Corporate Strategy and Capital Structure

Author(s): Sidney L. Barton and Paul J. Gordon

Source: Strategic Management Journal, Vol. 9, No. 6 (Nov. - Dec., 1988), pp. 623-632
Published by: John Wiley & Sons
Stable URL: http://www.jstor.org/stable/2486694
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 Strategic Management Journal, Vol. 9, 623-632 (1988)

CORPORATESTRATEGYAND CAPITALSTRUCTURE
SIDNEY L. BARTON
Department of Management, University of Cincinnati, Cincinnati, Ohio, U.S.A.
PAUL J. GORDON
School of Business, Indiana University, Bloomington, Indiana, U.S.A.

The basic thesis of this exploratory investigation was that a corporate strategy perspective
may complement the traditional financial paradiggmin explaining capital structure in large
U.S. corporations. Earlier fusion of strategic and financial literature led to a series of
propositions antecedent to this work. Inclusion of Rumnelt'sdiversification categories plus
elsewhere validated financial contextual variables led to hypotheses for the present study.
Results suggest a managerial choice perspective may help to explain the capital structure
choice at the firm level of analysis.

Neither financial theory nor research have been
able to provide satisfactory agreement as to what
factors affect the capital structure decision, or
even how (if) the decision affects firm perform-
ance (Weston and Brigham, 1981; Myers, 1984).
As a result, some financial scholars have suggested
a broader, managerial (behavioral) perspective
is necessary to fully understand the debt/equity
mix at the level of the individual firm (Carleton
and Silberman, 1977; Findlay and Whitmore,
1974).
In response to this situation, Barton and
Gordon (1987) recently proposed that a corporate
strategy perspective, with its emphasis on mana-
gerial choice, may provide a behavioral basis for
understanding the capital structure of large U.S.
firms at the firm level which is complementary
to the traditional finance paradigm at the level
of the economy. This conceptual development
was based on a fundamental strategy perspective
that functional (financial) decisions are made by
managers operating in a complex environment,
and not solely a deterministic product of external
market forces as implied by the finance paradigm.
Utilizing the strategy perspective and extant
financial research on the capital structure issue,
they posited that the fundamental management
concerns in formulating an appropriate capital
structure are financial risk, along with maintaining
control and flexibility in managerial decision-
making. Therefore, consistent with Andrews'
(1980) concept of corporate strategy, they pro-
posed that the capital structure decision is based
on the values and goals of management, in
combination with external and internal contextual
factors which impact the basic concerns of
risk and control. In effect, they suggested a
'strategy-capital structure' relationship analogous
to Chandler's (1962) 'strategy-organization struc-
ture' relationship.
ANTECEDENT PROPOSITIONS
Specifically, and as a connecting link to what
follows, five propositions were derived from the
Barton and Gordon literature review using
Andrews' dimensions of corporate strategy as an
organizing framework. The first three are related
to management values and aspirations. The fourth
is related to threats and opportunities external
to the firm. The fifth is related to specific internal
strengths and weaknesses of the firm.

