The Net Benets to Leverage

ARTHUR KORTEWEG

ABSTRACT
I estimate the markets valuation of the net benets to leverage using panel data from 1994 to 2004, identied from market values and betas of a companys debt and equity. The median rm captures net benets of up to 5.5% of rm value. Small and protable rms have high optimal leverage ratios, as predicted by theory but in contrast to existing empirical evidence. Companies are on average slightly underlevered relative to the optimal leverage ratio at renancing. This result is mainly due to zero leverage rms. I also look at implications for nancial policy.

Graduate School of Business, Stanford University. This paper is based on my dissertation entitled

The Costs of Financial Distress across Industries, completed at the University of Chicago. I thank my committee - Monika Piazzesi, Nick Polson, Morten Srensen, and Pietro Veronesi - for their guidance and support. This paper has beneted greatly from suggestions by an anonymous referee, an associate editor, and the editor, Campbell Harvey. I also thank Mike Barclay, Alan Bester, Hui Chen, Peter DeMarzo, John Heaton, Dirk Jenter, Anil Kashyap, Paul Peiderer, Michael Roberts, Jay Shanken, Ilya Strebulaev, Robert Stambaugh, Amir Su, Michael Weisbach, Je Zwiebel, and seminar participants at Boston College, Emory, the University of Chicago, Georgia, London Business School, Notre Dame, Rochester, Stanford, Wharton, and the Board of Governors of the Federal Reserve for helpful discussions, comments, and suggestions. All errors remain my own.

Theories of optimal capital structure typically explain companies choice of debt versus equity nancing by a trade-o: rms choose a leverage ratio that optimally weighs the benets of debt such as interest tax shields (Kraus and Litzenberger (1973)) and agency benets due to reductions in free cash ow (Jensen (1986)) against the costs of debt, which include the direct costs of bankruptcy (Warner (1977) and Weiss (1990)) as well as indirect costs such as debt overhang (Myers (1977)), asset substitution (Jensen and Meckling (1976)), and asset re-sales (Shleifer and Vishny (1992)). The literature tests this trade-o by running cross-sectional regressions of leverage on a set of variables that proxy for the benets and costs (see Harris and Raviv (1991) for an overview, and recent work such as Rajan and Zingales (2003) and Frank and Goyal (2004)). A short-coming of the regression approach is that it is not possible to detect whether rms have too much or too little debt on average. This question is important in light of the claim that companies leave a substantial amount of tax benets on the table and are therefore systematically underlevered (Miller (1977) and Graham (2000)). A second drawback of the regression method is the implicit assumption that rms are always optimally levered, resulting in misleading eects of protability and rm size on optimal capital structure. In reality, rms choose their capital structures in a dynamic setting. Companies let leverage ratios drift until the gain from rebalancing outweighs the cost of adjusting (Fischer, Heinkel, and Zechner (1989) and Leary and Roberts (2005)), so that rms are away from their optimal capital structures most of the time without behaving suboptimally. High prots mechanically lower leverage, so that cross-sectional regressions show a negative relation between protability and leverage, even if optimal debt ratios 1

are positively related to protability. Similarly, small rms face higher issuance costs and therefore wait longer between renancings, resulting in lower average leverage than big rms, even though in theory they may have higher optimal debt ratios. In light of these issues, this paper addresses four main questions in the capital structure literature: (i) how large are the net benets to debt nancing, (ii) how does optimal capital structure vary with rm characteristics, particularly protability and size, (iii) are rms on average underlevered, and (iv) how large are the friction costs of being away from the optimal leverage and do rms renance when these costs become large? Using a sample of 29,753 rm-months for 290 rms across 30 Fama-French industries (Fama and French (1997)), I estimate the net benets to debt nancing using a new relation between a rms market value, systematic risk (beta), and net benets to leverage, extending the Modigliani and Miller (1958) result. In this model, net benets are dened as the (ex-ante) present value of all future benets minus the costs of debt. Assuming that rms within an industry have the same asset beta, cross-sectional dierences in equity and debt betas are entirely driven by the net benets. I use this cross-sectional variation to identify the level of net benets, and how they vary as a function of rm characteristics. An important benet of this approach is that it is not susceptible to the two problems with cross-sectional regressions described above. The model identies rm-specic optimal capital structures even if rms leverage ratios oat around the optimum due to transaction costs, or if companies consistently take on too much or too little debt. In fact, such cross-sectional spread in leverage is needed for identifying the optimal capital structure. The papers primary ndings are as follows. First, I nd that the net benets to leverage 2

amount to as much as 5.5% of rm value. This means that the median rm at its valuemaximizing leverage ratio is worth 5.5% more than the same rm with no debt in its capital structure. The net benets are higher for highly protable rms with low depreciation, stable prots, and low market-to-book ratios, and during economic expansions. Severely distressed rms have negative net benets in the range of -15% to -30% of rm value. Assuming that these companies have no expected benets of future debt nancing, the costs of nancial distress are 15% to 30% for rms in or near bankruptcy. These distress costs represent the present value of future cash ows that are lost due to the presence of debt in the rms capital structure, and include both direct and indirect costs. Andrade and Kaplan (1998) estimate ex-post distress costs of 10% to 23% of rm value using a small sample of distressed buy-out rms. Since buy-out rms likely have lower distress costs, it is not surprising that I nd higher numbers. Second, net benets increase in leverage for low debt rms but decrease when leverage becomes high. This result implies that there is some optimal capital structure that maximizes the benets net of the costs of debt nancing. In a dynamic setting, this is the leverage ratio that rms will choose when renancing. I nd that smaller, more protable rms have higher optimal debt ratios. In contrast, existing empirical evidence, which is based on observed leverage ratios, nds the opposite relation (Graham (2000), Myers (2001), Korajczyk and Levy (2003), and studies cited in Harris and Raviv (1991)). This result highlights the distinction between analyzing observed and optimal leverage ratios. Similarly, I nd that optimal leverage moves procyclically, whereas Korajczyk and Levy (2003) nd the opposite result for observed leverage ratios. Bhamra, Kuehn, and Strebu3

laev (2008) show that both results are consistent with dynamic capital structure choice, where observed leverage moves countercyclically because of shocks to equity values and rms reluctance to renance due to transaction costs. Consistent with the literature, optimal leverage is positively related to the proportion of tangible assets and negatively related to depreciation, prot volatility, and market-to-book ratios. Third, I nd that rms are on average slightly underlevered, relative to the optimal capital structure at renancing. This does not necessarily imply that rms behave suboptimally if they face market frictions such as transaction costs to changing leverage. The underleverage result is mainly due to rms that pay little or no interest (true zero leverage rms). The most puzzling subset of rms are those without debt that pay dividends to their shareholders and should nd it easy to lever up (Minton and Wruck (2001) and Lemmon and Zender (2003)). These rms are highly underlevered, and a new result in this paper is that the market expects them to lever up in the future and capture some of the benets to leverage. Conversely, zero leverage rms that do not pay dividends are not expected to lever up. These companies act as if they face costs to levering up that are much larger than the issuance costs alone. Firms that are about to be taken private in a leveraged buy-out are substantially underlevered, whereas most non-investment grade rms have too much debt. Overlevered rms are likely to reduce their indebtedness when the gains of doing so are moderately large. The most overlevered companies with the highest potential gains to unlevering are the least likely to renance. This result is consistent with market frictions such as debt overhang (Myers (1977)) and creditor hold-out problems that prevent rms from renanc4

ing immediately. The cost of reducing debt levels for distressed rms is much higher than the mere cost of issuing new securities (Kane, Marcus, and McDonald (1985) and Gilson (1997)). In contrast, the cost of being underlevered is much lower than the cost of being overlevered. Two recent papers are related to this work. Almeida and Philippon (2007) use the estimates of ex-post costs of nancial distress in Andrade and Kaplan, and calculate the ex-ante distress costs using risk-neutral probabilities of default in a multiperiod setting. They nd that the average rm generally picks a capital structure that balances the costs of debt with the tax benets from Graham (2000), but they do not address the crosssection of rms. Binsbergen, Graham, and Yang (2008) use a large sample of companies that they argue are likely to make close to equilibrium leverage decisions. They estimate marginal cost of debt functions for individual rm-years from variations in the tax benets of debt using three identication approaches that aim to hold the marginal cost function xed. They then integrate under and between the marginal cost and simulated tax benet functions to estimate the net benets to debt, and nd it to be around 4% of asset value. Overall, it is reassuring that Binsbergen, Graham and Yang and my method yield similar results, given that we use very dierent empirical approaches. The paper is organized as follows. Section I explores the relation between the net benets to leverage and the market values and betas of corporate debt and equity. Section II explains the identication of net benets by inverting this relation. Section III describes the estimation methodology that applies the model to the data. The data are presented in Section IV. I discuss the results in Section V, and Section VI concludes. 5

