Financial Life Cycle and Capital Structure

Transcription

1 Financial Life Cycle and Capital Structure This draft: August 2009 Byungmo Kim a and Jungwon Suh b Abstract In this study, we present evidence of a distinctive inverted-u-shaped relation between leverage and retained earnings (RE) our proxy for financial life cycle stage. Our results suggest that (i) low-re firms have low leverage because of their heavy reliance on external equity due to financial constraints, (ii) medium-re firms have high leverage because of their active use of debt in funding high growth, and (iii) high-re firms have low leverage because of their ability to generate internal funds that exceed funding requirements. The traditional leverage regression that does not account for this inverted-u-shaped relation grossly underestimates the leverage of medium-re firms but overestimates the leverage of low- and high-re firms. The data show that retained earnings convey information about both asset growth and profitability. Thus, the inverted-u-shaped relation arises because capital structure decisions are determined by the interplay between funding requirements (i.e., asset growth) and the availability of internal funds (i.e., profitability). We find that the relation between leverage and profitability is also inverted- U-shaped and reflects a similar interplay between funding requirements and the availability of internal funds. These results enrich our understanding of the pecking order theory. JEL classification: G32; G35 Key words: Capital structure; Financial life cycle; Retained earnings; Pecking order theory a Byungmo Kim, School of Business Administration, Dankook University, Yongin, Korea, tel: , fax: , bmkim@dankook.ac.kr b Jungwon Suh, College of Business Administration, Ewha Womans University, Seoul, Korea, tel: , fax: , jungwon_suh@ewha.ac.kr. 1

2 1. Introduction A central question in corporate finance is whether optimal capital structure exists. The trade-off theory of capital structure postulates that firms choose leverage by balancing benefits and costs of using debt. These benefits and costs include the tax savings effects and financial distress (Modigliani and Miller, 1963), and agency costs (Jensen and Meckling, 1976). On the other hand, according to the pecking order model, firms do not seek to maintain a particular leverage. The pecking order model suggests that, due to adverse selection costs, firms prefer internal financing and prefer debt to equity when external financing is raised (Myers and Majluf, 1984). Prior studies generally identify four factors as key cross-sectional determinants of capital structure firm size, market-to-book, profitability and tangibility (Titman and Wessels, 1988; Rajan and Zingales, 1995; Mackay and Phillips, 2005; Lemmon, Roberts and Zender, 2008). In particular, those studies tend to view the negative relation between leverage and profitability as evidence in support of the pecking order model. The purpose of this study is to present a previously unidentified determinant of capital structure, namely, retained earnings. Retained earnings can be viewed as a proxy for a firm s financial life cycle stage. We document evidence that firms capital structure decisions vary over financial life cycle. It is not a new idea that a firm s life cycle may consist of several stages, for example, pioneering, expansion, maturity and decline. However, the concept of life cycle is rarely applied to corporate finance issues. A salient exception is DeAngelo, DeAngelo and Stulz (2006) who also use retained earnings as a proxy for financial life cycle stage. These authors report that a firm s decision to pay dividends is positively affected by the level of retained earnings. Our empirical investigation is conducted on firm-level data from the U.S. stock market over the period We divide sample firms each year into several subgroups by the level of retained earnings (RE) and evaluate whether the debt-to-equity ratio (our proxy for leverage) is related to retained earnings. Our findings show that there is a distinctive inverted-ushaped relation between leverage and retained earnings. In almost all sample years, the debt-toequity ratio tends to be low for low-re firms, high for medium-re firms, and low for high-re firms. Multiple regression analyses also show that even after controlling for the effects of previously identified leverage determinants, there is a significant tendency that leverage is low first and then goes up before it finally declines, as retained earnings increase. We also find that firms growth and financing methods vary substantially across 2

