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Two observations
Leverage is persistent – low/high leverage firms tend to maintain that level
Cross-sectional variation in leverage is characterized by an important firm specific effect
R2 from a regression of leverage on firm fixed effects is around 60%
Explanations offered:
Target capital structure (trade-off theory)
No target optimum (pecking order, market timing or price inertia)

Nice to Know You Don’t Matter

By examining conditions that make financial decisions irrelevant, we can learn when they will be relevant!
Modigliani-Miller (M&M) propositions give these conditions
M&M propositions:

This “theory” can be obtained from different perspectives.
Debt is “risky.”
Bankruptcy costs exist.
There is a “tax-bankruptcy” trade-off for debt:
tax benefit
bankruptcy cost.

Empirical evidence
Leverage increasing exchange offers increase firm value [Masulis (1980)]
Firms for which the tax benefit is highest use the most debt [Graham (1999)]
In US tax benefit of debt estimated to be 7% of firm value [Graham (2000)] but so are direct bankruptcy costs - for large companies 3.1% of total value on average [Weiss (1990)]

Tax changes

US Tax Reform Act of 1986 [Gordon & MacKie-Mason (1990)]
Aggregate capital structures changes consistent with Tax Reform Act providing incentives to convert equity into debt
Cross-sectional evidence consistent with tax induced capital structure changes around Tax Reform Act.
Dividend imputation of 1987 [Twite (2001)]
The aggregate level of debt in the corporate capital structure has declined
The higher the firm’s effective tax rate, the lower is the reduction in the proportion of debt in the firm’s capital structure

International transactions

Multinational are more levered than domestic corporations in Australia [Akhtar (2008)]
In US
Incentive to issue debt offshore as excess tax credits increase [Newberry (1998)]
Foreign debt placed in high tax domains [Desai (1997)]

Trade-off theory II

There is an “agency” perspective:
Debt disciplines manager and mitigates agency problems of free cash flow, since debt must be repaid to avoid bankruptcy. But, exacerbates shareholder-debtholder conflicts.
Here the costs of debt are from changes from “optimal” business operations
Jensen and Meckling (1976), Jensen (1986), and Hart and Moore (1994)

Trade-off theory III

There is a “stakeholder co-investment” perspective:
Some firms efficiency requires a firm’s stakeholders to make significant firm-specific investments. Firms making unique products will lose customers if they may go bankrupt.
The costs of debt are from disruption to normal business operations that arise under financial distress
Titman (1984), Maksimovic & Titman (1991)

Balancing Story

Benefit       Costs
PV tax   PV of             PV cost of      PV lost      PV
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