian (2003)). The second school, which we call the costly external financing theory, consists of the pecking order theory and the market timing hypothesis. The pecking order theory assumes that, because of asymmetric information, external financing costs are higher than internal financing costs and the relative costs are a major factor affecting corporate financing decisions. 2 The market timing phenomenon can arise either due to a dynamic version of the pecking order theory, where adverse 1 The tradeoff includes, among others, tax benefits versus bankruptcy costs (Modigliani and Miller (1963)), agency costs of debt and equity financing (Jensen and Meckling (1976), Myers (1977), Stulz (1990), Hart and Moore (1995), and Zwiebel (1996)), and signaling models (Ross (1977)). 2 In a strict version of the theory (Myers (1984) and Myers and Mujluf (1984)), it is assumed that the costs of external financing are higher than those of internal financing, and the costs of equity financing are higher than those of debt financing. These costs are so high that they outweigh other considerations. As a result, we observe a pecking order preference of internal funds, debt, and equity financing. In a dynamic version of the theory, Lucas and McDonald (1990) show that managers have private information on firm value, and can issue equity when stock price rises to or above the true value. 1

3 selection costs vary through time and across firms, or due to the possible existence of mis-pricing that changes the costs of equity financing and breaks the pecking order (Baker and Wurgler (2002)). The common feature of the pecking order theory and the market timing hypothesis is their emphasis on the role of external financing costs in capital structure decisions. 3 The market-to-book ratio and profitability have been major sources from which the costly external financing theory draws inspiration to interpret capital structure decisions. According to this theory, firms with higher market-to-book ratios are more likely to issue equity because a higher market-to-book ratio signals a lower cost of external equity financing. 4 This view of market-to-book ratio has been the main basis for a formal argument of the market timing hypothesis (Baker and Wurgler (2002)). Welch (2004) shows that the driving force of leverage ratios is market valuation of equity. Firms do not put countermeasures into effect to offset changes in these leverage ratios that stem from variations in market valuations. In fact, when resorting to external financing, firms with more favorable equity market valuations are more likely to issue equity, thus further deviating away from their original leverage ratios. This evidence is consistent with the notion that firms care more about external financing costs than their target leverage ratios. In addition, firms with higher profitability consciously (instead of passively) prefer internal to external funds to avoid the external financing costs, leading to a negative relationship between profitability and the leverage ratio. The significant role of profitability has been argued as the strongest evidence in support of the costly external financing theory (Fama and French (2002)). Therefore, a proper understanding of the roles of the market-to-book ratio and profitability is not only important for its own sake, but also critical for assessing the validity of the two major competing theories. Unfortunately, because the relevant empirical patterns can be simultaneously explained by the two schools of thought, current literature is more successful in establishing the prominence of these variables than in explaining why they are important. In many of the related studies, we can substitute the proposed explanation regarding the two variables with the opposing theory and reach an entirely different conclusion. 5 3 Throughout the paper, the term external financing costs refers to the fact that the costs of raising funds externally are different from (usually higher than) the costs of internal funds. This difference could be due to the adverse selection costs and it can be changed if there is market mis-pricing. 4 In particular, Myers and Mujluf (1984) point out that firms are more likely to issue equity when the external financing costs fall. Choe, Masulis, and Nanda (1993) argue that the pro-cyclical equity issue can be explained by the counter-cyclical external financing costs. Bayless and Chaplinsky (1996) document that during periods of higher equity issuance the magnitude of costs due to asymmetric information is lower. Korajczyk and Levy (2003) show that financially constrained firms exhibit dramatically different patterns of capital structure choice from financially unconstrained firms, where the source of this difference, according to the imperfect capital market theory, is the asymmetric information. 5 For example, Hovakimian et al. (2003) study dual issue versus pure equity issue. They argue that, because both groups can issue equity, the market timing ability is controlled, and whatever role is left for the market-to-book ratio 2

4 We confront this challenge by studying scenarios where the two theories present drastically different or even opposite predictions regarding these two variables. This approach provides the opportunity to identify the true reasons behind the two variables. It also directly echoes Harris and Raviv s (1991) argument that advocates designing tests to study capital structure determinants under different circumstances. 6 Specifically, we focus on the following three scenarios: (1) The tradeoff theory predicts that the market-to-book ratio only matters for firms with medium bankruptcy risks and close-to-target leverage ratios (see text for a formal argument). Similarly, the tradeoff theory predicts that profitability is only important for low bankruptcy risk, under-levered firms, and is unimportant for others. In contrast, the costly external financing theory does not emphasize the role of target leverage ratio, and thus predicts equal importance of the two variables for all types of firms. (2) The tradeoff theory predicts that firms with higher market-to-book ratios will never issue additional debt on a net basis, because it does not help to reduce the target ratios. On the contrary, if a higher market-to-book ratio signals lower external financing costs for both equity and debt, then the costly external financing theory predicts that firms with higher market-to-book ratios are not only more likely to issue equity, but also debt, or both. (3) The tradeoff theory argues that the market-to-book ratio matters because it represents new growth opportunities. The role of the market-to-book ratio should therefore diminish after controlling for these growth opportunities. By contrast, the costly external financing theory does not necessarily emphasize growth opportunities, and thus predicts that the impact of the marketto-book ratio persists even after controlling for growth opportunities. In every scenario, we find consistent and strong evidence that the roles of the market-to-book ratio and profitability favor the costly external financing theory, but are incompatible with the tradeoff theory. In particular, firms with higher market-to-book ratios are significantly more likely to access the external markets, including issuing equity only, debt only, or both. This pattern holds regardless of the firms positions relative to the target leverage ratios, and even after controlling for the growth opportunity variables. It is only when comparing equity to debt, that firms with higher market-to-book ratios are more likely to issue equity. However, this preference for equity must represent the growth opportunity, as predicted by the tradeoff theory. However, if we alternatively assume that firms issuing equity have different abilities to time the market, then the role of market-to-book ratio will represent this differential ability, and a different conclusion will be reached. 6 Harris and Raviv (1991) comment that empirical studies have identified a large number of potential determinants of capital structure. The empirical work so far has not, however, sorted out which of these are important in various contexts...with regard to further empirical work, it seems essential that empirical studies concentrate on testing particular models or classes of models in an attempt to discover the most important determinants of capital structure in given environments. 3

