SSRN Id1501

The Management of Corporate Capital Structure: Theory and Evidence*
Gerald T. Garvey
Finance Division
Faculty of Commerce and Business Administration
University of British Columbia
Vancouver BC Canada V6T 1Z2
FAX (604) 8228521
Gerald.Garvey@commerce.ubc.ca
Gordon Hanka
Smeal College of Business
Pennsylvania State University
ghanka@psu.edu
For an electronic copy of this paper, please visit: http://ssrn.com/abstract=1501
Abstract
Corporate managers exercise discretion over financial as well as investment policies. We present
a model in which a manager controls the firm’s dynamic capital structure in her own interest,
increasing leverage to fend off takeovers and decreasing leverage to avoid financial distress. An
increase in the cost of mounting a hostile takeover is shown to induce a substitution of equity for
debt finance; firms which are protected from takeover are less (more) likely to increase
(decrease) their leverage and will tend to issue equity rather than debt. We test these
implications by examining actual financial policies before and after "second-generation" state
antitakeover laws became effective. As predicted by the model, coverage by antitakeover laws
sharply reduces the use of debt finance. Firms which are not covered by antitakeover laws exhibit
no such policy shift.
JEL Classification Numbers G32, G34
* Thanks to Ron Giammarino for suggesting the use of second-generation antitakeover amendments and to Jon
Karpoff for providing the data on such amendments. For comments and suggestions we thank Bob Gregory, Peter
Hartley, Joseph Hirshberg, and Rohan Pitchford.
Electronic copy available at: https://ssrn.com/abstract=1501

Corporate capital structures are not chosen once and for all. Observed capital structures reflect
each firm’s history of exogenous shocks to profits and asset values as well as its financing and
distribution policies. This dynamic perspective on capital structure originates from Donaldson’s
(1969) field studies and Myers' (1984) pecking-order theory. Fisher, Heinkel and Zechner
(1989) (henceforth FHZ), Leland (1984) and Leland and Toft (1996) have characterized optimal
dynamic investment and financial policies and, in the case of FHZ, explained some of the cross-
sectional variation in the way firms manage their capital structures.
The above dynamic analyses make the standard assumption that financial decisions are
made with the sole aim of maximizing shareholder wealth. Donaldson’s (1969) original study,
by contrast, emphasized goals such as organizational survival and growth, objectives which can
conflict directly with the maximization of shareholder wealth (see especially Jensen, 1993 ).1
This managerial perspective on capital structure fits well with a dynamic approach, since
managers only have discretion when the firm’s founding shareholder(s) are unable to write a
comprehensive ex ante contract specifying all future financing decisions. Like Zwiebel (1994)
and Novaes and Zingales (1995), we analyze a model in which capital structure is chosen to keep
the firm and top managers safe from takeover or insolvency rather than to maximize shareholder
wealth. Unlike Zwiebel (1994) and Novaes and Zingales (1995), we test the model’s
implications for how capital structure policy should be affected by changes in the cost of
mounting a hostile takeover.
The presence or absence of “second-generation” state-level antitakeover laws adopted in

the late 1980's allows us to identify an exogenous variation in the cost of takeover for a large
sample of firms. The importance of such laws in increasing the cost of takeover is suggested by
Karpoff and Malatesta's (1989; 1995) finding that firm stock prices fell significantly upon the
announcement of antitakeover legislation, and by Wahal, Miles, and Zenner's (1995) finding that
large institutional shareholders pressured some firms to opt-out of the Pennsylvania law.
Comment and Schwert (1995) have questioned the effectiveness of antitakeover amendments by
showing that such laws do not appear to have greatly reduced takeover activity. This finding is
entirely consistent with our model, and indeed any model in which the threat of takeover
disciplines managers. When the cost of takeover is low, managers keep capital structure closer to
that which maximizes shareholder wealth so that the potential gain to mounting a takeover bid is
also low. Conversely, when the cost of takeover is high, managers maintain more “slack” in the
capital structure (and presumably in other policies not modeled here) so the gains to takeover are
1
Leland and Toft (1996) allow for financial structure to affect real decisions, but only because managers are
assumed to act in the interests of shareholders.

correspondingly greater. When managerial slack is endogenized, the net gain to mounting a
takeover need not be greatly affected by antitakeover amendments and legislation.
Since second-generation antitakeover laws became effective between 1987 and 1989, we contrast
firms’ financial policies before and after the legislation. To control for other contemporaneous
changes in the relative costs and benefits of debt finance, we use data from firms in states which
did not adopt any antitakeover laws along with a set of firm-specific controls. Our results are as
follows:
1. The model predicts that firms in which managers are shielded from the threat of takeover are
2
less likely to exhibit increases in leverage, and more likely to decrease leverage. We find
that firms which are covered by state antitakeover laws became significantly less inclined to
increase leverage, and more inclined to reduce leverage, after the laws become effective.
There is no such change in behavior for firms incorporated in states which did not pass
antitakeover legislation.
2. Not only do protected firms exhibit an overall relative decline in leverage, we find they also
use less long-term debt as a fraction of total net security issues. There is no identifiable effect
on dividends or share repurchases.
3. Under fairly mild conditions, the model predicts more variable leverage in protected firms.
The data provide little support for this implication.
4. An unexpected finding is that firms which were eventually covered by antitakeover