3 different levels of retained earnings. Typically, at low-re levels, firms grow rather slowly and use mostly external equity to finance growth. In contrast, the medium-re firms experience the highest asset growth and actively use debt financing. Finally, the asset growth of the high-re firms is relatively high, but it is not as high as that of the medium-re firms. Their asset growth is financed mostly through internal equity. In sum, our findings suggest that there are three distinctive stages in firms financial life cycle: (i) a low-re (low-leverage) stage where firms use predominantly external equity, (ii) a medium-re (high-leverage) stage where firms actively use debt to fund high growth, and (iii) a high-re (low-leverage) stage where firms accumulate internal equity considerably. We postulate that the inverted-u-shaped relation between leverage and retained earnings arises because retained earnings convey information about both asset growth (i.e., a measure of funding requirement) and profitability (i.e., the availability of internal funds). To elaborate, at a low RE level, the asset growth rate is low, but as retained earnings increase, the asset growth rate rises and then peaks at medium-re levels before it declines. On the other hand, profitability tends to increase linearly with retained earnings. Therefore, high-re firms are characterized by relatively low funding requirements and large internal funds, which explain why such firms have low leverage. On the other hand, medium-re firms are characterized by large funding requirements. As a result, they actively use debt finding to finance growth. Finally, low-re firms are characterized by slow growth and low profitability, which indicates that those firms may be financially constrained and thus use mostly equity financing. In sum, our findings suggest that leverage decisions are an outcome of the interplay between asset growth and profitability. The level of retained earnings reflects this interplay. It is important to emphasize that these observations are consistent with the pecking order model. The pecking order model postulates that leverage decisions are determined by growth and profitability in tandem. For example, Myers (1993) says: debt ratios change when an imbalance of internal cash flow and real investment opportunities occurs. Highly profitable firms with limited investment opportunities work down to a low debt ratio. Firms whose investment opportunities outrun internally generated funds are driven to borrow more and more. Prior studies tend to use profitability as a key variable in testing the validity of the pecking order model. By estimating cross-sectional leverage regressions, those studies find a negative coefficient for profitability and interpret it as evidence in favor of the pecking order 3

4 model. We find, however, that the relation between leverage and profitability is not exactly negative, but inverted-u-shaped. This inverted-u-shaped relation is obtained because low (negative) profitability firms use external equity as their main source of capital, medium profitability firms actively use debt to finance its growth and finally, high profitability firms rely predominantly on internal equity. In sum, the data show that profitability is similar to retained earnings in that it describes how capital structure decisions are determined by the interplay of growth and profitability. Finally, we examine whether retained earnings account for transitory or permanent components of the capital structure variation. 1 To this end, we trace the future evolution of retained earnings for four portfolios constructed by sorting firms according to their current retained earnings. Remarkably, retained earnings display a very high degree of stability. That is, firms with high (low) retained earnings tend to maintain high (low) retained earnings over a long period of time. This persistence indicates that retained earnings are associated with the permanent component of the capital structure variation. It also suggests that referring to the retained earnings effect on capital structure as a sort of financial life cycle effect may be inappropriate. The most important contribution of the present study to the capital structure literature is that it enriches our understanding of the pecking order model by providing evidence that growth and profitability jointly determine firms leverage decisions. Additional contributions can be described as follows. First, the present study identifies a new cross-sectional determinant of leverage, namely, retained earnings. Prior studies identify four major determinants of leverage firm size, the market-to-book ratio, profitability and tangibility (Titman and Wessels, 1988; Rajan and Zingales, 1995; Mackay and Phillips, 2005; Lemmon, Roberts and Zender, 2008). We find that the traditional cross-sectional leverage regression (i.e., the regression without the retained earnings as a predictor) grossly underestimates leverage for medium-re firms and overestimates leverage for high and low-re firms. Second, our findings suggest that, when it comes to capital structure decisions, there are three groups of firms external-equity-dependent, debt-dependent and internal-equitydependent firms. This observation calls for distinguishing between two forms of equity internal and external equity in evaluating capital structure decisions. Prior studies tend to treat these two forms of equity equally in approaching the issue of the leverage determinants. Indeed, 1 Lemmon, Roberts and Zender (2008) document that the capital structure variation has both transitory and permanent components. 4

5 however, a low leverage could be resulted from either a high use of external or a high use of internal equity. Our study shows that two distinct groups of low leverage firms low and high profitability firms exist. The former uses predominantly external equity but the latter uses mostly internal equity. The organization of the rest of the paper is as follows. The next section describes the data. Section 3 conducts empirical analyses and presents results. Section 4 concludes the paper. 2. Data Our sample consists of nonfinancial and nonutility U.S. firms over the period This selection of the sample period considers the shift in the industrial population that began in around It is well documented that the industrial population tilts toward small, unprofitable, high market-to-book firms from around that year (Fama and French 2001; Baker and Wurgler, 2004). In particular, DeAngelo et al. (2006) discuss the upsurge of negative retained earnings firms from the early 1980s. Negative retained earnings firms are typically small, unprofitable and high market-to-book firms. 2 Leverage in this study is measured by the ratio of the long-term debt to equity. The two leverage variables are the book leverage (the long-term debt over the book value of equity) and the market leverage, (the long-term debt over the market value of equity). To capture where a firm is located in its financial life cycle, we use the level of retained earnings scaled by total assets (RE). We also examine several firm-characteristics that prior studies identify as leverage determinants. In constructing our sample, we drop negative book value of equity firms since those firms result in negative book leverages which is hard to interpret. To deal with extreme observations, the variables used in this study are winsorized at the top and bottom one percents of their respective distributions. Table A1 provides definitions for the variables used in this study. 3. Empirical results 3.1. Median values for retained earnings subgroups Our first task is to examine the relation between leverage and retained earnings by calculating 2 We find that the inverted-u-shaped relation between leverage and retained earnings which we report later is rather weak for the period before This implies that the inverted-u-shaped relation is partially an outcome of the introduction (and gradual increase) of negative retained firms in the U.S. stock market after