I. Modigliani-Miller with Net Benets to Leverage

Modigliani and Miller (1958) consider the rm as a portfolio of all outstanding claims on the company. The total market value of the company at time t, VtL , is the sum of the market values of the individual claims VtL = Dt + Et , (1)

where Dt and Et are the market values of corporate debt and equity, respectively, at time t.1 A dierent way of decomposing the same company is VtL = VtU + Bt , (2)

where VtU is the market value of the unlevered rm. It is equal to the value of the company at time t if all its debt were repurchased by its shareholders. The dierence between VtL and VtU are the net benets to leverage, Bt , a ctitious security dened as the expected present value of the benets minus the costs of debt nancing. The benets of debt nancing include interest tax shields and decreases in agency costs due to the presence of debt in the rms capital structure, such as the reduction in free cash ows that managers can spend on perks or unproductive pet projects (Jensen (1986)). Costs of debt represent all future cash ows that are lost as a result of the presence of debt in the rms capital structure, and represent the direct and indirect (agency) costs that are realized both before and after default.2 Since Bt is a market expectation of future cash ows, it also reects the markets opinion of future nancing policy and transaction costs of adjusting capital structure. I discuss the interpretation of Bt in more detail in the next section. 6

L The company also has systematic risk, t , proportional to the (conditional) covariance

of returns to the rm with some risk factor. The decomposition in (1) yields the rms
D E systematic risk as a weighted average of the debt and equity betas t and t :

L t =

Dt D Et E t + L t . VtL Vt

(3)

Note that while this equation appears to be derived under the Modigliani and Miller (MM) assumption of zero taxes, equation (3) is a mechanical identity that holds even in a world with taxes, and under any nancial policy, since we have the levered rms beta on the
L U left-hand side. As I show below, with no taxes or distress costs, t = t and we nd the

traditional MM relation
U t =

Dt D Et E + L t . L t Vt Vt

(4)

L U The dierence between t and t is clearly seen when one writes the levered rms

beta using the decomposition in equation (2):

L t =

Bt B VtU U + L t . L t Vt Vt

(5)

U By denition, the systematic risk of the unlevered assets, t , is not aected by the rms L capital structure. The eect of leverage on the beta of the levered rm, t , is driven B entirely by the net benet of debt nancing, Bt , and its systematic risk, t . In the absence

of taxes and distress costs, Bt = 0, and the model reverts to the classic MM no-taxes case,
U L where VtL = VtU and t = t .

By the MM no-arbitrage argument, the market values and betas of the two portfolio

decompositions of the rm have to be equal, that is, VtU + Bt = Dt + Et , Bt B Dt Et VtU U + L t = L tD + L tE . L t Vt Vt Vt Vt (6a) (6b)

These are the key equations that I will use in the next section to identify the net
B benets. To illustrate how t accounts for taxes, consider the well-known special case of

a constant marginal corporate tax rate, , no non-tax benets to debt, and no costs of nancial distress. Bierman and Oldeld (1979) show that with constant face value of debt, the present value of the tax shield is Bt = Dt . Equations (6a) and (6b) then become VtL = VtU + Dt , tU = Dt Et (1 )tD + U tE . U Vt Vt (7a) (7b)

Equation (7a) shows that the value of the levered rm equals the value of the unlevered rm plus the present value of the interest tax shield, and equation (7b) is the textbook unlevering expression. With both benets and costs to leverage, the trade-o theory of optimal capital structure predicts that the companys market value becomes a hump-shaped function of leverage. Similarly, the rms beta, tL , varies with leverage as determined by the systematic risk of the net benets. In the next section I show how these two relations identify the net benets from the variation in levered rm values and betas within an industry, under certain identifying assumptions.

II. Identication of the Net Benets to Leverage

Consider a simple case in which equations (6a) and (6b) hold without error. We can observe the market values of corporate debt and equity, but since we do not observe unlevered rm values, it is not possible to calculate B directly from equation (6a).3 A similar problem arises when looking at betas instead of values: the right-hand side of equation (6b) can be estimated, but the unlevered asset beta cannot be observed. However, if rms in the same industry have a common asset beta, U , then dierences in L within an industry are driven entirely by the net benets to leverage. Assume that net benets are a function of an observable variable X, B = B(X), and that this function is the same for all rms. All companies in an industry then have the same L at the same X. Figure 1 illustrates the intuition behind this identication result. Industry peers fall on the same graph of L versus X, the shape of which depends only on B(X). We can therefore estimate B(X) from rms levered betas and X, both of which are observable. Fig.1

The variable X can be any characteristic of the rm, but a likely candidate is a rms around leverage ratio, L. The trade-o theory predicts that net benets to debt nancing rise here for companies with low debt but decrease as leverage becomes high, implying that B is a nonlinear function of L. Assume for now that B is a function of L only, B = B(L). Figure 1 shows that it is necessary to observe a spread in L within an industry in order to identify B(L). In a dynamic capital structure world, shocks to the rm exogenously change leverage (Welch (2004)). This gives rise to two distinct costs as L drifts away from the optimal

capital structure, L : the cost of moving to L , and the cost of being away from L . The former are transaction costs or, as referred to by Leary and Roberts (2005), adjustment costs. Transaction costs include issuance costs of new securities, coordination costs (such as creditor hold-out problems), adverse tax consequences of debt concessions, and asset resales. These costs are particularly important for highly levered, distressed rms (Gilson (1997)). Fischer, Heinkel, and Zechner (1989) show that even small transaction costs produce large variation in observed leverage ratios. Since individual rms have experienced dierent shocks in the past, we observe a spread in leverage ratios that can be used to estimate B(L). Certain market frictions, such as creditor hold-outs and regulations that discourage institutions from writing down debt or exchanging debt for equity, delay renancings (especially for highly levered rms). Consequently, even if rms want to renance, they may not be able to do so immediately. Firms then incur costs of being away from L , such as lost cash ows from nancial distress costs, and these costs are reected in B. Since out-of-court restructurings can take months to complete, and bankruptcies even longer, these costs can be especially large for distressed rms. At a given leverage ratio, B(L) reects the present value of all expected future benets and costs to debt, based on the markets expectation of the rms nancial policy. The dierence between B(L) and B(L ) is then a measure of the transaction costs of moving from L to L , and the costs of being away from L . I refer to the total of these costs as friction costs. Companies optimally allow leverage to vary, yielding a range of optimal leverage ratios, 10

consistent with the empirical ndings of Leary and Roberts (2005). However, a key feature of the approach in this paper is that it is not necessary to assume that rms are optimally levered, not even on average. If management is not maximizing rm value, or perceives optimal capital structure to be dierent than the market, then rms have leverage ratios that on average do not maximize net benets. For example, most rms in Figure 1 are overlevered, having leverage ratios that do not minimize the rms cost of capital, L . Nonetheless, as long as a spread in L is observed we will correctly identify the shape of B(L).4 We can therefore use observed leverage ratios to identify the markets assessment of B(L), which in turn pins down the markets opinion of optimal leverage as the point where net benets are maximized. This market-implied optimum can be compared to average observed leverage ratios to assess whether rms are on average under- or overlevered. Under restrictive assumptions, B is indeed a function of leverage alone.5 However, rms within an industry may dier, for example, in terms of growth opportunities and asset tangibility, and these characteristics may vary over time. We can extend the identication result to cases where rms within an industry have dierent net benets at the same leverage ratio. In general, two identication assumptions are necessary:
U U U A1: The unlevered asset beta, it , is either (i) the same for some subset of rms, it = t , U or (ii) constant over time for the same rm, it = iU .

A2: Net benets are a function of observable variables and the value and beta of the unlevered rm only: Bit = B(Xit ). Note that Xit can be a vector of observable variables. Equations (6a) and (6b) have to hold 11

for each rm i in month t, so with N rms and T months of data, there are 2N T equations.
U These equations have to be solved for 4N T unknowns: the value of unlevered assets, Vit , U B the net benet of debt nancing, Bit , and their respective betas (it and it ), for each rm-

month. Under assumption A1(i), the asset beta varies over time but is equal across the N rms, eliminating (N 1)T unknowns. Assumption (A2) reduces the 2N T unknown Bit
B and it to a set of k parameters that determine the value of B(Xit ). Together, assumptions

(A1) and (A2) reduce the problem to (N + 1)T + k unknowns: the N T unlevered rm values, the T unlevered asset betas, and the k parameters. With 2N T equations, where we observe N rms over T time periods such that (N 1)T k, we can solve for all parameters exactly. For example, with three parameters in the function for Bt , it is sucient to observe four rms for one month, or two rms for three months. A similar derivation holds under assumption A1(ii). The identication argument in this section is based on the model equations holding exactly. The next section allows for error terms in the model equations and describes the methodology used to estimate the model.

