eThesis - School of Business electronic theses

PURPOSE OF THE STUDY

Traditional capital structure theories, such as the trade-off and pecking order theories, do a poor job of explaining observed leverage ratios or capital structure choices as managerial decisions. This paper studies why European firms issue significant amounts of debt to induce the leverage ratio to jump and what factors affect the post-jump leverage adjustment. As debt-driven leverage increases are the focus of this thesis, I exclude from my sample market leverage increases induced by changes in the value of market equity. To sum up, this thesis belongs to the cohort of empirical studies that have recently studied distortions in corporate capital structure. Furthermore, my results also add to the existing body of literature exploring the speed of leverage adjustment.

DATA AND METHODOLOGY My final sample consists of 173 firm-years in which a European firm increases its market leverage at least by 0.10 between 1991 and 2004. To be included in my sample I also require the jump to be debt-driven, rather than induced by changes in market capitalization. To compute excess leverage, I predict target leverage ratio using a double-sided Tobit model, censored at 0 and 1. To identify why firms issue significant amounts of debt, I track the use of cash during the seven years follow- ing a jump. Finally, to study leverage adjustment, I group the observations according to the realized cash flows and their position relative to the predicted target leverage ratio. As robustness checks, I investigate whether firms could have pursued the chosen cash uses in the absence of the debt issuance and whether they increase equity issuance activity around jump.

RESULTS The results show that funding long-term internal investment opportunities (66%) or funding in- creases in working capital (23%) are the main uses of proceeds from debt issuance. Over 95 % of firms could not have pursued the chosen long-term investment targets in the absence of the proceeds. The respective figure for funding increases in working capital is 72.7 %. Firms remain at below-target leverage ratios three years prior to a jump, move to the target ratio within five years after the leverage jump. Firms do not proactively issue equity to rebalance the increased leverage ratio. Furthermore, I find no pattern explaining the relation between financial surplus (deficit), position relative to target leverage, and leverage adjustment. However, I find that firms with larger cash flow realization are more aggressive in leverage adjustment than respective firms with lower cash in- or outflows.