6 the median values of leverage for subgroups of firms classified by retained earnings. In presenting this relation, we select three representative sample years, 1985, 1995, and 2005 as well as the pooled sample of firm-years over the period Table 1 provides the median values for leverage ratios and other key firm characteristics for each retained earnings (RE) decile. The table clearly shows that there is an inverted-u-shaped relation between retained earnings and the use of debt. For example, in the year 2005, the median market leverage is relative low at for the lowest RE decile, but goes up and then peaks at for the fifth RE decile before it declines to for the highest RE decile. The median book leveage displays a similar inverted-u-shaped relation with retained earnings. Thus, this table provides an important pattern. The use of debt is relatively small for both low and high RE firms, while it is high for medium RE firms. This inverted-u-shaped pattern is observed in all three selected sample years and for both measures of leverage. The last panel of the table confirms this pattern for the entire firm-years over the period This panel shows that as we move from low to high retained earnings deciles, the leverage ratios first go up and then peak at middle deciles before it declines. The leverage ratios for medium RE firms are several times greater than those of low and high RE firms. Using the market leverage as a leverage measure, the median leverage in the fifth decile (at 0.388) is almost ten times greater than that for the lowest decile (at 0.040) and five times greater than that for the highest decile (at 0.064). This table offers several other interesting patterns as well. First, as we move from low to high RE deciles, the median firm size and profitability increase monotonically. This means that high (low) retained earnings firms tend to be large (small) and profitable (not profitable). Notice also that low retained earnings firms in particular, those in the first and second RE deciles tend to high market-to-book but low asset tangibility in compared to other firms. Second, it is well documented by prior research that the number and proportion of negative retained earnings firms have been on the gradual increase since 1980 (e.g., DeAngelo et al., 2006). The median retained earnings in the table reflect this trend. The median retained earnings are negative for the first three RE deciles in However, this median is negative for the first four RE deciles in 1995 and for the first five RE deciles in 2005, which is in accordance with the tilt in the industrial population towards negative retained earnings firms. 6

7 3.2. Augmented leverage regression vs. traditional leverage regression We now perform regression analysis to identify the inverted-u-shaped relation between retained earnings and leverage. Our regression model dubbed the augmented leverage regression model includes both the retained earnings decile and its square value as explanatory variables along with previously identified leverage determinants. We use the logarithm of the (market and book) debt-to-equity ratio as the dependent variable. 3 Table 2 presents the results of the regression analysis for three representative sample years as well as for the pooled sample of firm years over the period. These results clearly indicate that the relation between leverage and retained earnings is inverted-u-shaped after controlling for previously identified leverage determinants. In the first panel where the dependent variable is the logarithm of the market leverage, the coefficient for the RE decile is significantly positive and that for the decile squared is significantly negative in all selected years 1985, 1995 and 2005 as well as in the Fama-MacBeth regression (FM) and the fixed effect regression (FE). Additionally, a similar result is obtained in the second panel where the dependent variable is the logarithm of the book leverage. Except for the fixed effect regression, the coefficients for the RE decile and its squared value are positive and negative, respectively. These results are in accordance with the inverted-u-shaped relation that we find earlier using median values for RE deciles. Thus, the coefficients returned for RE deciles and their squared values suggest that there is a significant tendency for the use of debt to increase first, and then decrease as we move from low to high retained earnings firms. Then what do these results imply for the traditional leverage regression? We refer to the leverage regression without the RE decile and its square as the tradition leverage regression. How well does the traditional leverage regression capture this inverted-u-shaped relation between leverage and retained earnings? In order to evaluate the ability of the traditional leverage regression to capture this inverted-u-shaped relation, we plot both actual leverages and predicted leverages from the traditional leverage regression for each retained earnings decile. 3 The purpose of this log transformation is to map leverage onto the whole real line. An issue with this log transformation of leverage, however, is the presence of many zero-debt firms. We find that approximately 15% of the sample firms over the entire sample period carry no long-term debt. As a result of this log transformation, those firms are treated as missing and thus are not included in this regression analysis. However, we note that these zero-debt firms (i.e., low levered firms) typically have high retained earnings and belong to the top RE decile. Thus, we can say that our finding of the inverted-u-shaped relation between leverage and retained earnings is obtained despite the exclusion of these zero-debt firms. Alternatively, we assign a very small leverage number (0.0001) to these zero-debt firms to include them in the regression analysis, as Lemmons et al. (2008) do. The regression results remain unchanged qualitatively. 7

