managed vs. unmanaged changes in the capital structures of ...appendix d—an example firm: goodyear...

Green, Martin, and Rich

BAYLOR UNIVERSITY

Managed vs. Unmanaged Changes in the Capital Structures of Firms with

Extreme Leverage Is the extreme use of financial leverage a choice?

Steve Green: [email protected] John Martin: [email protected]

*Steve Rich: [email protected]

*Contact Author

3/26/2011

In this paper we study the capital structures of highly levered firms. Specifically, we differentiate between intentional or managed changes in the firm’s use of financial leverage versus unmanaged changes that are beyond the direct control of management. We find that the financial leverage (book and market) of extreme leverage firms rises rapidly in the years immediately prior to their identification as extreme-leverage firms, and the increase in leverage is not the result of managerial decisions to issue debt or repurchase common stock. Instead, firms become extremely levered primarily because of circumstances that are beyond the direct control of management. We conclude that firms do not become highly levered because it is their optimal capital structure. Consequently, any attempt to explain their use of financial leverage using capital structure theory cannot succeed.

mailto:[email protected]



Green, Martin, and Rich

TABLE OF CONTENTS 1 Introduction ............................................................................................................................................................ 1

2 Identifying Extreme Leverage Firms ....................................................................................................................... 1

Measuring Financial Leverage ................................................................................................................................... 2

Sample Selection ....................................................................................................................................................... 3

Who are the Extreme Leverage Firms? ..................................................................................................................... 3

Book versus Market Leverage ............................................................................................................................... 4

Extreme Leverage and Industry Group ................................................................................................................. 7

3 Sources of Change in the Leverage for Extreme Leverage Firms ............................................................................ 8

Evolution of Leverage Ratios for Extreme Leverage Firms ........................................................................................ 8

Managed versus Unmanaged Changes in Book Leverage ....................................................................................... 15

Isolating Managed versus Unmanaged Changes in Book Leverage .................................................................... 15

Analysis of Managed versus Unmanaged Changes in the Market Leverage Ratio ............................................. 21

4 Concluding Remarks ............................................................................................................................................. 26

References ................................................................................................................................................................... 27

Appendix A—How Recent Capital Structure Studies Measure Financial Leverage ..................................................... 29

Appendix B—Firm Classification with SIC and Historical SIC Codes ............................................................................ 31

Appendix C—Impact of Sample Restrictions on Sample Composition ........................................................................ 32

Appendix D—An Example Firm: Goodyear Tire & Rubber .......................................................................................... 33

Green, Martin, and Rich Page 1

MANAGED AND UNMANAGED CHANGES IN THE CAPITAL

STRUCTURES OF FIRMS WITH EXTREME FINANCIAL LEVERAGE

1 INTRODUCTION Capital structure theory seeks to explain the financial choices that firms make regarding their use of debt and

equity financing sources. The unstated assumption underlying empirical tests of these theories is that corporate

managers control the firm’s capital structure. Recent work by Denis and McKeon (2010) questions the degree to

which management does control the firm’s capital structure suggesting that we must differentiate between

intentional and unintentional changes in a firm’s use of leverage if we are to successfully identify the determinants

of corporate financing decisions and capital structures.

In this paper we study a group of firms that have extremely high financial leverage and analyze how they came to

be so highly levered. Specifically, we investigate whether their extreme-leverage capital structures are a

consequence of the exercise of managerial discretion (i.e., managed changes in the firm’s capital structure) or the

result of forces outside the direct control of the firm’s management (i.e., unmanaged changes). We find that most

firms with extreme levels of financial leverage become highly levered due to factors that are beyond the direct

control of management. That is, managerial decisions do not directly cause the firm’s use of extremely high

financial leverage. Consequently, our findings suggest that we should not expect capital structure theories

directed at explaining managerial financing decisions to be of much help in explaining the use of financial leverage

by these extreme-leverage firms.

The paper is organized as follows: In Section 2, we define financial leverage using both book- and market-based

metrics and use each to identify extreme leverage firms. This involves examining the cross-section of capital

structures for all industrial firms in the Compustat database for the period 1987-2009. In Section 3, we investigate

whether extreme-leverage firms became extremely levered as a result of capital structure choices or due to factors

management could not control. Finally, in section 4 we offer some summary comments regarding the implications

of our study of extreme-leverage firms for future capital structure research.

2 IDENTIFYING EXTREME LEVERAGE FIRMS To identify extreme leverage firms requires that we first identify an appropriate measure of financial leverage.

Although this may seem like a simple task, there is little agreement as to how to best measure leverage. In studies

of the level of financial leverage or of changes in financial leverage published in the Journal of Finance, the Journal

of Financial Economics, or the Review of Financial Studies from 2008 through 2010, about a third of the studies

present results for both market and book leverage ratios, about a third present results for only book leverage

ratios, and about a third present results for only market leverage ratios (See Appendix A).1 Although book and

1 The seven studies that report results for both market and book leverage include: Almazan, De Motta, Titman, and Uysal

(2010), Byoun (2008), Leary (2009), Lemmon, Roberts, and Zender (2008), Matsa (2010), Ovtchinnikov (2010), and Shivdasani and Steffanescu (2010). The seven studies that report results for only book leverage include: Brav (2009), Chang and Dasgupta (2009), Desai, Foley, and Hines (2008), Huizinga, Laeven, and Nicodeme (2009), Leary and Roberts (2010), Rauh and Sufi (2010), and Roberts and Sufi (2009). The six studies that report results for only market leverage include: Bharath, Pasquariello, and Wu (2009), Banerjee, Dasgupta, and Kim (2008), Carlson and Lazark (2010), Harford, Klasa, and Walcott (2009), Korteweg (2010), and Morellec and Zhandov (2008). Several studies that present results for only one of the measures of leverage state they find similar results with the other measure of leverage. Note also that several studies that report only results for book leverage examine private firms where market values are unavailable.


market based measures of financial leverage often yield similar results for the broad cross-section of firms, it is not

clear whether this holds for the extreme leverage firms we study. Therefore, we use both book- and market-

based leverage metrics in our analysis.

MEASURING FINANCIAL LEVERAGE

We measure book-value financial leverage as the Book Debt to Capital Ratio (BL) ratio which we define as follows:2

( )

( )

( )

( )

( )

( )

( )

(1)

The acronyms in parentheses are the Compustat variable names. Note that the numerator of the ratio only

contains interest bearing debt comprised of short-term debt plus long-term debt where debt in current liabilities

(DLC) includes both short-term notes as well as the current portion of long-term debt. The denominator equals

the sum of the firm’s invested capital which excludes consideration for non-interest bearing liabilities. Welch

(2010) discusses the problems that can arise where the treatment of non-interest bearing liabilities is not treated

consistently when calculating a firm’s financial leverage. Specifically, if these liabilities are considered debt in the

numerator of the debt ratio it is important that they be also be included in the denominator, and vice versa. We

exclude them from both numerator and denominator of both our book- and market-value based debt ratios.

Note that we did not use net debt (total debt less cash and short-term investments) as our measure of financial

leverage since it is not commonly used. Only two of the studies that we surveyed used a net debt measure.

However, Bates, Kahle, and Stulz (2009) report that the average net debt ratio has been declining since 1980 and

became negative in 2004 and remained below zero through the end of their sample period in 2006.

We define market leverage using a quasi-market value leverage debt ratio as follows:3

( )

( )

( )

( )

( )

( )

( )

( )

(2)

This is a quasi-market value ratio in that debt and preferred equity are measured using their book values and only

the firm’s common equity is measured using its market value. The use of book values for debt and preferred

2 In the capital structure studies published in the Journal of Finance, the Journal of Financial Economics, or the Review of

Financial Studies from 2008 through 2010, the most common method for measuring book leverage is (DLC + DLTT)/AT where AT equals the total assets of the firm. However, this measure only appears in nine of the 16 studies (while only 14 studies present results for book leverage, two discuss how they calculate book leverage in unpublished results) and is the only measure of book leverage in five of the 16 studies. In panel a. of Appendix A we show the measures of book leverage for all 16 studies. 3 In capital structure studies published in the Journal of Finance, the Journal of Financial Economics, or the Review of Financial

Studies from 2008 through 2010, the most common method for measuring market leverage is (DLC + DLTT)/(DLC + DLTT + CSHO*PRCC_F). However, this measure appears in only 5 of 14 studies (while only 13 studies present results for market leverage, one discusses how they calculate market leverage in unpublished results). In panel b. of Appendix A we show the measures of market leverage for all 14 studies.


equity reflects the difficulty involved in obtaining market values for these two classes of securities and is common

practice in previous capital structure studies.

SAMPLE SELECTION

Our sample includes North American industrial firms for the years 1987 through 2009. We exclude utilities (SIC

4900-4999), financials (SIC 6000-6999), firms with missing historical SIC codes (SICH), and firms lacking sufficient

Compustat data to calculate Equations (1) or (2). We begin with 1987 because we use historical SIC codes to

eliminate utilities and financial firms from our historical samples, and Compustat reports historical SIC codes for

only a handful of firms prior to 1987. Appendix B shows how differences between current and historical SIC codes

change over time. We impose two further restrictions on the firms we examine. First, when examining book

leverage we drop firms with book debt to capital ratios that do not fall between 0 and 1. Second, when examining

market leverage we drop firms with either outstanding shares (CSHO) or a market price at the end of the firm’s

fiscal year (PRCC_F) equal to zero. Since these restrictions are not the same for book and market leverage

measures, the samples used for each measure are not identical.4

WHO ARE THE EXTREME LEVERAGE FIRMS?

For our purposes we will define a firm as having extreme financial leverage if its leverage is in the 95th

percentile of

all firms using both book and market leverage ratios. To get an idea as to just how much financial leverage firms

use at different times over our sample period we prepared Figure 1. Panel a. depicts the time series of various

percentiles of leverage ratios for the period 1987-2009. Specifically we show the 95th

, 85th

, 50th

, and the 15th

percentiles for each year.5 In addition, Panel b. of Figure 1 indicates the number of firms for which we are able to

calculate book and market leverage ratios for each year 1987-2009. We can make several observations about debt

ratios from this figure:

First, the capital structures of high leverage firms (85th

, 95th

, and 99th

percentiles) exhibit distinct trends

over time. The market and book leverage of high leverage industrial firms generally rose prior to 1990, fell

between 1990 and 1993, rose from 1993 to 2002, fell from 2002 to 2006, and rose again through 2008.6

Second, the median firm’s leverage generally fell from 1987 through 2007 but temporarily rose in 2008 at

the beginning of the financial crisis.

Third, low debt firms (15th

percentile) reduced their debt towards zero through the year 2000 and

remained unlevered thereafter.

4 Differences in the two samples stem from differences in the data needed to calculate each of the leverage measures and

differences in the data available for each firm. In Appendix D we show the impact of each of the data restrictions on the size of our samples. Differences between the samples do not affect the results since we find the same basic results when we used a pooled sample of all firms for which we can calculate both book and market debt ratios. We show the sizes of both samples in Panel b of Figure 1. In 1987 through 1999, the book-leverage sample is larger and in 2000 through 2009, the market-leverage sample is larger. 5 We also examine the 5

th percentile, but these firms have no debt in any of the years we examine.

6 These general trends do not hold exactly for the 85

th, 95

th, and 99

th percentiles for both measures of leverage. The 85

th

percentile for book leverage reaches a local maximum in 1989, a local minimum in 1994, and a local maximum in 2000. The 95th

percentile of book leverage reaches a local maximum in 1989, a local minimum in 1994, and a local maximum in 2001. And the 99

th percentile of book leverage reaches a local maximum in 2001. And the 99

th percentile of market leverage reaches a local

minimum in 1994.


Fourth, while book leverage appears far less volatile over time than market leverage, book and market

leverage seem to generally move together over time.

We identify the extreme-leverage firms in 1993, 2002, and 2006 and explore how these firms came to be

so highly levered by examining the time series of their capital structure ratios leading up to the sample

year. We chose these years since these are the years where the leverage of high-debt firms reached local

minimums and maximums within the sample period we studied. Note that we get similar results when we

examine firms with extremely high leverage in mid-trend years such as 1998. In addition, by starting with

1993 we had up to six years of historical data for each extreme leverage firm.

