Changes in Capital Structure: Evidence of the 2008 Crisis

After discussing the financial theory behind optimal capital structure and the influences of macroeconomic factors, we would now like to share our findings in regards to changes in capital structure during the 2008 financial crisis. Specifically, we examined the total market and the individual industries for both the United States and the United Kingdom. Our sample period is 2006-2011, which we then divided equally into three parts: Pre-Crisis (06-07’), Crisis Period (08-09’), and Post-Crisis (10-11’). The two dependent variables we chose to observe were leverage (Total Debt/Total Assets) and long-term leverage (LT Debt/Total Debt). Additionally, we tested six other variables using a univariate regression consisting of firm size, market-to-book, profitability, tangibility, non-debt tax shield (NDTS), and growth.

Our results showed that tangibility had the highest explanatory power on the use of leverage for firms in both the US and UK. Our regression results also showed that in the UK, market-to-book and NDTS were important determinants, while in the US it was NDTS and profitability with the highest explanatory power. After this we did a similar regression to test for significance on long-term leverage and found that in the UK, firm size and profitability had the highest explanatory power, where in the US, market-to-book, firm size, and profitability explain the majority of the dispersion. Next we examined total leverage in the US and the UK over the same time period, the results for which are provided in the graph below.

Leverage US & UK

The graph shows that in the pre-crisis period firms, on average, were increasing their leverage up until its peak in 2008, where we see a substantial reduction in leverage during the crisis period. Lastly, we see a divergence in the post-crisis period between the two countries. The US begins to once again gradually increase leverage, while the UK shows an even more drastic decrease in leverage.

Lastly, we observed changes in leverage ratios for the individual industries within each country. We failed to find significant changes in leverage ratios for any of the industries at an alpha level of .05. What we did found instead is large gaps between the industries within each country, and large differences in the same industries between countries. For instance, the US telecommunications industry had a leverage ratio of 48% while the technology industry only had a leverage ratio of 13%. In terms of differences between countries, the same the telecommunications industry in the UK had a leverage ratio of only 28%, which is much lower than its US counterpart. This is consistent with the results found in Graham and Leary (2011), who found financial leverage varies more within industries than within firms over time. Our findings show that leverage ratios were effected by both macroeconomic and industry-specific factors within the country.

Phenomenon that Effect Firm’s Capital Structure During a Crisis

When the macroeconomic environment around any firm turns sour, managers must reevaluate where the company stands and where its resources should be allocated. In order to maximize shareholder wealth, most firms have chosen a general debt/equity level that they believe provides the most value to the company. When a large shock hits the market, i.e. the recent financial crisis, new factors must be taken into account.

Suppose you are the CEO of a large publicly traded car manufacturer in the United States, and the financial crisis has just set in. Before the crisis, your company hired a financial firm that found that the optimal debt ratio to be roughly a 40/60 split between debt and equity. As soon as the crisis begins the firm’s equity levels will start to fall, possibly drastically. This is a result of investors realizing the mispricing in the market and trying to sell their shares. The problem with this fast change in equity level is that your firm may now be far away from their target asset ratios. To continue our example, imagine in the crisis your car company’s stock price fell by one-third. Now the firm has a 50/50 debt-equity ratio. This can be dangerous, particularly for firms that already have high distress costs. Adding to the danger, recession causes individuals to cut spending in consumer spending. This means fewer sales for the firm, a drop in equity level, and higher overall debt ratios.

Firms have a few options to combat this risk. First they can provide themselves a buffer by keeping debt levels below their calculated ‘optimal capital structure’ prior to the recession. Keeping the debt slightly below what investors believe is optimal gives the firm opportunities to be flexible in an emergency. If this is not an option, firms may look at refinancing their debt through the banks. Refinancing for firms in a recession usually means extending the length of the agreement, while reducing each individual payment. Also, in this time it is more difficult for a firm to project cash flows or anticipate changes in the market. For these two reasons we see a general shift away from short-term debt and more towards long-term financing during the crisis period.

Lastly, recessionary periods cause managers to be more selective in choosing investment projects. The CEO of our car company is going to be much more wary of building a new manufacturing plant if he knows the market is in a downturn. Firms in cyclical industries, like our example, typically try to use a lean capital structure. This means that in the months where the product does not sell well the firm take on more debt and vice versa. The problem is that during a recession sales fall and more volatility is introduced. Firms must then make the decision: do the benefits from the added capital outweigh the distress associated with debt financing?

