Capital Structure and Business Cycles

Capital structure and business cycles
Shumi Akhtar
Australian National University, School of Finance, Actuarial Studies, and Applied Statistics,
College of Business and Economics, Canberra, ACT 0200, Australia
Abstract
This study investigates the relationship between business cycles and capital
structure. Specically, it extends the work of Lemmon et al. (2008), by incorpo-
rating the eect of four dierent stages of the business cycle peak, contraction,
trough and expansion on the relative importance of the unobserved permanent
component of the capital structure. Results indicate that business cycles play an
important role in explaining the unobserved permanent component of leverage
ratios after controlling for rm xed eects. In particular, the model becomes
much stronger in explaining the variation in leverage ratios after accounting for
business cycle phases.
Key words: Capital structure; Business cycle; Firm xed eects; Unobserved
permanent component
JEL classication: G37, F22, H21
doi: 10.1111/j.1467-629X.2011.00425.x
1. Introduction
This study investigates the relationship between business cycles and capital
structure.
1
Specically, it extends the work of Lemmon et al. (2008), by incorpo-
rating the eect of four dierent stages of the business cycle peak, contraction,
trough and expansion on the relative importance of the unobserved permanent
component of the capital structure.
I thank Professor Tom Smith and Dr Barry Oliver for valuable comments. This project
was funded by the CIGS/FASIGS SA10 and RF10.
1
The terms capital structure, leverage ratios and debt ratios are used interchangeably in
the paper.
Received 24 March 2011; accepted 5 May 11 by Robert Fa (Editor).
2011 The Author
Accounting and Finance 2011 AFAANZ
Accounting and Finance
Currently, research shows that after accounting for rm xed eects, there are
no additional variables with signicant explanatory power to explain capital
structure. For example, Chang and Dasgupta (2011)
2
show that rm xed eects
contribute as much as 95 per cent of the explained variation. They also conrm
the ndings of Lemmon et al. (2008), who nd that variables such as size, mar-
ket-to-book, protability, initial leverage, industry median, tangibility and cash
ow volatility (hereafter referred to as the extant determinants of capital struc-
ture) fail to completely capture the variation in leverage ratios when rm xed
eects are considered. Lemmon et al. (2008) suggest that the majority of the vari-
ation in leverage is determined by an unobserved, time invariant eect (alterna-
tively known as the unobserved permanent component). These ndings raise the
concern that previous models, which have ignored the time invariant factor, are
likely to be misspecied. Although Lemmon et al. (2008) state that identifying
the factors behind the long-lived satiability feature of leverage ratios is very
important, a detailed investigation of these factors was outside the scope of their
study. Therefore, the current study extends the work of Lemmon et al. (2008) by
investigating whether the inclusion of business cycle variables strengthens the
explanatory power of the model after accounting for rm xed eects.
The business cycle may explain the unobserved time invariant feature of lever-
age ratios for two reasons. First, dierent phases of the business cycle experience
a partial time invariant feature, which indicates the possible existence of comove-
ments between leverage ratios and business cycles. This means that they could
trend together on a partial basis towards a long-run steady-state equilibrium.
Hence, investigating the common partial comovement feature in a regression set-
ting can reveal if the inclusion of variables capturing phases of the business cycle,
in addition to the extant determinants, enhances the explanatory power of the
model, after accounting for rm xed eects. Second, the business cycle is a
2
Chang and Dasgupta (2011) highlight how challenging it is to do capital structure-
related research especially when it comes to modelling target debt ratios. According to
their study, the most important challenges are as follows. First, debt ratios have a non-
standard data generating process (e.g. debt ratios are bounded in the unit interval).
Second, capital structure data often involve several unbalanced panels, comprising many
young rms with only a few years of data, and large rms that have survived for long
periods. Third, there are diculties in determining from the evolution of the debt ratios
whether a given rm-specic variable aects the debt ratio because it aects the amount
of nancing decits and retentions, or whether it is a determinant of a desired capital
structure, i.e., the target debt ratios. While the current study is aware of these challenges,
the following counter arguments justify my research. First, the measure of target debt
ratio is controversial as Welch (2011) and Chang and Dasgupta (2011) themselves
acknowledge. Given that there is as yet no consensus about the appropriate measure of
target debt ratios, the non-standard data generating process issue therefore seem less rele-
vant. Second, the unbalanced panel does not seem to be a problem in my study given that
I use the rm xed eect technique. Third, the lagged-dependent variables should over-
come any issues associated with nancing decit and retentions versus determining desired
capital structure.
2 S. Akhtar/Accounting and Finance
2011 The Author
time-related factor, and based on the attempt by Lemmon et al. (2008) to solve
the capital structure issue linked to time-related issues, it seems logical to
explore business cycle phases as a possible solution to the mystery of capital
structure determinants.
Lemmon et al. (2008) argue that the estimated associations between leverage
and extant determinants are highly sensitive to changes in model specication.
These associations experience an average decrease in magnitude of 86 per cent
(65 per cent) in the book (market) leverage regression after controlling for rm
xed eects (accounting for the permanent component of leverage ratios) and
serially correlated errors (accounting for the transitory component of leverage
ratios). They suggest that the majority of the variation in leverage is determined
by an unobserved time invariant eect. In addition, they nd that leverage ratios
are remarkably stable over time. More specically, rms with relatively high
(low) leverage tend to maintain relatively high (low) leverage for periods of
20 years or more. This stability is considered an unobserved permanent compo-
nent of the leverage ratios. To explain this unobserved permanent component,
they use adjusted R squared from traditional leverage regressions. They state
that using various model specications, the adjusted R squared ranges between
18 and 29 per cent. However, in contrast, the adjusted R squared from a regres-
sion of leverage ratios using rm xed eects (in their words, statistical stands-
in for the permanent component of leverage) is 60 per cent, which implies that
the majority of variation in leverage ratios in a panel of rms is time invariant
and is largely unexplained by previously identied determinants.
By including the eect of business cycle stages on the relative importance of
this unobserved time invariant factor, this study addresses the following ques-
tion: does the relative importance of the time invariant factor, compared to
extant determinants, change or remain unaected when dierent phases of the
business cycle are considered?
This study contributes to the literature on the impact of business cycles on cap-
ital structure. Although previous studies have investigated the eect of macro-
economic conditions on capital structure (Gertler and Gilchrist, 1993; Korajczyk
and Levy, 2003; Amdur, 2009), this study is the rst attempt at examining the
impact of phases of the business cycle on capital structure, incorporating both
the time invariant factor and the previously identied determinants. Moreover,
this study provides a more comprehensive analysis of corporate capital structure
under dierent business cycle conditions. Further, I investigate whether business
cycles have a variable impact on long-term debt, whereas other studies most
often employ aggregate measures of leverage (i.e. leverage measures based on
total debt).
My sample consists of all US rms featured in the Compustat data le
between 1950 and 2010. The business cycle data are obtained from the National
Bureau of Economic Research (NBER). Results indicate that business cycles
play an important role in explaining the unobserved permanent component of
leverage ratios after controlling for rm xed eects. In particular, the model
S. Akhtar/Accounting and Finance 3
2011 The Author
becomes much stronger in explaining the variation in leverage ratios after
accounting for business cycle phases. These results are robust across various sen-
sitivity tests.