BOOK VERSUS MARKET LEVERAGE

Even though the 95th

percentile of book and market leverage metrics tend to move together over time,

firms with extremely high market leverage do not necessarily have an extreme level of book leverage and

vice versa. As a result, firms with extreme book leverage are not generally the same firms with extreme

market leverage. Figure 2 provides an indication of the lack of consistency between book and market

leverage ratios for firms classified as extremely levered. Specifically this figure contains the cross-

sectional distribution of book value leverage for firms classified as extremely highly leveraged using the

market leverage metric, and vice versa. For example, in 2006 the group of firms ranked in the highest 5%

of firms using book leverage contained 8 firms that had market leverage ratios that were less than 10%.

Similarly, for the firms in the top 5% of firms based on their market leverage, there were 2 firms with 20%

to 30% financial leverage measured using book leverage.7

7 These differences occur even if we use a common sample of all firms for which we can calculate both book- and market-

leverage ratios. With this common sample, we still end up with two sets of extreme leverage firms. For example, in 2006, we identify 246 firms with extreme book leverage and 246 firms with extreme market leverage. However, only 107 (43.5%) of the firms have both extreme book and extreme market leverage. We find similar disparities in 1993 and 2006. For the firms with extreme book leverage, the Spearman rank correlation between firms ranked on the basis of book and market leverage ranges between -0.0242 (2006) and +0.1629 (1993) and for firms with extreme market leverage, the Spearman rank correlation between firms ranked on the basis of their book and market leverage ranges between 0.2761 (2006) and 0.5139 (1993).


Figure 1. Distribution of Financial Leverage between 1987 and 2009 This figure presents the 95

th, 85

th, 50

th, and 15

th leverage percentiles for 1987 through 2009 using both book and

market leverage ratios calculated using equations (1) and (2). For example, the line labeled 95th

shows the level of leverage for a firm to be in the 95

th percentile of all firms in terms of their leverage.

Panel a. Average Financial Leverage Percentiles

0.0

0.1

0.2

0.3

0.4

0.5

0.6

0.7

0.8

0.9

1.0

19

87

19

88

19

89

19

90

19

91

19

92

19

93

19

94

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95

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96

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97

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00

20

01

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02

20

03

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20

06

20

07

20

08

20

09

Book Leverage

99th

95th

85th

50th

15th

0.0

0.1

0.2

0.3

0.4

0.5

0.6

0.7

0.8

0.9

1.0

19

87

19

88

19

89

19

90

19

91

19

92

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93

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94

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95

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00

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09

Market Leverage

99th

95th

85th

50th

15th

Panel b. Number of firms for which book and market leverage can be calculated Year 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997

Book 6081 5876 5704 5652 5782 6127 6647 7128 7849 8105 7824

Market 5432 5196 5030 4972 5005 5226 5737 6145 6820 7461 7517

Year 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009

Book 7891 7872 7307 6531 6128 5945 5762 5527 5289 5125 4717 4347

Market 7411 7601 7371 6886 6479 6132 5954 5680 5532 5420 5041 4687


Figure 2. Distribution of Leverage Measures for Extreme Leverage Firms

In Figure 2 we examine the consistency of book- and market-based leverage ratios in identifying extreme leverage firms. We show histograms of market leverage for firms with extreme book leverage and histograms of book leverage for firms with extreme market leverage. Some extreme market leverage firms have book leverage ratios that exceed 1 which can occur when a firm’s negative book equity pushes book capital below the firm’s debt. In extreme cases, book equity can become so negative that book capital becomes negative. Since the resulting negative book leverage ratios indicate high rather than low leverage, we show these firms to the right of > 100% book leverage. Book Leverage Market Leverage

8

16

23

28

35 35

24

18 19

00

5

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15

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25

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35

40

0 to 10%

10 to 20%

20 to 30%

30 to 40%

40 to 50%

50 to 60%

60 to 70%

70 to 80%

80 to 90%

90 to 100%

Distribution of Market Leverage for Firms with Highest

(highest 5%) Book Leverage in 2006

0 0 2 06

12

2535

29

15

88

65

0

20

40

60

80

100

0 to 10%

10 to 20%

20 to 30%

30 to 40%

40 to 50%

50 to 60%

60 to 70%

70 to 80%

80 to 90%

90 to 100%

> 100%

< 0%

Distribution of Book Leverage for Firms with Highest

(highest 5%) Market Leverage in 2006

913 12

1612

17

27

41

33

49

0

10

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40

50

60

0 to 10%

10 to 20%

20 to 30%

30 to 40%

40 to 50%

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80 to 90%

90 to 100%



0 0 1 2 615

26 31 3138

123

48

0

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80

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120

140

0 to 10%

10 to 20%

20 to 30%

30 to 40%

40 to 50%

50 to 60%

60 to 70%

70 to 80%

80 to 90%

90 to 100%

> 100%

< 0%



6 69

19

25

33

18

32 32

15

0

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10

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0 to 10%

10 to 20%

20 to 30%

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0 0 1 2

10

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49

38

63

10

0

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0 to 10%

10 to 20%

20 to 30%

30 to 40%

40 to 50%

50 to 60%

60 to 70%

70 to 80%

80 to 90%

90 to 100%

> 100%

< 0%




EXTREME LEVERAGE AND INDUSTRY GROUP In Table 1, we find significant clustering of extreme leverage firms by industry group for all three sample years:

1993, 2002, and 2006.8 In the table, we group the sample into 49 industry portfolios based on the Fama-French

industry definitions.9 We then calculate the percentage of firms in each industry that have extreme leverage and

rank the industries using this percentage. We find large differences across industries in the percent of firms that

are extremely levered. In 2006, for example, the percent of firms with extreme book leverage runs from 0% to

33.3% and the percent of firms with extreme market leverage falls within the range of 0% to 15.4%. We can reject

the independence of industry group and the percent extreme leverage firms at the 1% level for all years and for

both measures of leverage using Pearson’s Chi-squared statistic.10

As a result, we conclude that extreme-leverage

firms tend to cluster in certain industries.

Next we examine whether the same industries have a high/low percentage of firms with extreme leverage in 1993,

2002, and 2006. 11

When we rank industry leverage using book leverage, we can reject independence between

2006 and 2002 and between 2006 and 1993 at the 1% level and between 2002 and 1993 at the 5% level using

Kendall’s Tau rank correlation between the industry ranks across time (found in Panel b. of Table 1). If we

compare ranks between years based on market values, we reject independence between ranks in 2006 versus

2002 and between 2002 versus 1993 at the 1% level, and between 2006 versus 1993 at the 10% level. These

results suggest that firms with extremely high leverage tend to cluster in the same industries across time.

Despite the relationship across time in the industry rank based on percent of extreme leverage firms, it is difficult

to identify specific industries with a high percentage of extremely leveraged firms in all three of the years that we

examine. For example, when we rank industries according to the percent of firms with extreme book leverage,

only four (Fun, Coal, Telcm, and Trans) are ranked in the top third (ranks 1 through 14) in 1993, 2002, and 2006.

When we rank industries according to the percent of firms with extreme market leverage, only six (Agric, Cnstr,

Steel, Autos, PerSv, and Trans) are ranked in the top third in all three years. Similarly, it is difficult to identify

specific industries with a low percentage of extremely levered firms in all three years. When we rank industries

according to the percent of firms with extreme book leverage, only six (Clths, Drugs, Ships, Hardw, Chips, and

8 We selected the years 1993, 2002, and 2006 for further study based on observed patterns in the use of financial leverage by

the entire cross-section of firms. Both 1993 and 2006 represent local maximums in average leverage while 2002 represents a local minimum in average leverage. Because the number of firms in our sample varies over time, the number of firms identified as extremely levered also varies over time. For example, in 1993 there were 333 extreme book leverage firms and 287 extreme market leverage firms; in 2002 there were 307 extreme book leverage firms and 324 extreme market leverage firms; and 2006 there were 265 extreme book leverage firms and 277 extreme market leverage firms.

9 Fama and French’s industry listings can be found at:

http://mba.tuck.dartmouth.edu/pages/faculty/ken.french/data_library.html

Note that several firms are not included in Table 1 because their SIC codes do not fall into any of the SIC ranges in Fama and French’s definitions of 49 (or 48) industry portfolios. The statistical relationship between industry and extreme leverage is essentially unchanged if we include these firms from excluded industries. The excluded SIC codes include 900: Fishing, Hunting, and Trapping; 3990: Misc Manufacturing Industries; 9995: Nonoperating Establishments; and 9997: Industrial Conglomerates. This final group includes firms such as GE (2006 and 2002) and Berkshire Hathaway (2006). The number of firms excluded by year and SIC code follow:

2006: 900 = 1; 3990 = 17; 9995 = 94; 9997 = 9; 2002: 900 = 2; 3990 = 15; 9995 = 72; 9997 = 15

1994: 900 = 0; 3990 = 19; 9995 = 11; 9997 = 0.

10 Only 43 of Fama and French’s 49 industries show up in Table 2 since we have excluded utilities and financial firms from our

analysis.

11 Since there are numerous ties in the ranks, we report only Kendall’s tau-b to correct for these ties.

http://mba.tuck.dartmouth.edu/pages/faculty/ken.french/data_library.html


LabEq) are ranked in the bottom third (ranks 30 through 43) in 1993, 2002, and 2006. When we rank industries

according to the percent of firms with extreme market leverage, only four (MedEq, Drugs, Ships, and Hardw) rank

in the bottom third in 1993, 2002, and 2006. These results suggest that the firms in certain industries tend to drift

in and out of being extremely levered.

3 SOURCES OF CHANGE IN THE LEVERAGE FOR EXTREME LEVERAGE FIRMS In this section we address the basic question as to whether the observed changes in a firm’s use of financial

leverage over the years prior to our classifying it as having extreme leverage are due to managerial actions

(managed) or circumstances outside of managerial control (unmanaged). First we document how the leverage of

these firms changed in the years prior to our identifying them as extremely levered. Next we rule out changes in

the sample over time as the primary driver of the rising leverage for the extreme leverage firms. We then isolate

the managed and unmanaged components of changes in the financial leverage for the extreme-leverage firms and

compare them to the sources of change in financial leverage for the remaining firms in our samples.

EVOLUTION OF LEVERAGE RATIOS FOR EXTREME LEVERAGE FIRMS

Figure 3 shows the time series of median and average leverage ratios for the portfolios of extreme leverage firms

identified in 1993, 2002, and 2006. Several observations are readily apparent from the time series of debt ratios.

First, the average and median leverage ratios (book and market) tend to rise prior to the year in which the firms

were identified as extremely levered with much of the increased leverage occurring in the final few years before

the firm is identified as extremely levered. Second, the patterns of rising leverage are similar in all three years

despite a general decrease in critical leverage values prior to 1993 and 2006 and a general increase in critical

leverage values prior to 2002 (see Figure 1). Thus the leverage patterns of firms with extreme leverage in 2002

mimicked the general trend in the use of financial leverage before 2002 but ran counter to the general trend prior

to 1993 and 2006.

Figure 4 shows the number of extreme-leverage firms for which we can calculate the book and market leverage

ratios for each year prior to the firm’s identification as extremely levered. Note that this number rises over time in

a pattern that roughly mirrors the average and median leverage ratios. That is, the sample size increases in the

years prior to the year in which the extreme leverage portfolios are formed. This pattern shows up in all years for

both book and market measures of leverage. For example, for firms with extreme book leverage in 2002, the

sample size grows from 85 in 1987 to 307 in 2002. Over the same period, the sample size for firms with extreme

market leverage grows from 89 in 1987 to 324 in 2002. This suggests the possibility that the increasing leverage

ratios may be driven by changes in sample composition over time.


Table 1. Extreme Leverage and Industry Group Panel a. Percent of Extremely Levered Firms by Fama and French Industry Groups

In Panel a. we calculate the percent of firms that exhibit extreme leverage for each of the 49 Fama-French industry groups for 1993, 2002, and 2006. We select these years for further study based on the observed patterns in the use of financial leverage by the entire cross-section of firms. Both 1993 and 2006 represent local minimums while 2002 represents a local maximum in average leverage ratios. When we classify firms by book leverage in 2006, 8.33% of the firms in the Agriculture (Agric) industry were classified as having extreme leverage. In addition, we rank the industries by the percentages of firms having the highest book and market measures of financial leverage. In 2006, for example, Agriculture had the 13

th highest percentage of firms in its industry group classified as

extremely levered using book value. Note that in 2006, three industries had no firms with extreme book leverage, so all three are given the rank of 41. And in 2006, five industries had no firms with extreme market leverage and all five industries were given a rank of 39. At the bottom of the table we show Pearson’s Chi-squared statistics and p-values for independence between the percent of extreme leverage firms across industry groups. Note that only 43 of the 49 industries show up in the table since we excluded utilities and financial firms from our sample.