5 is unlikely to be driven by growth opportunities. This is because, when growth opportunities are measured by variables other than the market-to-book ratio, we find a stronger reliance on debt (rather than equity) financing for firms with high growth opportunities. These results suggest that firms with higher growth opportunities make financing decisions based mainly on the relative costs of debt versus equity issues. Firms with higher market-to-book ratios are more likely to issue equity simply because a higher market-to-book ratio signals relatively lower equity financing costs. There is no evidence indicating that firms intend to downwardly adjust their target ratios following better growth opportunities, as proposed by the tradeoff theory. Similarly, we find two pieces of evidence that clearly contradict the prediction by the tradeoff theory regarding the role of profitability. First, firms with higher profitability are more likely to issue debt regardless of whether or not they are under-levered. Second, the group predicted by the tradeoff theory to exhibit the strongest influence from profitability (i.e., low bankruptcy risk, under-levered firms) is usually much less active in issuing debt than other groups do. Therefore, the role of profitability seems to be more related to the external financing costs of debt than to the move-toward-the-target argument. All main conclusions in this paper hold steadily after extensive robustness tests, alternative variable measures, and different sample choices. 7 This paper thus contributes to the literature by providing fresh insights into the roles of the market-to-book ratio and profitability. Without a clear understanding of these variables, doubts may be cast on some recent interpretations of capital structure (e.g., the market timing hypothesis by Baker and Wurgler (2002), and firms lack of countermeasures by Welch (2004)), because it seems that the related empirical regularities can also be well explained by the tradeoff theory. Our work demonstrates that, to a large extent, the roles of the market-to-book ratio and profitability go far beyond the interpretation of the tradeoff theory, thus rendering support to the costly external financing theory. The rest of the paper proceeds as follows. Section 2 discusses theoretical predictions, on the basis of which testable hypotheses are formed. characteristics. Section 3 describes the data and analyzes firm Sections 4 and 5 provide univariate and regression-based analysis, respectively. Second 6 discusses robustness checks, and a brief conclusion is provided in Section 7. 7 One possible concern is that the target ratios are estimated with noise. We believe this cannot affect our conclusions in a significant way for the following reasons. First, we use eight alternative target ratio measures, all of which lead to the same conclusions. Second, our analysis indicates that over-levered firms are riskier and are significantly more likely to issue equity and retire debt than under-levered firms do. Thus it is hard to argue that all firms are content with their current leverage ratios. Yet, the conclusions in this paper are robust across different groups of firms. 4

6 2 Theoretical predictions and structure of the paper The roles of the market-to-book ratio and profitability can be explained by both schools of thought. Unless we study scenarios where the two theories have different predictions about these variables, there seems to be little hope of identifying which theory is more relevant. In this section, we discuss three experiments that might separate the predictions from the two theories, in an effort to shed light on the roles of the two variables. Partitioning firms according to their bankruptcy risks The tradeoff theory argues that firms with higher market-to-book ratios are more likely to issue equity because they realize new growth opportunities and thus issue equity to downwardly adjust the target leverage ratios. Such an argument only applies to firms with leverage ratios reasonably close to their targets. Specifically, imagine a high bankruptcy risk and over-levered firm issuing equity. Two alternative interpretations may be offered: (1) the firm wants to raise funds and reduce the leverage ratio (toward the target), and (2) the firm downwardly adjusts the target leverage ratio due to new opportunities. Given that the firm has a high bankruptcy risk and is over-levered, the former explanation is probably more reasonable than the latter. 8 Similarly, imagine a low bankruptcy risk and under-levered firm issuing equity. Since the firm is already under-levered, if the target leverage ratio falls due to the new investment opportunity, the firm should do nothing (instead of issuing equity) and let the target ratio fall naturally to the current leverage ratio. Hence, if the tradeoff theory is pertinent, we should find that the market-to-book ratio is critical only for firms around the target, but not vital for firms away from the target. On the other hand, the costly external financing theory argues that firms with higher marketto-book ratios enjoy more favorable external equity financing costs, which holds regardless of the target ratios. This theory thus predicts that firms with higher market-to-book ratios are more likely to issue equities across all groups of firms regardless of their deviation from the target ratios. Similar logic applies to the role of profitability. According to the tradeoff theory, firms with higher profitability are on average under-levered (Hovakimian et al. (2001)), and thus issue debt to move toward their target ratios (Hovakimian et al. (2003)). If this argument is true, then we should expect profitability to be important only for under-levered firms, and not significant for other groups (especially those high bankruptcy risk and over-levered firms). In contrast, the costly external financing theory believes that firms with higher profitability are more likely to issue debt 8 If the over-levered firm issues equity to reduce the target leverage ratio instead of moving toward the target, then the firm remains over-levered after the equity issue, which contradicts the prediction by the tradeoff theory. 5

