The Debt-Equity Choice of Japanese Firms

(ProQuest: ... denotes formulae omitted.)1. INTRODUCTIONThe selection of target debt-equity ratio has received increasing attention in recent years. One strand of the literature focuses on the determinants of the optimal target ratio (Graham and Harvey, 2001; Hovakimian et al., 2001; Booth et al., 2001; Baker and Wurgler, 2002; Frank and Goyal, 2003). There are three major competing theories explaining firms' debt-equity choice in the literature. The trade-off theory suggests that the optimal debt-equity choice of a firm can be determined by looking at the trade-offs between costs and benefits of financing through debt and equity. The pecking order theory states that firms prefer internal financing by retained earnings to external financing, and prefer debt to equity for external financing.1 The market timing theory argues that firms tend to issue equity under good market condition. 2 Another strand of the literature investigates how the leverage ratio moves towards the target.3 A representative study is Kayhan and Titman (2007), which examines the adjustment of debt-equity choice of US firms over a five-year horizon. They show that cash flows, investment expenditure and stock performance lead to deviations from the target ratio, and that the debt-equity choice adjusts towards the target ratio in the long run. The results of Kayhan and Titman (2007) apply to firms in a capital market oriented economy.In this paper, we examine the debt-equity choice of Japanese firms. The case of Japan is of interest because Japan is the largest bank-oriented economy in the world. A model containing variables associated with the tradeoff, pecking order and market timing theories will be estimated to evaluate the impact of different factors on the adjustment of book and market target leverage ratios. The persistence and reversal of the effects will also be analyzed.Some new results are obtained. First, in contrast to expectation, we find that an increase in tangible assets reduces the leverage ratio of firms in Japan. Second, we provide new evidence that these firms do adjust their leverage ratio to target in the long run. Third, we conclude that the market timing effect is not persistent in the case of Japan. In addition, we also show that the adjustment speed of the debt ratio for firms in Japan has dwindled after the Asian financial crisis.The structure of the paper is organized as follows: Section 2 describes the data and methodology. Section 3 presents the empirical results. Section 4 is the conclusion.2. DATA AND METHODOLOGYAnnual data for industrial firms with more than ten-year business operation over the period 1980 - 2003, are extracted from the PACAP database. The sample consists of 1,299 Japanese firms, excluding financial firms, firms with a leverage ratio greater than 1, and firms with a market-to-book ratio greater than 10. The descriptive statistics of firm characteristics are reported in Table 1.Compared with other Asian countries, Japan has relatively high average book leverage ratio and average market leverage ratio, 0.5239 and 0.4672 respectively. Note that the mean fixed asset ratio is 0.2453, the mean financial deficit is -0.1499, and the mean current ratio is 1.6612. These last three ratios are below average levels of other Asian countries.2.1. Estimation of the Target Leverage RatioTo investigate the relationship between the debt-equity choice of a Japanese firm and its characteristics, the following model of the leverage ratio Lt is investigated:Lt = α0 + β1TANGt + β2EBITt + β3SIZEt + β4LIQt + β5RETURNt + β6M/Bt + β7NDTSt + β8VOLt + β9Industry dummiest + et (1)Lt is the leverage ratio,TANG is the average fixed asset ratio,EBIT is the average earning before interest and taxes scaled by total assets,SIZE is the logarithm of average total assets,LIQ is average current ratio,RETURN is average one-year stock return,M/B is the average market-to-book ratio,NDTS is average non-debt tax shield, andVOL is the average volatility of earnings. …