Do Peer Firms Affect Corporate Financial Policy? (Digest Summary)

The authors find that peer firms’ financing decisions have significant influence on capital structure and financial policies of smaller, less successful (e.g., lower-profitability) firms. Industry leaders (i.e., larger, more profitable firms) do not follow the financing practices of their peers. Mimicking behavior by smaller, less successful firms supports models based on learning and reputational concerns. The interdependence of financial policy is stronger than other generally understood determinants of capital structure.

The authors report that one standard deviation increase in a peer firm’s leverage ratio is associated with a 10% increase in the sample firm’s leverage, and similar results are found for changes in equity. It is peer firms’ capital structure decisions, and not their investment, dividend, or research and development choices, that lead to changes in corporate financial policy.

The authors indicate that companies with lower profitability and market share (follower firms), using peer information, lean toward peer firms’ leverage. Managers may perceive the mimicking behavior as less risky. But following peer firms’ financial decisions could lead to suboptimal capital structure for firms that have fewer financing choices and higher cost of capital than larger, more successful firms in their industry. Financial officers may want to evaluate their capital structure strategies and reconsider whether their financing policies are optimal for their firm-specific factors.

With awareness of the interdependence of financial policy making, investors can better understand industry leverage effect when evaluating a company’s capital structure. The strong peer influence on financing choices should not be ignored.

The authors build on previous research that showed the use of industry leverage ratios as determinants of a firm’s capital structure and survey evidence that CFOs used peer firm financing information when determining their own financial policy.

Data are gathered from the CRSP Compustat database for 9,126 unique firms in 217 industries for 1965–2008, resulting in 80,279 firm-year observations. Past studies linked stock returns with capital structure choices. After showing that peer firm equity shocks isolate firm specifications, the authors use a linear probability model that reveals that a firm’s leverage and changes in leverage are strongly negatively associated with peer firm equity shocks. A firm’s decision to issue debt or equity is also associated with peer firm equity shocks.

To address the concern that the peer firm equity shocks may represent industry-wide shocks or may be caused by other latent industry factors, the authors substitute equity shocks of a peer firm’s customers that are in a different industry from that of the peer firm. Peer firm customers’ equity shocks are similarly negatively correlated with leverage and net debt issuance.

Two-stage least-squares estimation indicates that peer leverage and net debt issuance have an economically significant impact on sample firm leverage and net debt issuance. The peer firm effect is larger than that of other explanatory factors. Furthermore, the authors find that the peer effect amplifies the impact of other exogenous variables by as much as 70% for small industries and 8% for larger industries.

They conclude from the robust test results that firms use information about peer firm actions when making financing choices.

The authors provide convincing evidence that peer firm financing actions are economically significant determinants of financial policies. Future capital structure models should incorporate the peer firm effect on debt and equity issuance. Managers’ use of peer firm information may or may not lead to optimal financing choices.