Book Market

2006 2002 1993 2006 2002 1993

No. Name % Rank % Rank % Rank % Rank % Rank % Rank

1 Agric 8.33% 13 11.11% 6 3.33% 29 14.29% 4 7.41% 11 8.00% 12

2 Food 3.53% 28 10.71% 7 5.37% 21 4.65% 24 3.00% 27 6.40% 18

3 Soda 5.00% 22 5.88% 16 4.76% 23 0.00% 39 0.00% 38 5.56% 22

4 Beer 0.00% 41 0.00% 39 8.00% 11 5.00% 23 3.70% 23 0.00% 38

5 Smoke 33.33% 1 28.57% 1 0.00% 42 0.00% 39 0.00% 38 33.33% 1

6 Toys 2.33% 32 9.26% 11 2.56% 34 4.08% 26 3.33% 26 0.00% 38

7 Fun 11.11% 8 14.91% 3 12.05% 5 13.86% 7 7.20% 13 6.87% 15

8 Books 15.56% 4 9.09% 13 2.44% 35 14.89% 2 3.85% 21 1.32% 35

9 Hshld 5.63% 20 3.96% 29 3.25% 30 7.69% 16 1.92% 30 2.90% 27

10 Clths 1.32% 37 0.00% 39 2.70% 31 0.00% 39 4.55% 20 2.94% 26

11 Hlth 3.23% 30 4.85% 23 7.81% 13 6.25% 21 3.74% 22 9.14% 9

12 MedEq 0.49% 40 3.83% 30 3.61% 27 2.28% 32 0.83% 35 0.90% 36

13 Drugs 2.19% 33 1.63% 37 0.64% 41 1.58% 35 0.68% 36 0.00% 38

14 Chems 8.80% 12 9.92% 10 4.32% 25 4.51% 25 4.69% 19 2.40% 29

15 Rubbr 10.81% 9 16.67% 2 5.95% 19 13.95% 6 11.86% 7 3.90% 23

16 Txtls 13.33% 6 4.55% 24 6.90% 15 7.69% 16 23.08% 1 10.00% 6

17 BldMt 2.38% 31 5.13% 21 3.51% 28 5.68% 22 10.40% 10 9.46% 8

18 Cnstr 4.69% 24 5.88% 16 9.90% 6 11.29% 10 7.25% 12 14.94% 4

19 Steel 5.48% 21 4.55% 24 8.00% 11 9.09% 14 15.05% 3 8.04% 11

20 FabPr 0.00% 41 4.35% 26 2.70% 31 8.33% 15 16.67% 2 5.71% 20

21 Mach 3.43% 29 6.13% 15 2.64% 33 2.78% 31 3.46% 25 6.67% 17

22 ElcEq 4.26% 26 2.33% 34 5.66% 20 1.03% 36 1.04% 34 3.30% 25

23 Autos 7.79% 16 14.29% 4 6.09% 18 11.63% 9 11.58% 9 7.14% 13

24 Aero 9.09% 10 4.00% 28 9.09% 7 3.13% 30 3.70% 23 22.86% 2

25 Ships 0.00% 41 0.00% 39 0.00% 42 0.00% 39 0.00% 38 0.00% 38


Table 1 (continued). Extreme Leverage and Industry Group

Book Market

2006 2002 1993 2006 2002 1993

% Rank % Rank % Rank % Rank % Rank % Rank

26 Guns 20.00% 3 0.00% 39 8.33% 9 15.38% 1 0.00% 38 0.00% 38

27 Gold 4.71% 23 0.00% 39 1.96% 37 3.45% 28 1.16% 32 2.04% 31

28 Mines 1.10% 38 2.08% 35 6.45% 17 2.17% 33 1.12% 33 1.85% 32

29 Coal 8.33% 13 10.00% 9 14.29% 2 7.14% 19 0.00% 38 0.00% 38

30 Oi l 4.40% 25 2.72% 33 1.90% 40 0.96% 37 4.76% 18 1.66% 34

32 Telcm 12.50% 7 12.50% 5 8.27% 10 9.92% 12 11.73% 8 2.09% 30

33 PerSv 8.06% 15 10.53% 8 12.99% 3 12.31% 8 12.50% 6 9.84% 7

34 BusSv 6.52% 19 4.01% 27 6.81% 16 7.62% 18 6.56% 15 5.64% 21

35 Hardw 1.56% 36 2.81% 32 2.02% 36 0.00% 39 1.51% 31 1.83% 33

36 Softw 2.17% 34 2.02% 36 3.98% 26 3.17% 29 2.32% 29 0.71% 37

37 Chips 1.71% 35 3.03% 31 1.90% 39 2.15% 34 2.62% 28 2.74% 28

38 LabEq 0.79% 39 0.72% 38 1.90% 38 0.74% 38 0.68% 37 3.42% 24

39 Paper 13.85% 5 5.41% 18 7.69% 14 14.52% 3 7.14% 14 6.09% 19

40 Boxes 26.67% 2 5.26% 20 25.00% 1 14.29% 4 0.00% 38 16.67% 3

41 Trans 9.09% 10 9.14% 12 12.14% 4 10.53% 11 13.45% 4 14.37% 5

42 Whls l 4.15% 27 7.60% 14 5.30% 22 9.42% 13 6.48% 16 7.14% 13

43 Rtai l 6.87% 18 4.91% 22 4.71% 24 3.60% 27 5.57% 17 6.79% 16

44 Meals 7.45% 17 5.38% 19 8.54% 8 7.07% 20 12.88% 5 8.96% 10

Chi-squared (42 d.f.) 171.98 187.50 148.84 184.38 229.22 193.94

p-value <.001 <.001 <.001 <.001 <.001 <.001

Panel b. Industry Leverage Over Time We calculate Kendall’s tau-b rank correlation to test the independence of industry ranks based on the results

found in Panel a. across time.

Book Market

2006 v. 2002 2002 v. 1993 2006 v. 1993 2006 v. 2002 2002 v. 1993 2006 v. 1993

Kendall's tau-b 0.4215 0.2256 0.3415 0.3982 0.3720 0.1969

Kendall's score 377 202 307 354 330 175

SE of score 95.426 95.44 95.508 95.302 95.247 95.302

p-value 0.0001 0.0352 0.0014 0.0002 0.0006 0.0679


Figure 3. Evolution of Debt Ratios for Extreme Leverage over Time

This figure shows how the mean and median book and market leverage ratios change over time for the samples of extreme leverage firms identified in 1993, 2002, and 2006. For each graph, year 0 is the year in which the firm is identified as extremely levered.

0

0.2

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0.6

0.8

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-10 -9 -8 -7 -6 -5 -4 -3 -2 -1 0

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Years Relative to Identification as Extremely Levered

Median Book Leverage

1993

2002

2006

0

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Average Book Leverage

1993

2002

2006

0

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Median Market Leverage

1993

2002

20060

0.2

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Average Market Leverage

1993

2002

2006


Figure 4. Evolution of Sample Sizes for Extreme Leverage Firms over Time

This figure shows the number of extreme leverage firms identified in 1993, 2002, and 2006 for which we can calculate book and market leverage in the years before we identify them as extremely levered. For each graph, year 0 is the year in which the firm is identified as extremely levered.

0

100

200

300

400

-15 -13 -11 -9 -7 -5 -3 -1


Number of Firms in Sample: Book Leverage

1993

2002

20060

50

100

150

200

250

300

350

-15 -13 -11 -9 -7 -5 -3 -1


Number of Firms in Sample: Market Leverage

1993

2002

2006


To examine whether the patterns we have observed in the level of financial leverage found in Figure 3 stem from

changes in the financial leverage of the sample firms or from changes in the sample composition, we decompose

the change in the average leverage ratios as follows

(

) (

) (

)

Total change Change in average leverage Change in average leverage Change in average leverage in average leverage due to firms dropping for firms in the sample due to new firms being from year t -1 to year t out of the sample in both year t added to the sample (CHANGE) after year t-1 and t-1 in year t (DROP) (SAMPLE) (ADD)

ALL includes all firms in the sample and SAMPLE includes only firms found in both year t and t-1 samples. Thus

DROP measures changes in the average leverage ratio due to firms dropping out of the sample after year t-1,

SAMPLE measures the change in average leverage due to changes in the leverage of firms included in the sample in

both years t-1 and t, and ADD measures the change in average leverage due to firms being added to the sample in

year t. Note that firms may be added or dropped from the sample because of missing data in certain years or

because Compustat adds a firm to its database. We report the results of this decomposition for book and market

measures of leverage in Table 2.


Table 2. Impact of Changing Sample Size on Leverage In this table we examine whether the increase in average leverage of extreme leverage firms prior to the year they are identified as extremely levered stems from changes in the sample or changes within firms in the sample. CHANGE refers to the total change in leverage (book or market) between the current and prior year. DROP measures the change in the average leverage ratio due to firms dropping out of the sample. SAMPLE is the change in the average leverage ratio due to changing leverage within firms included in the sample in both the current and prior year. And ADD measures the change in the average leverage ratio due to firms being added to the sample. For all variables, a positive number indicates that the variable is contributing to an increase in the average leverage ratio and a negative number indicates the variable is contributing to a decrease in the average leverage ratio. Firms with Extreme Leverage in 2006

Book Leverage Ratios Market Leverage Ratios

Fiscal Year Average CHANGE DROP SAMPLE ADD Average CHANGE DROP SAMPLE ADD

1991 0.452 0.386

1992 0.450 -0.003 -0.008 0.017 -0.012 0.365 -0.021 -0.009 -0.004 -0.008

1993 0.463 0.013 0.002 0.001 0.010 0.334 -0.031 0.004 -0.025 -0.010

1994 0.454 -0.009 -0.015 -0.016 0.022 0.360 0.026 0.000 0.027 0.000

1995 0.476 0.022 -0.004 -0.013 0.040 0.395 0.035 -0.009 0.033 0.011

1996 0.476 0.000 0.001 -0.006 0.004 0.351 -0.043 0.003 -0.008 -0.038

1997 0.482 0.006 -0.004 0.003 0.007 0.362 0.011 0.002 0.013 -0.004

1998 0.508 0.026 -0.004 0.021 0.008 0.413 0.051 0.001 0.063 -0.013

1999 0.530 0.022 -0.002 0.037 -0.013 0.428 0.015 0.002 0.038 -0.025

2000 0.555 0.025 0.003 0.012 0.010 0.486 0.058 0.002 0.081 -0.025

2001 0.578 0.023 -0.013 0.034 0.001 0.521 0.035 -0.002 0.053 -0.016

2002 0.584 0.006 -0.007 0.018 -0.005 0.564 0.043 0.000 0.065 -0.023

2003 0.619 0.036 0.007 0.038 -0.008 0.529 -0.035 -0.003 -0.023 -0.009

2004 0.659 0.040 -0.003 0.038 0.004 0.542 0.013 0.000 0.013 0.000

2005 0.716 0.057 -0.001 0.059 -0.001 0.660 0.118 0.001 0.116 0.001

2006 0.857 0.141 0.000 0.136 0.005 0.764 0.104 0.000 0.105 -0.001 Firms with Extreme Leverage in 2002



