What Do We Know About Capital Structure? Some Evidence from International Data

Abstract

Thirty six years and hundreds of papers aner Modigliani and Miller's seminal work, what do we really know about corporate capital structure choice?Theory has clearly made some progress on the subject.We now understand the most important departures from the Modigliani and Miller assumptions that make capital structure relevant to a firm's value.However, very little is known about the empirical relevance of the different theories.Empirical work has unearthed some stylized facts on capital structure choice, but this evidence is based on tirms in the United States alone, and it is not at all clear how these facts relate to different theoretical models.Without testing the robustness of these fmdings outside the environment in which they were uncovered, we cannot determine whether these empirical regularities are merely spurious correlations, let alone whether they support one theory or another.l'his paper attempts to start tilling this gap in our knowledge.Our primary objective is to establish whether the choice of capital structure in other countries is based on factors similar to those influencing capital structure of U.S. firms.In doing so.we do not restrict ourself to attempting to reproduce the regularities found in the U.S. in other countries, but we try to go deeper in understanding the theoretical rationale behind them.The use of international data provides an unique opportunity for this analysis.To the extent other countries are similar to the U.S.. they provide an independent sample to test the received wisdom.To the extent they have different institutional structures, they increase our ability to discriminate among alternative theories.The cost of using an international sample is that some time has to be spent in analyzing the differences between the countries, ranging from accounting practices to legal and institutional environments.Thus, we start by presenting the typical balance sheet in each of the G-7 countries (the US, Japan, Germany, France.Italy, the U.K., and Canada).This analysis highlights the effects of different accounting rules, and also points to the corrections that need to be made so that measures of leverage are comparable across countries.After correcting for differences in reporting and valuation, we find that the extent to which firms are levered is fairly similar across the G-7 countries, with only the U.K. and Germany being relatively less levered.We then continue by analyzing the major institutional differences across countries and their likely impact on financing decisions.Although the G-7 countries are fairly homogeneous in their level or economic development (in addition to data availability, this is another good reason to focus on them), their institutionsas exemplified by the tax and bankruptcy code, by the market for corporate control, and by the historical role played by banks and securities marketsare fairly different.Apart from establishing a framework within which to understand between-country differences, the review of institutions is important because they may affect the within-country cross-sectional correlation between leverage and factors such as firm profitability and firm size.This discussion can help us better identify the true economic forces underlying the factors.The within-country cross-sectional analysis indicates that factors correlated with leverage in the United States are, in general, correlated in the same way in other countries also.But it is much harder to link these factors to specific theories of capital structure choice.For example, leverage increases in size in all countries except Germany.A possible explanation is that larger firms are better diversified, and have a lower probability of being distressed.Lower expected bankruptcy costs enables them to take on more leverage.But in Germany, the bankruptcy code ensures that firms entering bankruptcy are usually liquidated.Since liquidation values are generally lower than going concern values, bankruptcy is potentially more costly in Germany.So there should be a stronger positive correlation between size