8 Figure 1 documents that the traditional leverage regression does poorly in capturing the inverted-u-shaped relation between leverage and retained earnings. For each selected sample year and the pooled sample of firm years, the actual leverage ( ) i.e., the median market leverage increases first with retained earnings, peaks for medium RE firms and then declines for high RE firms. The predicted leverages from the traditional leverage regression ( ), however, do not trace these actual leverages very well. These graphs clearly show that the traditional leverage regression substantially underestimate the leverage of medium-re firms, while it considerably overestimates the leverage of high- and low-re firms. These graphs also show that while the predicted leverages ( ) from the augmented regression does a better job in tracing the actual leverages, they still underestimates the leverage of medium-re firms to some extent Interaction of asset growth and profitability The preceding analyses establish that leverage has an inverted-u-shaped relation with retained earnings. Now a question emerges: what is behind the inverted-u-shaped relation? In order to answer this question, we analyze how fast firms grow and how their growth is financed at different levels of retained earnings. In this analysis, we first divide the sample firms each year into quintiles based on the level of retained earnings. Then for each quintile, we calculate the median value for three-year growth rate for total assets and fixed assets (denoted by TA and PPE, respectively). Also, to examine how asset growth is financed, we calculate three variables for each quintile: (i) the change in retained earnings ( RE), (ii) net equity issuance, (iii) net long-term debt issuance. Table 3 presents the results for the three sample years and the pooled sample of firm years over the sample period Inspection of the table reveals that both asset growth (i.e., funding requirements) and financing choices vary systematically with retained earnings. To elaborate, both total assets growth ( TA) and fixed asset growth ( PPE) display an inverted-ushaped relation with retained earnings. For example, in the year 1985, the median value of three year total assets growth is negative in the lowest quintile at -5.18%, but gradually increases with retained earnings and peaks at the third quintile at 28.49% and then declines for higher quintiles. Firms in other years exhibit similar patterns. Thus, there are low-growth, high-growth and then low-growth firms as we move from low to high retained earnings deciles. The table also shows that there exist three distinctive types of financing choices as we move from low to high retained earnings deciles. There is a tendency for low-re firms use 8

9 external equity heavily. The median value for net equity issuance is greatest for the firms in the lowest quintile higher quintiles in all selected sample years as well as the entire sample. On the other hand, there is evidence that medium-re firms use debt more actively than firms in other quintiles. In all selected sample years as well as the entire sample, firms in the third quintile display the highest median or 75 th percentile value. Finally, high-re firms exhibit heavy reliance on internal financing. Firms in the highest quintile have the greater median value for the change in retained earnings ( RE) than do other firms. The heavy reliance of retained earnings by these firms is in contrast to the relative absence of their debt and equity issuances. Based on these observations, we postulate that the inverted-u-shaped relation between leverage and retained earnings arises because retained earnings convey information about both asset growth (i.e., a measure of funding requirement) and profitability (i.e., the availability of internal funds). To elaborate, at a low RE level, the asset growth rate is low, but as retained earnings increase, the asset growth rate rises and then peaks at medium-re levels before it declines. On the other hand, profitability tends to increase linearly with retained earnings. Therefore, high-re firms are characterized by relatively low funding requirements and large internal funds, which explain why such firms have low leverage. On the other hand, medium- RE firms are characterized by large funding requirements. As a result, they actively use debt to finance growth. Finally, low-re firms are characterized by slow growth and low profitability, which indicates that those firms may be financially constrained and thus use mostly equity financing. Figure 2 illustrates how the interplay of growth and profitability determines capital structures for low, medium and high retained earnings firms. It is important to recognize that the inverted-u-shaped relation between leverage and retained earnings the outcome of the interplay of growth and profitability is consistent with the pecking order model. The pecking order model postulates that leverage decisions are determined by growth and profitability in tandem. For example, Myers (1993) says: debt ratios change when an imbalance of internal cash flow and real investment opportunities occurs. Highly profitable firms with limited investment opportunities work down to a low debt ratio. Firms whose investment opportunities outrun internally generated funds are driven to borrow more and more. Indeed, our evidence suggests that for high retained earnings firms, the availability of internal funds exceeds funding requirements which results in low leverage for these firms. For medium retained earnings firms, the amount of internal funds falls short of funding requirements. As a result, those firms actively 9