1987 0.437 0.405

1988 0.451 0.014 -0.007 0.026 -0.006 0.425 0.020 -0.003 0.020 0.003

1989 0.484 0.034 -0.004 0.041 -0.004 0.416 -0.009 0.001 -0.009 -0.001

1990 0.469 -0.015 -0.011 0.001 -0.005 0.461 0.045 0.000 0.068 -0.023

1991 0.455 -0.014 0.000 -0.018 0.005 0.451 -0.010 0.002 0.006 -0.019

1992 0.502 0.046 0.003 0.035 0.008 0.414 -0.037 -0.012 0.002 -0.027

1993 0.466 -0.036 -0.010 -0.036 0.010 0.356 -0.058 0.005 -0.027 -0.036

1994 0.457 -0.009 -0.005 -0.018 0.014 0.395 0.039 0.003 0.059 -0.023

1995 0.485 0.028 0.004 0.027 -0.003 0.405 0.009 0.002 0.026 -0.019

1996 0.489 0.005 0.004 -0.003 0.004 0.403 -0.001 0.001 0.019 -0.021

1997 0.512 0.023 -0.011 0.035 -0.001 0.417 0.013 0.001 0.037 -0.025

1998 0.572 0.060 -0.001 0.069 -0.008 0.528 0.111 0.000 0.130 -0.019

1999 0.593 0.021 -0.009 0.036 -0.006 0.563 0.035 -0.002 0.072 -0.035

2000 0.649 0.056 -0.006 0.043 0.019 0.682 0.119 0.000 0.127 -0.008

2001 0.747 0.098 -0.003 0.096 0.005 0.801 0.120 0.001 0.126 -0.008

2002 0.906 0.159 0.000 0.156 0.002 0.932 0.131 0.000 0.130 0.000


Table 2 (cont). Impact of Changing Sample Size on Leverage Firms with Extreme Leverage in 1993



1987 0.561 0.512

1988 0.622 0.062 -0.012 0.065 0.008 0.561 0.049 0.002 0.052 -0.005

1989 0.655 0.033 -0.008 0.024 0.017 0.594 0.034 -0.002 0.057 -0.021

1990 0.686 0.031 -0.019 0.048 0.002 0.694 0.099 -0.002 0.105 -0.005

1991 0.701 0.015 -0.004 0.011 0.008 0.710 0.016 -0.001 0.021 -0.005

1992 0.761 0.060 0.000 0.049 0.011 0.746 0.036 0.001 0.045 -0.010

1993 0.888 0.127 0.000 0.123 0.005 0.783 0.037 0.000 0.036 0.001 From Table 2 we conclude that changes in average leverage ratios stem primarily from leverage changes within

firms in the sample rather than from changes in the makeup of the sample. For example, in the seven years prior

to firms being identified as extremely levered in 2006, changes in the sample plays an important role only in the

year 2000 and then only for book leverage (when high book leverage firms are added to the sample). In the seven

years prior to being identified as extremely levered in 2002, changes in the sample of firms only plays a role in the

change in average leverage in 1996 and then only for book leverage (when high book leverage firms are added to

the sample and low book leverage firms drop out of the sample). And in the six years prior to firms being identified

as extremely levered in 1993, changes in leverage plays a large role in changes in average leverage only in 1991

and only for book leverage. We conclude that when we examine the sources of changes in leverage in our

extreme-leverage samples, we can focus on changes in leverage by firms within the sample and can ignore the

impact of changes to the firms included in the sample.

MANAGED VERSUS UNMANAGED CHANGES IN BOOK LEVERAGE

We find that in most years, management actions drive changes in the book leverage for 65-75% of firms and

changes in market leverage for 55%-65% of firms. However, we also find that as firms become extremely levered,

managed changes in leverage play a diminishing role in explaining changes in a firm’s financial leverage. The

declining importance of managed changes in financial leverage occurs for both market and book leverage for firms

identified as extremely levered in 1993, 2002, and 2006. And when we examine the relative importance of

issuances/repurchases of debt and preferred stock and common stock, we find that debt issues/repurchases plays

the dominant role in managed changes in capital structure. Common stock issues/repurchases plays a relatively

small role while preferred stock issues/repurchases play almost no role. However, as firms become extremely

levered, the role of debt issues/repurchases drops dramatically. This result holds for both measures of leverage

for the 1993, 2002, and 2006 samples.

ISOLATING MANAGED VERSUS UNMANAGED CHANGES IN BOOK LEVERAGE The focus of our analysis is changes in financial leverage over time where financial leverage is measured using book

and market measures defined earlier by Equations (1) and (2). For each of these measures of financial leverage

there is a corresponding definition of the change in financial leverage over time. The change in the Book Debt-to-

Capital ratio for year t ( ) equals:

(

)

(3)


If the managers of a firm intentionally change the firm’s book leverage by issuing or retiring securities, the changes

in the firm’s Book Capital will show up as changes in its short- and long-term debt (DLC + DLTT), preferred stock

(PSTK), or in one or more common equity accounts that change when a firm issues or repurchases common stock

(par value of common stock (CSTKt), capital surplus/share premium reserve (CAPSt), and/or treasury stock (TSTKt)).

And changes in leverage due to profits or losses will show up as changes in retained earnings (RE). As a result, we

can restate equation (3) as follows:

(

)( ( ))

( ) (4)

where:

= change in debt in current liabilities + change in long-term debt from t to t-1. = change in book value of preferred stock from t-1 to t. = the change in par value of outstanding common shares from t-1 to t. = the change in paid-in-capital to the common stock account from t-1 to t. = change in retained earnings from t-1 to t. =the change in the firm’s treasury stock account from t-1 to t.

To isolate managed changes in book leverage, we measure how each firm’s leverage ratio would have changed if

the only changes in book leverage in equation (4) stemmed from the issuance or repurchase of securities. Since

the only part of equation (4) unrelated to issuing or repurchasing securities is the change in retained earnings, we

define managed changes in book leverage as the change in book leverage had the change in retained earnings

been equal to zero. We then define unmanaged changes in book leverage as the difference between the total

change in book leverage and the managed changes in book leverage.

In Table 3 we classify each firm according to whether the firm’s change in book leverage was primarily from

managed (issuing or retiring securities) or unmanaged (unrelated to issuing or repurchasing securities) sources.

We then report the proportion of firms where managed sources were the primary driver of the change in leverage.

In Table 3 we see that the proportion of firms where managed sources drive leverage changes is almost always

smaller for firms with extreme leverage than for firms that are not extremely levered. The only exception is in 1993

when we examine firms with extreme book leverage in 2002. However, these differences are not consistently

significant at the 1% level until the last five (1993 and 2002 samples) or six (2006 sample) years prior to the year

we identify the firms as extremely levered.12

During this window, the percentage of firms where managed sources

(issuing or repurchasing securities) drives changes in the firm’s capital structure drops dramatically for extremely

levered firms but remains essentially unchanged for firms that are not extremely levered. This time frame also

matches up with the time during which the leverage of the extreme leverage firms rises dramatically. We therefore

conclude that extreme book leverage stems primarily from factors unrelated to management decisions to

issue/repurchase securities and stem instead from factors beyond the direct control of management. In Table 4 we classify each firm according to whether the largest driver of the change in the firm’s book leverage

was debt issues/repurchases, or preferred stock issues/repurchases, or common stock issues/repurchases, or due

to unmanaged sources of changes in leverage. As in Table 3, we calculate the change in leverage due to

12

In the 2006 and 2002 extreme leverage samples, differences in the proportion of firms with extreme leverage are significant at the 5% and 10% level in several prior years but there does not appear to be any particular pattern to these differences.


unmanaged sources as the difference between the actual change in leverage and the change in leverage had RE

equaled zero in equation (4). Using the same basic idea, we calculate the change in leverage due to changes in

debt as the difference between the actual change in the firm’s leverage and the change in the firm’s leverage had

Debt equaled zero in equation (4). And we calculate the change in leverage from preferred stock

issues/repurchases as the difference between the actual change in the firm’s leverage and the change in the firm’s

leverage had PSTK equaled zero. Finally, we calculate the change in leverage from common stock

issues/repurchases as the difference between the actual change in the firm’s leverage and the change in the firm’s

leverage had (CSTK + CAPS – TSTK) equaled zero in equation (4). We then classify each firm according to

whether the change in leverage from debt or the change in leverage from preferred or the change in leverage from

common stock or the change in leverage due to unmanaged sources was the largest contributor to the actual

change in the firm’s leverage. In Appendix D we demonstrate our methodology with Goodyear Tire & Rubber.

In the columns of Table 4 we show the proportion of firms where the primary driver of leverage changes was

changes in debt or changes in preferred stock or changes in common equity, and we compare these proportions

for firms that are extremely levered to the proportions for firms that are not extremely levered. In the table, we

see that debt was the primary driver of changes in leverage for a smaller proportion of extremely levered firms

than for non-extreme leverage firms in every year prior to the years we separated extreme from non-extreme

leverage firms. This result holds when we seprate out extreme-leverage firms in 1993, 2002, and 2006. However,

the differences were not consistently significant at the 1% level until five (1993 sample), six (2002 sample), or

seven (2006 sample) years prior to our formation of extreme and non-extreme leverage portfolios. We also find

that while the proportion of firms where debt is the primary driver of leverage changes was fairly stable across

time for non-extreme leverage firms, the proportion drops dramatically for extreme leverage firms in the last few

years prior to their identification as extremely levered. The proportion for extreme leverage firms drops from

approximately 50% to 20.2% for the 2006 sample, from approximately 55% to 10.6% for the 2002 sample, and

from approximately 50% to 18.1% for the 1993 sample. Similar to our findings in Table 3, the proportion of

extreme leverage firms where debt was the primary driver collapses over the same period that the leverage of

these firms rises dramatically.

In Table 4 we also see that issues and repurchases of preferred and common stock are the primary drivers of

leverage changes for relatively few firms regardless of leverage and regardless of time period examined. In

addition, the differences are not consistently significant at the 10% level for any of the samples. We therefore

conclude that issues and repurchases of equity play a relatively small role in capital structure changes and that the

role of equity issues in capital structure changes does not differ between extreme and non-extreme leverage firms.


Table 3. Managed or Unmanaged Changes in Book Leverage

In Table 3 we classify each firm according to whether managed (issuing or retiring securities) or unmanaged (changes unrelated to issuing or repurchasing securities) sources were the primary driver of the change in the firm’s book leverage each year. We then report the proportion of firms where managed sources were the primary driver of the change in leverage. We report first the proportion for firms that were extremely levered (the 5% of firms that were included in the extreme-leverage sample) and then for firms that were not extreme levered (the 95% of firms that were not included in the extreme-leverage sample). We test for equality of the two proportions using a two-group proportions test. For example, when we classify firms according to whether they were extremely levered in 2006, we find that managed sources were the largest driver of changes in financial leverage from 1991 to 1992 for 46.9% of the firms classified as extremely levered but for 72% of the firms that were not classified as extremely levered. This difference was significant at the 1% level.