III. Estimation
The empirical implementation in this paper estimates the following specication of net benets relative to total rm value:
L Bit /Vit = X0it 0 + (X1it Lit ) 1 + X2it L2 2 . it

(8)

12

The squared leverage term captures the nonlinear eect of leverage on net benets: at low leverage, tax benets and reductions in agency costs increase rm value, but their marginal benet declines as leverage grows. In addition, the costs of nancial distress negatively impact B at high L. The vectors X0it , X1it , and X2it include a constant and rm characteristics such as protability, the proportion of intangible assets, and marketto-book ratios. These characteristics interact with leverage to make net benets grow or decline faster as rms change their capital structure. The parameter vectors 0 , 1 , and 2 are common to all rms. Substituting (8) into equations (6a) to (6b), and adding error terms that allow for violations of the Modigliani-Miller relations, the full model becomes
U Vit = 1 X0it 0 (X1it Lit ) 1 X2it L2 2 + uit , it L Vit U Vit U D E k(i)t = Lit it + (1 Lit ) it L Vit B X0it 0 + (X1it Lit ) 1 + X2it L2 2 it + vit , it U i B i + E i D i U k(i),t1 B i,t1 f M (rt rt ) + E i,t1 D i,t1

(9a)

(9b)

f U rit rt B f rit rt = E f rit rt f D rit rt

it ,

(9c)

U U kt = 0 + 1 k,t1 + kt .

(9d)

The error term uit is by assumption orthogonal to the explanatory variables X0it , X1it , X2it , and Lit , which rules out the potential simultaneity problem of Lit and Bit being jointly determined. All variables that aect Bit are included in Xit , and the optimal capital 13

structure is determined by B (Xit ), so that uit does not show up in the rst-order condition for optimal leverage. I assume that both uit and vit are distributed Normal with mean zero, and are i.i.d. over time. The errors are allowed to be contemporaneously correlated across rms in the same industry. Since the beta relation is derived from the value equation, vit is also allowed to be correlated with ujt for rms i and j in the same industry. In the discussion of identication it was assumed that the conditional betas of debt and equity are observed, but in reality they have to be estimated. The set of equations (9c) augments the model with the regression equations to estimate the conditional betas with
f M the market portfolio. I dene rt as a return from time t 1 to t, and rt rt is the return

on the market portfolio in excess of the one-month risk-free rate. Since the beta relations derived in this paper are mechanical, the regression equations in (9c) do not imply that the CAPM is the true asset pricing model. The intercepts are therefore not required to equal zero. The 4-by-1 idiosyncratic returns vector
it

is by assumption orthogonal to the excess

market return, and distributed Normal with mean zero and constant covariance matrix. The elements of
it

are independent over time but can be contemporaneously correlated

across rms in the industry since there is likely to be substantial cross-sectional correlation between idiosyncratic returns of debt, equity, and unlevered assets of the same rm, as well as between rms within the same industry. The estimation also allows for contemporaneously correlated with uit and vit .6
U The asset betas, kt , are assumed equal for the cross-section of rms within the same it

to be

industry, k. This assumption is frequently used in the academic literature (e.g., Kaplan and Stein (1990), and Hecht (2002)). The economic intuition behind this assumption is 14

that rms in the same industry have the same market risk of operation. Hamada (1972) and Fa, Brooks, and Kee (2002) provide empirical support for the hypothesis that asset betas with respect to the market portfolio are the same within industries (as dened by two-digit SIC codes). Simulations show that minor violations of (A1) increase the standard error of parameter estimates of the function B(Lt ), but do not cause severe inconsistency
U in the parameters, even when kt is correlated with Xit .7

The industry asset betas are allowed to vary over time and follow the mean-reverting
U AR(1) process (9d), with |1 | < 1.8 The AR(1) restriction on kt , although not strictly

necessary, helps to smooth the beta process so that results are more stable. The error terms kt are distributed i.i.d. Normal with mean zero and constant variance, and are uncorrelated with
t.

It is not necessary for the estimation to impose a time-series process

on the equity and debt betas, but to ensure smoothness and tighter estimation bounds I run the estimation with an AR(1) on debt and equity betas, with a general correlation structure. I estimate the parameters of the model jointly with the conditional betas and the unlevered asset values, using a Markov Chain Monte Carlo (MCMC) algorithm. This simulationbased estimation methodology is explained in detail in Robert and Casella (1999) and Johannes and Polson (2004), and in particular for structural models of the rm in Korteweg and Polson (2009). MCMC provides a way of sampling the posterior distribution of the models parameters and unobserved variables (the betas and unlevered asset values), given the observed values of debt and equity. Once this sample is obtained, the unobserved variables are numerically integrated out, leaving the distribution of the parameters 0 , 1 , and 15

2 , conditional on the observed data. This integration step needs to be done only once. At the core of this methodology lies the Cliord-Hammersley theorem, which allows for a break-up of the joint posterior distribution of parameters, betas, and unlevered asset values. Instead of drawing from the joint distribution, the theorem allows one to separately draw from (i) the distribution of parameters given the betas and unlevered asset values, (ii) the distribution of betas given parameters and unobserved values, and (iii) the distribution of unlevered asset values given parameters and betas. These complete conditionals are easy to evaluate and sample from, using simple regressions and basic linear lters. As an added bonus, MCMC provides a convenient way to deal with missing data. This is especially useful for companies with infrequently traded bonds. In essence, missing values are treated as additional model parameters. The sampling procedure automatically takes into account the uncertainty over these values, and they are integrated out in the end.9

IV. Data
I construct a sample of monthly debt and equity values for rms in the National Association of Insurance Commissioners (NAIC) database over the entire coverage period 1994 to 2004. Insurance companies are required to le all their trades in corporate bonds with the NAIC, which makes these records available in electronic form. Hong and Warga (2000) report that insurance companies account for about 40% of the trades in the investment grade bond market, and 25% of the trades in the market for non-investment grade bonds. With over 1.3 million transactions in total, the NAIC database is the most comprehensive source of corporate bond prices currently available. Data on the amount outstanding, se16

niority, and security of each bond come from the Fixed-Income Securities Database (FISD), compiled by Mergent. From the NAIC transactions data I compute month-end bond values for each outstanding bond issue of every rm. Since not all bonds are traded every month, it is not always possible to aggregate the individual bond values to obtain the market value of all publicly traded debt. To mitigate this missing data problem I group together bonds of the same rm that are of equal security and seniority, and that have a maturity within two years of one another. Assuming these bonds have the same interest rate and credit risk, missing values are calculated from contemporaneous market-to-book values of bonds in the same group that are observed in the same month. For those months in which none of the bonds in a group trade, the estimation algorithm treats the valuations as missing model parameters. The large bond issues of a rm trade more often than small issues, and I select those rms for which the largest bond groups representing at least 80% of the companys total bond face value trade at least 50% of the time. On a face-value weighted basis, the corporate bonds in the sample trade about 71% of the time. I also include rms from Compustat without any short- or long-term debt in their capital structure. Even though these rms are currently unlevered, their equity value is not necessarily equal to their unlevered value. If these rms are expected to lever up in the future, some net benets to future leverage will be impounded into their valuation.10 I supplement the sample with monthly market values of equity (common plus preferred) from CRSP and accounting data from Compustat, matching companies to the FISD by their CUSIP identier. I include the monthly dividend and interest payments in the calculation 17

of returns to debt and equity, to control for dierences in payout policies that may aect the estimates of rms unlevered asset betas. The assumption of homogeneous industry asset betas requires a working denition of industries. I consider two alternatives: (i) two-digit SIC codes (SIC2), and (ii) Fama-French (1997) classications (FF). The FF classication assigns rms to 48 industries based on four-digit SIC codes, and avoids some counterintuitive groupings of rms that occur within two-digit SIC industries. I use only those industries with data for at least two rms with some debt at any given time, a condition required for identication. Table I gives a list of the industries that are covered and the number of rms and rm-months in each industry. The SIC2 sample comprises 232 rms in 22 industries, for a total of 24,277 rm-months. Of Table I these rms, 199 had some debt in their capital structure over the sample period. The FF around sample spans 290 rms in 30 industries, for a total of 29,753 rm-months. Of the FF rms, here 233 had debt outstanding. Of the industries covered, the samples each represent about 7% of all rms, and a quarter of total equity market capitalization. The data are biased towards larger rms, which have more actively traded bonds, but there is no bias towards more or less distressed rms. Table II reports summary statistics for the FF sample. The SIC2 sample looks very similar (see the Internet Appendix). Table

I dene leverage as the market value of debt (net of cash) divided by the market value of II debt (net of cash) plus the market value of equity. Note that the market values of bank debt around and capitalized leases are never observed because these securities are not publicly traded. here On average I observe 61% of a rms debt on a book value basis. I calculate leverage and debt returns using the face value of the unobserved debt as a proxy for its market 18

value. Model estimates are quantitatively very similar when I calculate the market value of unobserved debt using the credit spread of the safest bonds (see the Internet Appendix). It is important to observe a wide range of leverage ratios within each industry to get a clear picture of how net benets vary with leverage. The intra-industry standard deviation of leverage is typically around 0.16, compared to an average leverage of 0.23, so leverage clearly varies substantially within industries. In terms of credit ratings, most industries contain rms with ratings that vary between AA and B, although some industries (such as Air Transportation (SIC 45) and Telecom (SIC 48)) have defaulted rms in the sample.