10 use debt which results in high leverage. Finally, the negative profitability of low retained earnings firms makes it difficult for them to raise debt. These firms rely heavily on external equity, which results in low leverage. These observations are consistent with the prediction of the pecking order theory that firms prefer internal financing and prefer debt to equity when external financing is raised Profitability and leverage Thus far, our results on the leverage effects of retained earnings indicate that asset growth (i.e., funding requirements) and profitability (i.e., the availability of internal funds) jointly affect capital structure decisions. This observation is consistent with the pecking order theory. Note, however, prior studies typically use profitability alone as a key variable in testing the validity of the pecking order theory (e.g., Rajan and Zingales, 1998). By estimating linear regression models, those studies find a negative coefficient for profitability and interpret it as evidence in favor of the pecking order theory. In this analysis, we give an in-depth look at the relation between leverage and profitability. It is widely acknowledged that profitability conveys information about growth opportunities (Alti, 2003). Thus, the estimated leverage effect of profitability from leverage regressions may reflect more than the effect of profitability per se but that of growth opportunities (that is, funding requirements) as well. We examine how profitability is related to growth opportunities by tabulating the median values for asset growth for five subgroups of firms classified by profitability. We also tabulate the median values for financing variables for those subgroups. Table 4 shows that asset growth tends to increase with profitability. In all selected sample years and the entire firm-years, the median values for both total assets growth and fixed assets growth go up as we move from low to high profitability deciles. This confirms that profitability conveys information about growth opportunities. We also note that three types of firms can be identified from the table. At low profitability levels, firms mostly rely on external financing probably due to difficulty to raise debt. Without exception in all four panels, the median net equity issuance is highest in the lowest profitability quintile. At medium profitability levels, firms actively use external debt. For example, in the last panel for all firm-years, the median net long-term debt issuance is highest in the third profitability quintile at 1.35%. This is because while these firms profitability is high, it is not large enough to meet funding 10

11 requirements entirely. Finally, at high profitability levels, firms display high reliance on internal funds in financing growth. The above observations predict that the relation between leverage and profitability may be inverted-u-shaped. Indeed, as we move from low to high profitability firms, leverage (both market and book) tends to go up first and peak at medium profitability before it declines for high profitability firms. Notice from the table that funding requirements as measured by both total assets growth and fixed assets growth are greatest for firms in the top profitability quintile, given the positive relation between growth opportunities and profitability. However, it appears that the availability of internal funds increases faster than funding requirements as profitability increases. For example, for all firm-years in the last panel, the median increase in retained earnings ( RE) in the highest quintile (at 17.90%) is more than twice that the median funding requirements for fixed assets ( PPE) in the same quintile (at 5.50%). This gap between the availability of internal funds and funding requirements is much smaller or even negative in lower profitability deciles. Thus, the data suggest that the inverted-u-shaped relation between leverage and profitability arises as an outcome of the interplay between funding requirements and the availability of internal funds. High profitability firms have low leverage because the availability of internal funds exceeds funding requirements. Medium profitability firms have high leverage because these firms actively use debt as the amount of internal funds falls short of funding requirements. Low profitability firms have low leverage because these firms use mostly external equity probably due to financial constraints coming from poor profitability. Note also that these patterns are obtained because the prediction of the pecking order theory firms prefer internal financing and prefer debt to equity when external financing is raised holds. Table 5 reports the results of the regression analysis that attempts to identify the inverted-u-shaped relation between leverage and profitability. We regress leverage on both the profitability decile and its square value along with previously identified leverage determinants. The results suggest that the relation between leverage and profitability is inverted-u-shaped. In the first panel where the dependent variable is the logarithm of the market leverage, the coefficient for the profitability decile is significantly positive while that for its squared value is significantly negative in all three selected sample years as well as in the Fama-MacBeth regression and the fixed effect regression. The same pattern is obtained in the second panel where the dependent variable is the logarithm of the book leverage. What are the implications of this inverted-u-shaped relation? First, it may be erroneous 11

