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1 August 2016 CFA Institute Journal Review

A Century of Capital Structure: The Leveraging of Corporate America (Digest Summary)

  1. Aditya Jadhav, CFA

Aggregate leverage for US nonfinancial publicly traded firms more than tripled from 10% in 1920 to 35% in 1970. Including an increase in nondebt liabilities, the aggregate balance sheet liabilities increased from 25% in the 1930s to more than 65% by 1990. These trends are in contrast to regulated US firms. The authors identify macroeconomic factors that alter a firm’s propensity to use debt and find that firm characteristics have no such effect.

What’s Inside?

The authors provide a complete picture of US capital structure and firms’ financial policies over the past century. They also discuss a broad-based, steep increase in the corporate leverage ratio of every unregulated industry.
The authors identify sharp differences between regulated and unregulated sectors as well as distinct similarities among unregulated industries and firms of different sizes. Changes in the broader economic and institutional environments have played an important role in explaining the changes in corporate leverage. Little of the increase in leverage over the past century is attributable to changes in firm characteristics.

How Is This Article Useful to Practitioners?

From 1920 to 1945, leverage among unregulated firms was fairly stable and relatively low. From 1946 to 1970, leverage increased steadily and significantly, but post-1970, leverage has remained stable. Much of the increase in financial leverage was because of an increase in long-term debt. Increased usage of short-term debt began in the late 1960s, and nondebt liabilities (e.g., pensions and accounts payable) began rising in 1970.
Much of the increase in leverage over this period was because of the substitution of debt for preferred equity. Preferred stock was more than 13% of aggregate assets in the early 1920s, dropping to 2% of assets in 1960. This shift toward a greater reliance on debt as a funding source resulted from an increase in corporate tax rates, the growth of financial intermediaries, and a large reduction in government borrowing.
The increase in leverage over 1945–1970 was an economy-wide phenomenon shared by firms of all sizes in all unregulated industries. But the authors’ regression results indicate that only a small portion of the leverage increase is explained by variation in firm characteristics. Their empirical analysis shows a significant negative relationship between corporate and government net issuing activity.
The authors find no significant positive relationship between tax rates and aggregate leverage. In the case of higher recapitalization costs, corporate leverage may not respond immediately to an increase in tax rates, but it may affect the choice of security the next time a firm wants to raise external capital.

How Did the Authors Conduct This Research?

Using the time frame 1920–2010, the authors consider all nonfinancial firms listed on (1) the NYSE since 1925, (2) the AMEX since 1962, and (3) NASDAQ since 1972. They obtain stock market data from the CRSP, accounting data from Compustat, and other data from Moody’s Industrial Manual.
The authors bifurcate these companies into regulated and unregulated on the basis of the industry-specific regulatory environment, restricting the scope of their study to the unregulated sector. They first estimate cross-sectional relationships between leverage and firm characteristics over 1920–1945 and predict each firm’s leverage ratio after 1945. Compared with the actual leverage ratios, their results indicate that only a small portion of the leverage increase can be explained by firm characteristics. They analyze long-term trends in aggregate leverage ratios for unregulated firms and leverage trends across the entire distribution of firms of all sizes and in all industries. The authors compare firm characteristics and leverage trends across all NYSE, AMEX, and NASDAQ firms.

Abstractor’s Viewpoint

Although the authors analyze and discuss various aspects of the increase in corporate leverage over the past century, they do not examine the implications of tax rates, monetary policies, and the regulatory environment in great detail. The period 1945–1970, during which aggregate leverage tripled, coincides with the time frame of the Bretton Woods system (1944–1971) and that relationship should be analyzed in future research.

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