0143-2095/88/060623-10$05.00 Received 10 March 1986

? 1988by John Wiley & Sons, Ltd. Revised 25 March 1987
624 S. L. Barton and P. J. Gordon
1. Top management's risk-takingpropensities will
affect the firm's capital structure. Since capital
structure represents a major source of financial
risk, it was posited that management's attitude
towards risk would be related to the firm's
capital structure.
2. Top management's goals for the firm will affect
the firm's capital structure. As pointed out by
Andrews (1980), top management may have
differing goals from firm to firm and strategic
decisions should 'fit' and be supportive of
these goals. Since Andrews specifically
included capital structure as a strategic
decision, it was proposed that the debt position
should facilitate top management's goals.
3. Top managers would prefer to finance a firm's
needs from internally generated funds rather
than from external creditors or even new
stockholders. Donaldson (1961) posited that
debt contracts restricted management preroga-
tives more than equity, especially in large
firms. Combining this with the idea that
management desires maximum control and
flexibility in decision-making resulted in this
proposition.
4. The risk propensity of top management and
specific financial context of the firm affect the
amount of debt lenders are willing to lend, and
what terms they are willing to use. This reflects
the external investor reaction to risk of
default based on the specific firm's financial
characteristics coupled with management's
approach to managing the risk.
5. Relevant financial contextual variables moder-
ate the ability of top management to select a
capital structure for the firm. Based on
the effects of capital structure on risk and
managerial control and flexibility, this prop-
osition suggests that any financial variables
which affect these same concerns will define
the 'risk and control context' of the debt/
equity decision for management.
The objective of this study was therefore to
provide an initial empirical assessment of the
possible value of these propositions to assist in
understanding the capital structure decision in
large firms. Because they represent a first attempt
at applying a behavioral explanation of the capital
structure decision, and this is the initial empirical
'test' of these propositions, the study must be
labeled exploratory. As Barton and Gordon
suggested, several phases of research will be
necessary to refine and properly evaluate any
behavioral theory of capital structure. This study
merely attempts to see if relevant strategy and
financial variables are related to capital structure
in ways consistent with the above propositions.
VARIABLES AND HYPOTHESES
Given the propositions above, the following
variables were expected to be related to capital
structure.
Corporate strategy variables
Obtaining the risk propensities and goals of
top management of large firms is admittedly
problematic. Therefore, a proxy measure was
used to represent these variables. Rumelt's (1974)
corporate strategy typology was the measure
selected.
First, it is a corporate-level strategic measure.
Since leverage data are generally not available
or meaningful at the business unit level, a firm
level measure was a basic requirement. Second,
Rumelt's measure is based on diversification. As
Bettis (1983) pointed out, a firm's diversification
strategy reflects top management's attitude and
approach toward risk. This is useful, since
management's risk-averse characteristics were
proposed as a key determinant of capital struc-
ture. Third, while it was not a 'mainstream' result
of the Rumelt (1974) study, leverage was one of
the financial characteristics of the diversification
groups that were systematically and significantly
different. While Rumelt's study did not attempt
to control for other possible causes of capital
structure, his findings provided background for
the development of hypotheses relating the
inferred goals of specific diversification strategy
categories to capital structure. Fourth, although
the categorization of firms requires judgement,
studies by Christensen and Montgomery (1981)
and Bettis (1981) provided extensive support for
the reliability of the measure. Lastly, the typology
approach to the representation of the multi-
dimensional strategy concept is consistent with
similar strategy studies done at the business unit
level (e.g. Hambrick, 1983).
Admittedly, this diversification strategy meas-
ure represents a gestalt, multi-dimensional meas-
 Corporate Strategy and Capital Structure 625