V. Results
In this section I discuss the estimates of the net benets to leverage and implications for optimal capital structure and nancial policy, paying special attention to zero leverage and leveraged buy-out (LBO) rms.

A. Net Benets to Leverage

Estimates for two specications of equation (8) are presented in Table III. Specication I groups variables that are associated with the benets of debt in X1it and variables that drive the costs of debt in X2it . The reason for this separation is that at low leverage ratios, the linear term X1it Lit dominates. Since costs of debt are negligible at low indebtedness, X1it captures the benets to debt nancing. As leverage increases, so do the probability of distress and the costs of debt, and the squared leverage term in (8) becomes important. Table III 19 around here

Table III shows that in this separated model, highly protable rms (measured by EBITDA / Sales) with stable prots have high present values of net benets at a given leverage ratio. Companies with high depreciation have lower net benets, consistent with existing empirical evidence (e.g., DeAngelo and Masulis (1980)). At high leverage, net benets decline faster for high market-to-book rms, and for companies with few tangible assets. Highly levered rms have lower net benets during economic recessions. The main benet of the separated model in Specication I is that it clearly shows the eects of individual variables on the net benets to debt. However, it is not obvious that the benets and costs of debt should be linked directly to the linear and quadratic terms in B. For example, as leverage increases, the marginal tax benet of debt nancing decreases as fewer earnings are left to be shielded with debt, and the realized marginal tax shield is less certain. Indeed, in the second specication in Table III, protability enters negatively into the quadratic term of (8). The presence of rm characteristics in both the linear and quadratic parts makes it more dicult to observe the total eect of these variables on the net benets. Figure 2 therefore plots the net benets versus leverage for the FF model.11 All rm characteristics in the model are xed at their median values except one, which is taken at its 10th, 50th, or 90th percentile. Most importantly, the plots in Figure 2 show that as leverage increases, net benets invariably increase and then decrease, implying the existence of an optimal capital structure. As in the separated model, the plots show that low market-to-book rms with many tangible assets, low depreciation, high protability and low volatility of earnings have higher net benets at all leverage ratios. Highly levered rms have lower net benets during recessions compared to expansions. 20 Fig.2 around here

For the median rm, the maximum attainable net benets are about 5.5% of rm value, but can be as high as 10% for highly protable rms or as low as 1% for companies with few tangible assets. However, in a dynamic setting with transaction costs, rms do not immediately adjust leverage to maximize net benets, and one would expect to see lower net benets at rms observed leverage ratios. The median (average) net benets across sample rms are 4.0% (4.3%) for the FF model, and 3.6% (3.8%) for the SIC2 model. These estimates are close to those in Binsbergen, Graham, and Yang (2008), who nd net benets of about 4% of rm value using a very dierent approach. However, their calculations assume that rms remain at their optimal capital structure forever, whereas the results obtained here are based on market expectations of the rms future nancing policies. Even at zero leverage ratios, the present value of future net benets is about 2.5% of rm value. If these rms remained unlevered forever, they would not capture any benets or suer any costs of debt, and Bit would be zero. This result therefore suggests that the market expects low leverage rms to lever up in the future to capture some benets from debt nancing, but not immediately or completely.12 Similarly, highly levered rms experience net benets as low as -10%, implying that these rms are worth less than their unlevered counterparts. This can only be the case if rms cannot immediately and costlessly unlever, that is, when there are friction costs to renancing. I take a closer look at nancial policy after discussing rms optimal leverage ratios.

21

B. Optimal Capital Structure

The model makes strong predictions regarding rms optimal leverage ratios. In this section I look at how optimal leverage varies with rm characteristics and whether companies are optimally levered.

B.1. Optimal Capital Structure and Firm Characteristics

A companys optimal capital structure, L , is determined by the leverage ratio at which the net benets are maximized. In a dynamic capital structure world, this is the leverage ratio that rms choose when they renance, taking into account that they will incur friction costs to change leverage in the future. Put dierently, if at a particular point in time rms are allowed to choose leverage without incurring friction costs at that point in time, then they choose L . The optimal leverage ratio is marked with an x in Figure 2. From the plots it is clear that L varies systematically with rm characteristics. To get a more complete picture of this relation, Figure 3 plots optimal leverage against rm characteristics. Consistent with previous ndings (see Harris and Raviv (1991) for a comprehensive overview), optimal leverage increases with tangible assets and is a decreasing function of the market-to-book ratio, depreciation, and the volatility of operating prots. Fig.3

The eects of protability and size on optimal capital structure are of particular interest. around Prior studies tend to nd a negative relation between protability and leverage, and a here positive relation between rm size and leverage (Graham (2000), Myers (2001), Fama and

22

French (2002), Korajczyk and Levy (2003), Frank and Goyal (2004), and studies cited in Harris and Raviv (1991)). In contrast, Figure 3 shows a strong positive relation between protability and optimal capital structure and a negative relation between size and optimal leverage. Since the net benets model captures optimal leverage, the estimates are not aected by rms temporary deviations from the optimum, unlike existing studies that use cross-sectional or panel regressions. Strebulaev (2007) and Kurshev and Strebulaev (2006) show that in a dynamic capital structure model with transaction costs, cross-sectional regressions will produce misleading results on leverage and protability. Highly protable rms tend to have performed well in the past, which mechanically lowers observed leverage ratios. Small rms have lower observed leverage ratios, on average, because they wait longer between renancings. In recessions, optimal leverage is lower than in expansions, whereas Korajczyk and Levy (2003) nd the opposite result for observed leverage ratios. Bhamra, Kuehn, and Strebulaev (2008) show that it is possible to have a procyclical optimal leverage ratio while observed leverage moves countercyclically when there are transaction costs, due to changes in equity market capitalization as in Welch (2004). However, since only one short recession occurred during the sample period (March to November 2001), this result should be taken with some caution.

B.2. Are Firms Underlevered?

Past research suggests that many rms leave substantial tax benets on the table and should therefore take on more debt than we observe (Miller (1977) and Graham (2000)). 23

However, this statement is dicult to evaluate without knowledge of the entire net benets to leverage curve. Armed with the net benets estimates in this paper, I look at whether rms are on average underlevered, and identify drivers of under- or overleverage. Table

Table IV compares model-implied optimal leverage with observed leverage ratios. For IV both the SIC2 and FF models, the median rm is underlevered: the median rm in the FF around (SIC2) model has a leverage ratio of 0.179 (0.196) compared to an optimal leverage of 0.269 here (0.221). Note that this does not imply that rms are necessarily suboptimally levered, as friction costs may prevent rms from renancing to the optimal leverage ratio (as in Leary and Roberts (2005)). Still, it is surprising that rms are on average underlevered over the sample period. Almeida and Philippon (2007) nd that rms are on average correctly levered, in contrast to the above ndings. Since they do not consider non-tax benets, such as reductions in agency problems between management and shareholders, when calculating the benets to debt nancing, Almeida and Philippon underestimate optimal leverage. On the other hand, they use the relatively low 10% to 23% ex-post cost of nancial distress estimates based on the LBO sample in Andrade and Kaplan (1998) to calculate the ex-ante cost of debt. In the next section I show that my results imply costs of distress in the 15% to 30% range. The consideration of non-tax benets coupled with higher distress costs suggests that net benets as a function of leverage are more spiked than Almeida and Philippon suggest, that is, net benets rise and fall faster with leverage. As a result, net benets at the optimal leverage ratio are higher, and the cost of being under- or overlevered is greater than their study implies. 24

Restricting the sample to rms that have interest-bearing debt, the underleverage becomes less severe but does not disappear altogether. Table IV shows that the average (median) interest-paying rm in the FF model has a leverage ratio of 0.259 (0.225) compared to an optimal leverage of 0.328 (0.279).13 The underleverage disappears entirely for rms with at least 5% leverage, dened as net debt relative to rm value: average (median) observed leverage in the FF model is 0.343 (0.313) versus optimal leverage of 0.341 (0.299). The importance of the low debt rms in the underleverage result warrants further investigation. Many public rms have a zero debt policy and some of these rms refrain from issuing debt for years (Minton and Wruck (2001) and Lemmon and Zender (2003)). Firms that do not pay interest (true zero leverage rms) have optimal leverage ratios around 0.2, and are therefore severely underlevered. Table IV shows that zero leverage rms that do not pay dividends are less underlevered than the zero leverage rms in general. Regressions of the degree of overleverage (observed minus optimal leverage) in Table V conrm these results, and show that they are robust to other variables that may capture rms deviations from optimal capital structures. When adding rm xed eects, the coecients on zero leverage rms largely disappear. This implies that zero leverage rms tend to remain unlevered but does not answer the question whether they do so optimally or whether they face friction costs that are too high relative to the benets of debt nancing. In the next section I discuss nancial policy in more detail, and look at whether the market expects zero leverage rms to remain unlevered. Table