The remainder of the paper is structured as follows. Section 2 discusses the
previous studies that have been conducted in this area and develops the hypothe-
ses. Section 3 describes the data selection and model development. Section 4
analyses the results. Section 5 presents conclusions.
2. Literature review and hypothesis development
2.1. Existing literature
The question of how rms choose their capital structure is a widely researched
area in nance. Bradley et al. (1984) study numerous determinants of the capital
structure of a rm, including non-debt tax shields, rm cash ow volatility,
advertising and research and development expenditure both with and without
controlling for industry eects. They nd evidence supporting a strong industry
inuence on rms leverage ratios. Titman and Wessels (1988) conduct a more
comprehensive study, extending the range of theoretical determinants of capital
structure by analysing the importance of the tangibility value of assets, non-debt
tax shields, growth, uniqueness, industry classication, size, volatility and prot-
ability as the determinants of capital structure choices. Their evidence indicates
a relationship between uniqueness, size and protability, and capital structure
choices by rms. Rajan and Zingales (1995) conduct a similar study in an inter-
national setting and identify tangibility, market-to-book, size and protability
as the main determinants of capital structure and show that these determinants
are relevant for all major industrialised countries, in addition to the United
States.
More recently, capital structure and its determinants are considered by
Graham and Harvey (2001), Baker and Wurgler (2002), Flannery and Rangan
(2006), Banerrje et al. (2008), Byoun (2008), Huang and Ritter (2009), Graham
and Leary (2011), Chang and Dasgupta (2011) and Welch (2011). Although
some of the identied determinants do impact rms leverage ratios, these studies
fail to consider the inuence of rm xed eects on capital structure and the
impact of the business cycle. Lemmon et al. (2008) study xed eects and capital
structure and show that xed rm eects generate an adjusted R squared of 60
per cent as opposed to an adjusted R squared of 1829 per cent for the extant
determinants. They also show that leverage ratios characterised by both a transi-
tory and permanent component tend to show a signicant amount of conver-
gence in the short run (transitory eect), but leverage ratios that are very stable
in the long run, i.e. rms with high (low) leverage, tend to remain as such for
nearly 20 years (permanent eect). Thus, they conclude that the most prevalent
determinants of capital structure, both individually and collectively, seem to
contain less information about leverage compared to the time invariant factor.
2011 The Author
Previous studies have led us to conclude that both the time invariant factor
and the extant determinants inuence capital structure over time. A reasonable
question that emerges from this is: what happens to these unobserved permanent
components (or the time invariant factor) of capital structure with changes in the
various stages of the business cycle? In other words, what is the eect that busi-
ness cycles have on rms leverage ratios as explained by both the time invariant
factor and the extant determinants?
It is possible that the time variation in business cycles leads to changes in the
relative pricing of asset classes, which can lead a given rm to choose dierent
capital structures at dierent points in time, if all else is constant. On the basis of
the market timing theory, Baker and Wurgler (2002) argue that rms are more
likely to issue equity when their market values are high, relative to book and past
values, and repurchase equity when their market values are low. They maintain
that this behaviour is consistent with capital structure behaviour, that is, rms
issue debt when market values are low relative to their book values (low market
values are observed during contraction and trough periods). However, they fail
to account for rms being nancially constrained (smaller rms) and nancially
unconstrained (larger rms). Given this omission, I argue that their ndings are
consistent with those of Gertler and Gilchrist (1993), Choe et al. (1993) and
Korajczyk and Levy (2003), to the extent that constrained rms issue debt
during good times (expansion and peak), whereas unconstrained rms issue debt
during contraction and trough periods, as explained below.
Korajczyk and Levy (2003) nd that macroeconomic conditions have an inu-
ence on rms leverage ratios. This impact is greater for unconstrained rms than
for constrained rms, with unconstrained rms showing counter-cyclical varia-
tion in aggregate leverage with macroeconomic conditions and constrained rms
showing pro-cyclical variation in aggregate leverage ratios. This indicates that
unconstrained rms (larger rms) issue more debt during contraction and trough
stages of the business cycle (equivalent to macroeconomic contraction and reces-
sion periods), while constrained rms (smaller rms) do not follow this pattern.
Instead, they might issue debt pro-cyclically, during expansion and peak stages
of the business cycle. Similarly, Choe et al. (1993) and Gertler and Gilchrist
(1993) have shown that aggregate net debt issues (private and public) increase
for unconstrained rms during recession (trough) associated with a monetary
contraction. Further, Gertler and Gilchrist (1994) show that aggregate net short-
term debt is fairly stable over the business cycle. Hackbarth et al. (2004) and
Drobetz et al. (2007) nd evidence to support the view that there is a link
between business cycles and capital structure choices. Most recently, Amdur
(2009) develops a business cycle model with nancial frictions and uses it to
explain some stylised facts regarding aggregate United States (US) debt and
equity ows. However, this body of literature on the inuence of macroeconomic
conditions on rm capital structure choices fails to incorporate the time invariant
eect. Furthermore, it does not consider the change in the relative importance
of this time invariant factor aecting capital structure with changes in
2011 The Author
macroeconomic conditions. Thus, the novelty of the current study lies in its
attempt to provide a comprehensive analysis of the eect of business cycles on
capital structure, incorporating both the unobserved permanent component and
the previously identied determinants.
For the purpose of illustration, consider the scenario of a booming economy.
As mentioned earlier, researchers have shown that for a constrained rm, a boom
(duration of expansion to peak phase of the business cycle) in the economy might
lead to an increase in leverage. Further, it is reasonable to expect that for a con-
strained rm, a boom in the economy might lead to an increase in rm size.
Because rm size has been identied as one of the determinants of capital struc-
ture and as the time invariant factor is by denition xed, this implies that in a
booming economy, the relative importance of the time invariant factor might
decrease and the relative importance of size, as a previously identied determi-
nant, might increase (for constrained rms). Stated dierently, for a constrained
rm, the adjusted R squared of rm xed eects might decrease in magnitude
during expansion and peak periods, and the adjusted R squared of size might
increase in magnitude during the same period (all other things remaining
constant). The reverse might be true for contraction and trough periods. Thus,
the current study explores whether the stability in capital structures observed by
Lemmon et al. (2008) holds true during dierent stages of the business cycle.
2.2. Core capital structure theory and testable hypothesis
The existing primary theories of corporate capital structure explaining rms
nancing decisions can be categorised as trade-o, pecking order, managerial
entrenchment and market timing theories. First, in the trade-o theory, rms
select target leverage ratios based on an exchange between the benets and costs
of increased leverage (Modigliani and Miller, 1958, 1963; Jensen and Meckling,
1976; Myers, 1977; Stulz, 1990; Hart and Moore, 1995; Baker and Wurgler,
2002). The trade-o theory determines an optimal capital structure by adding
various imperfections, including taxes, costs of nancial distress and agency
costs, but retains the assumptions of market eciency and symmetric informa-
tion. Some of the imperfections that lead to an optimal trade-o are as fol-
lows: higher taxes on dividends indicate more debt (Modigliani and Miller,
1963; Miller and Scholes, 1978); higher non-debt tax shields indicate less debt
(DeAngelo and Masulis, 1980); higher costs of nancial distress indicate more
equity and less debt; short of bankruptcy, senior debt can force managers to
forgo protable investment opportunities (Myers, 1977); agency problems can
call for more or less debt; too much equity can lead to free cash ow and con-
icts of interest between managers and shareholders (Jensen 1986); and too much
debt can lead to asset substitution and conicts of interest between managers
and bondholders (Fama and Miller, 1972; Jensen and Meckling, 1976).