7 probably because the costs of debt financing are relatively cheaper (compared to equity). Therefore, this theory expects the role of profitability to be important for all groups of firms, regardless of their deviation from the targets. The above discussion implies that if we separate firms into groups according to bankruptcy risks (deviation from the targets), the two theories will have drastically different predictions across these groups regarding the roles of the two variables. 9 Investigating equity as well as debt issues The tradeoff theory argues that firms with higher market-to-book ratios issue equity because they have better growth opportunities and want to retain the flexibility by downwardly adjusting the target ratios. It thus follows from the tradeoff theory that firms with higher market-to-book ratios will never issue debt on a net basis, because net debt issuance would raise the leverage ratios, which is contradictory to the target-ratio-adjustment argument. In contrast, if higher market-to-book ratios signal lower external financing costs for both debt and equity, then the costly external financing theory predicts that firms with higher marketto-book ratios are more likely to issue not only equity, but also debt, on a net basis. Therefore, the two schools of thought have opposite predictions in the case of debt issue. Hypotheses related to growth opportunities The tradeoff theory argues that a firm with a higher market-to-book ratio realizes new investment opportunities and issues equity on a net basis to downwardly adjust the target ratio. On the other hand, the costly external financing cost theory argues that a firm with a higher market-to-book ratio is more likely to issue equity because it faces relatively lower costs of external equity financing. These lower costs could be due to lower adverse selection costs, or market mis-valuation that is not part of the future growth opportunities (Baker and Wurgler (2002)). The above discussion leads to the following testable hypotheses: If the growth opportunities are the only reason why firms with higher market-to-book ratios issue equity, as argued by the tradeoff theory, the market-to-book ratio should be of minimal importance for firms with poor growth opportunities. In addition, the impact of the marketto-book ratio should diminish after controlling for growth opportunities. In contrast, the costly external financing theory argues that firms choose to issue equity because of more favorable equity financing. Thus the effect of the market-to-book ratio will persist even for firms with poor growth opportunities and even after controlling for growth opportunities. 9 As we shall see shortly, sorting firm according to bankruptcy risk is very similar to sorting them according to the deviation from the target ratio. We do not sort firms by the deviation from the target ratio directly because we do not want to rely too much on the accuracy of the estimation of the target ratios. 6

8 The costly external financing theory predicts that firms with higher growth opportunities (when measured by variables other than the market-to-book ratio) could either be indifferent between debt and equity financing, or even prefer the former to the latter. This is because higher growth opportunities are not necessarily linked to lower equity financing costs. The tradeoff theory, on the other hand, predicts that firms with higher growth opportunities always prefer equity to debt because it lowers the target leverage ratios. In summary, we have discussed a list of testable hypotheses, some of which are summarized in Table 1. In each case, the two theories put forward very different predictions regarding the effects of the market-to-book ratio and profitability on financing decisions. The rest of this paper will explore the roles of the two variables along these lines. We restrain from drawing conclusions until we reach a consensus from all tests. 3 The sample and firm characteristics 3.1 The sample Definitions of all variables are provided in Appendix A. We use Z-score, a measure developed by Altman (1968), to gauge a firm s bankruptcy probability. 10 This is arguably the most popular measure used in the capital structure literature (e.g., Mackie-Mason (1990), Graham (1996), and Frank and Goyal (2003 B)) to capture the probability of financial distress. represents a lower bankruptcy probability. A higher Z-score The financial accounting data are from COMPUSTAT s P/S/T and Research annual industrial tapes from 1971 to All dollar values are converted into 1983 constant dollars. Following the tradition in the capital structure literature, we delete financial firms ( ), firms involved in major mergers (COMPUSTAT footnote code AB), and firms that reported format code 4, 5, or 6. The equity return data are from the Center for Research in Security Prices (CRSP) where we require that firms have two years return data available. We also require the availability of data on long-term debt issuance or reduction (Items 111 or 114), and purchase or sales of stocks (Items 115 or 108). We delete observations with equity repurchases and pure debt reductions, for reasons we will explain later. We are left with 90,264 observations after this step. The requirement of additional variables in the estimation of firm target ratios, and grouping of firms based on lagged 10 Using multiple discriminant analysis, Altman (1968) shows that a combination of factors such as liquidity (working capital / assets), cumulative profitability (retained earnings / assets), productivity (earnings before interest and tax / assets), capital-turnover ratio (sales / assets), and leverage ratio (market value of equity / book value of debt) can predict more than 90% of corporate failures. A linear combination of these variables is used to create Z-score. 11 The flow of fund data are available in COMPUSTAT from

