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ABSTRACT
Prior studies on the debt-equity choice of firms focus on capital market oriented economies. This paper examines whether firms in Japan, the world's largest bank-oriented economy, adjust their debt-equity choice towards the target. We find that the leverage ratios of Japanese firms do adjust slowly towards their target levels. The adjustment speed has dwindled after the Asian Financial Crisis. In contrast to existing literature, we show that an increase in tangible assets reduces the leverage ratio of firms in Japan. It is also found that the effect of financial deficit is persistent while the market timing effect is not.
Keywords: Debt-equity Choice; Pecking Order Theory; Market Timing Theory; Trade-Off Theory.
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1. INTRODUCTION
The selection of target debt-equity ratio has received increasing attention in recent years. One strand of the literature focuses on the determinants of the optimal target ratio (Graham and Harvey, 2001; Hovakimian et al., 2001; Booth et al., 2001; Baker and Wurgler, 2002; Frank and Goyal, 2003). There are three major competing theories explaining firms' debt-equity choice in the literature. The trade-off theory suggests that the optimal debt-equity choice of a firm can be determined by looking at the trade-offs between costs and benefits of financing through debt and equity. The pecking order theory states that firms prefer internal financing by retained earnings to external financing, and prefer debt to equity for external financing.1 The market timing theory argues that firms tend to issue equity under good market condition. 2 Another strand of the literature investigates how the leverage ratio moves towards the target.3 A representative study is Kayhan and Titman (2007), which examines the adjustment of debt-equity choice of US firms over a five-year horizon. They show that cash flows, investment expenditure and stock performance lead to deviations from the target ratio, and that the debt-equity choice adjusts towards the target ratio in the long run. The results of Kayhan and Titman (2007) apply to firms in a capital market oriented economy.
In this paper, we examine the debt-equity choice of Japanese firms. The case of Japan is of interest because Japan is the largest bank-oriented economy in the world. A model containing variables associated with the tradeoff, pecking order and market timing theories...