Second, the pecking order theory suggests that investments are rst nanced
by internal funds, then external debt and, as a last resort, external equity (Myers
2011 The Author
and Majluf, 1984). According to this theory, there is no optimal capital structure.
To be more precise, if there is an optimum, the cost of deviating from it is insig-
nicant in comparison to the cost of raising external nance. Raising external
nance is expensive because managers have more information about the rms
prospects than external investors and because investors are aware of this. In
Myers and Majluf (1984), external investors rationally discount the rms stock
price when managers issue equity instead of riskless debt. To avoid this discount,
managers avoid equity whenever possible. The model proposed by Myers and
Majluf (1984) predicts that managers will follow a pecking order, using up inter-
nal funds rst, then using up risky debt, and nally resorting to equity. In the
absence of investment opportunities, rms retain prots and build up nancial
slack to avoid having to raise external nance in the future. According to this
theory, rms do not have a strong incentive to rebalance their capital structures.
Third, according to the dynamic theory of capital structure based on manage-
rial entrenchment by Zwiebel (1996), high valuations and good investment
opportunities facilitate equity nance, but at the same time allow managers to
become entrenched. They may then refuse to raise debt to rebalance in later peri-
ods. This has a market-timing avour, because managers issue equity when valu-
ations are high and do not subsequently rebalance, but in this case, any market
timing aspect has a very dierent interpretation. Managers are not attempting to
exploit new investors. Rather, they are exploiting existing investors ex post by
not rebalancing. According to Baker and Wurgler (2002), both views might be
valid.
Fourth, Baker and Wurgler (2002) propose the market timing theory of capital
structure, arguing that current capital structure is the cumulative outcome of
past attempts to time the market. In this theory, there is no optimal capital struc-
ture, and market valuation has a persistent impact on capital structure. How-
ever, Leary and Roberts (2005) provide evidence contradicting the implications
of market timing theory. They show that the persistent eect of shocks on lever-
age is more likely owing to the presence of adjustment costs than an indierence
towards capital structure.
No single theory of capital structure is capable of explaining all of the time ser-
ies and cross-sectional patterns that have been documented (Parson and Titman,
2009; Chang and Dasgupta, 2011; Graham and Leary, 2011). The relative impor-
tance of these explanations has varied in dierent studies. Generally, the pecking
order theory received greatest attention and credibility in the 1990s, but it has
recently fallen out of favour (Huang and Ritter, 2010). Similarly, the market tim-
ing theory of Baker and Wurgler (2002) has challenged both static trade-o and
pecking order theories. However, a number of papers have, in turn, challenged
the evidence provided by Baker and Wurgler (2002) that the securities have long-
lived eects on capital structure. Evidently, literature so far provides no explana-
tion of the relationship between the business cycle and the core theories of capital
structure. In this study, I consider this issue and develop possible theories
connecting core theories of capital structure and the business cycle.
2011 The Author
A trade-o model would imply pro-cyclical leverage since during expansions
(when the equity market is performing well, expected bankruptcy costs are lower,
rms are more likely to have taxable income to shield and rms have more free
cash) debt should be relatively more attractive for unconstrained rms (Jensen
and Meckling, 1976; Gertler and Hubbard, 1993; Zwiebel, 1996). A pecking
order theory would be consistent with these macroeconomic patterns because
rms prefer using internally generated funds to nance investments and having
more internal funds during expansion and peak periods. Baker and Wurglers
(2002) market timing theory would also be aligned with this argument.
Korajczyk and Levy (2003) suggest that unconstrained rms are substantially
more sensitive to variations in macroeconomic conditions than constrained
rms, consistent with arguments that unconstrained rms can deviate from their
target capital structure to time their issues to periods when market conditions
are most favourable. They nd that after correcting for a range of rm-specic
variables, the macroeconomic variables help explain some of the counter-cyclical
leverage patterns for the unconstrained rms. This result is consistent with Levy
(2001). Levy (2001) develops an agency model in which debt aligns managers
interests, which include private benet extraction, with those of the external
shareholders. In recessions, leveraged managers wealth is reduced relative to
external shareholders. This shift in relative wealth exacerbates the agency prob-
lem and increases the optimal amount of leverage to realign managers incentives
with those of the shareholders. This leads to counter-cyclical leverage for rms
that are not severely constrained. The literature, which often uses size as a proxy
for the level of nancial constraints, generally agrees with the proposition that
rms facing greater nancial constraints nd it dicult to borrow to smooth
cash ows following negative shocks to the economy. Gertler and Gilchrist
(1993) nd that aggregate net debt issues, following recessions, increase for large
rms but remain stable for small rms that rely on private debt.
It is not known what impact the business cycle has across all these theories in
explaining capital structure variation. Arguably, dierent phases of the business
cycle and dierent phases of the macroeconomy might show similar patterns,
which could lead rms to make similar nancial decisions. Ultimately, it is an
empirical question. Therefore, I examine the null and alternative hypotheses:
Null Hypothesis: Dierent stages of the business cycle have no impact on
the relative importance of the unobserved permanent component of capital
structure.
Alternate Hypothesis: Dierent stages of the business cycle conditions have an
impact on the relative importance of the unobserved permanent component of
capital structure.
The above hypothesis is investigated for long-term book leverage ratios and
market leverage ratios. For comparison purposes, I use both ordinary least
squares (OLS) regressions and xed eects specications.
2011 The Author
3. Data selection and variable measurements
3.1. Data
The initial sample consists of all US non-nancial rms year observations
from the annual fundamentals Compustat database between 1950 (which is the
rst year for which annual data were reported by Compustat) and 2010. This
includes data on annual company fundamentals as well as the market. The US
market is selected for this project for a number of reasons. First, because most
previous studies have been conducted using data from the US, using the same
country provides a comparability advantage. Second, because the US economy
is the largest in the world, the business cycle eect would be most clearly and
persuasively observed in that setting. Third, because a full business cycle typically
occupies many years, conducting a thorough analysis would require the maxi-
mum number of years possible. The US data oer the widest time frame.
From the original sample, I exclude observations with missing or negative val-
ues of book assets because most variables are calculated by scaling the values by
the corresponding values of book assets. In addition, I have eliminated any
observations with missing data for the full set of variables used in the analysis.
The analysis also requires leverage, both book and market, to lie in the closed
unit interval or within the range (0, 1). The nal sample consists of 225,717
observations across 24,102 dierent rms.