legislation used leverage more aggressively in the years preceding the effective adoption of
such amendments. After the laws were passed and their constitutionality was established
became clear (see Romano 1993), covered firms moved sharply away from the use of debt.
Overall, our results support the view that dynamic capital structure decisions are affected
by managerial discretion. Future research on this topic includes taking account of a richer set of
devices that push managers to consider their shareholders’ welfare. While state antitakeover laws
are less plagued by the endogeneity problems of disciplinary devices such as firm-level takeover
defenses, management incentive pay, or board structure, result (4) could indicate that
2
Some support for this proposition is found in Denis' (1990) study of 49 major leverage-increasing transactions,
which were explicitly aimed at defeating hostile bids. We find that takeover threats affect the management of capital
structure more generally.

antitakeover legislation occurred in states with a preponderance of firms which were otherwise
3
highly exposed to takeover threat. We intend to explore this issue in future research.
I. The Model
A. Wealth-Maximizing Capital Structure
Hostile takeovers in our model are essentially aimed at “restoring” shareholders’ preferred
structure. We begin by characterizing this capital structure choice. While our implications for
observed capital structure decisions hold for any setting in which shareholder wealth is
maximized at a unique debt/asset ratio, we focus on the traditional tradeoff between tax benefits
and financial distress costs. We merely require some conflict of interest between managers and
shareholders over the choice of financial policy. Here, managers place more weight on financial
distress costs than do shareholders. Similar results would be obtained if debt were used to
discipline managers as in Stulz (1990) or Hart and Moore (1995).
The firm has a single terminal cash flow denoted R + λ where λ is a mean-zero random
realization of λ is known. Decisions are made in the following order:
1. R is revealed.
2. Capital structure is chosen.
3. The realization of is revealed and payouts are made to investors.
untaxed. We generate an interior optimum for the debt-equity ratio by assuming a deadweight
cost of financial distress b which is proportional to the shortfall between realized revenues R + λ
A
because, as we confirm below, λ is invariant to firm scale. Moreover, since R is the firm’s
expected terminal value and D is the fixed claim on such value, the difference λ ≡ D – R is
essentially a log transformation of the firm's debt/asset ratio. Proposition 1 summarizes the
standard static optimal choice of this variable.
3
While it is plausible that corporate managers effectively lobbied for antitakeover legislation, Eckel (1995) finds no
significant linkage between campaign contributions and Senate votes on a series of failed federal bills proposed
between 1985 and 1986.

Proposition 1 immediately implies that if capital structure is costlessly chosen in the
interest of investors, firms will maintain the same degree of leverage for any expected terminal
value. If R is high, D will be increased by the same amount to maintain the wealth-maximizing
amount of leverage, λ I. FHZ (1989) show that even small costs of changing capital structure can
generate quite wide swings in wealth-maximizing capital structure choices when initial asset
value R is stochastic. Essentially, the firm chooses to recapitalize only if R is sufficiently large or
small relative to its expected value so that observed λ values fluctuate around the static
optimum 1,. We now turn to the capital structure choices of a manager who is solely concerned
with keeping her job, noting that the comparative static results of FHZ carry over so long as the
manager exhibits even an indirect concern for shareholder wealth.
B. Managerial Capital Structure Choices

We assume that the manager loses her job if the firm goes into distress (see Gilson,
1989). If shareholders could not exert any influence on the manager’s policies, she would choose
.
possibility that manager can also lose her job through a takeover which occurs after move 2
4
where the manager chooses capital structure. We assume the acquirer can choose the wealth-
maximizing capital structure of Proposition 1 at zero cost, but that there is no other gain to the
merger. Hence the acquirer places a value of V on the target. The assumption of zero cost
and no comparative advantage or disadvantage are purely for convenience; all our results go
through so long as the acquirer is sufficiently competent to threaten a manager who maintains too
5
much financial slack.
4
Raids that occur before the capital structure can be based only on conjectures about the manager’s actions and can
serve no disciplinary role.
5
A low adjustment cost is also plausible because in equilibrium the acquirer will always increase leverage.
Moreover, hostile acquirers tend to use debt to finance a takeover and are often highly leveraged themselves.
Friendly acquirers tend to have capital structures that are closer to that of the acquirer, but by definition they do not
threaten the manager’s job. The assumption that the acquirer has the same ability as the manager is also consistent
with our focus on disciplinary takeovers. We assess the effects of differential ability in the appendix.
5
While the acquirer has the same ability as the incumbent manager, we assume he must
pay a cost of h to take over the firm. This cost summarizes the effect of defensive strategies,
6
antitakeover laws, and any price run-up caused by free-riding target shareholders. We assume
that h > 0 so that the manager can always deter the acquirer if she chooses the capital structure
which maximizes investor wealth. Acquirers with synergy values above h will succeed in taking
over the firm regardless of the manager’s action and hence do not affect her capital structure
choice. Define &satisfying:
Since the manager is assumed to care only about keeping her job, (2) fully characterizes
—
minimizes the probability of distress subject to the constraint that the firm not be taken over.
Allowing the manager to be uncertain of the acquirer’s valuation would allow takeovers to occur
with positive probability even at her optimal choice, but does not produce any additional
implications for capital structure choice. We consider this case briefly in the appendix.
The most straightforward result is that the manager’s ideal choice of leverage strictly
decreases as the cost of takeover h increases. This follows directly from applying the implicit
function theorem to (2):
6
We take h as parametric, but our results also hold if h is a function of capital structure as in Israel (1991). The only
(1995) show the manager might choose more debt than shareholders would like if increased leverage is sufficiently
harmful to the acquirer.