ure of strategy. Fuirther,as Rumelt's initial study
indicated, selection of a diversification strategy
is largely the result of the technical, economic,
and competitive environment of the industries in
which the firm participates. However, Rumelt
also argued that the results supported the
contention that his measure at least partially
captured the values and goals of management as
well. Further, it is proposed that the extensive
prior analyses of the nature of the Rumelt
strategy categories provides a reasonable basis
for assessing the nature of these managerial
values and goals for use in an exploratory study
such as this. If results prove encouraging, a
more direct measure of these managerial choice
constructs would be warranted. Nonetheless, the
limitation of such a proxy measure in completely
capturing management values and goals is readily
admitted.
For the purpose of this study, Rumelt's nine
sub-categories were reduced to the four originally
developed by Wrigley (1970): (1) single;
(2) dominant, including all four dominant busi-
ness categories; (3) related, including both related
categories; and (4) unrelated, including both
unrelated categories. These categories represent
fundamentally different strategic approaches to
diversification and, more importantly, resulted in
different debt levels per Rumelt (1974).
Based on the characteristics of Rumelt's meas-
ure and our propositions, it was anticipated
that these categories might exhibit significantly
different relationships to debt levels, controlling
for financial context. Specifically, Rumelt sug-
gested single and related firms were likely the
most conservative (risk-averse), while unrelated
firms were likely the least risk-averse. (He did
not imply a relative risk posture for dominant
firms.) Given this, it was expected that single
and related firms would have the least positive
relationship to debt, unrelated firms would have
the highest positive relationship, and dominant
firms would be somewhere in between. Stated
as hypotheses:
Hypothesis 1: A single firm strategy will have study. This measure uses earnings before debt
a low positive relationship to debt levels, ceteris charges and the tax-reducing effects of debt
paribus.
Hypothesis 2: A dominant firm strategy will with the firm's leverage. Bettis (1981) supported
have an average positive relationship to debt the use of ROA as a profit measure, reporting
levels, ceteris paribus.
Hypothesis 3: A related firm strategy will have but highly correlated with other return measures.
a low positive relationship to debt levels, ceteris
paribus.
Hypothesis 4: An unrelated firm strategy will
have the highest positive relationship to debt
levels, ceteris paribus.
Contextual financial variables
The propositions suggested that firm-specific
factors might also influence the debt levels of
firms. Contextual financial variables were of
interest because they may affect riskiness of the
firm or managerial control and flexibility. For
these reasons and their inclusion in previous
financial empirical studies, profitability, size,
sales growth, capital intensity, and earnings
variability were expected to be related to capital
structure.
Profit
While profit is a variable not often posited in
financial empirical studies of capital structure, it
was proposed that a firm with a high earnings
rate would maintain relatively low debt levels
because of its ability to finance itself from
internally generated funds. This is consistent with
the proposition that the management of firms
desires flexibility and freedom from excessive
restrictions often associated with debt covenants.
Interestingly, and importantly, this prediction is
exactly counter to the expected relationship
derived from the finance paradigm (Myers, 1984).
Consequently, evaluation of this hypothesis was
extremely important for assessing the validity of
a behavioral theory of capital structure. The
result was the following hypothesis:
Hypothesis 5: Firm profitability (PROF) will
have a negative relationzship to debt levels,
ceteris paribus.
The specific profit measure used was average
return on assets (ROA) over the period of the
charges. Therefore, return is not confounded
it was not only widely employed by researchers,
626 S. L. Barton and P. J. Gordon
Size
Weston and Brigham (1981) suggested that
management of large firms may choose to use
equity financing, since sale of additional stock
has little influence on the control of the large
firm. Again, this is consistent with the proposition
of management's preference for maximum flexi-
bility in decision-making. Thus, an inverse
relationship was expected:
Hypothesis 6: Firm size (SIZE) will have a
negative relationship to debt levels, ceteris
paribus.
The size measure selected was average total sales
over the study period. The impetus for use of
this measure was that Ferri and Jones (1979)
found it discriminated among leverage classes of
firms better than other size measures tested.
Sales growth rate
Financial empiricists have historically agreed
upon the positive relationship between firm
growth and debt, ceteris paribus. This was also
the working hypothesis adopted for this study.
Gupta (1969) suggested that the rapid ability to
acquire and dispose of debt provided desired
financial flexibility for firms with a goal of
growth. Also debt would not reduce return on
equity or earnings per share for the growing firm.
Related to this study, it was posited that lenders
tend to lend based on future prospects, while
top management desirous of growth may require
funds in excess of those which can be internally
generated, and thus may be willing to accept
restrictive debt covenants in return for leveraged
growth. For this study:
Hypothesis 7: Firm sales growth rate
(GROW) will have a positive relationship to
debt levels, ceteris paribus.
To measure sales growth rate, a simple arithmetic
average of yearly growth rates is not acceptable,
since it yields a consistent upward bias (Rumelt,
1974). Thus average growth rates were calculated
using a regression fit to a uniform growth model.
Rumelt (1974) and Toy et al. (1974) also used
this measure.
Capital initenisity
Capital intensity, or the employment of fixed
assets, is generally synonymous with the concept
of operating leverage. Thus, increased capital
intensity implies increased risk of future income
variation. Therefore, top management's desire to
retain control of the firm, and the concern of
creditors to limit risk of default, were hypothe-
sized to result in lower debt levels for firms
choosing automation over labor as the primary
factor of production, ceteris paribus. Financial
theory suggests the same relationship (Ferri and
Jones, 1979):
Hypothesis 8: Firm capital intensity (CA P1)
will have a negative relationishipto debt levels,
ceteris paribus.
The measure selected for capital intensity was
the ratio of the average of net fixed assets to
total book assets over the time period of the
study. As with the profit and size measures, the
average is a better indicator of the use of
fixed assets than any single-period measure. In
addition, Ferri and Jones (1979) found this
measure provided the most reliable and significant
discrimination among different leverage groups
compared with other operating leverage meas-
ures.
Earnings risk
Total firm risk is generally thought of as the total
ex-ante expected variation in the earnings of the
firm. However, conventional finance practice
uses historic variability (in earnings or stock
price) as the best available indicator of overall
firm risk. For comparability this convention was
followed. The logic is similar to the capital
intensity hypothesis (i.e. higher earnings varia-
bility implies higher bankruptcy risk, especially
to creditors). As a result:
Hypothesis 9: Firm earnings risk (RISK) will
have a negative relationiship to debt levels,
ceteris paribus.
The coefficient of variation of profit over the
study period was the measure selected for
earnings risk. Use of the coefficient of variation
allows earnings variation to be de-coupled from
the absolute size of earnings, and thus it de-
 Corporate Strategy and Capital Structure
couples income variation from firm size. Also,
this measure was deemed appropriate because it
is variability of earnings which affects the ability
of a firm to service debt.
Capital structure variables
Along with the independent variables, it was
necessary to choose an appropriate measure for
debt. Among several possibilities, owner's equity/
invested capital (E/C), where invested capital is
represented by the book value of total assets
less current liabilities, was selected as most
appropriate. One reason for this choice was that
E/C is a measure of how the business is financed
long-term, without the fluctuations of short-term
financing. Further, the E/C measure was useful
because it was used by Rumelt (1974), and thus
allowed direct comparison of results with those
of Rumelt. (The only caveat associated with this
measure is that it is the inverse of what is
commonly known as leverage. In other words, a
high E/C measure indicates low debt levels, and
vice-versa.)
The values of the capital structure variable
(CSB) were based on an arithmetic average of
the annual ratios of E/C over the period of the
study. This is commonly done to capture the
'target' nature of leverage ratios by simple
smoothing of year-to-year data. This is justified
by the fact that firms do tend to have target
leverage ratios (Marsh, 1982; Gombola and Ketz,
1983), but year-to-year fluctuation may occur as
different forms of financing are used.
METHOD
Time period
A single time period was selected, 1970-74
(inclusive), to take advantage of firm strategy
classifications done by Rumelt (1978). Five-year
time periods have been selected by numerous
other researchers investigating the relationship
of strategy to performance (e.g. Christensen and
Montgomery, 1981; Bettis, 1981).
The implication of using a single 5-year time
period is a cross-sectional study. Such a study
cannot assess causal relationships because of
an inability to satisfy the time precedence
requirement. Further, such a 'non-experimental'
study cannot eliminate other causes, as is possible
with an experimental research design. However,
because of the exploratory nature of the study,
627
it was decided to put maximum effort into the
testing of the covariation criterion. Thus if
support were found for covariation of the
variables in the way predicted, future studies
might more meaningfully apply improved meas-
ures and longitudinal research designs. On the
other hand, while significant covariation would
not 'prove' support for the propositions, findings
of contradictory or no covariation would provide
excellent support for refuting the hypothesized
relationships.
Data and sample
Data on capital structure, firm size, profitability,
earnings, earnings growth, capital intensity, and
risk were calculated from the COMPUSTAT?
data tape.
The sample for the study was selected from
the 1974 Fortune 500 list of industrial companies
still in existence as of 1982. Among these, 304
were available on COMPUSTAT? tape, of
which 148 had been classified by Rumelt (1978)
for the 1970-74 period. The remaining 156 were
classified using Rumelt's classification procedure.
Of the 304 firms, 25 were eliminated because of
a change in strategy classification during the 5-
year period, or because of missing data from the
COMPUSTAT? tape records resulting in a final
sample of 279.
Evaluating hypotheses
Multiple regression with dummy variables was
used to test the hypotheses. Strategy was included
as a nominal variable and the financial contextual
variables were included as metric variables.
A necessary step in evaluating the hypotheses
was to test the implicit assumption of an additive
(or non-interactive) relationship. Recall that all
the working hypotheses were stated in ceteris
paribus form. To test the applicability of the
additive assumption, a full saturated model was
employed. (Note that for the full saturated model
all financial metric variables, the strategy dummy
variables, and terms for all contextual variables
interacted with all strategy dummy variables were
included.)
An F-statistic test was used to test the null
hypothesis of no interaction between strategy
categories and financial contextual variables. The
null hypothesis was rejected at the 0.01 level.
628 S. L. Barton and P. J. Gordon

