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DEFINITION OF CAPITAL STRUCTURE

A mix of a company's long-term debt, short term debt, common equity and preferred equity. The capital structure is how a firm finances its overall operations and growth by using different sources of fund.

The Determinants of Capital Structure Choice

JOURNAL OF FINANCE
Vol. 43, No. 1 (Mar., 1988) pages. 1-19

Authors Sheridan Titman and Roberto Wessels


Both authors are from the University of California, Los Angeles.

INTRODUCTION

1.

2.

3.

This paper analyzes the explanatory power of some of the recent theories of optimal capital structure The study extends empirical work on capital structure theory in three ways. Broader set of capital structure theories The authors analyze measures of short-term, longterm, and convertible debt rather than an aggregate measure of total debt The study uses a factor-analytic technique that mitigates the measurement problems encountered when working with proxy variables.

BASIS OF STUDY
Previous Studies lack following factors:
1.

No unique representation of the attributes

2.

Difficult to find measures of particular attributes that are


unrelated to other attributes that are of interest Observed variables are imperfect representations of the

3.

attributes they are supposed to measure


4.

Measurement errors in the proxy variables may be correlated with measurement errors in the dependent

variable

OBJECTIVES

Extension in the range of theoretical determinants of capital structure.

Some of these theories have different empirical

implications with regard to different types of


debt instruments.

Technique is used that explicitly recognizes and mitigates the measurement problems discussed above.

PROBLEM STATEMENT

The impact of unobservable attributes on

the choice of Capital Structure.

Research and Methodology

DATA COLLECTION
Data is collected from Large Firms. In total, 469 firms were available. The variables discussed in the previous sections were analyzed over the 1974 through 1982 time Period.
SECONDARY DATA

The source of all the data is the ANNUAL COMPUSTAT INDUSTRIAL FILES and from the U.S. DEPARTMENT OF LABOR, BUREAU OF LABOR STATISTICS, "Employment And Earnings" publication.

MODEL

Technique used by author is Linear Structural Modelling. This method assumes that, although the relevant attributes are not directly observable, we can observe a number of indicator variables that are linear functions of

one or more attributes and a random error


term.

The model estimated, is an application of the


LISREL system.

It can be conveniently thought of as a factor-analytic


model consisting of two parts:

1.

Measurement Model.

2.

Structural Model.

They Are Estimated Simultaneously.

Measurement Model
Unobservable firm-specific attributes are measured by Relating them to observable variables, e.g., Accounting Data.

Structural Model
Measured debt ratios are specified as functions of the Attributes defined in the measurement model.

VARIABLES
Dependent Variables

Capital Structure Choice

Independent Variables

Collateral Value of Assets Non-Debt Tax Shields Growth Uniqueness Industry Classification Size Volatility Profitability

HYPOTHESIS

COLLATERAL VALUE OF ASSETS


Collateral Value of Assets
Capital Structure Choice

Ho = It is observable attribute HA = It is unobservable attribute

HA = ACCEPTED

NON-DEBT TAX SHIELDS


Non-debt Tax Shields
Capital Structure Choice

Ho = It is observable attribute
HA = It is unobservable attribute HA = ACCEPTED

GROWTH

Growth Rates

Capital Structure Choice

Ho = It is observable attribute

HA = It is unobservable attribute
HA = ACCEPTED

UNIQUENESS
Uniqueness
Capital Structure Choice

Ho = It is observable attribute
HA = It is unobservable attribute

Ho = ACCEPTED

INDUSTRY CLASSIFICATION
Manufacturing Firms Ho = It is observable attribute
HA = It is unobservable attribute
Capital Structure Choice

HA = ACCEPTED

SIZE
Small Firm +ve
Short Term Debt in Capital Structure

Large Firms

+ve

Long Term Debt in Capital Structure

Ho = It is observable attribute HA = It is unobservable attribute Ho = ACCEPTED

VOLATILITY OF EARNINGS

Volatility Of Earnings

Capital Structure Choice

Ho = It is observable attribute HA = It is unobservable attribute HA = ACCEPTED

PROFITABILITY
Profitability
Capital Structure Choice

Ho = It is observable attribute
HA = It is unobservable attribute

HA = ACCEPTED

TEST

Following tests are applied:

T- Test Chi-Square

FINDINGS

1.

In particular, Author find that debt levels in Capital Structure are negatively related o the "uniqueness of a firm's line of business. Short-term debt ratios were shown to be negatively related to firm size.

2.

3. Authors results do not provide support for an effect on Capital Structure Choice arising from Non-debt Tax Shields Volatility Collateral Value Future Growth

CONCLUSION
This paper introduced a factor-analytic technique for estimating the impact of unobservable attributes on the choice of corporate debt ratios. While our results are not conclusive, they serve to document empirical regularities that are consistent with existing theory. (Titman & Wessels)

LIMITATIONS
It remains an open question whether our measurement model does indeed capture the relevant aspects of the attributes suggested by these theories. One could argue that the predicted effects were not uncovered because the indicators used in this study do not adequately reflect the nature of the attributes suggested by theory. (Titman & Wessels)

SUGGESTIONS
If stronger linkages between observable indicator variables and the relevant attributes can be developed, then the methods suggested in this paper can be used to test more precisely the extant theories of optimal capital structure choice.

Questions?