3.2. Variable measurement
3.2.1. Measures of leverage
There are dierent denitions of leverage used in the literature. For the pur-
pose of this study, I have used the denition of market and book leverage ratio
considered by Lemmon et al. (2008) as a long-term debt measure. This measure
is consistent with previous studies such as Titman and Wessels (1988) and Frank
and Goyal (2009).
3.2.2. Determinants of leverage
To examine the relative importance of determinants of leverage ratios under
four dierent stages of the business cycle (peak, contraction, trough and expan-
sion), I have examined a list of capital structure determinants that are common
in the studies of Rajan and Zingales (1995), Lemmon et al. (2008) and Frank
and Goyal (2009). These determinants are size, market-to-book, protability,
tangibility, industry median, cash ow volatility and dividend paying status.
Collectively, these variables accommodate the trade-o, pecking order, manage-
rial entrenchment and market timing theories. Data on all these variables are
obtained from the Compustat data le. Because the construction of the specied
2011 The Author
determinants has been discussed in the prior literature, a detailed discussion is
not provided here. Table 1 summarises the construction of the variables.
3.3. Summary statistics
Table 2 presents summary statistics for all sample rms. Following Lemmon
et al. (2008), all the variables are winsorised at the upper and lower one-percen-
tiles to mitigate the eect of outliers and to reduce the impact of errors in the
data. The table shows that, on average, the book value of leverage and market
value of leverage are 0.26 and 0.28, respectively. This is consistent with Lemmon
et al. (2008), among others. On average, US rms market-to-book value ratio
suggests that rms are valued relatively higher in the market than their book val-
ues. The average and the median ratio of asset tangibility (0.34 and 0.29), median
industry leverage (0.24 and 0.24) and cash ow volatility (0.11 and 0.07) are very
similar to Lemmon et al. (2008). Table 3 presents a correlation matrix for the
full sample. It shows that correlations between the variables are relatively low,
and so multicollinearity should not be a major problem for this study.
Table 4 presents a breakdown of descriptive statistics by decade for the depen-
dent and independent variables, showing how the sample changes over time. It
shows that both book and market measures of leverage were noticeably higher
prior to the 1980s, but they gradually decreased after this period. Similarly, the
proportion of dividend payers was higher in the early periods and especially in
the 1950s and 1960s, when almost all rms paid dividends. It has gradually
declined over time, and the proportion of rms that pay dividends is at its lowest
level in the current decade. This downward trend in dividends is consistent with
the disappearing dividends phenomenon documented by Fama and French
(2002).
3.4. Empirical specication
To test the proposed hypotheses, I have employed ve models. Model 1 is in
OLS form, while Model 2 accounts for rm xed eects in the regression:
Leverage
i;t
b
0
b
1
X
X
i;t1
b
2
Constrain
i;t1
b
3
Unconstrain
i;t1
m
t
/
t
e
i;t
1
Leverage
i;t
b
0
b
1
X
X
i;t1
b
2
Constrain
i;t1
b
3
Unconstrain
i;t1
g
i
m
t
/
t
e
i;t
2
where, i indexes rms, t indicates years, Leverage
i,t
is the leverage for rm i in
year t, X is a set of control variables, m
t
is a year xed eect, /
t
is industry
xed eect and e
i,t
is the error term. The control variables are the extant
2011 The Author
Table 1
Construction of variables
Variable
abbreviation
Variable
description Variable construction
Dependent variables
LEV_LTB Long-term book
leverage
Long-term debt/total assets.
LEV_LTM Long-term market
leverage
Long-term debt/(Long-term debt + market value of equity).
Independent variables
Size Total assets Ln (Total assets).
MB Market value of
equity to book
value of equity
Market value of equity/Book value of equity.
PROF Accounting
protability
Operating income before depreciation/Total book assets.
TANG Tangibility of assets (Net property, plant and equipment)/total book assets.
LEV_IMed Industry median
leverage
2 digit Global Industry Classication standard codes are
used to identify each industry. There are ten industries
under this classication.
CFVol Cash ow
variation
The standard deviation of historical operating income,
requiring at least 3 years of historical data.
DivPayer Whether a
rm pays
dividends
Equals to 1 if rm paid out dividends during a scal year
and 0 otherwise.
BCyc Four phases of
business cycle
Business cycle is classied into four phases: peak,
contraction, trough and expansion. To identify each
business cycle, I rely on NBER. For example, in any
given year when a phase occurs, it takes a value of 1,
otherwise 0. It is worth noting that multiple phases of
the business cycle can occur in a given year. For example,
according to NBER categorisation in 1981, all four phases
of the business cycle were observed. In some years, 2 phases
of the business cycle are observed; however, the phases do
not necessarily occur in an orderly sequence (e.g. an
expansion may not be followed by a peak).
Cons Financially
constrained
rms
Firms are dened nancially constrained following
Korajczyk and Levy (2003) (e.g. rms do not pay
dividends, do not have a net equity or debt purchase and
have market to book value >1). Firms are then ranked
from low to high based on their total assets. Firms that
belong to the rst quartile take a value of 1, otherwise 0.
Uncons Financially
unconstrained
rms
Financially unconstrained rms are those rms that are not
in the category of nancially constrained, and rms are
ranked from low to high based on their total assets. Then,
rms that belong to the fourth quartile take a value of 1,
otherwise 0.
Market value of equity is calculated as stock price times the shares outstanding (which is used to
calculate EPS). http://www.nber.org.
2011 The Author
determinants of capital structure (see Data and Sample Selection section for
details).
Note that the error term in Model 1 is assumed to be possibly heteroskedastic
and correlated within rms, while in Model 2, the errors are homoskedastic as g
i
controls for rm xed eects.
Both Models 1 and 2 are used as baseline cases for comparison purposes (to
conrm the key previous study (Lemmon et al., 2008) and for drawing a direct
Table 2
Summary statistics for full sample
Variable Mean Median Std. Dev. Min Max
LEV_LTB 0.26 0.24 0.23 0.00 0.98
LEV_LTM 0.28 0.25 0.19 0.00 0.97
Size 5.11 5.09 2.06 1.22 12.02
MB 1.63 1.11 1.87 0.02 8.34
PROF 0.09 0.12 0.20 )4.13 7.90
TANG 0.34 0.29 0.22 0.00 0.95
LEV_IMed 0.24 0.24 0.05 0.02 0.53
CFVol 0.11 0.07 1.53 0.01 5.69
DivPayer 0.41 0.00 0.50 0.00 1.00
Cons 0.23 0.00 0.34 0.00 1.00
Uncons 0.21 0.00 0.41 0.00 1.00
BCyc_P 0.15 0.00 0.35 0.00 1.00
BCyc_C 0.27 0.00 0.45 0.00 1.00
BCyc _T 0.11 0.00 0.31 0.00 1.00
BCyc_E 0.72 1.00 0.28 0.00 1.00
Tables 2 and 3 present summary statistics and a correlation matrix of the nal Compustat sample
comprising 225,717 observations across 24,102 rms from the years 1950 to 2010, while Table 4
presents a further breakdown of the summary statistics across variables by decade. The variables are
dened as follows. Long-term book leverage (LEV_LTB) is the ratio of long-term debt to total
assets. Market leverage (LEV_LTM) is the ratio of long-term debt divided by the sum of total debt
and market value of equity. Size (Size) is the natural log of Total assets. Market-to-book (MB) ratio
is the ratio of market value of equity to total book value of equity. Protability (PROF) is the ratio
of operating income before depreciation to total book assets. Tangibility (TANG) is the ratio of net
property, plant and equipment divided by total book assets. Industry Median Leverage (LEV_IMed)
is the median of the book (or market) value of the relevant type of debt by two digit GIC sector code
and by year. Cash ow volatility (CFVol) is measured as the standard deviation of historical operat-
ing income, requiring at least 3 years of historical data. Dividend Payer (DivPayer) is a dummy vari-
able equal to one if the rm paid dividends, otherwise zero. Financially constrained rms (Cons) are
deemed nancially constrained within the spirit of Korajczyk and Levy (2003) (e.g. rms do not pay
dividends, do not have a net equity or debt purchase and have market to book value >1). Firms are
then ranked from low to high based on their total assets. Firms that belong to the rst quartile take
a value of 1, otherwise 0. Financially unconstrained rms (Uncons) are those rms that are not in the
category of nancially constrained (as dened above), and rms are ranked from low to high based
on their total assets. Then, rms that belong to the fourth quartile take a value of 1, otherwise 0.