In a world where managers make a once-and-for-all choice of leverage, our empirical
implications would be completely summarized by (3). However, if such a choice were possible,
the firm’s founders would have chosen leverage to maximize the proceeds from initially
floating the firm. Managers have discretion over capital structure precisely because it is
impossible for any party to "pre-program" the firm's entire capital structure path. We introduce
dynamic considerations in the simplest possible fashion by assuming that the firm begins with
some arbitrary level of debt, D , and that expected cash-flows are drawn from the cumulative
0
distribution F(R). We focus on the manager’s decision to adjust capital structure from any initial
previous period rather than being exogenously imposed. As we show in the appendix, this
generalization would not affect the results of our stripped-down model.
We follow FHZ by assuming that the manager can re-adjust to her preferred capital
7
structure at a fixed cost of z. We assume that z < J* so that the manager will choose to
recapitalize rather than be taken over and lose J* in the event that beginning leverage is below
key testable features of the manager’s financing choice.
PROPOSITION 2: The manager will recapitalize only when initial leverage Do - R falls outside
For a given distribution F(R), an increase in the cost of a
hostile takeover, h:
a) reduces both the upper and lower bounds between which the manager will allow
leverage to fluctuate;
b) decreases the probability that the manager will increase leverage; and
c) increases the probability that she will reduce leverage.
Figure 1. The solid line in Figure 1 depicts the probability the manager keeps her job safe from
the threat of financial distress, 1 – G( λ ) for the case where G is unimodal and λ is always less
than the modal value of λ. The manager never allows leverage to fall below λ since her firm
would be taken over for sure. If she bore no adjustment cost, she would also never allow
7
I This cost is personal to the manager. Costs which are borne by investors are irrelevant to the manager as they are
sunk by the time a raid might threaten. Whether the cost is lump-sum or proportional to new debt is irrelevant for

Results (a-c) are all driven by the fact that an increase in h decreases both of the critical
from the fact that the manager’s utility at λ, J*, strictly increases as λ decreases. The manager
will recapitalize as soon as her gain from so doing is at least J* - z. When J* increases, so must
flows, firms that are insulated from takeovers are more likely to reduce leverage by, for example,
choosing equity over debt as a source of new funds or by retiring existing debt. They are less
likely to boost leverage through such measures as stock repurchases.
Proposition 2 summarizes the effect of takeover threats on two dimensions of the firm’s
financial policies. The first statement characterizes the leverage that the firm will exhibit when
the manager chooses not to adjust to innovations in asset values. The second two statements
indicate the adjustments the manager will choose to make when asset value shocks are
sufficiently large. Under reasonable conditions the model has implications for the width of the
leverage bounds as well as their placement. These results are summarized in Proposition 3.
PROPOSITION 3: The range of observed leverage choices,
of asset values, firms which are insulated from takeover will exhibit wider variation in observed
leverage.