9 Z-scores further cut the sample to 53,944 observations during the period of Firm characteristics We separate firm-years into quintiles according to Z-scores. General firm characteristics are summarized in Panel A of Table 2 with the following patterns. By construction, Z-score increases monotonically from Group 1 to 5, indicating a decreasing bankruptcy risk. The grouping is unlikely to be subject to industry bias because the industry adjusted Z-score, defined as the Z-score adjusted for its industry-year median, follows the same pattern. Higher bankruptcy risk firms have lower sales growth (as a measure of growth opportunity), lower profitability, and higher net operating losses carryforward. They are accordingly penalized in the financial markets as suggested by their lower equity returns. Consistent with the notion that higher bankruptcy risk firms also have lower growth opportunities, these firms also have lower market-to-book ratios. Lower advertising expenses and higher tangibility further suggest that Group 1 firms are mainly from the mature industries. One important factor of the costly external financing theory is the availability of internal funds. Panel B of Table 2 provides evidence addressing this issue. Interest coverage ratio monotonically increases, from 1.56 in Group 1 to in Group 5, which implies that, relatively speaking, firms with higher bankruptcy probability need greater amounts of additional funds for debt services. A monotonically growing trend of cash holding can also be seen from Group 1 to 5. Therefore, firms with higher bankruptcy probability not only need more additional funds, but also have more restricted sources of internal funds. Naturally, we expect firms in higher demand for additional funds to be forced to make tighter decisions on their uses of funds. Indeed, capital expenditure monotonically increases from % in Group 1 to 15.08% in Group Inventory also exhibits a rising trend from Group 1 to 3. Despite these tighter expenditure decisions, higher bankruptcy risk firms face higher financial deficits, which summarizes the gap between internal funds generated from operation and investment activities (excluding cash) and the amount needed to finance capital expenditure, dividend payout, and other business activities (e.g., Frank and Goyal (2003 A)). Financial deficit decreases from Group 1 (3.31%) to Group 5 (0.04%). 12 We delete observations whose accounting variables used in this study have missing codes (0.001 to 0.009). We exclude outliers whose Z-scores are three standard deviations away from the mean. The right cut-off point for the market-to-book ratio is three standard deviations away from the mean, and the left cut-off point for the variable is zero. The cut-off points for intangible assets, collaterals, and the leverage measures are zero at the left and one at the right. 13 We use the industry-adjusted capital expenditure in order to control for the difference in capital expenditure behavior across different industries. 8

10 Finally, we present leverage ratio characteristics. To ensure robustness, we use four measures of leverage ratio: total debt over market value of asset (TDM), long-term debt over market value of asset (LDM), total debt over book value of asset (TDA), and long-term debt over book value of asset (LDA). In addition, central to the tradeoff theory is the target leverage ratio. We use two relevant measures. The first estimate of the target ratio is the annual industry median leverage ratio. The second measure, similar to Hovakimian et al. (2001), is the fitted value of the following regression: T LEV it = X it 1 β + ε it, (1) where T LEV it is the target leverage ratio, β is the vector of coefficients, and X it 1 is a vector of the capital structure determinants. Because of their familiarity in the literature, we report the estimation results for the target ratio in Appendix B and Table A-1. The estimated coefficients are then used to calculate the fitted target ratio for each firm-year. We are now in a position to investigate the leverage patterns of firms partitioned by their bankruptcy probability. In Panel C of Table 2, under all four leverage ratios and two target ratio measures, there is a monotonically decreasing (increasing) trend in leverage (deviation from the target) from Group 1 to 5. In particular, Groups 1 and 2 seem to be clearly over-levered, and Groups 4 and 5 appear to be under-levered. Note that Group 5 firms, which include the top 20% of all firms, have extremely low leverage ratios (less than 5%), in spite of the fact that they are very profitable. Hence, it seems safe to conclude that these firms are under-levered even though estimation errors may exist. large sample size. These numbers are all significant at the 1 percent level, due to the What we have established from the firm characteristic analysis can be summarized as follows. First, firms with higher bankruptcy probability are riskier in the following sense. They have lower sales growth and profitability, suffer operational losses, and are penalized in the equity market. Second, as the bankruptcy risk increases, firms needs for external funds also rise. Firms with higher bankruptcy risks have, on average, lower interest coverage ratios and cash holding, and higher financial deficits. They seem to be forced to have lower inventory and capital expenditure. Third, our grouping of firms along the dimension of the bankruptcy risk appears to be perfectly in harmony with grouping based on the deviation from the target. High bankruptcy probability firms seem to be over-levered and low bankruptcy probability firms appear to be under-levered. These leverage characteristics across the Z-score groups are robust under alternative leverage ratio measures. Across these Z-score groups, the tradeoff theory and the costly external financing theory have drastically different predictions with regard to the importance of the market-to-book ratio 9

11 and profitability in corporate financing decisions, the subject on which we shall now focus. 4 Univariate results 4.1 Financing types Following Hovakimian et al. (2001) and Korajczyk and Levy (2002), an equity issue is identified if a firm s net equity issue (Item Item 105) divided by the book value of asset exceeds 5%. 14 Debt issue (reduction) is similarly defined by tracking the proportional change of total debt (Item Item 114). 15 We identify 5 types of financing decisions related to capital structure changes: Type 1: Issue both equity and debt within the same year Type 2: Issue debt only Type 3: Issue equity only Type 4: Do nothing Type 5: Issue equity and reduce debt An explanation is needed for Type 4, do nothing, which is usually ignored by earlier studies. The tradeoff theory predicts that if firms are over-levered (under-levered), they will make efforts to cut (increase) leverage. In contrast, the costly external financing theory argues that, regardless of current leverage, firms with more internal cash flows are more likely to avoid the external markets and do nothing, and the propensity to do nothing declines with the external financing costs. Therefore, investigation of those firms doing nothing also sheds light on the capital structure theories Univariate analysis The role of the market-to-book ratio Motivated by the theoretical predictions, we separate firms into 25 groups according to their bankruptcy risks and market-to-book ratios (5 by 5), and study their capital structure decisions. The results, reported in Table 3, reveal the following interesting patterns: 14 For robustness, we also changed the selection standard to 3% (instead of 5%). The main results in this paper are very persistent. 15 Both aforementioned studies find that these issue classifications are comparable to using the SDC new issue dataset when data are available. 16 In addition, we exclude firm-year observations involving stock repurchases because repurchases may be driven by concerns other than capital structure considerations (e.g. corporate control, reservation for stock option conversions, etc.). We also exclude observations with pure debt reduction because these do not seem to be directly related to the market-to-book ratio and profit, the key subject in this study. 10