Business Cycle BCyc_P, BCyc_C, BCyc_T and BCyc_E indicates Peak, Contraction, Trough and
Expansion and is a dummy variable equal to one if the year corresponds to a particular phase of the
business cycle in a given year and 0 otherwise.
2011 The Author
comparison with Models 3 and 4), in particular, showing the importance of busi-
ness cycle eects on the unobserved permanent component of the capital struc-
ture after controlling for rm xed eects.
To examine the eect of the stages of the business cycle on the relative impor-
tance of the unobserved permanent component of long-term leverage ratios,
Model 3 (OLS) and Model 4 (rm xed eects) are proposed:
Leverage
i;t
b
0
b
1
X
X
i;t1
b
2
Constrain
i;t1
b
3
Unconstrain
i;t1
b
4
Peak
t
b
5
Contraction
t
b
6
Trough
t
b
7
Expansion
t
m
t
/
t
e
i;t
3
Leverage
i;t
b
0
b
1
X
X
i;t1
b
2
Constrain
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b
3
Unconstrain
i;t1
b
4
Peak
t
b
5
Contraction
t
b
6
Trough
t
b
7
Expansion
t
g
i
m
t
/
t
e
i;t
: 4
The coecients b
4
to b
7
and the adjusted R square in Model 4 are of main inter-
est in this project. They will be compared with Model 2 to examine whether the
business cycle modelling has any major bearing on the relative importance of the
xed rm eects. A comparison between Models 3 and 1 and between Models 3
and 4 will also provide further insights. Finally, I propose Model 5 that is an
extension and modication of Model 2, for which there are four versions, associ-
ated with each phase of the business cycle. For example, in the case of the peak
phase:
Table 3
Correlation matrix for the full sample
[A] [B] [C] [D] [E] [F] [G] [H] [I] [J] [K] [L] [M] [N]
LEV_LTB [A] 1
LEV_LTM [B] 0.81 1
Size [C] 0.13 0.17 1
MB [D] )0.36 )0.18 )0.12 1
PROF [E] 0.01 0.01 0.03 )0.16 1
TANG [F] 0.28 0.29 0.02 )0.14 0.18 1
LEV_IMed [G] 0.24 0.18 )0.02 )0.15 0.19 0.33 1
CFVol [H] )0.07 )0.05 )0.11 0.17 )0.27 )0.11 )0.10 1
DivPayer [I] 0.08 0.06 0.32 )0.11 0.23 0.21 0.30 )0.10 1
Cons [J] )0.11 )0.10 )0.33 0.12 )0.30 )0.14 0.01 0.17 )0.22 1
Uncons [K] 0.16 0.12 0.36 )0.06 0.15 0.15 )0.01 )0.09 0.26 )0.29 1
BCyc_P [L] 0.03 0.05 0.02 )0.02 )0.01 0.07 0.03 0.09 0.01 )0.01 0.01 1
BCyc_C [M] 0.07 0.01 0.05 )0.08 0.08 0.05 0.04 0.01 0.04 )0.03 0.05 0.67 1
BCyc _T [N] 0.05 0.02 )0.03 )0.02 )0.01 0.03 0.11 )0.01 0.04 0.02 )0.03 0.44 0.57 1
BCyc_E [O] )0.04 0.01 )0.10 0.07 0.02 0.05 0.12 )0.03 0.04 0.06 )0.08 0.12 )0.49 0.11
2011 The Author
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2011 The Author
Leverage
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b
0
b
1
X
X
i;t1
b
2
Constrain
i;t1
b
3
Unconstrain
i;t1
b
4
Peak
t
b
5
Peak
t
X
X
i;t1
b
6
Peak
t
Constrain
i;t1
b
7
Peak
t
Unconstrain
i;t1
g
i
m
t
/
t
e
i;t
: 5
In Model 5, the interaction terms, dened as the product between the given
business cycle dummy and each leverage determinant, are designed to capture
the direct role that each business cycle phase has in dierentially enhancing
the explanatory power of the leverage model. Specically, the coecients b
5
to b
7
and the adjusted R squared are of key interest and will be compared
with the results in Model 2. In Models 3, 4 and 5, the signicance of the
business cycle coecients and the improved adjusted R squared will provide
evidence of whether business cycle modelling is important in explaining the
relative importance of the unobserved permanent component of long-term
debt.
4. Analysis and results
4.1. Eect of business cycle on leverage
Table 5 shows the results for the baseline OLS (Model 1) and xed eects
regressions (Model 2) in explaining the long-term market leverage ratios.
3
The
results presented in Column 1 and 2 are largely consistent with those of Lemmon
et al. (2008): in particular, the magnitude, direction of the determinants, statisti-
cal signicance and the adjusted R squared values. The results for Models 3 and
4 in Columns 3 and 4 of the same table show the signicance of incorporating
business cycle phases in explaining capital structure. Most importantly, these
ndings support the hypothesis that the business cycle plays a signicant role in
explaining the unobserved time invariant eect of leverage ratios.
The results shown from Model 4 (in comparison to Models 1, 2 and 3) support
the hypothesis in four key ways. First, the incorporation of the four phases of
the business cycle shows that these factors are important. That is, we see that the
business cycle phases have a signicant role in both the OLS and the xed eects
model. Specically, the contraction (BCyc_C: t-test = 2.40 in OLS and
t-test = 3.14 in xed eects) and trough (BCyc_T: t-test = 4.22 in OLS and
t-test = 4.49 in xed eects) phases of the business cycle are both highly signi-
cant in explaining the capital structure variation.
Second, it is notable that when business cycle factors are incorporated into
the xed eects regression, the explanatory power of the model increases by 0.14
3
Results for book leverage measures are very similar to the market leverage case. As such,
results for the book versions are suppressed to conserve space. Details are available from
the author upon request.