What other factors make rms deviate from optimal leverage? Intuitively, rms in V nancial distress and in economic hardship are likely to be overlevered. Table V shows around 25 here

that, indeed, the degree of overleverage is higher for non-investment grade rms and during economic recessions. Overleverage is also higher for large, low prot rms, which is simply a restatement of the opposite relation between leverage and protability, or size, when using observed or optimal leverage ratios (as discussed above). The coecient on market-to-book value has conicting signs and is therefore dicult to interpret. As a nal exercise, I look at a sample of LBO and management buy-out rms from Andrade and Kaplan (1998). With data for 25 of the 32 rms in their sample, Table VI shows that these rms are typically protable, with a high proportion of tangible assets and low market-to-book ratios. In the year before the buy-out, the median leverage ratio is 0.198, compared to a median optimal leverage in the FF (SIC2) model of 0.336 (0.449). Consistent with popular belief, LBO rms were underlevered before the buy-out. The gain to levering up is less than the 10% increase in rm value due to tax benets reported in Graham (2000), because of the compensating increase in the cost of debt. The median gain to levering up to the optimal leverage ratio, calculated as the change in net benets, is 0.8% (3%) of rm value for the FF (SIC2) sample, but is as high as 8.4% for the buy-out of Fort Howard in 1988. Immediately after the buy-out, the median leverage is 0.923, far above the optimum. This result is to be expected since the intention of an LBO is to pay down debt quickly in the post-LBO years, ultimately settling on the optimal leverage ratio.14 Table VI

C. Financial Policy

around

The results in the previous section show that, most of the time, companies have too little here or too much debt. Is this optimal behavior given that rms face friction costs to changing 26

capital structure, or are rms leaving money on the table by not adjusting leverage? In other words, do companies adjust their capital structure when the gains of doing so are large, or are they persistently under- or overlevered? Fig.4

Figure 4 plots the gains to renancing versus the degree of overleverage, dened as around observed minus optimal leverage. The gains to renancing are calculated as the change here in Bit from adjusting leverage from its current level to the model-implied optimum, and represent the increase in rm value if the rm could change its capital structure without incurring friction costs at that particular time. In a dynamic capital structure world, this gain is then a measure of the friction costs to renancing. Figure 4 shows separate plots for interest-paying investment grade rms, non-investment grade rms, zero leverage rms (with no interest-bearing debt), and zero leverage rms that pay dividends. Friction costs can generate substantial variation in leverage ratios, consistent with the theoretical results in Fischer, Heinkel, and Zechner (1989). Even with costs of rebalancing their capital structure of only 1% to 2% of rm value, Figure 4 shows that we could easily see rms leverage ratios vary by 0.2 above or below the optimal capital structure. Figure 4 shows that the potential gains of rebalancing are very large for overlevered companies, up to 30% of rm value. These gains clearly outweigh any issuance costs. Most of the highly overlevered rms are non-investment grade, nancially distressed rms. As Gilson (1997) argues, the costs of unlevering nancially distressed rms are much higher than the mere cost of issuing equity and buying back debt. Firms cannot force a settlement on all creditors, giving rise to hold-out problems. In addition, there are regulations that discourage institutional lenders from writing down debt or exchanging debt for equity. To 27

the extent that the extremely overlevered rms are likely economically distressed, they have few (if any) earnings to shield from taxes, and agency benets like the disciplinary eect of reduced free cash ows are small. If these rms tend to remain highly levered due to market frictions, as Gilson suggests, their future benets to leverage are arguably very low. The 15% to 30% potential gain to unlevering for the most extremely overlevered rms then consists mostly of reductions in distress costs, and we can roughly estimate costs of nancial distress at 15% to 30% of rm value. This estimate is higher than the 10% to 23% distress costs in Andrade and Kaplan (1998), which is not surprising given that their calculations are based on LBO rms that likely face low costs of distress and can therefore bear the extremely high leverage ratios of a buy-out. For the most severely underlevered rms, levering up to the optimal capital structure increases market value by as much as 5% to 8%. The issuance costs of adjusting the capital structure back to the optimum are much lower: increasing leverage by 0.5 costs 0.5% of rm value.15 Unless these highly underlevered rms face other friction costs, they should renance. A large fraction of the highly underlevered rms are zero leverage rms. The present value of net benets, Bit , is informative about market expectations regarding the nancial policy of these companies. If they are expected to remain unlevered, net benets are zero. The zero leverage rms that pay dividends have mean (median) net benets of 2.72% (2.28%) of rm value in the FF model. The market therefore expects these rms to lever up and capture some benets to debt nancing in the future. The mean (median) gain to levering up is 4.37% (3.32%) of rm value, so these rms certainly benet from renancing. 28

The zero debt rms that do not pay dividends are not expected to lever up in the future: the mean (median) net benets for this subset of companies are -0.84% (-0.73%).16 The mean (median) potential gain to relevering is 1.81% (1.29%). Given that these rms are on average underlevered by 0.163 (see Table IV), the costs of relevering are about 0.16%. The zero leverage rms that do not pay dividends act as if they face friction costs that are substantially larger than issuance costs alone, such as overvalued equity or managerial aversion to taking on debt. Pushing the question of nancial policy further, do rms actively rebalance capital structure when the potential gains of doing so are high? To address this question, I estimate two logit models of the relation between companies nancing activities and the gains to adjusting the capital structure. The basic idea is the same as that in Leary and Roberts (2005), the dierence being that I have direct estimates of the gain to renancing. The rst model estimates the probability of levering up as a function of the gain to renancing, using the subsample of underlevered rms: ln pi,t+1 1 pi,t+1 = 0 + 1 GAINit + 2 GAINit 2 + 3 GAINit 3 + it , (10)

where pi,t+1 is the probability of rm i issuing debt or buying back equity worth more than 20% of its book assets in year t + 1, and GAINit is the change in B/V L from rebalancing leverage from its current level to the optimum in year t. Figure 5 plots pi,t+1 against GAIN. In the SIC2 model, the probability that an underlevered rm increases its leverage modestly Fig.5 rises with the potential gain of doing so. In the FF model the probability drops to zero for around gains over 0.15 (i.e., 15% of rm value), but this region of the support is an extrapolation here 29

from the data, as the maximum gain to underlevered rms is 0.1 (see Figure 4). The second model takes the same functional form as (10), but estimates the probability of levering down for overlevered rms. The dependent variable is the probability of rm i issuing equity or buying back debt worth more than 20% of its book value in year t + 1. The results in Figure 5 are quite striking, as both the SIC2 and FF models predict that the renancing probability rst rises with the potential gain, but then drops down to zero as the gain becomes large. This drop in renancing probability is consistent with market frictions preventing these rms from immediately unlevering, causing signicant friction costs due to nancial distress. A dierent way of looking at nancial policy is to track rms leverage ratios over time. I sort rms into leverage portfolios in January 1994, including only rms that exist over the entire sample period, and plot the portfolios average leverage over time in Figure 6. Fig.6 Optimal leverage ratios are quite stable over time, consistent with Lemmon, Roberts, and around Zender (2008). The high leverage rms slowly lever down towards their optimal leverage here ratio, even though the 1998 debt crisis and the 2000 to 2001 downturn partially negate their eorts. The low leverage portfolio slowly drifts up over time, but never reaches the optimal leverage ratio. This result is due to rms that persistently keep zero leverage. The subset of companies that do issue debt lever up substantially towards the optimum. This result again highlights the puzzle of the zero leverage rms.

30

VI. Conclusions
The net benets to debt nancing are identied from the market values and betas of corporate debt and equity. Two identication assumptions are necessary: (i) rms within an industry have the same (unlevered) asset beta, and (ii) the ex-ante net benets to leverage are a function of observable variables. Using a panel data set of rms over the period 1994 to 2004, I estimate the present value of net benets to debt nancing as a function of rm-specic variables. Net benets are increasing in leverage for low debt rms but decrease as leverage becomes very high, implying the existence of an optimal capital structure. For the median rm in the sample, net benets can be as high as 5.5% of rm value. Unlike the cross-sectional regressions used in prior research, the results on optimal capital structure in this paper are not aected by rms deviating from their optimal capital structure. Contrary to prior empirical evidence but consistent with theoretical predictions, I nd that optimal leverage is increasing in protability and decreasing in company size. An important feature of the identication employed here is that it does not require rms to be optimally levered, not even on average. I nd that rms are generally slightly underlevered, but not as much as suggested by prior research. The underleverage result is mainly due to the rms that have no interest-bearing debt (true zero leverage rms). Firms that pay neither interest nor dividends are substantially underlevered, and there is no indication that these companies will lever up in the future. On the other hand, the rms that pay no interest but do pay dividends are expected to lever up in the future, suggesting

31

that they are only temporarily underlevered. Still, it is puzzling that zero leverage rms behave as if they face friction costs to relevering that are substantially larger than issuance costs alone, and the nature of these costs remains an open question. A sample containing 25 leveraged buy-out rms shows that these rms were substantially underlevered in the year before the buy-out. The median gain to increasing leverage to the model-implied optimum for these rms is 0.8% to 3% of rm value, depending on the model specication used. Many companies in the sample are overlevered. The most overlevered rms are distressed rms that are rated below investment grade. Assuming a low present value of the benets to debt for these severely distressed companies, I nd an estimate of the present value of the costs of nancial distress of 15% to 30%, higher than prior estimates of the costs of nancial distress that are based on a small sample of LBO rms. I nd that overlevered rms are more likely to rebalance their capital structures when gains to renancing are moderately high, but this likelihood decreases as the potential gains rise. This result indicates that the friction costs of renancing distressed companies are large. Renancing severely distressed rms is generally dicult, time-consuming, and costly to achieve due to debt overhang, bargaining issues, and conicts among creditors.