12 to view the relation between leverage and profitability as negative. Firms leverage does not simply increase (decrease) simply as their profitability goes down (up). This inverted-u-shaped relation suggests that capital structure is determined by the interplay between funding requirements and the availability of internal funds. Prior studies generally find a negative coefficient for profitability in linear regressions and interpret it as evidence in favor of the pecking order theory. We emphasize that while the relation between leverage and profitability is not exactly negative, their inverted-u-shaped relation does not contradict the pecking order theory. Rather, their inverted-u-shaped relation arises exactly because firms prefer internal financing and prefer debt to equity when external financing is raised Persistence of retained earnings Our results show that retained earnings are an important factor that explains the cross-sectional heterogeneity in capital structure. Lemmon et al. (2008) document that leverage has both transitory and permanent components. Our next analysis examines whether retained earnings are associated with permanent or transitory components of the capital structure variation. An additional motivation for this analysis comes from the view of some authors that retained earnings reflect financial life cycle stages. For example, DeAngelo et al. (2006) argue that retained earnings help identify those firms in the capital infusion stage and those firms in the capital distribution stage. One of the unavoidable connotations of the phrase life cycle is that firms may transition from one stage to another gradually over time (e.g., from capital infusion stage to capital distribution stage). Hence, viewing retained earnings as a proxy for life cycle stages inevitably implies that the effects of retained earnings may be transitory, rather than permanent. Figure 3 traces the future evolution of the average retained earnings for four portfolios constructed by sorting firms according to their current retained earnings. These four portfolios are Very high, High, Medium and Low retained earnings portfolios. The graph illustrates that retained earnings display a very high level of stability. There is little tendency of convergence in the average retained earnings among these four portfolios. Over the fifteen year period, firms with high (low) retained earnings maintain high (low) retained earnings over a long period of time. This persistence suggests that referring to the leverage effect of retained earnings as a sort of financial life cycle effect may be inappropriate. The data do not suggest that firms 12

13 transition from a low retained earnings stage to a high retained earnings stage or vice versa. Also, this persistence indicates that retained earnings may be associated more with the permanent component of the capital structure variation than with its transitory component. Lemmon et al. (2008) show it has a sizable permanent component in the sense that high (low) leverage firms tend to remain as such for a long term. Thus, the leverage effect of retained earnings may constitute part of the reason for the persistence of leverage. 4. Conclusion In this study, we provide evidence of a distinctive inverted-u-shaped relation between leverage and retained earnings. Our results suggest that (i) low-re firms have low leverage because of their heavy reliance on external equity due to financial constraints, (ii) medium-re firms have high leverage because of their actively use of debt in funding high growth, and (iii) high-re firms have low leverage because of their ability to generate internal funds that exceed funding requirements. The traditional leverage regression that does not account for this inverted-ushaped relation grossly underestimates the leverage of medium-re firms but overestimates the leverage of low- and high-re firms. We document that the inverted-u-shaped relation between leverage and retained earnings arise because the capital structure decisions are affected by the interplay between funding requirements (i.e., asset growth) and the availability of internal funds (i.e., profitability). The data show that retained earnings convey information about both asset growth and profitability. We also find that the relation between leverage and profitability is inverted-ushaped and reflects a similar interplay between funding requirements and the availability of internal funds. These results conform to the prediction of the pecking order theory that firms prefer internal and prefer debt to equity when external financing is raised. 13

14 Appendix Table A1 All numbers in parentheses are the annual Compustat item numbers. Book equity = Book assets (6) total liabilities (181) preferred stock (10) + deferred taxes (35) + convertible debt (79). Market equity Stock price (199) shares outstanding (25) Book leverage = Market leverage = Long-term debt (9)/book equity. Long-term debt (9)/market equity. Retained Earnings (RE) = Retained earnings (36)/ book assets (6). Size = Market-to-book (M/B) = The logarithm of net sales (12). Net sales are consumer-price-index adjusted with 1981 as the base year. (market equity + short-term debt (34) + long-term debt (9) + preferred stock (10) deferred taxes and investment tax credits (35)) / book assets (6). Tangibility = Net PPE (8) / book assets (6). Profitability = Operating income before depreciation (13)/ book assets (6). Net debt issuance = Long-term debt issue (11) repayment of longterm debt (114) Net equity issuance = Equity issue (108) repurchases (115) 14