II. Empirical Tests
A. The Data
Propositions 2 and 3 both focus on exogenous changes in h, the cost of mounting a hostile
takeover. We capture high values of h by the presence of at least one of the “second-generation”
antitakeover laws adopted between 1987 and 1989 (see Karpoff and Malatesta (1989) and
Comment and Schwert (1995) for a description and assessment of the laws). Most of our tests
examine the effect on financial policy of dummies indicating that the firm’s state of
incorporation (from Compustat) had in place a second-generation anti-takeover law.
The vast majority of the anti-takeover laws were passed during the period of 1987-1989;
8
a few states that passed laws in other years are excluded from the sample. The sample includes
the years 1983-1993. 1989 seems to have been a watershed year for anti-takeover law, as it
marked the passage of the Delaware law shielding many large corporations, the unusually
restrictive Pennsylvania law, and the Supreme Court’s decision supporting the Wisconsin law.
The prior two years, 1987 and 1988, were periods of uncertainty and anticipation, during which a
few states passed anti-takeover laws of uncertain enforceability. Furthermore the crash of 1987
was followed by large share repurchases. The regression influence of these large repurchases
may reduce the model’s applicability to leverage changes in other years, so in most tests the years
1987-1989 are excluded as a transition period. Where required, we report findings with these
years included in various ways.
We wish to assess the financial policies of firms before and after the incidence of
antitakeover laws as well as those of firms which were never covered by such laws. If firms with
missing data were included in such a test, changes in sample composition could generate
spurious differences between the before and after samples. While this procedure may in
principle involve some selection bias, it is important to recall that in our model, and in reality,
firms drop out of the sample for two reasons: insolvency (too-high leverage) and takeover (too-
low leverage). Our model essentially states that firms manage their capital structures to
minimize the chance of dropping out for these two reasons. Thus, there should be no systematic
leverage pattern for firms which leave the sample. To address survivor bias in a fully satisfactory
8
85 firms were excluded by this criterion. As Romano (1993) stresses, there was essentially no effective
antitakeover legislation at the federal or state level between the passage of the Williams Act in 1980 and the
Supreme Court’s upholding of the Indiana Law in 1987.
9
Firms could opt out of the Pennsylvania law. Excluding Pennsylvania firms does not change our results, but these
firms are left in the reported tests because the decision to opt out is made by the same managers who make leverage
decisions, so opting in or out it will not so much determine the preferences of managers as it will reveal them. See
Wahal, Miles, and Zenner (1995) for more details on opting out of the Pennsylvania law.
9
matter, we would need additional data as to why firms drop out of the sample. Our sample is
therefore the set of all Compustat industrial firms with complete data for the years 1980 to 1993,
excluding financial-services firms (SIC 60-69) and utilities (SIC 40,48,49). 2329 non-utility,
non-financial firms were covered by Compustat for the entire sample period. 1312 were deleted
because of missing data, and 85 were deleted because their states passed laws in years other than
1987-1989, leaving a final sample of 932 firms.
Table 1 presents some key descriptive statistics in our sample. Overall, firms appeared to
increase leverage over the mid to late 1980's and subsequently to deleverage. While this finding
is consistent with our model given the overall “chilling” of the corporate control market during
this period, it could also reflect changes that are unrelated to takeover threats and managers’
discretion to choose capital structure. Our model is supported only to the extent that temporal
patterns in financial policies differ between firms which were covered by antitakeover legislation
and those which were not. All our estimates of such differences include the log of total assets
and operating earnings as a fraction of assets (ROA) to capture effects of scale and earnings
capacity. To capture the effects of other relevant omitted variables, we also use the
contemporaneous industry mean of the dependent variable, where “industry mean” is defined as
the same-year mean among other firms (i.e., excluding the firm in question) in the narrowest SIC
that includes at least four other firms. Estimates of leverage changes also include prior leverage,
change in size and ROA, and a dummy variable to indicate whether the firm reported a net loss in
the prior year.
Leverage is measured by book value of long-term debt as a fraction of total assets. 10 Our
results are unaffected by the choice of assets or market value of equity as the scale variable. Our
measures of leverage are right-skewed, so to ensure that the results reflect pervasive phenomena
l1
rather than scattered outliers, all variables are Winsorized at both the upper and lower one
percent tails. As a further precaution against outliers, the significant results were replicated with
regressions in which all variable values are replaced by their sample rank.
We first examine the effect of antitakeover laws on leverage changes to test the
hypotheses in Proposition 2. We then refine our tests to examine how the effect of profitability
on leverage differs across firms.
10 Long-term debt is appropriate given our focus on managerial objectives. Managers are more likely to be displaced
following a default on long-term, primarily public debt than on short-term bank loans (eg., Gilson and Vetsuypens,
1993). Similarly, Zwiebel's (1994) model suggests that long-term debt is more likely to be a deterrent to hostile
takeover.
11
In other words, values outside the 1st or 99th percentile are set equal to the 1st or 99th percentile,
10
B. State Antitakeover Laws and Leverage Changes
B. 1 Overall Leverage Changes
Tables 2-6 assess the predictions of Proposition 2 that firms which are protected from takeover
are less inclined to increase leverage and more inclined to reduce leverage. Tables 2 and 3 focus
on observed leverage changes in each of our sample years . Our model envisions a potential
leverage change every period, which will or will not occur depending on its target range and by
cash-flow shocks. Antitakeover laws shift the firm’s target range and thus its decision on leverage
changes each period. Since the recapitalization choice could occur almost any time, we examine
the shortest period over which the relevant data are available. We do not distinguish between the
two reasons for leverage changes characterized in Proposition 2. That is, we do not ask whether
bring leverage back inside the bounds. After presenting the overall results in tables 2 and 3, we
focus on active changes to the firm’s financial structure.
The models in Table 2 test for effects of anti-takeover laws by splitting the sample into
the pre-law and post-law periods, and comparing the pre-law and post-law regression coefficients
on a dummy variable state that indicates whether the firm’s state of incorporation passed an anti-
takeover law. The significance of the pre- to post-law change is tested by pooling the two time
periods and adding both a time dummy (to distinguish pre-law from post-law) and a protected
dummy which equals the product of the state and time dummies. Protected indicates whether
managers were protected by an in-place law.
Table 2 shows results with leverage changes defined in the most obvious way, as the net
change in long-term debt/assets. The state coefficients in the first two columns reveal that firms
in the anti-takeover states tended to increase their leverage, relative to similar firms in other
states, in the period before the anti-takeover laws were passed but not in the period after. In the
final column, the pooled sample, the coefficient on protected is significantly negative, indicating
that protected managers significantly reduced their leverage. The coefficient of -0.012 is about
5% of the average leverage of 0.21, indicating that protected managers reduced their leverage by
about 5% per year. The coefficient on protected is still negative and significant at the 95% level
if the transition years 1987-1989 are included and the time dummy is set to indicate either 1989
or 1990, or is set to indicate the year that the specific state passed its law (or 1988 for states with
no law).
The remaining variables in Table 2 serve mainly as controls. While our model makes no
strong predictions regarding the effects of these variables, we are not aware of any other
empirical studies of leverage changes. Hence, our findings may be of some independent interest.
11