32

FOOTNOTES
1

The debt and equity claims can be decomposed further into corporate bonds, bank debt and capi-

talized leases, and common and preferred equity, but it is not necessary to do so for the purpose of this paper.
2

Examples of costs of debt are the impaired ability to do business due to customers concerns for

parts, service, and warranty interruptions or cancelations if the rm les for bankruptcy (Titman (1984) and Titman and Opler (1994)), investment distortions due to debt overhang (Myers (1977)) and asset substitution (Jensen and Meckling (1976)), employees leaving the rm or spending their time looking for another job, and management spending much of its time talking to creditors and investment bankers about reorganization and renancing plans instead of running the business.
3

Cutler and Summers (1988) and Andrade and Kaplan (1998) take rst dierences of (6a) to eliminate

V U and achieve identication through a natural experiment. This approach tends to yield very small samples.
4 5

I conrm this in simulations where I force rms to stay in a suboptimal region of leverage. Specically, B = B(L) if all rms within an industry have similar investment opportunities, pro-

duction technology, and asset tangibility, if they produce similar goods or services (e.g., durable versus nondurable goods), and if these characteristics are stable over time. Structural models (e.g., Merton (1974) and Leland (1994)) then imply a one-to-one relation between L and tax benets as well as a rms probability of default. As an example of a structural motivation for the specication of B, Lelands (1994) model implies B/V = 1 L + 2 LX+1 with 1 = loss-given-default, X = 2r/ 2 , and L VB /V .
6 B Note that it is estimated from the time series of Bit as implied by (8), and is therefore implicitly a 1+X X 1

and 2 =

1+X X 1

+ , where is the

function of leverage, the explanatory variables X0it , X1it , and X2it , and parameters 0 , 1 , and 2 .
7 8

The simulation results are reported in the Internet Appendix, available at http://www.afajof.org/supplements.asp. Previous studies (e.g., Berk, Green, and Naik (1999)) argue that betas should be mean-reverting to

ensure stationarity of returns.

33

The algorithm and sampling distributions, and a simulation study analyzing the performance of the

methodology in simulated data are available in the Internet Appendix.

10 11 12 13

My thanks go to Ilya Strebulaev for suggesting the addition of zero leverage rms to the sample. The results for the SIC2 model are quantitatively similar, see the Internet Appendix. My thanks go to an anonymous referee for making me aware of this point. Some interest-paying rms still have zero eective leverage as measured by net debt relative to total

value because they have cash in excess of the amount of debt outstanding.
14 15

Since these rms went private it is not clear what leverage ratio they ultimately settled on. Altinkilic and Hansen (2000) document bond oering costs of about 1% of issue size. Equity

repurchase costs are probably quite small, consisting primarily of trading costs and SEC restrictions on the timing and amount of share repurchases (rule 10-18b).
16

The results for the SIC2 model are quantitatively similar: rms that pay no interest but do pay

dividends have mean (median) net benets of 1.68% (1.29%). The mean (median) net benets for rms that pay no interest nor dividends are -1.2% (-0.88%).

34

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41

Table I

Sample Breakdown by Industry

This table presents a breakdown of the 1994 to 2004 sample into industries dened by two-digit SIC code (SIC2, in Panel A) or Fama-French (1997) classication (FF, in Panel B). The observed number of rms (# rms) and rm-months (N ) are reported for each industry.

Panel A: SIC2 Name code # rms N Oil & Gas 13 11 684 Builders 15 5 504 Food 20 12 1,416 Paper 26 6 768 Publishing 27 7 827 Chemicals 28 24 2,844 Petroleum Products 29 4 480 Primary Metals 33 5 480 Machinery 35 16 1,572 Electric Equipment 36 26 2,275 Cars 37 8 972 Instruments 38 5 648 Transport (Air) 45 5 619 Telecom 48 17 1,358 Utilities 49 17 1,894 Wholesale (Non-dur) 51 9 1,128 Retail (Misc) 53 8 1,032 Insurance 63 7 495 Patent & Royalty 67 7 648 Hotels 70 2 216 Equipment Services 73 19 2,132 Health 80 12 1,285 Total 232 24,277

42

Panel B: FF industries Name code Food Products Food Recreational Products Toys Entertainment Fun Printing & Publishing Books Consumer Goods Hshld Apparel Clths Healthcare Hlth Medical Equipment MedEq Pharmaceutical Products Drugs Chemicals Chems Construction Materials BldMt Construction Cnstr Steel Works, Etc. Steel Machinery Mach Electrical Equipment ElcEq Automobiles & Trucks Autos Aircraft Aero Petroleum & Natural Gas Enrgy Utilities Util Telecommunications Telcm Business Services BusSv Electronic Equipment Chips Measuring & Control Equipment LabEq Business Supplies Paper Transportation Trans Wholesale Whlsl Retail Rtail Restaurants, Hotel, Motel Meals Insurance Insur Trading Fin Total

Table I - Continued

# rms N 10 1,224 3 360 4 515 7 827 11 1,222 3 396 12 1,285 10 939 13 1,212 10 1,246 3 396 9 708 5 480 9 1,044 17 1,387 5 576 3 396 16 1,167 17 1,920 17 1,366 18 2,100 6 732 6 464 6 768 12 1,181 12 1,441 19 2,240 6 514 9 759 12 888 290 29,753

43

Table II

Summary Statistics
This table presents summary statistics for the 29,753 rm-month observations in the FF sample. Variables are dened as follows: PROF is the most recent EBITDA/Sales (annual Compustat item 13 divided by item 12); DEPR is depreciation over book assets (item 14 / item 6); VOL is the standard deviation of (P ROFi,t+1 P ROFit )/P ROFit ; PPE is property, plant, and equipment divided by book assets (item 8 / item 6); MB is equity market capitalization divided by book equity (item 6 minus item 181); LN(TA) is the natural logarithm of total assets (item 6, in millions); and L is the net debt value (market value of debt net of cash) divided by the sum of net debt and market value of equity, bounded below by zero. The book value of the unobserved portion of debt is used as a proxy for its market value. Source: FISD, CRSP, Compustat.

PROF DEPR VOL PPE MB LN(TA) L

Panel A: Summary Statistics Mean Percentile St.Dev. 10 50 90 0.174 0.045 0.157 0.338 0.123 0.044 0.120 0.328 1.739 7.508 0.234 0.015 0.040 0.017 0.045 0.055 0.307 0.289 1.014 0.073 0.274 0.663 3.717 9.684 0.573 0.033 0.238 0.229 3.044 1.859 0.233

4.968 7.655 0 0.179

PROF DEPR VOL PPE MB LN(TA)

Panel B: Correlation Matrix DEPR VOL PPE MB LN(TA) L 0.185 -0.189 0.167 0.091 0.189 0.002 -0.067 0.404 -0.043 -0.060 0.069 -0.129 0.181 -0.272 -0.126 -0.172 0.178 0.333 -0.163 -0.346 0.258

44

Table III

Parameter Estimates
This table reports the posterior mean and standard deviation of parameter estimates over the 1994 to 2004 sample, dening industries either by their two-digit SIC code (SIC2) or the Fama-French (1997) industry classications (FF). The model species the net benets to leverage relative to rm value (B/V L ) as a function of rm characteristics:
L Bit /Vit = X0it 0 + (X1it Lit ) 1 + X2it L2 2 . it

The explanatory variables are as dened in Table II. The dummy variable D RECESS equals one in a recession, as dened by NBER peak-to-trough periods, and zero otherwise. Standard errors are in parentheses. ***, **, and * denote parameter estimates for which zero falls outside the 99%, 95%, and 90% posterior condence intervals, respectively.