2011 The Author
Table 5
The eect of business cycles on leverage ratios
Model 1: OLS Model 2: Firm FE
Model 3:
OLS (BC)
Model 4:
Firm FE (BC)
Coe t-test Coe t-test Coe t-test Coe t-test
Constant 0.0521 1.75* 0.0663 1.14 0.0299 1.55 0.2115 1.18
Size 0.0672 8.32*** 0.2471 9.12*** 0.0332 10.38*** 0.1836 24.83***
MB )0.0891 )26.13*** )0.0876 )22.19*** )0.0681 )26.12*** )0.1121 )2.93***
PROF )0.1003 )3.12*** )0.1075 )2.96*** )0.1021 )3.47*** )0.1390 )8.64***
TANG 0.1782 10.18*** 0.1642 8.07*** 0.1522 10.18*** 0.7471 8.01***
LEV_IMed 0.8324 11.17*** 0.7844 7.08*** 0.7665 11.77*** 0.0222 5.77***
CFVol )0.0741 )5.31*** )0.0932 )5.14*** )0.0191 )4.98*** )0.0478 )5.33***
DivPayer )0.0532 )4.05*** )0.0433 )4.02*** )0.0431 )3.88*** )0.0321 )3.29***
Cons )0.0765 1.12 )0.1539 )1.54 )0.1315 )1.11 )0.1198 )1.25
Uncons 0.1042 1.98** 0.0895 3.15*** 0.1243 2.11** 0.1432 2.47**
BCyc_P )0.2417 )1.61 )0.2076 )1.59
BCyc_C 0.2539 2.40** 0.0532 3.14***
BCyc _T 0.5148 4.22*** 0.5125 4.49***
BCyc_E )0.2241 )0.19 )0.01 )0.07
Year xed eect Yes Yes Yes Yes
Industry xed eect Yes Yes Yes Yes
Adj R
2
0.31 0.68 0.37 0.82
This table presents the results of estimating four regression models using market leverage as the
dependent variable. The nal Compustat sample comprising 225,717 observations across 24,102 rms
from the years 1950 to 2010 is used for the analysis. The OLS and xed eect specications are
discussed in the text refer to equations (1)(4). Year xed eects denote that the calendar year xed
eects are included in the specication. Industry xed eect indicates the inclusion of dichotomous
variables, indicating membership of one of the nine industries, as assigned by the global industrial
classication standard. Market leverage (LEV_LTM) is the ratio of long-term debt divided by the
sum of total debt and market value of equity. Size (Size) is the natural log of Total assets. Market-
to-book (MB) ratio is the ratio of market value of equity to total book value of equity. Protability
(PROF) is the ratio of operating income before depreciation to total book assets. Tangibility
(TANG) is the ratio of net property, plant and equipment divided by total book assets. Industry
Median Leverage (LEV_IMed) is the median of the book (or market) value of the relevant type of
debt by two digit GIC sector code and by year. Cash ow volatility (CFVol) is measured as the stan-
dard deviation of historical operating income, requiring at least 3 years of historical data. Dividend
Payer (DivPayer) is a dummy variable equal to one if the rm paid dividends, otherwise zero. Finan-
cially constrained rms (Cons) are deemed nancially constrained within the spirit of Korajczyk and
Levy (2003) (e.g. rms do not pay dividends, do not have a net equity or debt purchase and have
market to book value >1). Firms are then ranked from low to high based on their total assets. Firms
that belong to the rst quartile take a value of 1, otherwise 0. Financially unconstrained rms
(Uncons) are those rms that are not in the category of nancially constrained (as dened above),
and rms are ranked from low to high based on their total assets. Then, rms that belong to the
fourth quartile take a value of 1, otherwise 0. Business Cycle BCyc_P, BCyc _C, BCyc _T and BCyc
_E indicates Peak, Contraction, Trough and Expansion and is a dummy variable equal to one if the
year corresponds to a particular phase of the business cycle in a given year and 0 otherwise. ***, **,
* indicate statistical signicance at the level of 1, 5 and 10%, respectively.
2011 The Author
(i.e. the dierence in adjusted R squared between Model 2 versus Model 4). This
nding reinforces the conjecture that the business cycle plays a signicant role in
explaining the unobserved time-invariant eect. Also, xed eects capture
substantially more of the variation in leverage than does the OLS counterpart
(Model 3 versus Model 4). More specically, OLS produces an adjusted R
squared of only 37 per cent, whereas the xed eects counterpart more than
doubles this to 82 per cent.
Third, it is also noteworthy that the increase in explanatory power from
including the business cycle eects in the OLS model of 0.06 (0.310.37, Model 1
versus Model 3) is clearly dominated by the increase of 0.14 in the xed eects
case (0.680.82, Model 2 versus Model 4). That is, while business cycle modelling
is clearly important regardless of the estimation setting, its value becomes espe-
cially evident in the xed eects regression.
Fourth, to test the combined qualitative eect of the inclusion of all four busi-
ness cycle phases in explaining the unobserved time invariant component of the
leverage ratios in the rm xed eects regression, I conduct a likelihood ratio test
between Model 2 (restricted model) and Model 4 (unrestricted model) in Table 5.
The likelihood ratio test statistic reveals a value of 314.22 which easily exceeds
the 1 per cent chi-square cut-o value of 13.28, thus supporting the need to
include business cycle eects in the model. Collectively, these four ndings sup-
port the proposition that business cycle phases have a signicant impact on the
relative importance of the unobserved permanent component of capital structure
variation.
The theoretical interpretation of the above ndings suggests that in a shrinking
economy, when businesses are experiencing a contraction phase of the business
cycle, long-term market leverage tends to increase. This is consistent with the
macroeconomic factors justication (Levy, 2001). Similarly, a positive and signif-
icant relationship is also observed between market leverage and the trough phase
of the business cycle. Specically, in a trough phase, the model suggests that the
market value of leverage will increase. This suggests that during an economic
recession or bearish market, rms tend to seek or rely more on external debt
relative to peak or boom periods. These results suggest that, on average, the
mean intercept leverage ratio of 0.21 will increase by a magnitude of 5.32 per
cent in a contraction phase and 51.25 per cent in a trough phase of the business
cycle. This is intuitively appealing, as during tough economic times, rms might
struggle to generate sucient prots to fund new investment from internally gen-
erated cash ows.
Finally, regarding the general role played by the extant determinants of lever-
age, the following observations can be made based on the general outcome
across all four models. First, the directions and the magnitude of the coecients
in the extant variables are found to be relatively similar to Lemmon et al. (2008)
and Frank and Goyal (2009). Second, the statistical signicance of the variables
is also found to reasonably comparable to Lemmon et al. (2008) for both OLS
and rm xed eect models.
2011 The Author
4.2. Further analysis
Table 6 presents the interaction eects between each business cycle phase
(Model 5) and the leverage determinants. The aim of this interaction testing
approach is to assess whether any particular variable has additional signicance,
in any given business cycle phase, in explaining the variation of leverage ratios.