The negative coefficient on prior leverage is consistent with the existence of target leverage
levels that tend to be near the average leverage. The fact that leverage falls in ROA, however,
suggests that targets are not strictly maintained. This finding is consistent with Myers’ (1984)
pecking-order argument, or with the type of leverage-adjustment cost introduced by FHZ and
adopted here. The remaining results do not permit such simple interpretation. The industry
mean of leverage changes, a catch-all control for omitted determinants of leverage, is significant
only in the latter period of our study. The other puzzling result is that larger and growing firms,
ceteris paribus, tended to increase their leverage during the sample period.
Table 2 analyzes continuous changes in capital structure. When the fixed costs of
recapitalization z are significant, firms should exhibit relatively large, discontinuous changes in
capital structure policy. Table 3 therefore concentrates on relatively dramatic leverage events
and separates leverage increases from leverage reductions. Table 3 presents logit models which
predict the incidence of major leverage changes, defined as a 0.1 change in the ratio long-term
debt/assets. A change of 0.1 is equal to about half the average total leverage and is roughly the
90% percentile of leverage changes.
The results indicate that, as predicted in Proposition 2, protected managers are less likely
to sharply increase leverage, and more likely to sharply reduce leverage. Both effects are
significant at the 95% confidence level. Since these leverage change events are relatively rare,
the logit coefficients on a dummy variable can be interpreted as roughly alp/p, the implied
proportional change in probability. Hence the protected coefficients of -0.55 and 0.63 imply that
protected managers are less than half as likely to increase their leverage sharply and more than
half again as likely to reduce their leverage sharply.
B.2 Deliberate Changes in Leverage
Thus far, we have focused on the firm’s observed leverage and have not examined how
managers deliberately alter capital structure through the choice of securities or payout policy.
Tables 4-6 look directly at the firm’s financing decisions. Table 4 begins by examining the
leverage effects of external financing, defined as debt issues less debt retirements, plus stock
repurchase less stock issues, as a fraction of the prior year’s assets. The results indicate that after
1989 the external financing decisions of protected managers shifted from abnormally pro-
leverage to abnormally anti-leverage. Both the pre-law and post-law effects are significant at the
95% confidence level, and in the pooled sample the coefficient on protected is negative and is
significant at the 99% level. The effect of antitakeover legislation is actually stronger in the case
of deliberate leverage changes since as column two indicates, protected firms reduce their use of
debt not only relative to their own past behavior but also relative to their unprotected
12

contemporaries. Moreover, our results are similar if the transition years 1987-1989 are included
and the time dummy is set to indicate 1989, 1990, or the year that the specific state passed its
law. This result is not easily attributable to the collapse of the junk bond market, but is
consistent with the hypothesis that managers’ external financing decisions are affected by state
anti-takeover laws.
Table 5 separates out the effects of security issues and retirements. The coefficient on
protected is significant only for security issues, indicating that state anti-takeover laws tilted
security issues away from long-term debt, but did not significantly affect security retirements.
Thus far we have assumed that managers only change capital structure by issuing or
retiring securities. In principle, leverage is also a function of the firm’s dividend policy.
Proposition 2 suggests that protected managers should be more willing to cut dividends, and less
anxious to increase dividends. Table 6 tests this hypothesis with models of dividend changes,
dividend initiations, and dividend omissions. The coefficients on protected have the predicted
sign, but are not statistical y significant. Hence state anti-takeover laws appeared to have no
significant effect on corporate dividend policy. This inconclusive result is consistent with
DeAngelo, DeAngelo and Skinner (1996) who find that dividends and dividend changes are
simply too small, relative to the firms’ resources, to credibly signal managerial discipline.
B. 3 The Variability of Observed Leverage
Proposition 3 shows that—it is quite possible for the bounds within which managers are
willing to let leverage fall, [&A], to expand as the cost of takeover increases. Effectively,
protected managers will appear to be less concerned about maintaining their optimal target
leverage so that leverage will be more variable over time. Table 7 tests this hypothesis by
extending the approach of FHZ (1989)) to account for the presence or absence of antitakeover
laws. We estimate a model of the 4-year variability in leverage, defined as the difference
between 4-year maximum and minimum. The coefficient on protected is positive as predicted,
but is less than a standard error from zero. State anti-takeover laws have little power to explain
the variability in total leverage.
C. Robustness Checks
Thus far, we have assumed that state antitakeover laws represented the major change to the
corporate control market over the years 1987-89. In fact, the year 1989 also saw the collapse of
the junk-bond market, which increased the financing costs of many would-be hostile acquirers. It
is at least conceivable that this event reduced pre-existing differences between the attractiveness
of mounting a takeover in the pro- versus the anti-takeover states, thereby spuriously inflating the
apparent effect of anti-takeover laws. Hence, the collapse of the junk-bond market could be
13
responsible for the disappearance of a preexisting difference between pro- and anti-takeover
states documented in Tables 2 and 3. This interpretation of the results is not inconsistent with
the predictions of the model, as the collapse of the junk-bond market is, like passage of an anti-
takeover law, an exogenous event that increases the cost of mounting a hostile takeover.
Furthermore, the more direct look at external financing decisions presented in table 3 shows that
the 1987-1989 period brought on significant differences between the financial policies of
protected and unprotected managers, an event not easily explained by the collapse of the junk
bond market.
Significant differences in leverage changes should eventually translate into significant