The Volcker Rule: Impact on Banking Regulation

Financial institutions have undergone considerable transformations since the financial crisis in 2008, as they face stricter regulatory capital requirements and tier – one capital requirements. In response to the crisis, the Volcker Rule was a US federal regulation that was implemented as part of the 2010 Dobb-Frank Wall Street Reform and Consumer Protection Act. The rule’s main purpose is to prevent banks from engaging in risky and speculative activities that could threaten their client’s positions. Specifically, the rule forces banks away from making risky bets that can lead to colossal losses, as well as, engage in bets made to only profit the bank, known as proprietary trading. Since the Volcker Rule requirements clamps down on one of the most profitable businesses, Wall Street banks are opposed to the new regulations claiming that proprietary trading was not responsible for the financial crisis and would cause them to sacrifice a significant profit source. As a result, US banks lobbied Congress for a multiyear delay of the requirement in order to unwind some of their positions in thinly traded assets. According to the Wall Street Journal, “The Federal Reserve said it would give banks two additional years to sell stakes in private-equity, venture-capital and hedge funds covered by the “Volcker rule” (WSJ). By holding more liquid assets, such as cash or government securities, on their balance sheets, banks will be able to better manage liquidity risk. Similar to liquidity, increasing the capital requirements of banks will create a buffer and increases the overall safety of banks as well. However, although both increased liquidity and capital on the balance sheets provide benefits, they similarly burden financial institutions with overheads. By holding more liquid assets, the banks earn minimal return on their investment relative to other asset classes. Furthermore, by holding more capital on the balance sheets, banks face higher capital costs since they are not able to diversify their business models by engaging in more profitable activities and managing their risks more effectively making them safer. Thus, by curtailing the banking activities through regulatory prevention, the banks are forced to change their business model, sacrifice potentially profitable activities and decrease their ability to gather valuable market information. All in all, many governments have passed legislation to curtail excessive risk taking by specifically targeting financial institutions. Although this intuitively makes sense to understand why, it is not necessarily good or bad to have widespread banking regulations as it impacts many aspects of business such as how firms finance themselves.

Impact of Interest Rate Changes on Bank’s Financing and Capital Structure

This week brought exciting news for the financial world. Janet Yellen, the fledging US Federal Reserve Chair, softened her stance once again on the quantitative easing process that has been going on for more than five years. Yellen pointed to the unemployment rate hovering at 5.5% and GDP growth stabilizing around their 2% target as the decision criterion.¹ Now that the Federal Reserve’s two directives have been met, low unemployment and stable growth, the FOMC wants to stop forcing low interest rates with their bond-buying programs. This will have a huge impact on the banking sector in the United States. More specifically, we are going to look at what changes the banks will have to make on their balance sheet and any capital structure changes that might optimize shareholder wealth.

First of all, we know that banks are able to borrow at extremely low rates right now. As the risk-free interest rate rises the banks will also have to raise the coupon payments on new loans given out. This means that fewer projects will be accepted, and fewer loans will be given out. Also, in these times of low interest rates, banks have moved a lot of their loans into long-term obligations, because there is so little profit in the short term. As the risk-free rate rises and the economy moves towards a more normal interest rate curve, we expect banks to shift their balance sheet away from long-term debt and more towards short-term debt.

As far the firm’s capital structure is involved, we know a few things for sure and we can make educated guesses about more. A firm has maximized shareholder wealth when the weighted average cost of capital (WACC) is the smallest. Within the WACC we have the cost of equity and the cost of debt. The formula for the cost of equity is provided below, and we clearly see that if the Federal Reserve allows the risk-free rate to rise, equity will become more expensive for the firm. We believe this coupled with what we mentioned earlier namely, a change in bank’s balance sheet towards short-term loans will cause these firms to shift their capital structure more towards debt financing.

The last thing we want to look at is what banks have been doing in the exchange rate futures market and how it will change in the near future. Below is a sensitivity analysis done by Vincent Papa, PhD, CFA on the effect of interest rate changes on Barclays’ profits (in millions) in 2014.

What we see is that Barclays has been betting against rising interest rates. This makes sense because the Federal Reserve, in the midst of a financial crisis under Ben Bernanke’s watch, held fast to their promise of continued low interest rates. Now that Yellen feels we are out of the crisis, it’s clear that Barclays will have to change their positions on interest rate forwards and futures, or face significant losses.