In all cases, the business cycle factor becomes signicant, indicating a mean shift
in the leverage ratios. Essentially, the results in Table 6 reinforce the importance
of the business cycle in explaining the relative importance of the unobserved per-
manent component of the capital structure. This is indicated by the signicant
business cycle phase dummy, interaction coecients and the high adjusted R
squared, compared with results in Table 5. The adjusted R squared values in
Table 6 range between 0.71 and 0.74, and this is noticeably higher than the
adjusted R squared value of 0.68 for Model 2 in Table 5. Further, holding
all else constant, rms, on average, tend to have less long-term leverage during
peak and expansion phases (peak: t-test = )3.34, expansion: t-test = )3.76),
while they tend to hold signicantly higher debt ratios during contraction
(t-test = 2.15) and trough (t-test = 4.71) phases. These results suggest that
there is a signicant mean (intercept) shift in long-term leverage ratios for rms
during the business cycle. The economic signicance of these results can be
observed in the magnitude of the business cycle coecients. The dichotomous
coecient of peak and trough phases of the business cycle shows that, on aver-
age, the leverage ratios decrease during peak ()3.90 per cent) and expansion
()27.03 per cent) and expand during contraction (5.81 per cent) and trough
(32.18 per cent), as compared to the mean intercept leverage ratios of 0.01,
)0.01, 0.02 and )0.37 during peak, expansion, contraction and trough period,
respectively (Model 4 in Table 5). These results are consistent with prior studies
(Gertler and Gilchrist, 1993; Levy, 2001; Korajczyk and Levy, 2003).
In addition, unconstrained rms appear to borrow more long-term debt dur-
ing trough and contraction periods (based on the positive and signicant coe-
cients on the interaction terms BCyc_D*Uncons in these cases), while in
contrast, constrained rms borrow more long-term debt during peak and expan-
sion periods (based on the positive and signicant coecients on the interaction
terms BCyc_D*Cons in these cases).
Are the extant determinants sensitive to each of the phases of business cycle in
explaining the variation of leverage ratios? The market-to-book interaction coef-
cient is positive and statistically signicant in explaining the market value of
long-term debt during peak and expansion phases of the business cycle (peak:
t-test = 3.21, and expansion: t-test = 9.17). Interestingly, this evidence contra-
dicts Baker and Wurglers (2002) market timing theory (e.g. when the equity
valuation is high, managers issue more equity and are reluctant to issue debt)
but is consistent with the counter-cyclical pattern arguments of Korajczyk and
Levy (2003). A possible explanation may be that when a rm is highly valued in
the market, it becomes relatively cheaper (i.e. faces relatively favourable costs)
2011 The Author
Table 6
The interaction eect of business cycles and rms characteristics on leverage ratios
Peak Contraction Trough Expansion
Coe t-test Coe t-test Coe t-test Coe t-test
Constant 0.0126 1.22 0.0183 0.80 )0.0112 )0.37 )0.3710 )5.57***
Size 0.0249 4.90*** 0.0141 3.84*** 0.0090 5.31*** 0.0531 2.54**
MB )0.0493 )16.84*** )0.0475 )15.58*** )0.0646 )18.24*** )0.1745 )7.39***
PROF )0.1082 )3.43*** )0.1011 )3.09*** )0.1095 )3.33*** )0.1433 )3.90***
TANG 0.1431 9.15*** 0.1295 8.90*** 0.1447 9.16*** 0.1294 9.14***
LEV_IMed 0.8573 11.37*** 0.8762 9.34*** 0.7481 9.35*** 0.6760 8.81***
CFVol )0.0135 )2.28** )0.0096 )2.36** )0.0119 )2.76** )0.0105 )2.29**
DivPayer )0.0281 )1.61 )0.0232 )1.26 )0.0305 )1.78* )0.1003 )0.90
Cons 0.1317 3.25*** 0.0755 2.24** )0.0903 )3.25*** 0.2904 2.24**
Uncons 0.1131 2.72** 0.0831 3.55** 0.1062 2.72** 0.0802 1.55
BCyc_D )0.0390 )3.34*** 0.0581 2.15** 0.3218 4.71*** )0.2703 )3.76***
BCyc_D*Size 0.0412 0.25 0.0104 0.69 0.0198 0.84 )0.0311 1.68*
BCyc_D*MB 0.0622 3.21*** )0.0620 )1.18 )0.0334 )2.46** 0.2447 9.17***
BCyc_D*PROF )0.1573 )10.11*** 0.2690 1.09 0.4011 0.98 )0.1532 )3.69***
BCyc_D*TANG 0.0224 1.13 0.0846 1.62 0.0945 1.16 0.0783 1.11
BCyc_D*LEV_Imed 0.2091 1.47 0.4615 1.43 0.2096 1.31 0.1225 1.15
BCyc_D*CFVol )0.0244 )1.47 )0.0095 )1.57 )0.0311 )2.17** )0.0219 )1.34
BCyc_D*DivPayer 0.0197 3.19*** )0.0321 )0.48 )0.1159 )1.16 0.0690 2.61**
BCyc_D*Cons 0.0488 3.02*** 0.0223 1.51 0.0231 1.62 0.0275 2.88***
BCyc_D*Uncons 0.0265 1.41 0.0214 3.17*** 0.0127 2.71** 0.0208 1.57
Year and industry FE Yes Yes Yes Yes
Industry xed eect Yes Yes Yes Yes
Adjusted R
2
0.71 0.71 0.72 0.74
This table presents the results of four sets of parameter estimates using market leverage as a dependent vari-
able. The nal Compustat sample comprising 225,717 observations across 24,102 rms from the years 1950 to
2010 is used for the analysis. The rm xed eect specication for Model 5 is discussed in the text. Year xed
eects denote that the calendar year xed eects are included in the specication. Industry xed eect indicates
the inclusion of dichotomous variables, indicating membership of one of the nine industries, as assigned by the
global industrial classication standard. Market leverage (LEV_LTM) is the ratio of long-term debt divided by
the sum of total debt and market value of equity. Size (Size) is the natural log of Total assets. Market-to-book
(MB) ratio is the ratio of market value of equity to total book value of equity. Protability (PROF) is the ratio
of operating income before depreciation to total book assets. Tangibility (TANG) is the ratio of net property,
plant and equipment divided by total book assets. Industry Median Leverage (LEV_IMed) is the median of
the book (or market) value of the relevant type of debt by two digit GIC sector code and by year. Cash ow
volatility (CFVol) is measured as the standard deviation of historical operating income, requiring at least
3 years of historical data. Dividend Payer (DivPayer) is a dummy variable equal to one if the rm paid divi-
dends, otherwise zero. Financially constrained rms (Cons) are deemed nancially constrained within the spirit
of Korajczyk and Levy (2003) (e.g. rms do not pay dividends, do not have a net equity or debt purchase and
have market to book value >1). Firms are then ranked from low to high based on their total assets. Firms
that belong to the rst quartile take a value of 1, otherwise 0. Financially unconstrained rms (Uncons) are
those rms that are not in the category of nancially constrained (as dened above), and rms are ranked
from low to high based on their total assets. Then, rms that belong to the fourth quartile take a value of 1,
otherwise 0. Business Cycle BCyc_P, BCyc _C, BCyc _T and BCyc _E indicates Peak, Contraction, Trough
and Expansion and is a dummy variable equal to one if the year corresponds to a particular phase of the busi-
ness cycle in a given year and 0 otherwise. Business Cycle (BCyc)_D is a dummy variable equal to one if the
year corresponds to a particular phase of the business cycle in a given year and 0 otherwise. (BCyc)_D times
the leverage determinants are the interactions variables. ***, **, * indicate statistical signicance at the level of
1, 5 and 10%, respectively.