differences in leverage levels. However, while Table 4 demonstrates that the imposition of state
anti-takeover laws was followed by a significant difference in the external financing decisions of
protected versus unprotected states, Tables 2 and 3 show that this change in external financing
was powerful enough only to erase the pre-law trend in changes to total observed leverage, and
did not create a significant post-law trend of opposite sign. Consistent with this result, a model
of debt-asset levels rather than changes, estimated in 1986 and 1993 with additional controls for
cross-sectional leverage determinants like asset composition and R&D intensity, reveals no
significant difference between the ultimate total leverage levels of protected and unprotected
firms.
The pre-1987 difference in financial policies is neither consistent nor inconsistent with
our model. Our tests all focus on the change induced by antitakeover laws, which is
unambiguously anti-leverage as predicted by the model. The pre-existing differences does,
however, indicate some heterogeneity which is not captured by our control variables. Of
particular concern is the possibility that non-linear size or profitability effects maybe driving our
key results. Tables 2 and 3 allow only for linear effects and from Table 1 it is clear that firms in
protected states tend to be larger than those in unprotected states. As Table 8 shows, however,
the deleveraging effects documented in Tables 2 and 3 are not affected by the inclusion of
additional size controls such as market value and non-logged assets. Also, Table 9 shows that
our conclusions are not driven by the presence of large outlier firms in the protected states
(especially Delaware) since protected continues to significantly reduce the use of leverage when
our variables are specified in terms of rank rather than levels. The fact that firms which were
eventually covered by antitakeover laws began with more aggressive leverage policies remains a
puzzle, but does not alter our conclusions about the anti-leverage effects of the amendments.
14
111. Concluding Remarks
This paper adopts a view of capital structure which is not entirely at odds with the standard
assumption of shareholder wealth-maximization, but which recognizes the potentially important
role of dynamics and managerial discretion. We do not assume that managers actively strive to
implement a leverage ratio which maximizes shareholder wealth or firm value. Rather, managers
inherit a debt burden which reflects past financing choices and the returns to assets in place. If
the firm is profitable and the debt burden is light, managers will gladly accept the resulting
"suboptimal" capital structure. But the tax shields and other benefits of leverage still exist and
managers who ignore these benefits will eventually invite a hostile takeover bid.
Our managerial model predicts that firms in which managers are shielded from the threat
of takeover are less likely to exhibit increases in leverage, and more likely to decrease leverage.
We find that state antitakeover laws have just this effect on actual debt-asset ratios. Takeover
protection induces firms to reduce their overall leverage, and to use less long-term debt as a
fraction of total net security issues.
Since takeover threats are driven by shareholder wealth considerations, all the standard
comparative statics based on the assumption that managers maximize shareholder wealth
continue to hold in our model. To test our model of capital structure, it is necessary to identify
exogenous differences in the considerations which are important to managers. State anti takeover
legislation is an attractive candidate and does appear to explain some of the differences in the
ways firms actually manage their financial structure. Future research will consider a richer set of
such devices.
15
I
APPENDIX
A.1 Proofs of Propositions 1-3
PROOF OF PROPOSITION 1: The market value of the firm including tax and bankruptcy costs
can be expressed:
That D1 is a unique optimum follows from the fact that:
(A.3)
Applying the implicit function theorem to the first-order condition for DI, we also have:
(A.6)
16
(A.7)
Applying the implicit function theorem to (A.8) yields:
(A.9)
A.2 The Case of Multiple Periods and Uncertain Synergy Gains
utility at her optimal leverage choice with zero adjustment costs, J*, now satisfies:
We now establish that there is no 1o SS in generality in treating initial leverage as exogenous. To

do so, we consider the case where the manager expects to make a recapitalization choice in each
gains nothing from looking forward to period 2 in making this choice. Her problem in period
one is to maximize the probability of retaining her job in both periods,
17

where
flows.
period

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20

21
Table 1: Descriptive Statistics
Mean
(Median)
1983-1993 1983 1988 1993
Pro-Takeover States (128 firms)
Long-term debt / assets 0.145 0.165 0.134 0.156
(0.104) (0.117) (0.098) (0.1 05)
Log total assets ($ MM) 4.17 3.99 4,16 4,32
(3.66) (3.42) (3.72) (3.68)
Operating Earnings /Assets 0.086 0.098 0,087 0.074
(0.102) (0.115) (0.115) (0.087)
Anti-Takeover States (804 firms)