2006 Book Sample 2002 Book Sample 1993 Book Sample

Average Average Average

Fiscal Extreme Not Fiscal Extreme Not Fiscal Extreme Not

Year Leverage Extreme Extreme Diff z-value Year Leverage Extreme Extreme Diff z-value Year Leverage Extreme Extreme Diff z-value

1991 0.452 1987 0.437 1987 0.561

1992 0.450 0.469 0.720 -0.252 -4.431 *** 1988 0.451 0.667 0.682 -0.015 -0.273 1988 0.622 0.665 0.691 -0.026 -0.705

1993 0.463 0.629 0.734 -0.106 -1.981 ** 1989 0.484 0.671 0.702 -0.031 -0.572 1989 0.655 0.576 0.705 -0.128 -3.571 ***

1994 0.454 0.644 0.721 -0.077 -1.461 1990 0.469 0.662 0.667 -0.005 -0.091 1990 0.686 0.500 0.677 -0.177 -4.969 ***

1995 0.476 0.684 0.729 -0.045 -0.896 1991 0.455 0.679 0.695 -0.016 -0.310 1991 0.701 0.495 0.707 -0.212 -6.177 ***

1996 0.476 0.707 0.747 -0.040 -0.878 1992 0.502 0.614 0.719 -0.106 -2.177 ** 1992 0.761 0.446 0.729 -0.283 -8.354 ***

1997 0.482 0.676 0.753 -0.077 -1.781 1993 0.466 0.755 0.734 0.022 0.473 1993 0.888 0.324 0.745 -0.421 -13.611 ***

1998 0.508 0.692 0.724 -0.032 -0.735 1994 0.457 0.647 0.722 -0.075 -1.659 *

1999 0.530 0.664 0.731 -0.067 -1.628 1995 0.485 0.713 0.728 -0.015 -0.365

2000 0.555 0.653 0.713 -0.060 -1.458 1996 0.489 0.709 0.749 -0.040 -1.078

2001 0.578 0.548 0.678 -0.130 -3.078 *** 1997 0.512 0.685 0.755 -0.071 -1.970 **

2002 0.584 0.468 0.650 -0.182 -4.194 *** 1998 0.572 0.620 0.730 -0.110 -3.057 ***

2003 0.619 0.560 0.689 -0.129 -3.158 *** 1999 0.593 0.613 0.735 -0.122 -3.502 ***

2004 0.659 0.468 0.708 -0.241 -6.380 *** 2000 0.649 0.556 0.720 -0.164 -4.897 ***

2005 0.716 0.513 0.720 -0.207 -5.666 *** 2001 0.747 0.338 0.685 -0.347 -10.174 ***

2006 0.857 0.404 0.714 -0.310 -9.161 *** 2002 0.906 0.159 0.652 -0.493 -14.986 ***


Table 4. Primary Drivers of Changes in Book Leverage

In Table 4 we classify each firm year according to whether issues/repurchases of debt, issues/repurchases of preferred stock, issues/repurchases of common stock, or factors unrelated to issuing or repurchasing securities were the primary driver of changes in the firm’s book leverage. We classify firms for every year prior to the years that we classify them according to whether they are extremely levered (2006, 2002, and 1993). For a firm year’s change in capital structure to be classified as debt driven, the change in leverage due to debt issues/repurchases must be greater than the change in leverage due to preferred stock issues/repurchases, the change in leverage due to equity issues/repurchases, and the change in leverage due to unmanaged sources. Similarly, for a firm year’s change in capital structure to be classified as preferred-stock driven, the change in leverage due to preferred stock issues/repurchases must be greater than the change in leverage due to debt issues/repurchases, the change in leverage due to equity issues/repurchases, and the change in leverage due to unmanaged sources. And for a firm year’s change in capital structure to be classified as common-stock driven, the change in leverage due to common stock issues/repurchases must be greater than the change in leverage due to debt issues/repurchases, the change in leverage due to preferred stock issues/repurchases, and the change in leverage due to unmanaged sources. We then calculate the proportion of firms for each year and each sample where debt, preferred stock, and common stock were the primary drivers of the firm’s change in leverage. We test for equality of the two proportions using a two-group proportions test. For example, when we classify firms according to whether they have extreme leverage in 2006, we find that debt issues/repurchases were the largest driver of changes in financial leverage between 1991 and 1992 for 43.8% of the firms that were classified as extremely levered and for 59.6% of the firms that were not classified as extremely levered. This difference was significant at the 1% level. And when we classify firms according to whether they have extreme leverage in 2006, we find that preferred stock issuances/repurchases were the largest driver of leverage changes between 1991 and 1992 for 0% of the firms classified as extremely levered and for 1.3% of the firms that were not classified as extremely levered. This difference was not significant at the 10% level. And when we classify firms according to whether they have extreme leverage in 2006, we find that common stock issuances/repurchases were the largest driver of changes in financial leverage between 1991 and 1992 for 6.3% of the firms classified as extremely levered and for 13.3% of the firms that were not classified as extremely levered. This difference was significant at the 10% level.

2006 Book Sample

Debt Preferred Common

Average

Fiscal Extreme Not Not Not

Year Leverage Extreme Extreme Diff z-value Extreme Extreme Diff z-value Extreme Extreme Diff z-value

1991 0.452

1992 0.450 0.438 0.596 -0.158 -2.553 ** 0.000 0.013 -0.013 -0.913 0.063 0.133 -0.070 -1.651 *

1993 0.463 0.529 0.583 -0.054 -0.916 0.000 0.009 -0.009 -0.815 0.171 0.161 0.011 0.241

1994 0.454 0.521 0.621 -0.101 -1.761 * 0.000 0.009 -0.009 -0.809 0.164 0.122 0.043 1.109

1995 0.476 0.481 0.622 -0.141 -2.563 ** 0.025 0.010 0.016 1.369 0.228 0.123 0.105 2.814 ***

1996 0.476 0.522 0.602 -0.081 -1.568 0.000 0.012 -0.012 -1.069 0.237 0.160 0.077 2.000 **

1997 0.482 0.471 0.640 -0.170 -3.531 *** 0.029 0.013 0.017 1.491 0.223 0.129 0.094 2.802 ***

1998 0.508 0.542 0.632 -0.090 -1.911 ** 0.019 0.015 0.004 0.338 0.157 0.116 0.041 1.308

1999 0.530 0.521 0.604 -0.083 -1.835 ** 0.034 0.029 0.005 0.326 0.158 0.133 0.026 0.817

2000 0.555 0.460 0.597 -0.137 -3.065 *** 0.008 0.020 -0.012 -0.925 0.192 0.142 0.050 1.569

2001 0.578 0.452 0.607 -0.155 -3.498 *** 0.032 0.008 0.023 2.729 *** 0.111 0.100 0.011 0.395

2002 0.584 0.405 0.583 -0.178 -3.982 *** 0.000 0.007 -0.007 -0.914 0.119 0.094 0.025 0.935

2003 0.619 0.403 0.595 -0.192 -4.444 *** 0.045 0.013 0.032 3.037 *** 0.163 0.106 0.057 2.118 ***

2004 0.659 0.338 0.576 -0.238 -5.850 *** 0.026 0.012 0.014 1.606 0.149 0.136 0.013 0.467

2005 0.716 0.325 0.598 -0.273 -6.871 *** 0.019 0.010 0.009 1.113 0.186 0.134 0.052 1.881

2006 0.857 0.202 0.591 -0.389 -10.652 *** 0.021 0.013 0.008 0.911 0.199 0.136 0.063 2.476 Table 4 (cont). Primary Drivers of Changes in Book Leverage


2002 Book Sample


Average



1987 0.437

1988 0.451 0.583 0.608 -0.025 -0.427 0.000 0.005 -0.005 -0.605 0.111 0.085 0.026 0.786

1989 0.484 0.534 0.619 -0.084 -1.471 0.014 0.009 0.004 0.374 0.123 0.091 0.033 0.960

1990 0.469 0.541 0.588 -0.047 -0.819 0.000 0.008 -0.008 -0.793 0.122 0.093 0.028 0.831

1991 0.455 0.506 0.584 -0.078 -1.406 0.025 0.010 0.015 1.306 0.173 0.120 0.053 1.437

1992 0.502 0.523 0.596 -0.073 -1.376 0.000 0.013 -0.013 -1.058 0.102 0.133 -0.031 -0.853

1993 0.466 0.500 0.585 -0.085 -1.659 * 0.043 0.008 0.034 3.430 *** 0.213 0.162 0.051 1.325

1994 0.457 0.500 0.619 -0.119 -2.438 ** 0.010 0.010 0.000 0.007 0.157 0.124 0.033 0.984

1995 0.485 0.583 0.621 -0.038 -0.837 0.026 0.010 0.016 1.721 * 0.122 0.123 -0.002 -0.050

1996 0.489 0.539 0.603 -0.064 -1.540 0.014 0.012 0.002 0.228 0.191 0.161 0.031 0.984

1997 0.512 0.530 0.641 -0.111 -2.787 *** 0.020 0.014 0.006 0.643 0.148 0.130 0.018 0.642

1998 0.572 0.500 0.637 -0.137 -3.513 *** 0.025 0.015 0.010 0.986 0.151 0.117 0.034 1.320

1999 0.593 0.482 0.607 -0.125 -3.266 *** 0.024 0.030 -0.006 -0.435 0.164 0.133 0.031 1.176

2000 0.649 0.418 0.603 -0.185 -5.087 *** 0.026 0.019 0.007 0.681 0.163 0.142 0.022 0.837

2001 0.747 0.268 0.616 -0.348 -9.803 *** 0.045 0.009 0.037 5.077 *** 0.100 0.099 0.001 0.029

2002 0.906 0.106 0.581 -0.475 -14.065 *** 0.026 0.007 0.019 3.109 *** 0.074 0.101 -0.027 -1.350

1993 Book Sample


Average



1987 0.561

1988 0.622 0.589 0.619 -0.031 -0.777 0.006 0.005 0.001 0.233 0.095 0.082 0.013 0.584

1989 0.655 0.494 0.620 -0.126 -3.313 *** 0.018 0.010 0.007 0.928 0.129 0.089 0.041 1.820 **

1990 0.686 0.412 0.594 -0.182 -4.885 *** 0.027 0.008 0.020 2.811 *** 0.115 0.096 0.019 0.864

1991 0.701 0.301 0.596 -0.294 -7.970 *** 0.032 0.011 0.021 2.575 *** 0.183 0.120 0.062 2.537 **

1992 0.761 0.272 0.602 -0.331 -8.930 *** 0.038 0.013 0.025 2.926 *** 0.152 0.135 0.017 0.666

1993 0.888 0.181 0.590 -0.410 -11.913 *** 0.019 0.010 0.008 1.115 0.162 0.168 -0.006 -0.221


ANALYSIS OF MANAGED VERSUS UNMANAGED CHANGES IN THE MARKET LEVERAGE RATIO To identify sources of changes in the quasi-market value debt ratio, we follow the same basic methodology that we

used to analyze the book debt-to-capital ratio. Specifically, the change in the quasi-market value debt ratio for

year t (QMLt) equals:

(

)

(5)

If a firm’s managers intentionally change the firm’s market leverage by issuing or retiring securities, the changes in

the firm’s leverage will show up as changes in its short- and long-term debt (DTC + DLTT), preferred stock (PSTK),

and/or number of shares outstanding (CSHO). Changes to quasi-market leverage that are beyond the direct

control of management stem from changes in stock price (PRCC_F). As a result, we can restate equation (6) as

follows:

(

)( )

(6)

where all variables are as defined in equation (4) except:

= change in fiscal year-end stock price from t-1 to t. = the change in common shares outstanding from t-1 to t.

To isolate managed changes in quasi-market leverage, we measure how each firm’s leverage would have changed

if the only variables in equation (6) that had changed were those related to the firm issuing or repurchasing

securities: , (preferred stock), and/or (outstanding shares). Since the only part of

equation (6) that is unrelated to issuing or repurchasing securities is the change in stock price, we define managed

changes in market leverage as the change in market leverage had the stock price not changed. We then define

unmanaged changes in market leverage as the difference between the total change in market leverage and

managed changes in market leverage.

In Table 5 we classify each firm according to whether the firm’s change in market leverage was primarily from

managed sources (issuing or retiring securities) or unmanaged sources (unrelated to issuing or repurchasing

securities). The proportion of firms where managed sources drive leverage changes is almost always smaller for

firms with extreme leverage than for firms that are not extremely levered. The only exception is in 1992 when we

examine firms with extreme market leverage in 2006. However, these differences are not consistently significant at

the 1% level until the last four (2002 sample), five (1993 sample), or six (2006 sample) years prior to the year we

identify the firms as extremely levered.13

During this window of time, the proportion of firms where managed

sources (issuing or repurchasing securities) drive changes in the firm’s capital structure drops dramatically for

extremely levered firms but remains essentially unchanged for firms that are not extremely levered. This time

frame also matches up with the time during which the leverage of the extreme leverage firms rises dramatically.

13

In the 2006 and 2002 extreme leverage samples, differences in the proportion of firms that were extremely levered and those that were not are significant at the 1%, 5%, and 10% levels in several prior years but there does not appear to be any particular pattern to these differences.


We therefore conclude that extreme market leverage stems from factors unrelated to management decisions to

issue/repurchase securities, and stem instead from factors beyond the direct control of management. In Table 6 we classify each firm according to whether the largest driver of the change in the firm’s market leverage

was debt issues/repurchases, or preferred stock issues/repurchases, or common stock issues/repurchases, or due

to unmanaged sources of changes in leverage. In Table 6 we classify firms in essentially the same way as we did in

Table 4. The difference is that we classify firms using equation (6) rather than equation (4). And since we are using

equation (6), we calculate the change in leverage from unmanaged sources as the difference between the actual

change in leverage and the change in leverage had PRCC_F equaled zero. Similarly, we calculate the change in

leverage from issuing/repurchasing shares as the difference between the actual change in leverage and the change

in leverage had CSHO equaled zero.