Is there an optimal capital structure?

Here we are again with our next post. Now we have given you an introduction in what is meant by capital structure, we can go a step further. Perhaps you were thinking while you were reading the previous post; is there an optimal capital structure for companies? This post will answer that question.

To understand whether there is an optimal capital structure, we have to explain a few things first. As we have introduced in our previous post, there is a pecking order theory. This theory describes the order companies prefer to finance themselves are: 1.Internal finance; 2.Debt; 3.Newly issued equity. There are different reasons why companies prefer this order of financing and the primary reason is the cost of capital. Companies ideally want to pay as little as possible for their financing because by doing so, they increase their margin. To finance corporate activities by capital obtained from own activities, such as retained earnings, is the cheapest form of financing. Contrarily by using debt, a company has to pay interest to the lender. Lastly, newly issued equity is the most expensive because shareholders are subordinated in case of bankruptcy. Thus, companies are always looking for the cheapest form of financing.

If we link this to our initial question, is there an optimal capital structure for companies? we can say: Yes there is! The optimal capital structure for a company is one where the weighted average cost of capital (WACC) is minimized. But does that mean that every company has to finance itself internally? Ideally yes, but in practice it is hardly possible because the internal generated capital is not sufficient to finance the whole business. Since debt is cheaper than equity, companies prefer to use debt above equity. As an example, imagine you’re a bank, and a firm that is fully financed with debt comes to you for financing. You (the bank) will ask a higher interest because there is no equity involved so the shareholders of the firm are not financially involved and the risk of bankruptcy is higher. However, if the company, which is fully financed with equity, asks you for financing the interest rate charged for borrowing the money will be lower because the credit risk is lower. Thus, we can conclude from this example that the cost of capital is not only dependent on the type of capital, but also on the capital structure itself. Thereby, the optimal capital structure differs from industry to industry, meaning there is no “one rule fits all” determining an optimal capital structure that all companies can apply. However, as mentioned earlier, the optimal capital structure is when a firms WACC is minimized. This is illustrated in the graph below:

We’re done for now. Please leave a comment if something is unclear and we hope to see you all at our next post.

Mark-Paul, Tom, Mark

Capital Structure

How have the financing needs of multinational companies changed in a pre and post financial crisis in both the developed and emerging market economies? In determining the financing needs of a firm, one needs to examine its capital structure. Capital structure refers to how firms finance their overall operations and growth opportunities by using various sources of funding. Traditionally, firms finance themselves by using either debt, equity or a combination of the two. Modigliani-Miller (M&M) proposition 1, investigates the capital structure of firms under perfect market conditions. A perfect market is defined as a market where there are no transaction costs, no taxes, homogenous goods and that all firms are price takers, meaning they cannot influence the price of the goods. In this setting, M&M claim that regardless of their financing means, a firm’s capital structure does not change the value of a company under the perfect market conditions. Furthermore, the pecking order theory in corporate finance states that the cost of capital becomes more expensive for company’s due to the asymmetrical information between insiders and outsiders of the company. Specifically, the pecking order theory proposes that firms prefer to use internal funding through retained earnings or cash, followed by debt and lastly newly issued equity. This intuitively makes sense because using internal funding through the profits earned allows firms to use this excess capital to be reinvested in its operations. If internal funding is not sufficient, a company can reach out to external borrowings using debt since it is cheaper than newly issued equity. By externally borrowing through debt, the company overcomes the issue of asymmetrical information with its creditors since has a legal obligation to repay the loans granted to it, which to the contrary, is not the case with dividends and shareholders. Additionally, debt provides companies to take advantage of the tax shield since interest payments are tax deductible, which, as a result, increases the firm’s bottom line and decreases the firms cost of capital. As a last resort, a firm can choose to issue new equity to shareholders, but at a great expense due to the large investment banking fees the company must pay to complete the transaction. However, firms can profit from the newly issued equity when they have a high share price during a booming stock market. Although there is no simple way to determine the optimal capital structure of a firm, there are many other factors that influence the decision in how firms finance themselves such as the specific industry they are in, the lifecycle stage they are in, as well as, major macroeconomic factors.

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Welcome everyone,

From now on, we will post some small updates about our current research paper on this page. We hope you will learn something from it and feel free to comment on the posts or to ask us a question.

Mark-Paul, Tom & Mark