Long-term debt /assets 0.192 0.176 0.197 0.182
(0.161) (0.1 50) (0.1 70) (0.145)
Log total assets ($MM) 4.74 4.43 4.80 4.93
(4.74) (4.40) (4.82) (5.02)
Operating Earnings /Assets 0.115 0.123 0.120 0.104
Sample is all Compustat firms, excluding firms lacking complete 1980-1993 data, utilities, financial, and firms in
states that passed their anti-takeover law before 1987 or after 1989. All variables are Winsorized at the 1% tails.

Table 2: State Anti-Takeover Laws and Leverage Changes
Sample is pooled cross-sectional time-series of all Compustat firms in the Periods 1983-1986 and 1990-1993,
excluding firms lacking complete 1980-1993 data, utilities, financial, and firms in states that passed their anti-
takeover law before 1987 or after 1989. Debt is defined as book value of long-term debt. ‘Industry mean” is the
same-year mean among other firms in the narrowest SIC that includes at least four other firms. All variables are
Winsorized at the upper and lower 1 % tails. Intercepts not reported. Models estimated by OLS. Standard errors in
parentheses. =95% significant, **=99%.
●

Table 3: State Anti-Takeover Laws and Sharp Leverage Changes
Panel A: Sharp Leverage Increaes
Logit Model of Probability of >0.1 Increase in Long-term Debt/Assets
1983-1986
1983-1986 1990-1993 and
1990-1993
State = 1 iff state passed an 0.50** -0.04 0.51”
anti-takeover law in 1987-1989. (0.20) (0.18) (0.19)
Time = 1 for 1990-1993, 0.30
0 for 1983-1986. (0.25)
Protected = Time State
● -0.55’
(0,26)
All Control Variables in Table 2 yes** yes** yes**
Events / Sample Size 34613728 27813728 62417456
Fraction Concordant Pairs ,74 .66 .70
I Panel B Sharp Leverage Reductions

Logit Model of Probability of >0.1 Reduction in Long-term Debt/Assets

1983-1986
1983-1986 1990-1993 and
1990-1993
State = 1 iff state passed an -0.28 0.33 -0.30
anti-takeover law in 1987-1989, (0.20) (0.24) (0.20)
Time = 1 for 1990-1993, -0.42
0 for 1983-1986. (0.29)
Protected = Time* State 0.63’
(0.31)
All Controls in Table 2 yes** yes*’ yes**
Events / Sample Size 23613728 28313728 51917456
Fraction Concordant Pairs .86 .85 .85
Sample is pooled cross-sectional time--series of all Compustat firms in the periods 1983-1986 and 1990-1993,
takeover law before 1987 or after 1989. All variables are Winsorized at the upper and lower 1% tails. Intercepts not
reported. Standard errors in parentheses. =95% significant, **=99%.
●

Table 4: State Anti-Takeover Laws and External Financing
Dependent Variable is
(Debt Issue - Debt Retirement +
Stock Repurchase - Stock Issue)
/lag (Assets)
1983-1986
1983-1986 1990-1993 and
1990-1993
tate = 1 iff state passed an 0,012’ -0.010* 0.013*
anti-takeover law in 1987-1989. (0.006) (0,005) (0.006)
Time= 1 for 1990-1993, 0.024**
O for 1983-1986. (0,008)
rotected = Time * State -0.024”
(0.008)
AII Controls in yes** yes** yes**
Table 2
Sample Size 3728 3728 7456
Adjusted R2 .11 .06 .08
I Sample is pooled cross-sectional time-series Of all Compustat firm years in the periods 1983-1986 and 1990-1993,
takeover law before 1987 or after 1989. ‘(Industry mean” is the same-year mean among other firms in the narrowest
SIC that includes at least four other firms. All variables are Winsorized at the upper and lower 1 % tails. Intercepts
not reported. Models estimated by OLS. Standard errors in parentheses. * = 95°/0 significant, **=99%.