In the columns of Table 6 we show the proportion of firms where the primary driver of leverage changes was

changes in debt or changes in preferred stock or changes in shares of common stock, and we compare these

proportions for firms that are extremely levered to the proportions for firms that are not extremely levered. In the

table, we see that debt was the primary driver of changes in leverage for a smaller proportion of firms that were

extreme leveraged than for firms that were not extremely levered in almost every year prior to the year we

separate extreme from non-extreme leverage firms. This result holds when we identify extreme-leverage firms in

2006, 2002, and 1993. However, the differences were not consistently significant until four (1993 sample) or five

(2002 and 2006 samples) years prior to our formation of extreme and non-extreme leverage portfolios. We also

find that while the proportion of firms where debt is the primary driver of leverage changes was fairly stable across

time for non-extreme leverage firms, the proportion drops dramatically for extreme leverage firms in the last few

years prior to their identification as extremely levered. The proportion for extreme leverage firms drops from

approximately 50% to 19.8% for the 2006 sample, from approximately 40% to 12.4% in the 2002 sample, and from

approximately 40% to 20.4% in the 1993 sample. Similar to our findings in Table 5, the proportion of extreme

leverage firms where debt was the primary driver collapses over the same period in which the leverage of these

firms rises dramatically.

In Table 6 we also see that issues and repurchases of preferred and common stock are the primary drivers of

leverage changes for relatively few firms regardless of leverage and regardless of time period examined. However,

preferred stock seems to play a larger role for firms with extreme leverage than for firms that are not extremely

levered in the final few years before we identify them as extremely levered in all of our samples. The differences

were significant at the 1% level in all four years prior to portfolio formulation in the 2006 sample. The differences

are significant at the 1% level in both 2000 and 2002 in the 2002 sample. And the differences are significant at the

5% level in 1991, the 10% level in 1992, and the 1% level in 1993 for the 1993 sample. The differences for common

stock are not consistently significant at the 10% level for any of the samples.


Table 5. Managed or Unmanaged Changes in Market Leverage

In Table 5 we classify each firm according to whether managed (issuing or retiring securities) or unmanaged (changes unrelated to issuing or repurchasing securities) sources were the primary driver of the change in the firm’s market leverage each year. We then report the proportion of firms where managed sources were the primary driver of the change in leverage. We report first the proportion for firms that were extremely levered (the 5% of firms that were included in the extreme-leverage sample) and then for firms that were not extreme levered (the 95% of firms that were not included in the extreme-leverage sample). We test for equality of the two proportions using a two-group proportions test. For example, when we classify firms according to whether they were extremely levered in 2006, we find that managed sources were the largest driver of changes in financial leverage from 1991 to 1992 for 62.3% of the firms classified as extremely levered but only for 52.1% of the firms that were not classified as extremely levered. This difference was significant at the 10% level.

2006 Market Sample 2002 Market Sample 1993 Market Sample

Average Average Average

Fiscal Extreme Not Fiscal Extreme Not Fiscal Extreme Not

Year Leverage Extreme Extreme Diff z-value Year Leverage Extreme Extreme Diff z-value Year Leverage Extreme Extreme Diff z-value

1991 0.386 1987 0.405 1987 0.512

1992 0.365 0.623 0.521 0.102 1.682 * 1988 0.425 0.500 0.534 -0.034 -0.618 1988 0.561 0.474 0.545 -0.071 -1.927 *

1993 0.334 0.413 0.541 -0.128 -2.206 ** 1989 0.416 0.450 0.527 -0.077 -1.358 1989 0.594 0.441 0.536 -0.096 -2.650 ***

1994 0.360 0.488 0.544 -0.056 -1.024 1990 0.461 0.348 0.440 -0.092 -1.725 ** 1990 0.694 0.240 0.450 -0.210 -6.158 ***

1995 0.395 0.340 0.549 -0.210 -4.224 *** 1991 0.451 0.402 0.478 -0.076 -1.439 1991 0.710 0.277 0.492 -0.215 -6.398 ***

1996 0.351 0.418 0.560 -0.142 -3.129 *** 1992 0.414 0.521 0.522 -0.001 -0.019 1992 0.746 0.279 0.532 -0.253 -7.706 ***

1997 0.362 0.503 0.554 -0.051 -1.216 1993 0.356 0.368 0.544 -0.176 -3.582 *** 1993 0.783 0.279 0.555 -0.276 -8.728 ***

1998 0.413 0.465 0.488 -0.023 -0.558 1994 0.395 0.484 0.544 -0.059 -1.331

1999 0.428 0.398 0.496 -0.098 -2.532 ** 1995 0.405 0.430 0.549 -0.118 -2.870 ***

2000 0.486 0.319 0.402 -0.083 -2.288 ** 1996 0.403 0.476 0.561 -0.085 -2.318 **

2001 0.521 0.365 0.474 -0.109 -3.038 *** 1997 0.417 0.500 0.555 -0.055 -1.604

2002 0.564 0.340 0.456 -0.116 -3.354 *** 1998 0.528 0.408 0.492 -0.085 -2.562 **

2003 0.529 0.323 0.492 -0.169 -5.027 *** 1999 0.563 0.284 0.503 -0.219 -6.851 ***

2004 0.542 0.351 0.553 -0.201 -6.082 *** 2000 0.682 0.189 0.409 -0.220 -7.482 ***

2005 0.660 0.300 0.566 -0.266 -8.261 *** 2001 0.801 0.192 0.485 -0.293 -10.019 ***

2006 0.764 0.278 0.578 -0.301 -9.524 *** 2002 0.932 0.200 0.467 -0.267 -9.225 ***


Table 6. Primary Drivers of Market Leverage Changes for Firms

In Table 6 we classify each firm year according to whether issues/repurchases of debt, issues/repurchases of preferred stock, issues/repurchases of common stock, or factors unrelated to issuing or repurchasing securities were the primary driver of changes in the firm’s market leverage. We classify the firms for every year prior to the years that we classify them according to whether they are extremely levered (2006, 2002, and 1993). For a firm year’s change in capital structure to be classified as debt driven, the change in leverage due to debt issues/repurchases must be greater than the change in leverage due to preferred stock issues/repurchases, the change in leverage due to equity issues/repurchases, and the change in leverage due to unmanaged sources. Similarly, for a firm year’s change in capital structure to be classified as preferred-stock driven, the change in leverage due to preferred stock issues/repurchases must be greater than the change in leverage due to debt issues/repurchases, the change in leverage due to equity issues/repurchases, and the change in leverage due to unmanaged sources. And for a firm year’s change in capital structure to be classified as common-stock driven, the change in leverage due to common stock issues/repurchases must be greater than the change in leverage due to debt issues/repurchases, the change in leverage due to preferred stock issues/repurchases, and the change in leverage due to unmanaged sources. We then calculate the proportion of firms for each year and each sample where debt, preferred stock, and common stock were the primary drivers of the firm’s change in leverage. We test for equality of the two proportions using a two-group proportions test. For example, when we classify firms according to whether they have extreme leverage in 2006, we find that debt issues/repurchases were the largest driver of changes in financial leverage between 1991 and 1992 for 52.2% of the firms that were classified as extremely levered and for 45.3% of the firms that were not classified as extremely levered. This difference was not significant at the 10% level. And when we classify firms according to whether they have extreme leverage in 2006, we find that preferred stock issuances/repurchases were the largest driver of leverage changes between 1991 and 1992 for 0.6% of the firms classified as extremely levered and for 0.9% of the firms that were not classified as extremely levered. This difference was not significant at the 10% level. And when we classify firms according to whether they have extreme leverage in 2006, we find that common stock issuances/repurchases were the largest driver of changes in financial leverage between 1991 and 1992 for 13.0% of the firms classified as extremely levered and for 7.6% of the firms that were not classified as extremely levered. This difference was significant at the 10% level.

2006 Market Sample


Average



1991 0.386

1992 0.365 0.522 0.453 0.069 1.140 0.014 0.006 0.009 0.933 0.130 0.076 0.054 1.682 *

1993 0.334 0.373 0.461 -0.087 -1.506 0.013 0.004 0.009 1.165 0.040 0.080 -0.040 -1.263

1994 0.360 0.407 0.521 -0.114 -2.100 ** 0.012 0.005 0.007 0.935 0.093 0.058 0.035 1.380

1995 0.395 0.282 0.495 -0.213 -4.275 *** 0.000 0.004 -0.004 -0.603 0.087 0.067 0.021 0.828

1996 0.351 0.336 0.503 -0.167 -3.643 *** 0.000 0.003 -0.003 -0.622 0.107 0.075 0.031 1.289

1997 0.362 0.455 0.504 -0.049 -1.166 0.007 0.005 0.002 0.320 0.069 0.071 -0.002 -0.084

1998 0.413 0.452 0.472 -0.020 -0.496 0.019 0.005 0.014 2.299 ** 0.051 0.061 -0.010 -0.512

1999 0.428 0.327 0.440 -0.113 -2.925 *** 0.012 0.006 0.006 1.059 0.058 0.060 -0.001 -0.070

2000 0.486 0.303 0.399 -0.096 -2.639 *** 0.021 0.003 0.018 3.832 *** 0.037 0.049 -0.012 -0.741

2001 0.521 0.375 0.458 -0.083 -2.313 ** 0.015 0.005 0.010 1.775 * 0.035 0.045 -0.010 -0.648

2002 0.564 0.302 0.440 -0.137 -3.973 *** 0.014 0.007 0.007 1.243 0.060 0.051 0.009 0.607

2003 0.529 0.241 0.414 -0.172 -5.213 *** 0.022 0.006 0.015 2.797 *** 0.082 0.047 0.035 2.170 **

2004 0.542 0.280 0.482 -0.202 -6.094 *** 0.025 0.004 0.021 4.691 *** 0.092 0.071 0.021 1.225

2005 0.660 0.257 0.510 -0.253 -7.820 *** 0.020 0.003 0.017 4.405 *** 0.055 0.071 -0.015 -0.934

2006 0.764 0.198 0.540 -0.342 -10.763 *** 0.015 0.002 0.013 3.709 *** 0.084 0.062 0.022 1.429


Table 6 (cont). Primary Drivers of Market Leverage Changes for Firms

2002 Market Sample


Average



1987 0.405

1988 0.425 0.476 0.499 -0.024 -0.428 0.000 0.004 -0.004 -0.604 0.024 0.053 -0.028 -1.141

1989 0.416 0.350 0.483 -0.133 -2.351 ** 0.038 0.003 0.034 4.659 *** 0.088 0.056 0.032 1.221

1990 0.461 0.315 0.414 -0.099 -1.881 * 0.000 0.003 -0.003 -0.538 0.056 0.047 0.009 0.389

1991 0.451 0.359 0.403 -0.045 -0.865 0.011 0.004 0.007 0.993 0.033 0.062 -0.030 -1.172

1992 0.414 0.427 0.454 -0.027 -0.531 0.021 0.006 0.015 1.925 * 0.125 0.076 0.049 1.793 *

1993 0.356 0.292 0.463 -0.170 -3.476 *** 0.028 0.004 0.024 3.739 *** 0.094 0.079 0.015 0.569

1994 0.395 0.453 0.520 -0.067 -1.500 0.000 0.005 -0.005 -0.793 0.078 0.058 0.020 0.947

1995 0.405 0.377 0.493 -0.116 -2.805 *** 0.007 0.003 0.003 0.686 0.060 0.068 -0.008 -0.384

1996 0.403 0.429 0.503 -0.075 -2.014 ** 0.000 0.003 -0.003 -0.777 0.095 0.075 0.021 1.055

1997 0.417 0.431 0.504 -0.074 -2.130 ** 0.005 0.006 -0.001 -0.183 0.083 0.072 0.012 0.659

1998 0.528 0.391 0.476 -0.085 -2.575 *** 0.013 0.005 0.007 1.494 0.042 0.062 -0.020 -1.269

1999 0.563 0.249 0.445 -0.196 -6.193 *** 0.012 0.005 0.007 1.385 0.027 0.061 -0.034 -2.258 **

2000 0.682 0.179 0.406 -0.227 -7.723 *** 0.014 0.003 0.010 2.752 *** 0.034 0.049 -0.015 -1.130

2001 0.801 0.153 0.472 -0.319 -10.943 *** 0.010 0.006 0.004 0.943 0.042 0.044 -0.002 -0.150

2002 0.932 0.124 0.452 -0.329 -11.415 *** 0.029 0.006 0.023 4.639 *** 0.048 0.051 -0.004 -0.296

1993 Market Sample


Average



1987 0.512

1988 0.561 0.443 0.511 -0.068 -1.839 * 0.010 0.004 0.007 1.414 0.046 0.053 -0.007 -0.418

1989 0.594 0.401 0.490 -0.089 -2.476 ** 0.010 0.004 0.006 1.227 0.054 0.056 -0.001 -0.078

1990 0.694 0.187 0.423 -0.237 -7.009 *** 0.004 0.004 0.001 0.219 0.062 0.047 0.016 1.068

1991 0.710 0.209 0.416 -0.207 -6.282 *** 0.013 0.004 0.009 2.034 ** 0.060 0.064 -0.004 -0.261

1992 0.746 0.194 0.466 -0.272 -8.329 *** 0.016 0.006 0.010 1.922 * 0.081 0.075 0.006 0.320

1993 0.783 0.204 0.473 -0.270 -8.540 *** 0.015 0.004 0.011 2.631 *** 0.072 0.081 -0.009 -0.533


4 CONCLUDING REMARKS In this study we identified a sample of firms with extremely high financial leverage. We then examined whether

these firms became extremely levered due to managerial decisions (leverage stemming from the issuance or

repurchase of securities) or due to factors beyond the direct control of management (leverage stemming from

changes in the price of the firm’s stock in the instance of market leverage and changes if firm profitability with

respect to book leverage).