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17 Table 1 Median values of key variables for retained earnings deciles The table reports the median value for leverage ratios and other firm characteristics for each retained earnings decile (based on the retained-earnings-to-totalassets ratio) for three sample years, 1985, 1995, and 2005 as well as for the pooled sample of firm-years over the period The last panel for all firmyears is constructed by first calculating the median value of a given variable each year and then taking the median value of those median values. The definitions of the variables are provided in Table A1. RE deciles All 1985 RE Leverage (market) Leverage (book) Size M/B Tangibility Profitability RE Leverage (market) Leverage (book) Size M/B Tangibility Profitability RE Leverage (market) Leverage (book)

18 Size M/B Tangibility Profitability All RE Leverage (market) Leverage (book) Size M/B Tangibility Profitability

19 Table 2 Augmented regression results The table reports the results of the augmented regressions for three sample years, 1985, 1995, and 2005 as well as for the pooled sample of firm-years over the period The dependent variables are the logarithms of the book debt-to-equity ratio (Panel A) and the market debt-to-equity ratio (Panel B), respectively. The explanatory variables for this augmented regression include retained earnings decile and its squared value along with the previously identified determinants of leverage. The definitions of these variables are provided in Table A1. In the Fama-MacBeth regression (marked by FM), the reported numbers are the average of coefficient estimates returned for a given explanatory variable from each individual year. In the fixed effect regression (marked by FE), year dummies and industry indicators (for Fama-French 38 industries) are included as additional explanatory variables, though the results for them are suppressed. *, ** and *** indicate significance at the 10%, 5% and 1% levels, respectively. RE decile RE decile 2 Size M/B Tangibility Profitability Constant Adj. R 2 log of leverage (market) *** *** 0.122*** *** 2.520*** *** (4.27) (-9.22) (9.63) (-18.25) (17.40) (-0.76) (-7.68) *** *** 0.160*** *** 2.414*** *** *** (5.50) (-9.06) (12.61) (-24.11) (16.39) (-4.90) (-9.34) *** *** 0.152*** *** 2.169*** *** *** (5.10) (-7.37) (8.92) (-16.03) (11.02) (-4.25) (-5.52) FM 0.298*** *** 0.151*** *** 2.264*** *** *** (15.43) (-27.97) (49.05) (-48.56) (65.62) (-6.48) (-26.99) FE 0.104*** *** 0.280*** *** 2.314*** *** *** (5.20) (-17.14) (20.24) (-56.30) (25.47) (-17.66) (-30.68) log of leverage (book) *** 0.149*** *** 2.152*** 0.461** *** (0.32) (-5.92) (11.91) (-6.25) (14.73) (2.11) (-5.89) *** *** 0.222*** *** 2.256*** *** *** (2.75) (-7.05) (17.63) (-10.74) (15.22) (-3.07) (-7.16) 19

20 *** *** 0.194*** *** 2.044*** *** *** (3.34) (-5.88) (11.20) (-6.38) (10.38) (-3.40) (-4.76) FM 0.114*** *** 0.202*** *** 2.089*** *** (5.70) (-20.40) (35.73) (-17.45) (50.42) (-23.89) FE ** *** 0.290*** *** 2.120*** *** *** (-2.56) (-11.96) (20.74) (-11.18) (23.71) (-9.87) (-24.15) 20

21 Table 3 Asset growth and its financing for subgroups classified by retained earnings The table reports the median values for asset growth and financing choices for each retained earnings quintile (based on the retained-earnings-to-total-assets ratio) for three selected years and the entire sample period Total assets is the three-year growth rate in total assets (i.e., TA(0) TA(-3) / TA(-3)). PPE is the three-year growth rate in net fixed assets (i.e., PPE(0) PPE(-3)/TA(-3)). RE is the change in retained earnings over three years (i.e., RE(0) RE(-3)/TA(-3)). Net equity issuance and net long-term debt issuance are the sum of the issuances over three years scaled by TA(-3). The numbers in brackets are 75 th percentiles. All numbers are expressed in percentages. RE quintile All 1985 Total assets (3 yr) PPE (3 yr) RE (3 yr) Net equity issue (3 yr) [96.44] [30.29] [20.19] [11.62] [1.57] [16.46] Net L-T debt issue (3 yr) [12.93] [34.41] [30.76] [15.59] [3.14] [14.22] 1995 Total assets (3 yr) PPE (3 yr) RE (3 yr) Net equity issue (3 yr) [135.10] [49.85] [33.18] [13.74] [1.81] [30.03] Net L-T debt issue (3 yr) [6.12] [13.88] [29.70] [15.88] [4.40] [11.66] 2005 Total assets (3 yr) PPE (3 yr) RE (3 yr) Net equity issue (3 yr) [142.02] [42.46] [11.52] [5.22] [2.30] [13.88] Net L-T debt issue (3 yr) [4.91] [6.73] [16.58] [10.37] [2.62] [7.64] All years Total assets (3 yr) PPE (3 yr) RE (3 yr) Net equity issue (3 yr)