This suggested that the relationship of financial
contextual variables to capital structure was
dependent upon which strategy the firm was
pursuing. Statistically, it meant that to properly
evaluate the hypotheses it was necessary to include
important interactive terms in the final model,
since the implicit assumption of additivity was
not supported by the data.
While the full saturated model was shown to
provide more significant explanatory power than
the additive model, the fact that dummy variables
were involved required that additional steps be
taken to understand the exact nature of the
corporate strategy-capital structure relationship.
Any single regression analysis of this type can
not provide significance tests of the differences
among the coefficients of included dummy and
slope dummy variables. Therefore, in order to
gain an understanding of the estimated differences
in financial variable relationships among strategy
categories, the full saturated model was run four
separate times. For each run a different strategy
category acted as the implicit dummy.
Based on these runs it was possible to develop
individual equations for each strategy category,
as well as to indicate significant differences across
categories. These equations are shown in Table
1. Note that they are simply another way of
presenting the results of the full saturated model,
not the result of separate regression runs.
The information contained in Table 1 forms
the foundation for the assessment of hypotheses.
Table 2 shows the capital structure characteristics
of the strategy categories found in this study
versus those found in Rumelt's original study.
Since a significant interactive relationship
existed between corporate strategy and specific
financial contextual variables for this sample, no
absolute statements about the relationship of a
particular strategy category or contextual variable
to capital structure can be made. However, this
does not obviate an evaluation of the hypotheses.
What it does require is that discussion of the
relationship of any one variable to capital
structure must include the variables that combirie
to moderate or accentuate it.