Table 5: State Anti-Takeover Laws and External Financing by Type
Issues Retirements
Debt Issue / Stock Repurchase /

(Debt + Stock Issue) (Stock Repurchase +
Debt Retirement)
State = 1 iff state passed an 0.052 0.15”
anti-takeover law in 1987-1989. (0.035) (0.04)
Time = 1 for 1990-1993, 0.1 4** 0.035
0 for 1983-1986. (0.05) (0.056)
Protected = Time* State -0.16” “0.034
(0.05) (0.059)
All Controls in yes** yes**
Table 2
Sample Size 4475 5492
Adjusted R2 from OLS.
Sample is pooled cross-section and time-series of all Compustat firms in the periods 1983-1986 and 1990-1993,
excluding firms lacking complete 1980-1993 data, utilities, financial, firms in states that passed their anti-takeover
law before 1987 or after 1989, and observations in which the denominator of the dependent variable is less than 1%
of assets. ‘Industry mean” is the same-year mean among other firms in the narrowest SIC that includes at least four
other firms. All variables are Winsorized at the upper and lower 1%. tails. Model estimated by Tobit regression, which
allows for both left and right censoring. OLS gives similar results, Intercepts not reported. Standard errors in
parentheses. * =95% significant, **=99%.

Table 6: State Anti-Takeover Laws and Dividend Changes
Sample is pooled cross-section and time-series of all Compustat firms in the periods 1983-1986 and 1990-1993,
takeover law before 1987 or after 1989. “Industry mean” is the same-year mean among other firms in the narrowest
SIC that includes at least four other firms. All variables are Winsorized at the upper and lower 1% tails. Intercepts
not reported. Standard errors in parentheses. * =95% significant, **=99%.

Table 7: State Anti-Takeover Laws and Leverage Variability
Protected = Time* State 0,006

(0.018)
Sample is all Compustat firms in the years 1986 and 1993, excluding firms lacking complete 1980-1993 data,
utilities, financial,” and firms instates that passed their anti-takeover law before 1987 or after 1989. ‘Industry mean”
is the same-year mean among other firms in the narrowest SIC that includes at least four other firms. All variables
are Winsorized at the upper and lower 1% tails. Model estimated by OLS. Intercepts not reported. Standard errors
in parentheses. * =95% significant, **=99%.

Table 8: Main Results with Extra Controls for Size and Stock Returns
Sample is all Compustat firms in the periods 1983-1986 and 1990-1993, excluding firms lacking complete 1980-1993
data, utilities, financial, and firms in states that passed their anti-takeover law before 1987 or after 1989, “Industry
mean” is the same-year mean among other firms in the narrowest SIC that includes at least four other firms. Models
estimated by OLS. Intercepts not reported. Standard errors in parentheses. * =95% significant, **=99%.

Table 9: Main Results with Semi-Market Value Specification

Table 10: Main Results With Rank Specification
Dependent Variable
Net Change Deliberate Change
(Debt Issue
Change in - Debt Retirement
Long-Term + Stock Repurchase
Debt /Assets - Stock Issue)
/lag (Assets)
State = 1 iff state passed an 161 309**
anti-takeover law in 1987-1989, (99) (99)
Industry mean of dependent 0.005 0.051 **

variable, (0.011) (0.011)
Previous year’s long-term debt / -0.25” -0.1 9*’
assets (0.01) (0.01)
ROA = Prior year's operating -0.085** 0.009
cash flow I assets. (0.014) (0.014)

LOSS = 1 iff prior year's net 0.007 -0.1 o**
income was negative. (0.013) (0.01)
SIZE = Total assets, log ($MM). 0.11** 0.14’”
(0.01) (0.01)
Sample Size 7456 7456
Adjusted R2. .07 .08
All non-dummy variables are replaced by their sample ranks. Sample is all Compustat firms in the periods 1983-
1986 and 1990-1993, excluding firms lacking complete 1980-1993 data, utilities, financial, and firms in states that
passed their anti-takeover law before 1987 or after 1989. “Industry mean” is the same-year mean among other firms
in the narrowest SIC that includes at least four other firms. Models estimated by OLS. Intercepts not reported.
Standard errors in parentheses. * = 95% significant, **=99%.

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The Management of Corporate Capital Structure: Theory and Evidence*

JEL Classification Numbers G32, G34

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The presence or absence of “second-generation” state-level antitakeover laws adopted in

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4. An unexpected finding is that firms which were eventually covered by antitakeover

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realization of λ is known. Decisions are made in the following order:

2. Capital structure is chosen.

3. The realization of is revealed and payouts are made to investors.

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B. Managerial Capital Structure Choices

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c) increases the probability that she will reduce leverage.

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PROPOSITION 3: The range of observed leverage choices,

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B. 1 Overall Leverage Changes

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B.2 Deliberate Changes in Leverage

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B. 3 The Variability of Observed Leverage

Significant differences in leverage changes should eventually translate into significant

That D1 is a unique optimum follows from the fact that:

Applying the implicit function theorem to (A.8) yields:

A.2 The Case of Multiple Periods and Uncertain Synergy Gains

We now establish that there is no 1o SS in generality in treating initial leverage as exogenous. To

Electronic copy available at: https://ssrn.com/abstract=1501

Electronic copy available at: https://ssrn.com/abstract=1501

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Anti-Takeover States (804 firms)

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I Panel B Sharp Leverage Reductions

Logit Model of Probability of >0.1 Reduction in Long-term Debt/Assets

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Debt Issue / Stock Repurchase /

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Protected = Time* State 0,006

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Industry mean of dependent 0.005 0.051 **

cash flow I assets. (0.014) (0.014)

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