22 [107.03] [29.96] [14.25] [5.99] [1.06] [13.16] Net L-T debt issue (3 yr) [6.01] [21.78] [18.65] [13.45] [4.28] [11.38] 22

23 Table 4 Asset growth and its financing for subgroups classified by profitability The table reports the median values for asset growth and financing choices at different levels of profitability for three selected years and the entire sample period To construct this table, the sample firms each year are divided into quintiles by the retained-earnings-to-total-assets ratio (RE). Total assets is the three-year growth rate in total assets (i.e., TA(0) TA(-3) / TA(-3)). PPE is the threeyear growth rate in net fixed assets (i.e., PPE(0) PPE(-3)/TA(-3)). RE is the change in retained earnings over three years (i.e., RE(0) RE(-3)/TA(-3)). Net equity issuance and net long-term debt issuance are the sum of those issuances over three years scaled by TA(-3). The numbers in brackets are 75 th percentiles. All numbers are expressed in percentages. Profitability quintile All Profitability Total assets (3 yr) PPE (3 yr) RE (3 yr) Net equity issue (3 yr) [89.52] [18.27] [14.10] [8.98] [5.57] [15.91] Net L-T debt issue (3 yr) [13.25] [20.21] [17.90] [15.70] [6.17] [14.03] Leverage (market) Leverage (book) Profitability Total assets (3 yr) PPE (3 yr) RE (3 yr) Net equity issue (3 yr) [166.77] [24.71] [19.21] [10.49] [9.37] [28.54] Net L-T debt issue (3 yr) [6.70] [14.89] [17.73] [12.07] [4.95] [11.39] Leverage (market) Leverage (book) Profitability Total assets (3 yr) PPE (3 yr) RE (3 yr) Net equity issue (3 yr)

24 [227.16] [14.29] [6.19] [5.11] [5.60] [13.84] Net L-T debt issue (3 yr) [9.16] [8.56] [10.51] [8.08] [2.83] [7.55] Leverage (market) Leverage (book) All years Profitability Total assets PPE RE Net equity issuance [128.05] [13.73] [6.66] [6.08] [4.78] [12.78] Net L-T debt issuance [7.20] [12.73] [15.23] [11.73] [6.00] [11.23] Leverage (market) Leverage (book)

25 Table 5 Leverage regression with profitability decile and its square value as additional explanatory variables The table reports the results of the augmented regressions for three sample years, 1985, 1995, and 2005 as well as for the pooled sample of firm-years over the period The dependent variables are the logarithms of the book debt-to-equity ratio (Panel A) and the market debt-to-equity ratio (Panel B), respectively. The explanatory variables for this augmented regression include profitability decile and its squared value along with the previously identified determinants of leverage. The definitions of these variables are provided in Table A1. In the Fama-MacBeth regression (marked by FM), the reported numbers are the average of coefficient estimates returned for a given explanatory variable from each individual year. In the fixed effect regression (marked by FE), year dummies and industry indicators (for Fama-French 38 industries) are included as additional explanatory variables, though the results for them are suppressed. *, ** and *** indicate significance at the 10%, 5% and 1% levels, respectively. Profitability decile Profitability decile 2 Size M/B Tangibility Constant Adj. R 2 log of leverage (book) *** *** 0.055*** *** 2.714*** *** (6.10) (-8.97) (4.48) (-16.62) (18.51) (-8.17) *** *** 0.108*** *** 2.495*** *** (4.33) (-7.25) (8.55) (-21.60) (16.60) (-8.59) *** *** 0.091*** *** 2.205*** *** (2.92) (-4.68) (5.52) (-14.36) (11.22) (-5.00) FM 0.319*** *** 0.092*** *** 2.372*** *** (17.38) (-29.70) (26.58) (-51.76) (66.02) (-29.66) FE 0.088*** *** 0.211*** *** 2.360*** *** (6.18) (-15.94) (15.78) (-53.12) (25.37) (-34.98) log of leverage (market) *** *** 0.061*** *** 2.296*** *** (3.81) (-5.97) (4.85) (-4.11) (15.22) (-7.10) * *** 0.150*** *** 2.243*** *** (1.72) (-3.96) (11.72) (-7.92) (14.54) (-6.53) 25