The Choice Between Equity and Debt: An Empirical Study

This empirical study of security issues by UK companies between 1959 and 1974 focuses on how companies select between financing instruments at a given point in time. It throws light on a number of interesting questions. First, it demonstrates that companies are heavily influenced by market conditions and the past history of security prices in choosing between debt and equity. Second, it provides evidence that companies appear to make their choice of financing instrument as if they have target levels of debt in mind. Finally, the results are consistent with the notion that these target debt levels are themselves a function of company size, bankruptcy risk, and asset composition. AN IMPORTANT QUESTION FACING companies in need of new finance is whether to raise debt or equity. In spite of the continuing theoretical debate on capital structure, there is relatively little empirical evidence on how companies actually select between financing instruments at a given point in time. Furthermore, almost none of the existing empirical evidence is based on British data. Sametz's [31] comment that "we know very little about how the great non-routine financial decisions are made" is still no understatement. In this paper, we develop a descriptive model of the choice between equity and long term debt. The coefficients of the model are estimated using logit analysis applied to a sample of 748 issues of equity and debt made by UK companies over the period 1959-70. The predictive ability of the model is tested on a holdout sample of 110 equity and debt issues made between 1971 and 1974. The study throws some light on a number of interesting questions such as whether companies behave as though they have target debt ratios; whether they have similar targets for the composition of their debt; whether market conditions or the company's historical share price performance affects their choice of instrument; and whether debt ratios or the choice of financing instrument are influenced by other factors such as operating risk, company size, the composition of the company's assets, and the rate at which retentions are generated. The study also provides a direct answer to the following question: given that we know that a company is in need of new long term or permanent capital, how accurately can we predict whether the company will issue equity or debt.