Article Review on shareholders valuation of long term debt and decline in firms’ leverage

ratio:
The Evidence from: United States

From International Journal: ELSEVIER Journal of Corporate Finance

Assumption University, Ranjan D’mello, Mark Gruskin, Manojo Kulchanioa
Journal home page: www.elsevier.com/locate/jcopfin
Mike litch school of Business, Woyne state Universty, Detroit M14202 United states
Penn state University Lehigh Valley, Center Valley, PA 18034, United States

1. Theme of the article

The purpose of this paper is cost benefit tradeoff to shareholders, captured by the valuation
impact of an additional dollar of debt on owners equity, that is an explanation for the observed
change in leverage and shareholders view increasing debt to have a negative impact on their
wealth, that is, share holders perceive firms to be over-levered. Managers respond to the
changing cost shareholders by reducing (increasing) leverage when the cost of debt increases
(decreases).The time–series pattern in the marginal cost of debt persists after controlling for
firm-specific characteristics .The result shows that macroeconomic factors such as federal debt,
play a role in explaining the marginal of debt.
2. Objectives of the article

The objective of the article is to examine the importance of cost-benefit tradeoff of

debt from the viewpoint of shareholders by estimating the net value that firms'
owners place on an incremental dollar of debt. It argue that focusing on the tradeoff
from the equity holders' per-spectives provides a more comprehensive valuation of
the net contribution of an additional dollar of debt. Shareholders consider not only
the cost of borrowing and the implication on financial distress and bankruptcy but
also how the proceeds from the debt issue are used to fund investment
opportunities, manage agency costs, determine payout policy, increase tax shields,
thus incor- porating benefits costs, as well as the of these factors in determining the
net valuation impact of issuing debt. Additionally, examining the variation in the
annual net value of additional debt across the sample period allows us to ascertain
whether shareholders view the cost-benefit tradeoff to be changing over time.

3. Data collection and analysis

Data are collected from January 2010 - December 2014 that also have valid stock price
information available in the CRSP database. Similar to Bates et al (2017) and
Strebulaev and Yang (2013), They exclude firms not headquartered in the U.S. and
those that are classified as utility and financial service firms. They also require that
firm-year

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observations have valid information about total assets (AT), sales (SALE), and total
long-term debt, which is the sum of long-term debt that matures in more than a
year, DLTT, and long-term debt in current liabilities, DLC. This denition of long-term
debt has been used by recent papers that examine capital structure and related
issues. Our final sample consists of 125,960 firm-year observations. This article is
quantitative type, which uses samples to make inference the population. To analysis the
collected data the regression analysis is used by taking stock return as dependent variable and
the four macroeconomic variables as independent variables.

4. Findings and conclusions

The result they proceed to examine if the pattern of the net cost of additional
debt during our sample period holds for groups of firms classified on different
sample characteristics. It first form groups annually based on the proxies for the
same firm characteristics that they used to examine the time-series pattern of
leverage ratios. For example, when They investigate how the net cost of issuing
additional long-term debt has changed over the sample period for firms classified
on tax shields, They use the amount of depreciation expense, income taxes paid,
and tax-loss carry forwards as proxies. They estimate the net cost of issuing
additional long-term debt for each group of firms.

They present the results for each group by decade. In general, They observe that
the time series trend in the net cost of debt documented earlier holds for different
groupings of firms by decade and characteristics; the net costs are higher in the
1990s than they are in the 1980s and costs in the 2000s are higher than the costs
in the 1990s before declining in 2010s. The pattern deviates a little when looking at
technology firms in the 1990s and also for firms holding the highest quartile of cash
in the 1990s. Both of these groups, we know, could be affected by the dot-com bubble
in the late 1990s. The pattern of increasing net cost of incremental debt over time
holds for firms grouped by corporate governance, financial constraints, and risk
classification criteria. These results confirm our earlier conclusion that for the
majority of the sample period the net cost (benefit) of debt as viewed by
shareholders is increasing (decreasing) over time result further show that the
pattern holds when considering different firm characteristics known to affect debt
issuances.

They examine the relation between these variables by plotting in Figer the 10-
year moving average of leverage of the median firm and the corresponding 10-
year moving average of the marginal cost of issuing long-term debt. The graph
shows an inverse relation between the two variables; as the marginal cost to
shareholders of issuing debt increases, the median firm's leverage decreases. The
implication of this is that the change in the leverage ratio of the median firm is

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 related to varying shareholder perception of the net cost of issuing additional long-
term debt.

They proceed to investigate whether the changing marginal cost of debt to the
firm's owners plays a role in the manager's decision to issue/repurchase debt. While
a rational manager needs debt capital to finance long-term projects, she can vary
the amount of new debt issued (beyond just rolling over the maturity by issuing
debt to replace old debt which does not increase long-term debt). They would
expect the manager, who is assumed to work in the best interest of the firm's
existing owners, to issue more debt when debt issuance is viewed less unfavorably
by shareholders and even retire debt when it is viewed more un- favorably by the
owners.

