Content area
Full Text
Executive Summary
We test the trade-off theory of capital structure in a setting in which a crisis suddenly changes the probability of bankruptcy. In this setting, the trade-off theory of capital structure predicts that the optimum level of capital structure would shift to a lower level of debt, and thus would lead to a negative market reaction for a firm at its optimum level of debt. Because the optimum level of debt is unobservable, we predict that the level of debt affects the market reaction. In other words, we predict that firms with higher level of debt will experience greater negative stock returns.
We also predict greater negative stock returns for firms with lower capacity to service debt. We use stock price declines after the terrorist attacks of 2001 to test this prediction. Our sample consists of 2,137 U.S. manufacturing firms. For our analysis, we use both portfolio and individual cumulative abnormal returns for three days after the terrorist attacks. Findings of the study support our predictions: firms with high level of debt (especially long-term debt) and a lower capacity to service debt experienced greater negative abnormal returns in the three days after the terrorist attacks.
1. Introduction
There are two main sources of financing for a business: debt and equity. The choice of debt and equity (the capital structure decision) is one of the most important financial policy decisions, and one of the most researched topics in finance. Because owners of a business need to contribute some equity, the decision narrows down to the amount of debt.
The prevalent range of debt in business is between zero and (nearly) one hundred percent. The range varies with industries, but also varies within an industry, indicating that there is no universal rule for determining the right level of debt. The choice of capital structure is important because it has an impact on the value of the firm. While it is evident that the level of debt affects the value of the firm, it is not clear at what level of debt the value of the firm is highest.
Modigliani and Miller (1963) theorize the relation between financial leverage and stock returns. Their proposition (referred to as the MM Il proposition) states that an increase...