Capital structure theory and flotation costs: an empirical analysis of utility debt and equity decisions

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Virginia Polytechnic Institute and State University

This research investigates which theory -- an optimal, irrelevance, or modified pecking order -- best explains a firm's capital structure. A sample of 457 debt and equity utility offerings made from 1973-1982 is used in logit regression analysis to test the predictions of the different theories and the relevance of flotation costs to the financing decision. Target leverage ratios are constructed as averages from industry and firm-specific data. These ratios change over time suggesting that leverage targets are moving in response to general economic conditions.

Miller's irrelevance and the modified pecking order theories (if utilities operate well below their debt capacity) are supported. In spite of using leading and lagging targets, no support is found for an optimal capital structure theory. Also, there is no support for flotation costs when measured as the savings from issuing debt rather than equity.

An anomalous finding that overlevered firms continue to lever with their next financing decision seems to be robust to the different measures of a target leverage ratio. This finding is inconsistent with the three capital structures theories tested.