12 First, the tradeoff theory predicts that the role of the market-to-book ratio will be material for the equity issuance decisions for firms with medium bankruptcy risks and around-the-target leverage ratios, but weak for other groups. In contrast, we find that the market-to-book ratio is important for all groups of firms. For example, Panel E includes the top 20% firms that have the lowest bankruptcy risks and are clearly under-levered (with raw leverage ratio less than 5%). If these firms realize new investment opportunities, they should let the target ratio naturally fall to the current leverage ratio instead of issuing new equities because they are under-levered. Nevertheless, Panel E exhibits a strong increasing trend of pure equity issue as the market-to-book ratio grows: from 1.29% for the first market-to-book ratio quintile, to 18.26% for the fifth market-to-book ratio quintile. This rising trend is monotonic among the groups in Panel E, and the differences, according to the proportion tests, are significant at the 5 percent level. Similarly, for firms with the highest bankruptcy risks (Panel A), the propensity to issue equity also increases with the market-to-book ratio. It is difficult to reconcile this pattern with the growth opportunity argument by the tradeoff theory because Panel A includes firms with poor growth opportunities, as suggested in Table 2, and this argument predicts that the market-to-book ratio should be of minimal importance to these firms. Furthermore, as we have argued in Section 2, it is awkward to apply the target-ratio-adjustment scenario to these over-levered firms. The pattern of equity issuance is the same for all five panels, regardless of the bankruptcy risk (deviation from the target), and the patterns seem to be even stronger for firms with low or high bankruptcy risks than those with medium bankruptcy risks. In addition, the same pattern across different market-to-book ratio groups also holds for equity issue/debt reduction types, except that the pattern gets stronger when the bankruptcy risk increases. These observations are not consistent with predictions from the tradeoff theory as outlined in Table 1. Therefore, in a test where we can separate the predictions from the tradeoff theory and the costly external financing theory, we find strong support for the latter, but not the former. Second, the tradeoff theory argues that firms with higher market-to-book ratios shall not issue debt on a net basis, because debt issuance raises (instead of reduces) the leverage ratios. In contrast, Table 3 shows that the propensity to issue debt generally increases with the market-to-book ratio. For example, Panel B demonstrates that percent of firms within the first market-to-book ratio quintile participate in debt financing, and this number increases to percent for the fifth market-to-book ratio quintile. The same pattern can be seen for other panels and for dual issues. Therefore, it appears that as the market-to-book ratio increases, firms are not only more likely to issue equity only, but also debt only, or both. The statistical significance of these trends is 11

13 confirmed by the proportion tests as shown in the last two columns of the table. While the patterns clearly violate the tradeoff theory, they seem to suggest that the market-to-book ratio is a proxy for the external financing costs of both debt and equity. Hence, in a test where the tradeoff theory and the costly external financing theory have opposite predictions, the latter clearly prevails. 17 To summarize, with respect to the role of the market-to-book ratio, the tradeoff theory and the costly external financing theory carry drastically different predictions about firms with different combinations of bankruptcy risks and the market-to-book ratios. In all cases we find strong evidence in favor of the costly external financing theory but not the tradeoff theory Alternative measures of growth opportunities We have three sets of hypotheses that are related to the use of alternative growth opportunity proxies. First, the tradeoff theory predicts that the market-to-book ratio and equity financing is weak for firms with poor growth opportunities. The costly external financing theory predicts a strong role of the market-to-book ratio even for these firms. Second, the tradeoff theory predicts that, after controlling for growth opportunities, the relationship between the market-to-book ratio and equity financing will diminish. The costly external financing theory, on the other hand, predicts a persistent relationship even after controlling for growth opportunities. Third, the costly external financing theory predicts that if higher growth opportunities are not fully captured by higher market-to-book ratios, firms with higher growth opportunities but relatively lower market-to-book ratios may not necessarily resort to external equity financing; they may even prefer debt financing. By contrast, the tradeoff theory predicts that firms with higher growth opportunities will always prefer equity to debt. In this subsection we test these hypotheses using two alternative measures of growth opportunities: the sales growth rate and the capital expenditure. 18 The results are reported in Table 4. In Panel A of Table 4, we first use the sales growth rate to represent growth opportunities, and partition observations into quintiles along this dimension. We observe patterns compatible 17 Almazan, Suarez, and Titman (2003) develop a model where firms might prefer to attain conservative leverage ratios to avoid the possible negative effect that external scrutiny levies on them. Following this logic, it can be argued that firms with higher market-to-book ratio are already positively identified by the market, and thus are more willing to raise the target leverage ratios. This thus has the potential to explain why firms with moderate leverage ratios but relatively higher (lower) market-to-book ratios are more (less) likely to issue debt only, whereas the traditional tradeoff theory predicts that firms with higher market-to-book ratios will never issue debt on a net basis. However, this external scrutiny story can not explain the consistent debt financing pattern across all groups of firms, regardless of whether or not they are under-levered. 18 We choose not to use R&D as the measure of growth opportunities because the use of this variable would sharply reduce our sample size as a result of the limited data availability. Omission of this variable may cause specific problems for high-tech industries that are R&D heavy. We address this problem by excluding the high-tech industries in the robustness check section. 12