We find that the leverage (book and market) of extreme leverage firms rises rapidly in the years just prior to their

identification as an extreme-leverage firm. We also found that this increase in financial leverage was due primarily

to unmanaged rather than managed changes in the firm’s financial leverage. We conclude that extreme leverage

firms become extremely levered primarily because of factors beyond the direct control of their management. This

implies that these extreme leverage firms do not become highly levered because their management believes this is

the firm’s optimal capital structure since the increase was not due to managerial actions. Our findings suggest that

capital structure theories that presume management is actively controlling the firm’s capital structure (measured

in terms of either book or market values) will have little success in explaining the capital structures of extreme

leverage firms. More importantly, our findings suggest that when we attempt to explain changes in a firm’s capital

structure we need to differentiate between changes stemming from managerial actions and changes that stem

from factors beyond the direct control of management.

We also find that book- and market-based measures of leverage do not generally identify the same firms as

extremely levered. And we find significant differences in the percentages of firms with extreme leverage across

industries. Finally, we find that while we can reject independence across time of which industries had a high or low

proportion of extreme leverage firms, few industries show up as having extreme leverage firms in all three of the

years we examined.


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APPENDIX A—HOW RECENT CAPITAL STRUCTURE STUDIES MEASURE FINANCIAL LEVERAGE Book Leverage Metrics

Authors Year Journal Classification of Financial Leverage Measure

Almazan, De Motta, Titman, and Uysal 2010 JF (Total Liabilities-Deferred Taxes + PrdStk)/Total Assets

Banerjee, Dasgupta, and Kim 2008 JF Long-term Debt/Total Assets

Total Debt/Total Assets

Bharath, Pasquariello, and Wu 2009 RFS Total Debt/Total Assets

Brav 2009 JF (Short-term Debt + Long-term Liabilities)/Total Assets

Total Debt/Total Assets

(Short-term Debt + Long-term Liabilities)/Total Assets

Byoun 2008 JF Long-term Debt/Total Assets

Long-term Debt/Total Assets

Chang and Dasgupta 2009 JF (Total Liabilities + PfdStk - Convertible Debt)/Total Assets

Long-term Debt/Total Assets

Desai, Foley, and Hines 2008 JFE Total Debt/Total Assets

Huizinga, Laeven, and Nicodeme 2008 JFE Total Liabilities/Total Assets

Net Debt/(Total Assets - Accounts Payable-Cash)

Leary 2009 JF Long-term Debt/Total Assets

Leary and Roberts 2010 JFE Long-term Debt/Total Assets

Lemmon, Roberts, and Zender 2008 JF Long-term Debt/Total Assets

Matsa 2010 JF Total Debt/Total Assets

Net Debt/(Total Assets-Cash)

Ovtchinnikov 2010 JFE Total Debt/Total Assets

Rauh and Sufi 2010 RFS Total Debt/Invested Capital

Roberts and Sufi 2009 JF Total Debt/Total Assets

Shivdasani and Stefanescu 2010 RFS Total Debt/(Total Assets-Prepaid Pension Cost)

Total Debt/Invested Capital


Market Leverage Metrics

Authors Year Journal Classification of Financial Leverage Measure

Almazan, De Motta, Titman, and Uysal 2010 JF (Total Debt + Preferred Stock)/(Total Debt+ PfdStk +Market Value of Equity)

(Total Debt + Preferred Stock-Cash)/(Total Debt + PfdStk +Market Value of Equity)

Banerjee, Dasgupta, and Kim 2008 JF Long-term Debt/(Total Liabilities+ Market Value of Equity)

Total Debt/(Total Liabilities + Market Value of Equity)

Bharath, Pasquariello, and Wu 2009 RFS Total Debt/Firm Value

Total Debt/(Total Debt + Market Value of Equity)

Byoun 2008 JF Total Debt/(Total Debt + Market Value of Equity)

Long-term Debt/Enterprise Value

Carlson and Lazark 2010 JF Long-term Debt/(Long-term Debt + Market Value of Equity)

Harford, Klasa, and Walcott 2009 JFE Total Debt/Firm Value

Korteweg 2010 JF Net Debt/Enterprise Value

Leary 2009 JF Total Debt/(Total Debt + Market Value of Equity)

Leary and Roberts 2010 JFE Total Debt/(Total Debt + Market Value of Equity)

Lemmon, Roberts, and Zender 2008 JF Total Debt/(Total Debt + Market Value of Equity)

Matsa 2010 JF Total Debt/Firm Value

Morellac and Zhandov 2008 JFE Total Debt/(Total Debt + Market Value of Equity)

Ovtchinnikov 2010 JFE Total Debt/(Total Debt + Market Value of Equity)

Shivdasani and Stefanescu 2010 RFS Long-term Debt/Firm Value

Long-term Debt/(Long-term Debt + Market Value of Equity)

Legend:

Definitions:

Firm Value = Total Liabilities + Market Value of Equity Enterprise Value = Total Debt – Cash + Market Value of Equity

Journal Abbreviations:

JF Journal of Finance

JFE Journal of Financial Economics

RFS Review of Financial Studies


APPENDIX B—FIRM CLASSIFICATION WITH SIC AND HISTORICAL SIC CODES In this appendix we show the percentage of firms in the Compustat database that are classified as industrial firms, utilities or financial firms, or as unknown (due to missing historical SIC codes) when they are classified as industrial firms by current SIC codes (SIC). We show the same breakdown for Compsutat firms classified as utilities or financial firms by current SIC codes. SIC Classification: Industrial Utility or Financial

Historical SIC Classification:

Industrial Utility or Financial

Missing Utility or Financial

Industrial Missing

1987 91.9% 2.0% 6.1% 49.1% 9.5% 41.3%

1988 90.1% 2.1% 7.8% 46.0% 8.7% 45.3%

1989 89.1% 2.0% 8.9% 43.9% 8.1% 48.1%

1990 87.6% 2.0% 10.5% 43.4% 7.3% 49.3%

1991 85.6% 2.0% 12.4% 43.5% 6.2% 50.3%

1992 85.3% 1.9% 12.8% 41.7% 4.8% 53.5%

1993 86.3% 1.7% 12.0% 43.0% 4.1% 52.9%

1994 87.5% 1.5% 11.0% 43.5% 4.2% 52.3%

1995 91.1% 1.5% 7.4% 47.0% 4.1% 48.9%

1996 91.3% 1.3% 7.4% 49.5% 4.0% 46.5%

1997 89.1% 1.2% 9.6% 49.4% 3.8% 46.8%

1998 90.8% 1.1% 8.1% 49.9% 3.7% 46.3%

1999 90.4% 1.0% 8.6% 51.5% 3.3% 45.2%

2000 87.4% 0.9% 11.7% 50.0% 3.2% 46.8%

2001 85.8% 0.8% 13.4% 48.9% 2.9% 48.2%

2002 84.3% 0.7% 15.0% 47.9% 2.7% 49.4%

2003 84.0% 0.5% 15.5% 46.1% 2.1% 51.8%

2004 82.7% 0.5% 16.8% 63.6% 1.7% 34.8%

2005 81.7% 0.4% 18.0% 60.7% 1.0% 38.3%

2006 80.6% 0.2% 19.2% 55.6% 0.6% 43.9%

2007 81.9% 0.2% 18.0% 49.5% 0.3% 50.2%

2008 82.3% 0.0% 17.7% 47.1% 0.1% 52.8%


APPENDIX C—IMPACT OF SAMPLE RESTRICTIONS ON SAMPLE COMPOSITION

1993 2002 2006

Number Percent Number Percent Number Percent

Book Leverage

Compustat Firms 11497 11585 10997

Loss: Missing data to calculate leverage 1900 16.5% 1402 12.1% 1603 14.6%

Loss: Zero Capital 6 0.1% 6 0.1% 7 0.1%

Possible to Calculate Book Leverage 9591 10177 9387

Missing SICH 934 9.7% 1484 14.6% 1503 16.0%

Utilities 340 3.5% 374 3.7% 338 3.6%

Financials 1129 11.8% 1151 11.3% 1543 16.4%

Industrial Firms 7188 7168 6003

Book Leverage > 1 (neg equity, pos capital) 383 5.3% 576 8.0% 380 6.3%

Book Leverage < 0 (neg equity, neg capital) 158 2.2% 464 6.5% 334 5.6%

Sample 6647 6128 5289

1993 2002 2006

Number Percent Number Percent Number Percent

Market Leverage

Compustat Firms 11497 11585 10997

Loss: Missing data to calculate leverage 3829 33.3% 2571 22.2% 2560 23.3%

Loss: No outstanding shares 1 0.0% 2 0.0% 1 0.0%

Loss: Zero stock price 0 0.0% 0 0.0% 0 0.0%

Possible to Calculate Market Leverage 7667 9012 8436

Missing SICH 733 6.4% 1340 11.6% 1264 11.5%

Utilities 298 2.6% 201 1.7% 187 1.7%

Financials 899 7.8% 992 8.6% 1453 13.2%

Sample 5737 6479 5532


APPENDIX D—AN EXAMPLE FIRM: GOODYEAR TIRE & RUBBER Table D – 1 . Historical Book and Market Leverage Ratios for Goodyear Tire & Rubber

In Table E – 1 we show the book and market leverage ratios for Goodyear Tire & Rubber from 1996 through 2002. “Industry” equals the average book and market leverage ratios for firms in the “Autos” industry as defined by Fama and French. We use Equation 1 to measure “Book Leverage” and Equation 2 to measure “Market Leverage”.

Book Leverage Market Leverage

Year Industry Goodyear Change Industry Goodyear Change

1996 0.379 0.296 0.282 0.147

1997 0.406 0.285 -0.011 0.281 0.119 -0.027

1998 0.431 0.345 0.061 0.344 0.201 0.081

1999 0.460 0.495 0.150 0.395 0.447 0.247

2000 0.459 0.510 0.014 0.409 0.501 0.054

2001 0.481 0.555 0.045 0.405 0.479 -0.023

2002 0.456 0.848 0.294 0.388 0.753 0.274

As shown in Table D-1, the leverage (both book and market) of Goodyear jumped above the average leverage of

the Auto industry (as defined by Fama and French”) in 1999 and then it jumped again in 2002. According to

Goodyear’s financial statements, the firm’s leverage spiked in 1999 as its debt jumped from $1.98 billion to $3.55

billion. Goodyear issued the debt to help finance acquisitions related to its forming a strategic global alliance with

Sumitomo Rubber Industries. Goodyear’s market leverage also jumped in 1999 due to its stock price falling from

more than $50 per share to approximately $28 per share over the year. However, the spike in Goodyear’s leverage

in 2002 had little to do with Goodyear’s management deciding to issue or retire securities. Instead, Goodyear’s

book leverage rose as it wrote off deferred tax assets and recognized an adjustment to its pension liability. And

Goodyear’s market leverage jumped as its stock price fell from $23.81 per share to $6.81 per share. Thus the jump

in Goodyear’s leverage in 1999 resulted from an intentional act by the firm’s management to boost the firm’s

leverage by using debt to finance acquisitions. But the jump in leverage in 2002 was unrelated to the firm’s

management deciding to change the firm’s capital structure by issuing or repurchasing securities. Rather, the

change was unmanaged and stemmed from factors beyond the direct control of management. In what follows we

examine how we can use Equations (4) an (6) and Goodyear’s balance sheet to differentiate between managed

and unmanaged changes in Goodyear’s leverage.


