The cost of equity is positively correlated with the extent to which a firm’s
financial leverage deviates from target optimal leverage. The cost of equity is lower
(higher) when the firm’s leverage is below (above) optimal leverage. Firms with a
cost of equity more sensitive to leverage deviation exhibit a more rapid speed of
adjustment toward the optimal leverage level.
How Is This Research Useful to Practitioners?
Capital structure decision making on the traditional basis of the Modigliani–Miller
(American Economic Review 1958 and 1963) propositions I and II poses
several unresolved questions for practitioners. The authors find that a firm’s cost
of equity is positively related to leverage deviation (i.e., actual leverage minus target
optimal leverage) for overleveraged firms. Overleveraged firms exhibit a smaller leverage
deviation when their cost of equity is more sensitive to leverage deviation. Underleveraged
firms do not exhibit the same link; thus, the
increase in the cost of equity is important for overleveraged firms but not for
underleveraged firms. The speed of adjustment toward target optimal leverage is not
homogeneous across firms because firms whose cost of equity is more sensitive to leverage
deviation adjust more rapidly.
Prior research on capital structure has focused on three primary theories: the static
trade-off model, the pecking order model, and the market-timing model. These theories are
effective at explaining broad patterns but not the observed cross-sectional heterogeneity in
capital structure. The trade-off theory, however, can hold in significant subsamples, such
as firms that are more sensitive to leverage deviation. The speed of adjustment of the
subsample of firms whose cost of equity is highly sensitive to leverage deviation is
significantly higher than that of the entire pooled sample. This more rapid speed of
adjustment supports the trade-off theory. The results in the capital structure literature
are mixed, and capital structure decisions are not equally important across all firms.
Therefore, it is important to explore meaningfully chosen subsamples.
How Did the Authors Conduct This Research?
The authors use a sample of 12,147 firm-year observations over 1980–2011, obtained
from CRSP, Compustat, and Federal Reserve Banks. The dependent and independent variables are
winsorized at the first and ninety-ninth percentiles to reduce the impact of outliers, and
observations with missing marginal tax rate data are omitted.
The authors’ three hypotheses concern the impact of leverage deviation on the cost
of equity, the impact of cost-of-equity sensitivity on leverage deviation, and the impact of
cost-of-equity sensitivity on the speed of adjustment. The authors use regression models to
test the three hypotheses. In testing the first and second hypotheses, they split the full
sample into a subsample of overleveraged firms and a subsample of underleveraged firms. In
testing the third hypothesis, they compare results from the full sample with results from
subsamples ranked by the sensitivity of the cost of equity to leverage deviation. The
authors conduct robustness tests by checking the results obtained using alternative measures
of the corporate leverage ratio, an alternative set of determinants in target leverage
estimation, and an alternative sample period. Although the results for the three hypotheses
are robust, support for the second and third hypotheses is weak under the alternative market
The Modigliani–Miller propositions I and II suggest, among other things, a positive
correlation between the cost of equity and leverage. The Modigliani–Miller theory is
one of the most famous in finance, despite the fact that additional research is needed to
reconcile weaknesses arising from the offsetting effect of heterogeneous firms and the
overall mixed results in the empirical literature. The authors successfully expand on the
Modigliani–Miller theory by demonstrating how deviations from the target optimal
leverage affect the cost of equity.
Practitioners who make financing decisions (e.g., company treasurers and chief financial
officers) can use the authors’ research in setting their own firms’ capital
structure. Understanding to what extent other firms adhere to the Modigliani–Miller
theory can provide a meaningful frame of reference for capital structure practitioners. We
know from the literature that a firm’s capital structure is often comparable to that
of similar firms in the same industry. Academics will appreciate the extension of the
Modigliani–Miller theory, which has yielded many empirical disappointments and
requires additional research to reconcile theory with practicality.