14 with the costly external financing theory. In particular, even for firms with relatively poor growth opportunities (Panel A1), a strong mounting trend of equity financing is evident with the rise in the market-to-book ratio. In addition, across all sub-panels and after controlling for the growth opportunity variable, firms with higher market-to-book ratios are in general significantly more likely to raise not only equity, but also debt, or make dual issues. Furthermore, firms with higher sales growth rates exhibit stronger reliance on pure debt issues. From Panel A1 to A5 and within the same market-to-book ratio quintile, there is a clear trend of increasing reliance on pure debt financing. In comparison, we do not observe the same smooth trend of equity financing when we move within the same market-to-book ratio quintile from Panel A1 to A5. 19 These patterns are consistent with the notion that, when accessing the external market, firms with higher growth opportunities choose the type of financing that is relatively cheaper instead of simply issuing equity to lower the target ratio. It can be argued that the current sales growth is a result of past (instead of future) investment opportunities and the firms have made necessary adjustments in their capital structure in the past. To mitigate this concern, we replace the sales growth with the industry-adjusted capital expenditure as the proxy for future growth opportunities. The rationale is that capital investments provide the platform for growth in the future. The result is reported in Panel B of Table 4. We observe exactly the same patterns as in Panel A. Therefore, in each of the three sets of hypotheses related to growth opportunities, we find evidence that clearly favors the costly external financing theory but that is inconsistent with the target-ratio-adjustment argument put forward by the tradeoff theory The role of profitability The tradeoff theory argues that firms with higher profitability are, on average, under-levered, and tend to issue new debt to move toward the target (Hovakimian et al. (2001), Hovakimian et al. (2003)). It follows from this argument that profitability should matter only for under-levered firms, but not for other groups. The costly external financing theory, on the other hand, does not base its interpretation on the deviation from the target, and thus predicts equal effectiveness of this variable across different groups. We directly test this pair of hypotheses in Table 5, where firms are sorted by their bankruptcy risks and profitability. Two patterns emerge. First, firms with higher profitability are always more 19 For example, for firms with the highest market-to-book ratios, 22.72% of those with the lowest growth opportunities (Panel A1) are engaged in pure equity financing. The same number drops to 3.88% in Panel A2 and 4.09% in Panel A3. The number climbs to 18.08% in Panel A5. 13

15 likely to issue debt, and this pattern is robust across all panels. This finding is not in harmony with the tradeoff theory, because issuing pure debt will push high bankruptcy risk and over-levered firms further away from the target. Second, a comparison across panels reveals that under-levered firms (in Panel E) do not appear to have a higher propensity to issue debt than other firms do. For example, among firms with the highest profitability, 16.71% of those with the lowest bankruptcy risks (in Panel E) issue pure debt. This number monotonically increases to 40.43% for those with the highest bankruptcy risks (in Panel A). In other words, a combination of the following two patterns contradicts the predictions of the tradeoff theory: (a) profitability is important for all groups; and (b) the group predicted by the tradeoff theory to exhibit the strongest influence from profitability is least active in issuing debt. Therefore, movement towards the target does not seem to be the main reason why high profitability firms issue debt. Overall, the robust role of profitability across all five groups indicates that profitability matters not because firms intend to move toward their leverage targets; instead it seems that higher profitability is in general related to lower debt financing costs. In summary, we use univariate analysis to test a list of hypotheses where the tradeoff theory and the costly external financing theory have different theoretical predictions regarding the roles of the market-to-book ratio and profitability in capital structure decisions. In every scenario, we find clear evidence in favor of the costly external financing theory but not the tradeoff theory. Specifically, it seems that firms with higher market-to-book ratios face lower external financing costs. As a result, they are more likely to access the external markets, including equity, debt, or dual issues. These patterns hold even after controlling for growth opportunity variables. In addition, although firms with higher market-to-book ratios prefer equity to debt, when growth opportunities are proxied by variables other than the market-to-book ratio, firms with higher growth opportunities exhibit a stronger reliance on debt than equity financing. This implies that firms choose the types of external financing depending on their relative costs instead of on the basis of target ratio adjustment. Firms with higher market-to-book ratios are more likely to issue equity simply because they face relatively cheaper costs of equity financing. Furthermore, firms with higher profitability are more likely to issue debt, not because they are under-levered and intend to move toward the targets, but probably because of the relatively lower debt financing costs they face. We shall now address regression-based analysis to see whether these patterns hold after controlling for other capital structure determinants. 14