Table 1. Estimated models by strategy type

Single firms:
U(0.02) R(0.03), U(0.08) U(0.05)
CSB 0.58 + 1.01 PROF + 0.O1E-4 SIZE - 0.06 CAPI + 0.02 RISK + 0.37 GROW
(0.00) (0.00) (0.80) (0.70) (0.50) (0.70)
Dominant firms:
R(0.07) U(0.05) R(0.06) U(0.02)
CSB 0.50 + 1.55 PROF + 0.11E-4- SIZE + 0.05 CAPI - 0.03 RISK - 0.29 GROW
(0.00) (0.00) (0.10) (0.50) (0.40) ((.(9)
Related firms:
D(0.07), U(0.1) U(0.10) D(0.06) S(0.03), U(0.00)
CSB 0.65 + 1.4 PROF - 0.05E-4 SIZE - 0.19 CAPI - 0.07 RISK - 0.26 GROW
(0.00) (0.00) (0.04) (0.02) (0.18)
Unrelatedfirms:
R(0.10) S(0.02), R(0.10) D(0.05) D(0.02), R((.00) S(0.05)
CSB 0.50 + 2.14 PROF - 0.30E-4 SIZE - 0.15 CAPI + 0.11 RISK - 0.58 GROW
(0.00) (0.00) (0.12) (0.30) (0.02) (0.02)

Note: The numbers in parentheses below the coefficients are the significanice values. The letters above the
individual terms indicate that the coefficient for this particular term is significantly different from the coefficient
of the same term in the annotated category. For example, looking at the constant term in the unrelated
category, the estimated value of the coefficient is 0.50. The 0.00 number below it indicates that it is significant
at the 0.00 level. The R(0.1) directly above it means that this effect is significantly different from the
corresponding effect in the related category at the 0.10 level of significance. ft2 for total model = 0.472.
 Corporate Strategy and Capital Structure 629

Table 2. Corporate strategy-capital structure Corporate strategy hypotheses

comparisons
One-way A NOVA The first four hypotheses dealt with the relation-
ship of diversification strategy to capital structure.
CSB Ave. Referring to Table 2, the relative debt levels of
CSB Avg. Rank (Rumelt) Rank the strategy categories are as expected based on
the hypotheses, with single firms significantly
S 0.7888 1 0.781 2 higher than related. When controlling for the
D 0.6602 3 0.752 3
R 0.6985 2 0.799 1
relationships of relevant financial contextual
U 0.6167 4 0.696 4 variables, Table 1 reveals a slightly different, but
nonetheless consistent, result. Referring to the
Total 0.6792 0.769 constant terms in the regression equations, related
and single firms have the lowest fundamental
F4,275 = 9.768, ox = 0.000 tx = 0.01 relationship to debt levels, with unrelated and
dominant the highest.
Note: a= alpha; Rank is in terms of inicreasing debt, i.e.
1 = low. These results are for different time periods, tlhus Perhaps more significant, though not antici-
they are not directly comparable. Rumelt figures are for pated a priori, is that the relationships between
1949-69. This study results are for 1970-74. Rumelt did not contextual financial variables and capital structure
provide an F value, only a significance level for his test.
are contingent on strategy category. While admit-
Post-hoc comparisons tedly conjecture, this result may suggest manage-
ment of firms with different diversification
Dominant Related Unrelated strategies react differently to their financial
context when choosing a capital structure. If true,
Single this result would support the managerial choice
Dominant contention of the behavioral propositions. At the
Related very least it is a result inconsistent with a pure
Runmelt finance paradigm perspective.
results:

Single No significant difference from grand Contextual financial hypotheses

mean
Dominant Category mean less than average @ a
= 0.10 level (higher debt ratio)
Related Category mean greater than average @
a = 0.01 level (lowest debt ratio)
Unrelated Category mean lower than average @ ox
= 0.01 level (highest debt ratio)
(Note: Rumelt did t-tests comparing category means with
the grand mean. While this type of test tends to understate
a, his results are shown for comparison purposes, with his
calculated ox levels of significance.)
(* Denotes pairs significantly different in CSB, a = 0.05,
Scheffe test).
FINDINGS
The basic findings generally provided support for
the behavioral explanation of the capital structure
decision at the firm level. The specific findings
are discussed below. Table 3 contains a summary
of the hypotheses results.
While interaction makes direct assessment of
financial contextual hypotheses difficult, for some
factors the relationships were consistent enough
across strategy categories to allow general state-
ments of support or refutation.
Clearly, the strongest support for any contex-
tual hypothesis was developed for the negative
relationship between profitability and debt levels.
This result is particularly significant since profit
is rarely a posited variable in financial empirical
studies of capital structure. Even more important,
reasoning based on the finance paradigm suggests
that profitable firms should have higher debt
levels than less profitable ones (Myers, 1984).
Obviously, the results of this study do not support
that prediction, but instead support the hypothesis
of this study based on the behavioral propositions.
As for the other financial variables, reasonable
support was shown for the hypothesized positive
relationship between sales growth and debt. While
earnings risk appeared to be strongly related to
debt, it was clearly a function of the particular
strategy category of the firm. Therefore, no
630 S. L. Barton and P. J. Gordon
general statement of support or rejection could
be made regarding the earnings risk hypothesis.
The hypothesized negative relationship between
capital intensity and debt was not supported, but
the overall effect of this variable was very weak
in all but the related firm category. Therefore,
it is possible that capital intensity has no
appreciable relationship to capital structure.
Lastly, the size relationship was not significant
for any category, but this may have been because
the sample was restricted to only the largest of
firms.
DISCUSSION
The results have provided initial support for the
use of the strategy perspective as a promising
basis for a behavioral theory of the capital
structure decision in large firms.1 Admittedly,
the limitations previously discussed, of a diversi-
fication strategy measure as proxy for managerial
values and goals and of a cross-sectional research
design, make any claims of support for causality
impossible. However, it is proposed that enough
consistency in predicted relationships existed to
encourage more in-depth work on the further
development and testing of a behavioral theory
of capital structure. Specifically, a relationship
between corporate strategy and capital structure
was maintained in the predicted way even
after controlling for relevant financial contextual
variables. This is particularly significant given the
admitted limitations of Rumelt strategy categories
i It is important to point out two clarifications with respect
to this study. First, we used a measure of capital structure
which reflected the long-term debt versus equity situation
and not total debt to equity. As discussed, this best reflects
the finance definition of capital structure (i.e. long-term
financing mix). However, the mix of short- and long-term
debt can affect financial risk. For this reason we initially
carried a measure that reflected total debt (i.e. long- and
short-term). This measure was dropped after it was found to
correlate 0.90+ with the E/C measure, and showed similar
regression results. However, as pointed out by an anonymous
referee, firms in more recent years have become more
aggressive and creative in their use of short-term finanicing
techniques. Thus, differences may now be present with
respect to financing mix as well as level.
Secondly, the same referee rightly points out that current
firms may be more aggressive in using capital structure as a
strategic variable than they were during the time of this
study. This suggests that there may in fact be more of a
corporate strategy-capital structure relationship thani is
indicated by this study.
as a proxy for managerial values anid goals.
Perhaps more significantly, strong support for
the behavioral propositions comes from the
relationship of profit with debt.
Across all strategy categories profit was shown
to have large and significant negative relationships
with debt levels. It is argued this is prima facie
evidence that managerial choice is operating in
the capital structure decision. Finanice theory
suggests the opposite result should occur. The
fact that profit is negatively correlated with debt
levels therefore suggests that pure economic
factors are not the sole mechanism for establishing
capital structure. Indeed, this result is consistent
with the behavioral proposition that management
of firms desires flexibility and freedom from
excessive restrictions of debt whenever possible.
Profitability provides the ability to avoid debt by
using self-generated funds to finance the business.
In terms of empirical financial research these
results suggest that a possible (if perhaps only
partial) reason for the instability of previous
findings with respect to capital structure is the
omission of the firm's strategy in empirical tests.
The implication for both empirical and theoretical
research is that managerial choice and multiple
firm objectives, not all of which may be rep-
resented in terms of economic rationality, may
be important to include in the study of individual
financial decisions. While this point is not
entirely new, and does not nullify alternate and
complementary explanations (see Barton and
Gordon, 1987), incorporating the strategy per-
spective as an aspect of understanding the capital
structure decision is new. The value of the
strategy concept is that it can incorporate
traditional financial effects while recognizing
the complex, idiosyncratic nature of managerial
behavior at the individual firm level.
From a practitioner point of view, a behavioral
explanation of capital structure may partially
explain a competitive advantage Japanese indus-
trial firms have over their U.S. counterparts. As
an example, U.S. semiconductor manufacturers
have complained that the higher debt leverage
of Japanese firms allows them a lower weighted
average cost of capital. The result is that
acceptable return on invested capital can be
lower for these firms than for U.S. firms. This
allows the Japanese to price below U.S. firms
even if costs are the same, thus placing U.S.
manufacturers at a distinct competitive disadvan-
 Corporate Strategy and Capital Structure 631

