11/19/2007 - Ask a different question and get a different — and perhaps more illuminating — answer.
Mitchell Petersen, the Kellogg School’s Glen Vasel Professor of Finance, and Michael Faulkender, visiting assistant professor of finance from Washington University, applied this logic to a longstanding finance question in recent research published in The Review of Financial Studies.
In his paper, “Does the Source of Capital Affect Capital Structure?” Petersen examines whether a firm’s ability to issue public debt affects its decision about how to finance new ventures.
Companies seeking to raise money for new projects typically take on debt or issue equity. A higher debt load may be seen as the more desirable option, since debt can confer certain tax advantages.
“Most empirical work has been undertaken from the standpoint of ‘how much debt does a firm want?’ Petersen notes. The authors were the first to ask instead, “Are there situations where a firm would like to have debt and can’t issue enough?”
Yes, according to the researchers, who found that firms with access to the public debt market, defined as those firms with a bond rating, had 35 percent more debt than those without access. Though they used statistical methods employed by previous researchers, it was the new way of asking the question that yielded results.
This innovative approach earned the pair a runner-up prize in the Barclays Global Investors Michael Brennan Best Paper Award. The annual prize recognizes authors of important finance research that is published in The Review of Financial Studies. Their work appeared in volume 19 of the journal. Winners were announced at the Western Finance Association meeting in June.
“A company can ask the bank for a loan and the bank can say no,” Petersen explains. “If someone were investigating the situation, all he would see is that the company doesn’t have any debt. But it’s really not clear if the company doesn’t want any debt or no one will lend them the capital.”
As Petersen and Faulkender write in their paper: “The implicit assumption has been that a firm’s leverage is completely a function of a firm’s demand for debt. In other words, the supply of capital is infinitely elastic at the correct price and the cost of capital depends only on the risk of the firm’s projects.
“An alternative explanation,” they note, “is that firms may not be able to issue additional debt. The same type of market frictions that make capital structure choices relevant also imply that firms sometimes are rationed by their lenders.”
Though the authors acknowledge that differences in leverage ratios between firms with and without access to the public debt market could be caused by firm characteristics such as size and familiarity of company name, they conclude that these factors alone don’t explain all the differences: “[E]ven after controlling for firm characteristics, which theory and previous empirical work argue determine a firms’ choice of leverage, firms with access to the public debt market have higher leverage that is both economically and statistically significant.”
This new line of questioning also may pay dividends for future researchers. “Once you say that supply matters, people want to think about the other ways in which it matters,” Petersen says.