16 5 Regression-based analysis 5.1 Multinomial logit regressions We first conduct a multinomial logit regression involving all 5 financing types. In particular, we use Type 4 (doing nothing) as the base case, and assume that financing decisions can be described as e β k (Levit Lev it 1)+X i,t 1 γ k P ik = 1 + (2) k=1,2,3,5 eβ k (Levit Lev it 1)+X i,t 1 γ k where P ik represents the probability of the ith firm-year falling into the kth financing type. Levit Lev it 1 measures the deviation from target, and X t 1 are the other lagged explanatory variables. Besides a list of general independent variables, we create five group-specific variables for the marketto-book ratio and profitability. In particular, we first separate firms into quintiles according to their bankruptcy risks. For the market-to-book ratio and profitability respectively, we create five dummy variables that are equal to the variable (either the market-to-book ratio or profitability) times a dummy that is equal to one if the firm is within a particular bankruptcy risk group, and zero otherwise. The intuition of this model specification is to allow the same variables to have different impact on firms from different Z-score groups, in an effort to investigate their consistency with the theoretical predictions in Table 1. The coefficients are estimated via the maximum likelihood method, and are reported in Table 6 (coefficient estimates are reported in the first row and standard errors are reported in parentheses in the second row). 20 We will discuss the variables in turn. General variables Compared to firms doing nothing, firms with higher deviations from the target (meaning relatively less levered) are more likely to issue pure debt, pure equity, or both, and are less likely to conduct equity issue and reduce debt at the same time. The patterns for pure debt issue and equity issue/debt reduction are consistent with the tradeoff theory, whereas the pattern for pure equity issue contradicts the theory s predictions. The inconsistent role of the deviation from the target is contradictory to Hovakimian et al. (2001), but compatible with Hovakimian (2003). Firms with higher stock returns in the past two years are significantly more likely to resort to equity financing, including pure equity issue, dual issue, and equity issue/debt reduction. In addition, smaller firms seem to be more likely to change their leverage ratios actively, and firms that resort to external markets tend to have higher financial deficits. Finally, firms are more likely to both issue and retire debt when the T-bill rates are significantly lower, and issue pure equity or 20 The regression results are very robust to alternative leverage ratio measures. Because of space limitation, Table 6 only reports the results using TDM and the fitted target ratio. 15

17 conduct dual issues when the T-bill rates are significantly higher. Because of the counter-cyclical monetary policy conducted by the Federal Reserve, interest rates are higher during booms and lower during recessions. Therefore, firms are more likely to issue equity during booms (e.g., Choe, Masulis, and Nanda (1993) and Bayless and Chaplinsky (1996)), but are forced to issue debt, or cutback the leverage ratio when the economy is in recessions. Market-to-book ratio We find a strong role of the market-to-book ratio across all Z-score groups. Firms with higher market-to-book ratios are significantly more likely to tap the external markets, including pure equity issue, pure debt issue and dual issues. These firms also appear to take advantage of the favorable equity financing costs to issue equity and retire debt. The fact that firms with higher market-to-book ratios are also more likely to issue debt is not compatible with the tradeoff theory. Furthermore, the coefficients of the market-to-book ratio exhibit a monotonically increasing trend from Group 5 to 1 for all financing types. Without reporting details, we find these trends to be statistically significant from the Wald tests. This finding is inconsistent with the target-ratioadjustment argument by the tradeoff theory, which predicts the relationship to be important only for equity issuance and only for firms around targets. In contrast, this finding agrees with the costly external financing theory. Our earlier firm characteristic analysis indicates that, as bankruptcy risk increases from Group 5 to 1, firms needs for external financing also rise. As higher market-to-book ratios signal lower external financing costs, they become more precious for firms in higher demand of external funds, which explains their stronger impact on higher bankruptcy risk firms. Therefore, the market-to-book ratio plays a significant role in corporate financing decisions, but it is hard to reconcile its role with the target-ratio-adjustment argument from the tradeoff theory; instead it seems to agree more with the costly external financing theory. The findings from the multinomial logit regressions are consistent with those from the univariate analysis. Profitability Compared to firms doing nothing, firms with higher profitability are more likely to issue debt, whereas those with lower profitability are more likely to resort to external equities. The patterns hold true across different Z-score groups after controlling for common capital structure determinants. If the move-toward-the-target argument is relevant, we should expect the profitability coefficients, in the context of pure debt issue, to be significant only for firms with low bankruptcy risks, but insignificant for other firms. At the very least, we should observe a weakening trend in the 16

18 magnitude of this coefficient from Group 5 to 1. In contrast, we find that the coefficients are statistically significant, and demonstrate an increasing trend from Group 5 to 2. The relationship between profitability and pure debt issue thus cannot be explained by the move-toward-target argument put forward by the tradeoff theory. Instead, it is consistent with the idea that firms with higher profitability might face lower external debt financing costs. Again, the patterns we observe in the univariate analysis continue to be strong and significant even after controlling for other capital structure determinants. 5.2 Logit analysis We next use logit regressions to focus on pure debt versus pure equity financing decisions, which has been studied extensively in current literature. We use pure equity issue as the base case (y=0) and compare it with pure debt issue (y=1). 21 We use the same set of explanatory variables as in the multinomial logit analysis. The regression results with four alternative leverage ratio measures are presented in Table 7. We discuss the variables in turn. General variables Firms with higher deviation from the target (i.e., relatively less levered) are less likely to resort to debt financing, which runs contrary to the tradeoff theory. As Hovakimian (2003) argues, the significant role of the deviation from the target that is in line with the tradeoff theory and documented in earlier studies (e.g., Hovakimian et al. (2001)) is primarily driven by firms simultaneously issuing equity and retiring debt. Consistent with his findings, when we only use pure equity versus pure debt decisions, we find evidence contradicting the tradeoff theory. Firms with higher stock returns in the past two years are less likely to resort to debt rather than equity financing. The multinomial logit regression suggests that this pattern is mainly driven by the fact that these firms are much more likely to resort to equity financing (instead of debt financing). Larger firms are more likely to issue debt instead of equity, and there is no significant difference in financial deficits between debt versus equity issuing firms. Finally, firms are more likely to issue debt instead of equity when the interest rate is lower. As we have discussed, the economy is usually in a better state when the interest rate is higher, during which periods we also 21 In particular, we assume that financing decisions can be described in the following equation: e β (Lev it Lev it 1)+X t 1 γ Pr (y it = 1) = 1 + e β (Lev it Lev it 1)+X t 1 γ = Λ (β (Levit Lev it 1 ) + X t 1 γ), (3) where P r(y it = 1) is the probability a firm chooses one transaction type versus another at year t. Λ is the logistic function, Lev it Lev it 1 measures the deviation from target, and X t 1 are the other lagged explanatory variables. We study one pair of financing decisions: pure equity (y =0) versus pure debt financing (y =1). 17