Managed vs. Unmanaged Change in Goodyear’s Leverage in 1999

Table D – 2 . Book and Market Data for Goodyear in 1998 and 1999

Table D – 2 includes the book and market data for Goodyear Tire & Rubber from 1998 and 1999 needed to calculate the sources of the change in Goodyear’s leverage in 1999 using equations (4) and (6).

14

1998 1999 Change

DLC 789.3 1204.4 415.1

DLTT 1186.5 2347.9 1161.4

Debt 1975.8 3552.3 1576.5

PSTK 0.0 0.0 0.0

CSTK 155.9 156.3 0.4

CAPS 1015.9 1029.6 13.7

RE 2574.0 2431.2 -142.8

TSTK 0.0 0.0 0.0

CSHO 155.944 156.335 0.391

PRCC_F 50.4375 28.0625 -22.3750

Capital:

Book 5721.6 7169.4 1447.8

Market 9841.2 7939.5 -1901.8

Leverage:

Book 0.3453 0.4955 0.1502

Market 0.2008 0.4474 0.2467

Book Leverage

To isolate the managed change in Goodyear’s book leverage, we use equation (4) to calculate how Goodyear’s

leverage would have changed if its retained earnings had remained unchanged. This isolates the managed change

in Goodyear’s book leverage by measuring how its book leverage would have changed if the only source of

leverage changes had been issuances and/or repurchases of securities. Goodyear’s managed change in book

leverage in 1999 thus equals:

( ) (

) ( ( ))

( )

The unmanaged change in Goodyear’s book leverage thus equals:

( )

Based on these results, we see that the change in Goodyear’s book leverage in 1999 was almost exclusively

managed as the firm issued debt to fund acquisitions related to its joint venture with Sumitomo Rubber.

14

In 1998, Goodyear’s book capital equaled 5721.6 = 1975.8 + 0.0 + (155.9 + 1015.9 + 2574.0 – 0.0) and its market capital equaled 9841.2 = 1975.8 + 0.0 + 155.944*50.4375. And in 1998, Goodyear’s book leverage equaled 0.3453 = (1975.8/5721.6) and its market leverage equaled 0.2008 = (1975.8/9841.2).


Market Leverage

To isolate the managed change in Goodyear’s market leverage, we use equation (6) to calculate how Goodyear’s

market leverage would have changed had its stock price remained unchanged. This isolates the managed change in

Goodyear’s market leverage by measuring how its market leverage would have changed if the only source of

leverage changes had been issuances and/or repurchases of securities. Goodyear’s managed change in market

leverage in 1999 thus equals:

( ) (

) ( )

The unmanaged change in Goodyear’s market leverage in 1999 thus equals:

( )

Thus while Goodyear’s market leverage rose in 1999 to a large extent because it issued debt to fund acquisitions

related to its joint venture with Sumitomo Rubber, the greater driver of Goodyear’s rising leverage was its

dropping stock price.

Managed vs. Unmanaged Change in Goodyear’s Leverage in 2002

Table D – 2 . Book and Market Data for Goodyear in 2001 and 2002

In Table D – 2 we show the book and market data for Goodyear Tire & Rubber from 2001 and 2002 needed to calculate the sources of the change in Goodyear’s leverage in 2002 using equations (4) and (6).

15

2001 2002 Change

DLC 364.7 653.2 288.5

DLTT 3203.6 2989.0 -214.6

Debt 3568.3 3642.2 73.9

PSTK 0.0 0.0 0.0

CSTK 163.2 175.3 12.1

CAPS 1245.4 1390.3 144.9

RE 1455.4 -915.0 -2370.4

TSTK 0.0 0.0 0.0

CSHO 163.166 175.307 12.141

PRCC_F 23.8100 6.8100 -17.0000

Capital:

Book 6432.3 4292.8 -2139.5

Market 7453.3 4836.0 -2617.2

Leverage:

Book 0.5547 0.8484 0.2937

Market 0.4788 0.7531 0.2744

15

In 2001, Goodyear’s book capital = 6432.3 = 3568.3 + 0.0 + (163.2+1245.4+1455.4 – 0.0) and its market capital equals 7453.3 = 3568.3 + 0.0 + 163.166*233.81. And in 2001, Goodyear’s book leverage = 0.5547 = (3568.3/6432.3) and its market leverage = 0.4788 = (3568.3/7453.3).


Book Leverage

To isolate the managed change in Goodyear’s book leverage, we again use equation (4) to calculate how

Goodyear’s book leverage would have changed if the only source of changes in its book leverage had been

issuances and/or repurchases of securities. Goodyear’s managed change in book leverage in 2002 thus equals:

( ) (

) ( ( ))

( )

The unmanaged change in Goodyear’s book leverage thus equals:

( )

Based on these results we see that Goodyear’s issuance and repurchases of securities would have pushed the

firm’s leverage slightly lower in 2002 had nothing else changed. However, unmanaged changes in its leverage

stemming from Goodyear writing off assets and recognizing a change in its pension liability swamped the relatively

small managed change in book leverage and drove leverage much higher.

Market Leverage

To isolate the managed change in Goodyear’s market leverage, we again use equation (6) to calculate how

Goodyear’s market leverage would have changed if the only source of changes in its market leverage had been

issuances and/or repurchases of securities. Thus, Goodyear’s managed change in market leverage in 2002 equals:

( ) (

) ( )

The unmanaged change in Goodyear’s market leverage in 1999 thus equals:

( ) ( )

Equation (6) shows that the securities Goodyear issued in 2002 pushed Goodyear’s market leverage slightly lower

than it would have otherwise been. However, Goodyear’s leverage jumped as its collapsing stock price swamped

these managed efforts to reduce leverage.

Sources of Managed Changes in Goodyear’s Book Leverage

We can also use equation (4) to isolate the effect on Goodyear’s book leverage of issues and/or repurchases of

individual classes of securities. In this section we therefore use equation (4) to examine the impact of

issues/repurchases of debt, preferred stock, and common stock on Goodyear’s book leverage.

Sources of Managed Changes in Goodyear’s Book Leverage in 1999

To isolate the impact of debt issues/repurchases on Goodyear’s book leverage, we calculate the difference

between the actual change in Goodyear’s book leverage in 1999 and the change in its leverage had it not issued or

repurchased any debt. The change in Goodyear’s book leverage in 1999 due to debt issues thus equals:


( ) (

) ( ( ))

( )

To isolate the impact of preferred stock issues/repurchases we use equation (4) to measure the difference

between the actual change in Goodyear’s book leverage in 1999 and the change in its leverage would had it not

issued or repurchased any shares of preferred stock. The change in Goodyear’s book leverage in 1999 due to

preferred stock issues/repurchases thus equals:

( ) (

) ( ( ))

( )

And to isolate the impact of common stock issues/repurchases we calculate the difference between the actual

change in Goodyear’s book leverage in 1999 and the change in its leverage had it not issued or repurchased any

shares of common stock. The change in Goodyear’s book leverage in 1999 due to common stock issues/repurchase

thus equals:

( ) (

) ( )

These numbers make sense. As previously discussed, Goodyear issued significant amounts of debt in 1999 that

drove its leverage higher. Preferred stock had no impact on the change in Goodyear’s leverage since it neither

issued nor retired preferred shares. And the small number of shares Goodyear issued as part of its stock

compensation plan actually pushed Goodyear’s leverage slightly lower than it would have otherwise been. In 1999,

the only source of managed leverage that contributed to the rise in Goodyear’s leverage was debt issues.

Sources of Managed Changes in Goodyear’s Book Leverage in 2002

Using the same approach, we can also calculate the change in Goodyear’s book leverage from individual classes of

securities in 2002. The change in Goodyear’s book leverage in 1999 due to debt issues equals:

( ) (

) ( ( ))

( )

The change in Goodyear’s book leverage in 2002 due to preferred stock issues/repurchases equals:

( ) (

) ( ( ))

( )

And the change in Goodyear’s book leverage in 1999 due to common stock issues/repurchase equals:

( ) (

) ( )

These numbers again make sense. In 2002, Goodyear’s debt rose slightly as it restructured its bank debt and its

receivables securitization facilities. This increase pushed its book leverage slightly higher. And as in 1999, preferred

stock had no impact on the change in Goodyear’s leverage since it neither issued nor retired preferred shares.

Finally, the small number of shares Goodyear issued to fund its pension obligations, to fund acquisitions, and as


part of its stock compensation plans actually pushed Goodyear’s leverage slightly lower than it would have

otherwise been. None of the managed sources played a dominant role in the rise in Goodyear’s leverage in 2002.

Rather, unmanaged sources of leverage were the primary driver of Goodyear’s increased leverage.

Sources of Managed Changes in Goodyear’s Market Leverage

We can use equation (6) to isolate the effects of issues and/or repurchases of individual classes of securities on

Goodyear’s market leverage. In this section we therefore use equation (6) to examine the impact of

issues/repurchases of debt, preferred stock, and common stock on Goodyear’s market leverage.

Sources of Managed Changes in Goodyear’s Market Leverage in 1999

To isolate the impact of debt issues/repurchases we calculate the difference between the actual change in

Goodyear’s market leverage in 1999 and the change in its leverage had it not issued or repurchased any debt. The

change in Goodyear’s market leverage in 1999 due to debt issues thus equals:

( ) (

) ( ( ))

( )

To isolate the impact of preferred stock issues/repurchases we measure the difference between the actual change

in Goodyear’s book leverage in 1999 and the change in its leverage had it not issued or repurchased any shares of

preferred stock. The change in Goodyear’s book leverage in 1999 due to preferred stock issues/repurchases thus

equals:

( ) (

)( ( ))

( )

And to isolate the impact of common stock issues/repurchases we calculate the difference between the actual

change in Goodyear’s book leverage in 1999 and the change in its leverage had it not issued or repurchased any

shares of common stock. The change in Goodyear’s book leverage in 1999 due to common stock issues/repurchase

thus equals:

( ) (

) ( )

These numbers make sense. As previously discussed, Goodyear issued significant amounts of debt in 1999 that

drove its leverage higher. However preferred stock had no impact on the change in Goodyear’s leverage since it

neither issued nor retired preferred shares. And the small number of shares Goodyear issued as part of its stock

compensation plan actually pushed Goodyear’s leverage slightly lower than it would have otherwise been. In 1999,

the only source of managed leverage that contributed to the rise in Goodyear’s leverage was debt issues.

Sources of Managed Market Leverage Changes in 2002

Using the same approach, we can also calculate changes in Goodyear’s leverage from individual classes of

securities in 2002. The change in Goodyear’s book leverage in 2002 due to debt issues equals:

( ) (

) ( )


The change in Goodyear’s book leverage in 2002 due to preferred stock issues/repurchases equals:

( ) (

) ( )

And the change in Goodyear’s book leverage in 1999 due to common stock issues/repurchase equals:

( ) (

) ( )

These numbers again make sense. In 2002, Goodyear’s debt rose slightly as it restructured its bank debt and its

receivables securitization facilities. This pushed Goodyear’s book leverage slightly higher. As in 1999, preferred

stock had no impact on the change in Goodyear’s leverage since it neither issued nor retired preferred shares. And

the small number of shares Goodyear issued to fund its pension obligations, to fund acquisitions, and as part of its

stock compensation plans actually pushed Goodyear’s leverage lower than it would have otherwise been. None of

the managed sources played a dominant role in the rise in Goodyear’s leverage in 2002. Rather, the increase in

leverage was driven by unmanaged sources.

managed vs. unmanaged changes in the capital structures of ...appendix d—an example firm: goodyear...

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