I Constant PROF DEPR VOL PPE MB D RECESS LN(TA) SIC2 FF 0.030 0.041 (0.009)*** (0.012)*** . . . . . . . . . . . . . . . . . . . . . . . . . . . . SIC2 -0.013 (0.003)*** 0.126 (0.005)*** -0.301 (0.046)*** -0.066 (0.006)*** 0.110 (0.023)*** -0.001 (0.000)*** -0.003 (0.002) 0.001 (0.001)

II FF -0.012 (0.004)*** 0.150 (0.008)*** -0.288 (0.034)*** -0.075 (0.003)*** 0.078 (0.010)*** -0.001 (0.000)*** 0.004 (0.002)** 0.001 (0.001)

45

Table III - Continued

II SIC2 0.171 (0.008)*** 0.415 (0.010)*** -1.970 (0.287)*** -0.106 (0.006)*** 0.243 (0.025)*** -0.001 (0.001) -0.035 (0.003)*** -0.002 (0.001)*** FF 0.143 (0.018)*** 0.539 (0.014)*** -1.940 (0.116)*** -0.086 (0.004)*** 0.353 (0.064)*** 0.002 (0.005) -0.037 (0.005)*** -0.003 (0.001)**

SIC2 L* Constant PROF DEPR VOL PPE MB D RECESS LN(TA) L2 * Constant PROF DEPR VOL PPE MB D RECESS LN(TA) -0.193 (0.006)*** . . . . . . 0.164 (0.015)*** -0.096 (0.001)*** -0.060 (0.004)*** -0.000 (0.001) 24,277 0.0358 0.116 (0.013)*** 0.218 (0.008)*** -0.531 (0.030)*** -0.103 (0.010)*** . . . . . . 0.008 (0.003)***

FF 0.140 (0.020)*** 0.227 (0.015)*** -0.574 (0.027)*** -0.095 (0.004)*** . . . . . . 0.003 (0.004)

-0.214 (0.006)*** . . . . . . 0.198 (0.010)*** -0.122 (0.001)*** -0.079 (0.015)*** 0.001 (0.000)*** 29,753 0.0345 46

-0.343 (0.040)*** -0.202 (0.071)*** 1.679 (0.041)*** -0.098 (0.004)*** 0.124 (0.012)*** -0.060 (0.003)*** -0.048 (0.002)*** -0.001 (0.001) 24,277 0.0241

-0.346 (0.052) -0.203 (0.053)*** 1.655 (0.059)*** -0.184 (0.004)*** 0.149 (0.018)*** -0.063 (0.003)*** -0.052 (0.003)*** -0.006 (0.001)*** 29,753 0.0276

N MSE

Table IV

Optimal versus Observed Leverage

Panels A and B show summary statistics of observed and model-implied optimal leverage for the twodigit SIC (SIC2) and Fama-French (FF) samples, respectively, where leverage is as dened in Table II. Optimal leverage is calculated for each rm-month from Specication II in Table III. Each sample is split into subsamples of interest-paying rms, non-interest-paying rms, and rms that pay neither interest nor dividends. N is the number of rm-months in each subsample.

Panel A: SIC2 Sample Mean Percentile St.Dev. 10 50 90 Full sample (N = 24,277) Observed 0.240 0 0.196 0.563 0.226 Optimal 0.258 0.128 0.221 0.432 0.152 Interest-paying rms (N = 22,595) Observed 0.256 0 0.227 0.575 0.225 Optimal 0.264 0.133 0.224 0.441 0.154 Non-interest-paying rms (N = 1,682) Observed 0 0 0 0 0 Optimal 0.180 0.042 0.196 0.258 0.088 Non-interest, non-dividend-paying rms (N = 1,060) Observed 0 0 0 0 0 Optimal 0.150 0 0.163 0.247 0.091 Panel B: FF Sample Mean Percentile St.Dev. 10 50 90 Full sample (N = 29,753) Observed 0.234 0 0.179 0.573 0.233 Optimal 0.316 0.142 0.269 0.575 0.176 Interest-paying rms (N = 26,868) Observed 0.259 0 0.225 0.591 0.232 Optimal 0.328 0.155 0.279 0.591 0.176 Non-interest-paying rms (N = 2,885) Observed 0 0 0 0 0 Optimal 0.205 0.065 0.189 0.379 0.127 Non-interest, non-dividend-paying rms (N=1,972) Observed 0 0 0 0 0 Optimal 0.163 0 0.159 0.289 0.100

47

Table V

Drivers of Over- and Underleverage

This table presents OLS regressions of observed minus model-implied optimal leverage for the two-digit SIC (SIC2) and Fama-French (FF) samples, respectively. Leverage (L) is as dened in Table II. The dummy variables D INT0 and D DIV0 equal one when a rm does not pay interest or dividends, respectively, in that month. The dummy variable D NONINV equals one if a rm is rated below investment grade in that month. Other variables are as explained in Table II. Specication III includes both rm and year xed eects. Standard errors are in parentheses. ***, **, and * denote signicance at the 1%, 5%, and 10% level, respectively.

48

Dependent = Observed L - Optimal L SIC2 I II III D INT0 -0.143 -0.126 0.017 (0.007)*** (0.008)*** (0.010)* D INT0 0.081 0.039 0.005 (0.011)*** (0.009)*** (0.022) D DIV0 D NONINV . 0.177 0.021 . (0.003)*** (0.003)*** . 0.101 0.071 D RECESS . (0.005)*** (0.006)*** PROF . -0.373 -0.481 . (0.010)*** (0.014)*** MB . 0.008 0.009 . (0.000)*** (0.000)*** LN(TA) . 0.015 0.011 . (0.001)*** (0.002)*** Intercept -0.006 -0.120 0.026 (0.001)*** (0.007)*** (0.016)*** Firm-FE N N Y Year-FE N N Y adjusted-R2 0.044 0.253 0.698 F 559.743 1175.170 227.476 p 0.000 0.000 0.000 N 24,277 24,277 24,277

FF I II III -0.094 -0.016 0.015 (0.005)*** (0.005)*** (0.012) 0.133 0.088 -0.028 (0.009)*** (0.008)*** (0.012)** . 0.164 0.048 . (0.003)*** (0.003)*** . 0.124 0.083 . (0.004)*** (0.005)*** . -0.510 -0.540 . (0.009)*** (0.011)*** . -0.027 -0.012 . (0.001)*** (0.001)*** . 0.012 0.001 . (0.001)*** (0.002) -0.069 -0.085 -0.127 (0.001)*** (0.006)*** (0.016)*** N N Y N N Y 0.040 0.312 0.773 617.633 1929.622 330.715 0.000 0.000 0.000 29,753 29,753 29,753

Table VI

Leveraged Buy-Out Firms

This table presents rm characteristics and model-implied optimal leverage ratios for 25 leveraged buy-out rms from Andrade and Kaplan (1998), using accounting data from Compustat in the scal year before the buy-out. Leverage (L) is the book value of debt (net of cash) relative to net debt plus market equity, calculated from Andrade and Kaplan. Firm characteristics are dened in Table II. I report leverage both in the year before (Pre) and after (Post) the buy-out. Optimal leverage (Opt) is calculated from Specication L II in Table III for both the SIC2 and FF models. The gain to renancing (GAIN ) is calculated as Bit /Vit at the optimal leverage L minus Bit /Vit at the pre-buy-out leverage.

L HLT date 9/87 5/89 11/88 10/88 7/87 PROF 0.092 0.143 0.123 0.253 0.178 DEPR 0.063 0.014 0.042 0.057 0.031 VOL 0.209 0.183 0.365 0.144 0.147 PPE 0.496 0.130 0.549 0.582 0.325 MB 0.523 1.055 0.619 1.059 0.625 LN(TA) 7.688 4.526 5.634 7.694 7.444 Pre 0.107 -0.033 0.198 0.113 0.235 Post 1.007 0.417 1.058 0.903 0.965