19 observe more equity issues. Market-to-book ratio and profitability We find in the multinomial logit regression that, compared to firms doing nothing, firms with higher market-to-book ratios are more likely to issue both equity and debt. The logit regressions imply that firms with higher market-to-book ratios prefer equity to debt. This is consistent with the notion that a higher market-to-book ratio signals lower costs of equity relative to debt. A preference of equity to debt is in the direction of reducing leverage ratios. The target-ratioadjustment argument by the tradeoff theory thus predicts that the pattern should be strong for firms around the target, but becomes weaker or insignificant for other firms. In contrast, we find the variable to be important across all groups of firms. In addition, there is no evidence that the role of the market-to-book ratio is stronger for the firms around the target than for other firms. These patterns thus violate the tradeoff theory. The logit regression also suggests that firms with higher profitability are significantly more likely to issue debt instead of equity, which is in the direction of increasing leverage ratios. Earlier analysis in the multinomial logit regression indicates that this is driven by two simultaneous trends in different directions: firms with higher profitability are significantly more likely to issue debt, and are significantly less likely to issue equity. Because the importance of profitability is robust across all five bankruptcy risk groups, it cannot be explained by the move-toward-the-target argument. Therefore, the evidence favors the costly external financing theory instead of the tradeoff theory. In summary, our conclusions regarding the market-to-book ratio and profitability are robust in the logit regressions, after controlling for common capital structure determinants. 5.3 Decomposition of the market-to-book ratio The regression-based analysis thus far has tested two sets of hypotheses: separating firms by bankruptcy risks (i.e., deviation from the target) and studying both equity and debt issues. In this subsection we focus on the hypotheses related to growth opportunities. Instead of including the growth opportunity variables in the regressions, we first conduct a decomposition of the marketto-book ratio. The idea is to separate the component of the market-to-book ratio that is related to growth opportunities from the rest of the components. In particular, we run the following 18

20 industry-year regression: 22 LogMB it = (α 0 + α 1 Profit it + α 2 Leverage it ) + (α 3 Gsales it + α 4 CAPX it ) + (ε it ), (4) where LogMB represents the natural logarithm of the market-to-book ratio, Profit is the profitability variable, Leverage is TDA (total debt over total book assets), Gsales is the log sales growth rate, and CAPX is the industry adjusted capital expenditure. The regression is run for each industry year. We first separate all firms into 12 industries, as defined by Fama and French (1997). Within each industry year, we run the above cross-sectional regression. Using the estimated coefficients for each industry year, we decompose the market-tobook ratio into three components as separated by the brackets in the above equation. The first bracket, (α 0 + α 1 profitability it + α 2 Leverage it ), which we call the non-growth component (NGROW T H), is the predicted part of the market-to-book ratio that is not directly related to growth opportunities. The second bracket, (α 3 Gsales it + α 4 CAPX it ), includes the two variables we used earlier to measure growth opportunities, and we call this the growth component (GROW T H). Finally, the last bracket is simply the error term, which we call the firm-specific component (F IRM). It captures the part of market-to-book ratio that can not be explained. The industry-by-industry, year-by-year estimation not only ensures that we are not subject to industry bias, but also captures time variations in the two components of the market-to-book ratio that can be explained by firm-specific variables. We report the estimation results in the appendix in Table A-2. After decomposition of the market-to-book ratio, we then rerun the multinomial logit and logit regressions. We use the same general variables as before, with the following changes: (a) We substitute the five market-to-book ratio variables by their decomposed components; and (b) we add five change-of-growth variables, which are defined as the changes in the growth component (GROW T H t -GROW T H t 1 ). The rationale behind the inclusion of the change-of-growth variables is that the tradeoff theory believes that firms issue new equity because they realize new investment opportunities, which the change-of-growth variables are meant to capture. This exercise is not meant to prove that the market-to-book ratio is not related to growth opportunities. Instead, we intend to show that growth opportunities are not the only reason why the market-to-book ratio is significantly related to firm financing decisions. We discuss the results from multinomial logit and logit regressions in turn. The results regarding the general variables 22 The method of decomposition follows the accounting literature (see Barth, Beaver, and Landsman (2001), Penman (1998), and Collins, Maydew, and Weiss (1997)) and has been adopted in several finance studies (see Lee, Myers and Swaminathan (1999), and Rhodes-Kropf, Robinson and Viswanathan (2003)). 19