Table 3. Summary of hypothesis and results

Variable Hypothesis Result

Strategy variables
Single Low positive debt Average debt lowest of all categories. Significantly
relationship lower than all other strategy categories, but cannot
directly assess hypothesis due to significant interaction
with financial variables.
Dominant Average positive debt Average not significantly higher than any group other
relationship than single firm-s.Interaction precludes direct
assessment.
Related Low positive debt Average debt below all firm average and significantly
relationship lower than unrelated category. Interaction precludes
direct assessment.
Unrelated High positive debt Average debt levels highest of all categories and
relationship significantly higher than single and related category
firms. Interaction precludes direct assessment.
Financial variables
Profitability Inversely related to debt Hypothesis strongly supported in spite of significant
interaction.
Firm size Inversely related to debt No significant or consistent effects precludes direct
assessment. Very weak effect, if any.
Growth rate Directly related to debt Partial support for hypothesis. For str-ategycategories
where coefficients of GROW were significant, effect
was positively correlated with debt.
Capital intensity Inversely related to debt Hypothesis not supported. However, very weak overall
and differential effect.
Earnings risk Inversely related to debt Interaction precludes direct assessment.

tage (Rappa, 1985). As Rappa explained, Japan's
unique post-war financial system protects firms
using debt financing from bankruptcy risk and
merges the interests of debt and equity holders.
In line with the findings of this study, this unique
financial system may allow Japanese managers
to be less concerned than American managers
with risk and loss of control associated with debt.
ironically, this artificial market constraint may
actually allow Japanese managers to pursue
optimal economic efficiency (as predicted by
the finance paradigm) by removing managerial
concern about (and thus avoidance of) financial
risk and loss of control associated with debt
financing.
Finally, the contribution of this work rests in
suggesting variables and interactions based on a
corporate strategy framework that appears to
hold promise in pursuing a behaviorally based
theory of capital structure. Specifically, it is
suggested that additional qualitative studies be
undertaken to further refine the original prop-
ositions. More direct measures of management's
values and goals are necessary, as is the need for
longitudinal research. Given consistent findings,
further research would be warranted to determine
if consistency of capital structure with strategy is
related to a firm's performance. Such work
may eventually lead to prescriptions for capital
structure. Clearly, much work is necessary to be
done before a behavioral theory of capital
structure can be recognized. However, those who
believe in managerial choice and equifinality
must pursue it.
ACKNOWLEDGEMENTS
The authors gratefully acknowledge the expertise
and critical support of Indiana University col-
leagues Ned Hill, Elton Jackson, and Hans
Thorelli, plus that of Richard Bettis of Southern
Methodist University, throughout this project.
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