SIC2 Opt GAIN 0.532 0.046 0.277 0.040 0.546 0.037 0.632 0.084 0.432 0.013

Opt 0.345 0.233 0.387 0.487 0.336

FF GAIN 0.017 0.033 0.013 0.049 0.004

49

Name Burlington Inds Cherokee Florida Steel Fort Howard Harcourt Brace Jovanovich Hills Stores Interco KDI Leaseway Transp R H Macy Mayower National Gypsum Papercraft Payless Cashways Pay N Pak Plantronics Republic Health Revco RJR Nabisco Seaman Furniture Specialty Eqpmt Southland Supermarkets Gnrl USG Jim Walter Mean Median Stdev 12/85 12/88 12/88 6/87 7/86 12/86 4/86 10/85 10/88 3/88 4/89 8/86 12/86 3/89 2/88 9/88 12/87 10/87 7/88 1/88 0.087 0.096 0.100 0.097 0.122 0.070 0.198 0.177 0.072 0.057 0.187 0.210 0.058 0.205 0.145 0.174 0.052 0.041 0.184 0.182 0.132 0.123 0.060 0.037 0.032 0.036 0.094 0.044 0.056 0.040 0.021 0.043 0.024 0.039 0.032 0.035 0.035 0.020 0.044 0.054 0.066 0.046 0.036 0.042 0.039 0.017 0.200 0.100 0.176 0.166 0.084 0.210 0.374 0.142 0.105 0.080 0.138 0.190 0.237 0.055 0.200 0.200 0.122 0.040 0.385 0.153 0.176 0.166 0.090 0.350 0.241 0.326 0.558 0.464 0.467 0.453 0.217 0.522 0.455 0.171 0.634 0.305 0.346 0.379 0.161 0.664 0.540 0.568 0.313 0.409 0.453 0.153 0.162 0.588 0.581 0.507 1.356 0.663 0.953 1.218 0.475 0.361 1.160 0.229 0.837 1.158 2.805 0.464 0.664 0.765 0.718 0.818 0.815 0.664 0.517 6.640 7.594 5.212 6.820 7.765 5.547 6.957 4.968 6.703 5.847 4.773 6.724 6.895 9.784 4.625 5.393 8.138 7.067 7.647 7.983 6.643 6.820 1.317 0.169 0.161 0.205 0.245 0.265 0.307 0.030 -0.035 0.221 0.248 0.106 0.554 0.171 0.133 0.013 0.231 0.267 0.081 0.265 0.213 0.179 0.198 0.124 0.839 0.891 1.045 0.475 0.855 0.917 0.850 0.795 0.901 0.968 0.976 0.924 1.041 0.923 0.943 0.961 0.897 0.911 1.025 1.013 0.900 0.923 0.153 0.442 0.348 0.405 0.649 0.477 0.490 0.449 0.335 0.612 0.565 0.292 0.764 0.331 0.431 0.340 0.292 0.739 0.612 0.554 0.402 0.478 0.449 0.139

0.022 0.012 0.013 0.031 0.015 0.009 0.063 0.056 0.041 0.030 0.013 0.013 0.009 0.033 0.052 0.001 0.054 0.065 0.027 0.013 0.032 0.030 0.022

0.310 0.254 0.301 0.391 0.351 0.331 0.337 0.282 0.429 0.415 0.246 0.585 0.228 0.336 0.279 0.234 0.485 0.398 0.396 0.311 0.347 0.336 0.089

0.007 0.003 0.003 0.005 0.003 0.000 0.040 0.045 0.013 0.009 0.008 0.000 0.001 0.017 0.037 0.000 0.013 0.026 0.007 0.004 0.014 0.008 0.015

Figure 1. Levered rm beta as a function of leverage. This gure depicts the hypothetical relation between a rm characteristic, X, and the beta of the levered rm, L , when there are net benets to debt that depend only on the characteristic (B = B(X)). Levered rm beta is dened as the weighted average D of debt and equity betas: L = V L D + VE E . The line traces the relation between L and X. The dots L on the line represent rms with identical (unlevered) asset betas, U .

50

0.15 0.1
L

median 10% 90%

PROF 0.15 0.1 B/VL 0.05 0

DEPR

B/V

0.05 0 0.05 0 0.2 0.4 VOL 0.1 0.05 0.6

0.05

0.2

0.4 PPE

0.6

0.3 0.2 B/VL 0 0.2 0.4 MB 0.6 0.1 0 0.1 0 0.2 0.4 D_RECESS 0.15 0.1 B/VL 0.05 0 0 0.2 L 0.4 0.6 0.05 0 0.2 L 0.4 0.6 D_RECESS = 0 D_RECESS = 1 0.6

B/V B/V

0 0.05 0.1

0.1 0.05
L

0 0.05 0.1

Figure 2. Net benets to leverage. This gure shows how net benets to leverage, as a fraction of total rm value (B/V L ), varies with leverage (L, on the horizontal axis). The plots are based on parameter estimates of the full model (Specication II) and using the FF industries, as reported in table III. The graphs compare the median rm (in an economic expansion) to the same rm but with one characteristic at either its 10th or 90th percentile of the sample distribution. Firm characteristics are as dened in Table II. The bottom-right graph shows the net benets for a rm with median characteristics in an expansion period versus in a recession (peak-to-trough as dened by the NBER). Optimal leverage ratios, as determined by maximum net benets, are marked with an X.

51

0.45 0.35 0.25 0.15

0.35 0.3 L
*

0.25 0.2

0.1

0.2 PROF

0.3

0.4

0.15

0.025

0.05 DEPR

0.075

0.1

0.35 0.6 0.3 L

*

0.25 0.2 0.15 0 0.15 0.3 VOL 0.45 0.6

L* 0.45 0.3 0.15

0.2

0.4 PPE

0.6

0.8

0.35 0.3 L
*

0.35 0.3 L
*

0.25 0.2 0.15 0 2 MB 4 6

0.25 0.2 0.15 4 6 LN(TA) 8 10

Figure 3. Optimal capital structure. This gure shows how optimal leverage (L ) varies with rm characteristics (on the horizontal axis), based on parameter estimates of the full model (Specication II) and the FF sample, as reported in Table III. Firm characteristics are as dened in Table II. Each plot allows one rm characteristic to range between the 5th to 95th percentile of the observed data, while keeping the other characteristics at the median of the sample distribution.

52

Investment grade interestpayer 0.35 0.3 0.25 GAIN GAIN 0.2 0.15 0.1 0.05 0 0.8 0.4 0 0.4 Observed L Optimal L Noninterestpayer 0.35 0.3 0.25 GAIN GAIN 0.2 0.15 0.1 0.05 0 0.8 0.4 0 0.4 Observed L Optimal L 0.8 0.35 0.3 0.25 0.2 0.15 0.1 0.05 0 0.8 0.8 0.35 0.3 0.25 0.2 0.15 0.1 0.05 0 0.8

Noninvestment grade

0.4 0 0.4 Observed L Optimal L Noninterest, dividendpayer

0.8

0.4 0 0.4 Observed L Optimal L

0.8

Figure 4. Gain to renancing. This gure shows plots of the gain to renancing from observed leverage to the model-implied optimal leverage versus the degree of overleverage, for the 29,753 rmmonth observations in the FF model. Overleverage is dened as observed leverage minus optimal leverage. Observed leverage (L) is the net debt value (market value of debt net of cash) divided by the sum of net debt and market value of equity. Optimal leverage is calculated from the full model (Specication II) using the FF model, as reported in Table III. The gain to renancing (GAIN ) is calculated as the dierence in net benets (B/V L ) at the optimal leverage minus B/V L at the observed leverage ratio. The sample is split into rm-years in which rms were rated investment grade and paid interest (top left), rm-years in which rms were rated below investment grade (top right), rm-years in which rms paid no interest (bottom left), and rm-years in which rms paid no interest but did pay dividends (bottom right).

53

Leverage Increase (SIC2) Underlevered firms 0.4 0.1 0.08 probability 0.06 0.04 0.02 0

Leverage Decrease (SIC2) Overlevered firms

0.3 probability

0.2

0.1

0.05

0.1

0.15 GAIN

0.2

0.25

0.05

0.1

0.15 GAIN

0.2

0.25

Leverage Increase (FF) Underlevered firms 1 0.8 probability 0.6 0.4 0.2 0 probability 0.1 0.08 0.06 0.04 0.02 0

Leverage Decrease (FF) Overlevered firms

0.05

0.1

0.15 GAIN

0.2

0.25

0.05

0.1

0.15 GAIN

0.2

0.25

Figure 5. Probability of renancing. This gure shows plots of the probability of rebalancing the capital structure to the optimum as a function of the gain to renancing. Underlevered rms are dened as rms with a leverage ratio below the model-implied optimum in a particular year, where optimal leverage is calculated from Specication II in Table III. The probability of levering up for underlevered rms is calculated from a logistic regression: ln pi,t+1 1 pi,t+1 = 0 + 1 GAINit + 2 GAINit 2 + 3 GAINit 3 + it ,

where pi,t+1 is the probability of rm i issuing debt or buying back equity worth more than 20% of its book assets in year t + 1. The gain to renancing (GAIN ) is calculated as in Figure 4. There are 1,213 underlevered rm-years in the SIC2 sample and 1,748 in the FF model. Similarly, the probability of levering down is calculated for overlevered rm-years. The dependent variable is the probability of rm i issuing equity or buying back debt worth more than 20% of its book value in year t + 1. There are 743 overlevered rm-years in the SIC2 model, and 656 in the FF model.

54

0.6

High observed Low observed High optimal Low optimal

0.5

0.4 L 0.3

0.2

0.1

0 1994

1995

1996

1997

1998

1999 2000 Year

2001

2002

2003

2004

Figure 6. Time-series of leverage. This gure shows the observed and optimal leverage for high and low leverage portfolios. I sort the 132 rms that exist over the entire 1994 to 2004 sample period into four leverage portfolio, based on initial leverage in January 1994. The plot graphs the average observed leverage ratio of the highest and lowest leverage portfolios, and the associated model-implied optimal leverage from the FF model. Leverage (L) is as dened in Table II.

55