2011 The Author
for managers to raise debt. However, the estimated coecient on the interaction
term with protability is negative and signicant for the peak and expansion
cases (peak: t-test = )10.11, expansion: t-test = )3.69), and the dividend payer
interaction coecient is positive and signicant for the same phases (peak:
t-test = 3.19, expansion: t-test = 2.75). These results are in agreement with
pecking order theory, managerial entrenchment and market timing theory. For
instance, during the peak and expansion stages of the business cycle, rms per-
form relatively better in generating prots. These prots can be sucient for a
regular dividend, and the remaining internally generated funds can be utilised to
nance positive net present value investment projects.
Cash ow volatility is negatively signicant in determining long-term market
leverage ratios only during trough times (t-test = )2.17). In all other phases, it
has no statistical importance. This result is consistent with trade-o theory.
Specically, during a trough period, a rms cash ows may be relatively more
volatile and, as a result, may lead rms to be nancially stretched or distressed.
Higher costs associated with nancial distress attract more equity and less debt.
4.3. Robustness analysis
4.3.1. Long-run and short-run eects of the business cycle
If managers are concerned only about changes in the long-run equilibrium level
of leverage determinants (Lemmon et al., 2008), the results of Model 2 could be
unreliable. This is because Model 2 assumes that the eect on leverage of pre-
determined variables (X) is delayed by one period and is complete, with no per-
sistent eects. However, if managers are slow to respond to changes in (X) or if
managers gradually adjust leverage to changes in X, Model 2 provides an incom-
plete description of the leverage data generating process. Alternatively, if manag-
ers ignore short-term or transitory uctuations in the factors that determine
leverage, Model 2 still provides an incomplete description of capital structure.
To examine these alternatives, I rely on Lemmon et al. (2008) to estimate a dis-
tributed lag model of long-term leverage ratios, essentially expanding the tradi-
tional specication in Model 2 to incorporate deeper lags of the leverage
determinants.
4
To assess the appropriate lag length, I carry out two specication
searches using the Akaike Information Criterion (AIC) and the Bayesian Infor-
mation Criterion (BIC). Both searches indicate an appropriate lag length of ten
periods. Results for short-run impacts and long-run impacts are estimated.
Results remain very similar across the short-run (maximum lag of 2) and long-
run (lag >3 inclusive), and, most importantly, the business cycle factors direc-
tional signs remain similar (especially for lag one and two) while the signicance
4
Results are qualitatively similar to Table 5 and therefore are not presented in tabular
form.
2011 The Author
level of the business cycle coecients disappears as deeper lags are considered
(lags three to ten).
To summarise, when deeper lags are taken, the impact of the business cycle in
explaining long-run variation of leverage ratios diminishes gradually, and the
eective impact of the business cycle is evidence for short-run variation in lever-
age ratios. This indicates that each phase of the business cycle has a distinct
impact and is relatively instantaneous (lag of one or two) on leverage ratios but
loses its intensity as higher order lags are considered. This could be a matter of
rms nancial characteristics being more simultaneously and contemporaneously
aligned with the business cycle and leverage ratios. In relation to the relative
importance of the business cycle in explaining the unobserved time invariant com-
ponent of leverage ratios, the results (not reported) indicate that when deeper lags
for (X) are analysed, the business cycle phases gradually lose their signicance.
Also, a reduction in adjusted R squared is observed in the xed eect model,
when more than 2 lags are considered. In total, these results suggest that business
cycle phases explain short-run variation of leverage, but not long-run variation.
4.3.2. Business cycle and persistence
Powell et al. (2009) show that if the dependent variable and independent vari-
ables are persistent over time, then this persistence in both variables leads to spu-
rious results with overstated R-squared, coecients and t- statistics. Powell et al.
(2009) investigate this issue using a monthly sampling interval. They show that
once the independent variable persistence is accounted for, the signicance of
most of the coecients in the regressions disappears. They present an economet-
ric procedure for the detection of persistence.
5
I employ the Powell et al. (2009)
procedure and examine all four stages of the business cycle to identify persis-
tence. The test results indicate that the persistence problem is unlikely. It is possi-
ble that persistence is observed more in high frequency monthly data than in
yearly data (as used in this study).
4.3.3. Validity of the model
To test the robustness of the models, residuals, goodness of t and drop in
deviance tests are conducted. The residuals from models tend to accord with the
5
The procedure requires the calculation of transparent probability by using a transition
matrix (it is four by four in this case since there are four phases of business cycle). In par-
ticular, the authors provide a benchmark to compare the transition matrixs probability
outcome (q) with a value of 0.50. The interpretation of their proposed value is that if q
equals 0.5, then the rst-order autocorrelation of the test variable is zero (no autocorrela-
tion). If the q value falls within a range of 0.20 around 0.50, it is still considered to be
insignicant autocorrelation. Test results indicate that the transition probability value q
falls well within the acceptable range of 0.400.66.
2011 The Author
standard normal distribution, and values outside the range of 3 standard
deviations from the mean are considered potential outliers. An inspection sug-
gests no evident outliers. In addition, no pattern of heteroskedasticity is evident
from the residual plots, suggesting independence of the data. A residuals analysis
of the goodness-of-t test is performed for the models, resulting in no cause for
concern. In addition, a range of alternative proxies for size, cash ow volatility
and growth measures produce robust ndings. Further, as argued by Ramsey
and Schafer (2002), it is often dicult to make strong conclusions solely on basis
of the goodness-of-t test. Therefore, the overall signicance of the models is
tested using the drop in deviance test (maximum likelihood), and the results are
supportive.
5. Conclusion
Overall, the results of this study are consistent with those of Lemmon et al.
(2008), who show that leverage ratios have a permanent component to them,
and that the extant determinants explain little of the variation in leverage when
rm xed eects are taken into consideration. However, the results become
somewhat dierent when business cycle phases are incorporated into the xed
eect model. The unobserved permanent component of the leverage ratios varia-
tion is well explained by the incorporation of the four stages of a business cycle:
peak, contraction, trough and expansion. This is because of the fact that the
business cycle phases carry signicant explanatory power, which is important in
the relative signicance of the unobserved permanent component of the leverage
ratios. This is primarily evidenced by the relatively signicant improvement in
the xed eect model, captured by a high adjusted R squared after the inclusion
of the business cycle phases and high signicant coecients for the business cycle
phases themselves. In particular, I nd that business cycle phases become much
more statistically signicant in explaining variation in leverage after accounting
for xed rm eects. This is the rst study to provide insight into the capital
structure decisions of rms during dierent stages of the business cycle after con-
trolling for rm xed eects. By examining the relative importance of the perma-
nent component and the extant determinants during dierent stages of the
business cycle, this research may help regulators (including regulators of interest
rates and tax rates) to target dierent business cycle period policies accordingly.
Further, this may also assist institutions and lenders in aligning their decisions
with capital structure choices for rms that are constrained and unconstrained.
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