Theoretical and conceptual back ground of the article

The researchers try review different theories and concepts about the title. Because of the good
theoretical background and simple representation of the model, the CAPM is very popular
regarding this title. However, the numerous sets of assumptions inconsistent with the real world
lead to many criticisms of CAPM. Many scholars propose the multi-factor model instead of
single model. Chen, Roll, and Ross (1986) perform the empirical study issuing additional
long-term debt stock return significantly.
First, it adds to the growing literature explaining the changing leverage among
U.S. firms. Empirical findings of Denis and McKeon (2017), Kahle and Stulz (2017),
and Michaely et al. (2017) in- dicate that firms have been reducing leverage
beginning in the early 1990s, contradicting the implications of the models in
Graham (2006), Binsbergen et al. (2010), and Korteweg (2010) that firms are
under-levered and are leaving money on the table (as potential tax benefits).
Recent studies have provided some explanations from the firm's perspective. Corrado
et al. (2009) and Falato et al. (2013) find that the increase in the proportion of
difficult to collateralize intangible assets over time made it harder for firms to raise
debt, a finding also supported by Bates et al. (2009). Denis and McKeon (2017)
suggest that the proportion of firms with negative operating cash flow has
increased and such firms hold less debt.

Our results suggest an alternate explanation of debt level in U.S. firms. Examining
the issue from the perspective of share- holders they find that increasing long-term
debt is value destroying to firms' owners. Further, the way investors view costs and
benefits of debt is not static and shareholders have been displaying an increasing
aversion to issuing additional debt since the1980s that lasted till the end of the
recent great recession. Managers respond to equity holders' perception of
increasing net cost of debt by reducing the fraction of leverage in firms' capital
structures. Beginning in 2011, debt levels have increased with declining marginal
cost of issuing long-term debt while the corporate tax structure has not changed

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 drastically. Overall, our results seem to indicate that tax benefits are one of many
considerations that investors focus on (including governance, access to financial
markets, etc.) when valuing debt. Shareholders consider many other “factors” (e.g.
investment opportunities, corporate governance, financial constraints, etc.) when
valuing leverage decisions of firms (e.g. see Frank and Goyal, 2009) and this
process is not static.

Second, we contribute to the growing number of studies that quantify the value of
corporate decisions from the perspective of equity holders (e.g., Faulkender and
Wang, 2006 and Pinkowitz et al., 2006). Denis and Sibilkov (2010), Dittmar and
Mahrt-Smith (2007), Bates et al. (2017), and others have added to that literature.
However, all of these papers look at the value of an additional dollar of cash. Ours is
the first paper that looks at the value of an additional dollar of debt using this
framework. Further, the ap- proach of this paper can explain the changing levels of
debt between 1980 and 2014, which encompasses periods of expansion, recession,
crises, and many other changes that potentially affects leverage decisions.Finally,
our study also adds to the growing literature that examines trends in corporate
activities. Studies have examined time series patterns in firms' dividend policies
(DeAngelo, DeAngelo, and Skinner, 2004), investment decisions (Falato et al., 2013),
op- erating performance (Denis and McKeon, 2017), security listing . (Doidge et al.,
2017 and Gao et al., 2013), financing policies (Graham et al., 2015), debt choices
(Custódio et al., 2013), and cash policies (Bates et al., 2017).

6. Comments regarding the conclusions

I appreciate the researchers work regarding their findings and conclusions. First they run the
regression by taking stock return as dependent variable and the macroeconomic variables are
explanatory variables. They show that changing share- holder valuation of debt
affects firms' decisions – by extension, they suggest that changing shareholder
valuation of corporate activities may play an important role in determining corporate
decisions over time.Finally their conclusion is correctly drawn from their findings and
their finding is supported with appropriate statistical evidence.

7. The relationship and contribution of this article to the course financial

market and institutions

Financial market is a market in which financial assets (securities) such as stock and bond is
purchased and sold and financial institutions are the institutions like banks, insurance companies,
credit unions and pension funds that facilitate purchasing and selling of securities, giving loan
and other similar activities. This article deals about stock which one of widely known capital
market security. Stock is one of the most frequently traded securities in the secondary market in
different countries. So that, this article directly related to the course and contributes a great
knowledge to our course; because it raises different finance theories and arguments regarding
this theories.

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 Generally this article gives clear information about the results presented so far show that
the leverage ratio of firms has generally been steadily declining and that the net costs
to shareholders of issuing additional long-term debt has been steadily increasing over
most of the sample period factors that affect the stock returns in the market. Stock is one of
widely known security in the financial market and frequently traded in the secondary market. So
that, as a reviewer I think that this article contributes to expand my knowledge regarding this
course.
8. Strengths and weaknesses of the paper

Any article may have strengths and weakness. As a reviewer I listed the strengths and weakness
of this separately as follows:
Strengths of the article:
a. The researchers performed appropriate Diagnostic tests regarding the valuation of the
five assumptions of Classical Linear Regression Model
b. They included recent and important literature review
c. Their conclusion is correctly drawn from their finding
d. The sample period is enough for this type of research
e. The model development is good and easily understand

Weakness of the article:

a. The researchers no clearly indicates the meaning of some abbreviations

b. The researchers didn’t indicate the future researchable problems in this area. As reviewer I
know that more research is needed on multi factor models to find a model that is
theoretically sound, empirically verified, and easy to use

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