Does risk affect capital structure adjustments?

Abstract

Purpose

This paper aims to theorize that if risk affects costs and benefits of capital structure adjustments, then it should affect the speed at which firms adjust their leverage toward the target. To investigate this hypothesis, the author empirically examines the role of firm-specific and macroeconomic risk on firms’ capital structure adjustments.

Design/methodology/approach

The author augments the standard reduced-form partial adjustment model of capital structure by incorporating firm-specific and macroeconomic risk. The two-step robust system-generalized method of moments (GMM) estimator is used to estimate the proposed model for a large panel of UK manufacturing firms. An unbalanced annual panel data set covering the period from 1981 to 2009 is utilized for empirical analysis.

Findings

The estimated adjustment speeds indicate that both firm-specific risk and macroeconomic risk significantly affect the speed at which firms adjust their capital structure toward the target. In particular, the author shows that firms adjust their leverage faster toward the target when firm-specific risk is relatively low. This is perhaps because firms face lower costs of adjustment when both firm-specific and macroeconomic risks are low. Overall, the paper provides evidence that different levels and different types of risk exert asymmetric effects on capital structure adjustments.

Practical implications

The results presented in this paper suggest that managers have to carefully consider both the overall state of the economy and the solvency of their own business activities when making their financing decisions. The results also help in explaining why firms time equity and debt markets.

Originality/value

The paper significantly adds to our understanding of asymmetries in adjustment speed across firms and over times. The paper can also be useful to understand why firms would not aggressively act to offset the effects of changes in the market value of equity or gains and losses in earnings.

Citation

Rashid, A. (2016), "Does risk affect capital structure adjustments?", Journal of Risk Finance, Vol. 17 No. 1, pp. 80-92. https://doi.org/10.1108/JRF-06-2015-0060