Asian Review of Financial Research Vol.23 No.2 pp.89-120
Financing Market Accessibility and Capital Structure Adjustment Speed
Key Words : Capital Structure,Target Debt Ratio,Financing Market Accessibility,Capital Structure Adjustment Speed
The financing market accessibility is an important factor to consider when investigating firms' financing choices. However, many studies on the capital structure adjustment speed, derived from traditional capital structure theories, have largely ignored the importance of financing market accessibility especially when they investigate the speed toward the target debt ratio. Thus, this paper investigates the role of financing market accessibility in the process for a firm to adjust their debt ratio to its target debt ratio. Since Modigliani and Miller suggested irrelevance proposition regarding the relationship between leverage and firm value in 1958 (Modigliani and Miller, 1958), many researchers have raised the question about the validity of the argument. Initially, they questioned whether the Modigliani and Miller's irrelevance proposition is well supported by the available firms' data and whether the imperfections of capital market make firm value links to debt ratio. A trade off theory was created on the basis of the latter case, claiming that a firm would select a target debt ratio by taking into consideration both costs and benefits of the debts. While Modigliani and Miller (1963) suggested a correction theory about irrelevance proposition, Baxter (1967) presented the bankruptcy cost theory arguing that the increase of the expected bankruptcy costs could countervail the tax shield of debt as the debt ratio increases. Jensen and Meckling (1976) showed the optimal debt ratio could be influenced by the agency cost occurring because stockholders entrust managers with the firm's management. Since Modigliani nd Miller's correction theory (Modigliani and Miller, 1963), the trade off theory developed by many researchers suggest that the optimal capital structural is determined by the relationship (trade off) between cost and benefit of using of debts. Survey result suggested by Graham and Harvey (2001) shows that 81% of 392 firms indeed consider a target debt ratio (or range) an important factor when they make their financing decisions. However, Myers (1984) refutes this trade off theory of capital structure with an updated version of Donaldson's (1961) pecking order theory, according to which asymmetric information leads managers to believe that the market generally underprices their shares (Flannery and Rangan, 2006). As a result, a firm's investment is financed first with internal funds before the firm gets into debt if internally generated funds are not sufficient, and equity financing is used only as a last choice of financing instrument. In a pecking order theory, the observed firm's leverage shows primarily the result of a firm's historical profitability and investment opportunities. Firms have no strong preferences about their debt ratios and no obvious propensity toward adjusting leverage alteration caused by financing needs or operating profit (loss). Other theories about capital structure also do not support the view of timely convergence toward a target debt ratio. Baker and Wurgler (2002) argue that a firm's observed debt ratio shows its cumulative ability to catch the opportunity which equity shares are highly evaluated; that is, stock prices fluctuate around their true values, and managers tend to issue shares when the firm's market-to-book ratio is high (Flannery and Rangan, 2006). This market timing theory, on the other hand, argues that a firm's manager continuously takes the advantage of information asymmetries to benefit current shareholders. Thus, this theory suggests, like the pecking order hypothesis, that there is no reversion to a target debt ratio if market timing is the dominant determinant on firm's leverage. The pecking order and market timing theories suggest that firms' managers, generally not aware of any leverage effect on firm value, do not endeavor to modify changes in leverage. On the other hand, the tradeoff theory of capital structure implies that the factors of market imperfection can damage both leverage and firm value, thereby forcing firms to take management initiatives to offset deviations from their optimal debt ratios (Flannery and Rangan, 2006). Thus, estimating the adjustment speed of capital structure could be an important first step in verifying conflicting theories of capital structure. Using manufacturing firms listed on Korean security markets from Jan. 1, 2001 to Dec. 31, 2008, this study analyses the relationship between financing market accessibility and capital structure adjustment speed toward target debt ratio. This paper shows that the capital structure adjustment speed overall increases when the debt and equity financing market accessibility is good. This result holds regardless of the use of book and market debt ratio as dependent variable. Furthermore, firms can adjust their leverage toward the target faster when they have good equity financing market accessibility than debt financing market accessibility. These results suggest that financing market accessibility is the crucial determinant of capital structure adjustment speed, and this finding should shed important light into ways for policy makers to support firms' smooth debt and equity financing.