Do Behavioral Biases Explain Capital Structure Decisions

Anchoring bias: is a cognitive bias that defines the tendency of relying of an individual on the first piece of information.

Problem statement:

A number of researches are conducted on the capital structure and determinants of capital structure is developed and developing countries by focusing on the work of Modigliani and miller (1958). These researches focus on the extant and type of source of capital used by the organizations. These researches focus on three theories of capital structure like agency cost theories, bankruptcy and tax based theories and information asymmetric theories. While all these theories focus on the adoption of any of these theories and find out their relation with the capital structure. These theories are silent on the issue of manager’s perception regarding adoption of different sources of finance, due to which the proper identification of management decisions regarding capital structure is quite impossible.

Research Gap:

The area of discussing behavioral aspects of management in capital structure is not properly explored and limited research has been conducted before in this area. There is a gap in the academic literature that link corporate financial and behavioral financial decisions with regard to the issue of capital structure, however there has been some attempts to explain capital structure from a behavioral standpoint. This paper examines the relationship between anchoring as a behavioral bias exhibited by managers and their decisions on whether to issue debt or equity. This relationship is based upon the argument of market timing, on which managers perceive what the value of firm is and what kind of sources of financing is best suitable for them. Either debt or equity.

Variables:

We investigate whether anchoring captured by a number of proxies including market to-book ratios, the proportion of shares sold off that are held by managers, the exercising of stock options held by managers long before their expiration dates, share repurchases, stock returns, bond yields, 52-week share price highs, and share prices at last equity issue and last debt issue, sufficiently explains the changing levels of debt or capital structure mix adopted by firms.

Theoretical background:

The research on capital structure is start its life from Modigliani Millar capital irrelevance theory, which is further enhanced by introducing the trade off and packing order theories for determination of capital structure by an organization. These Trade off theories and packing order theories are used widely in making the capital decisions, both of these theories does not define the behavior of managers regarding any kind of capital structure decisions. To complement the traditional theories in further explaining capital structure choices, a new stream of research based on behavioral biases is emerging.

Market timing is used to measure behavior because shefrin (2005) is of the view that capital structure affected by behavioral biases through market timing as well as financial flexibility. The argument for market timing emphasize the point that new equity is issued when management perceive that their share price is overvalued or has reached a peak. This market perception is measured through high market-to-book ratio. an indicator to capture whether the managers think that their firm’s share

price has peaked is to observe the proportion of their personal portfolio that they sell off and vice versa.

The debt to equity choices of firm is based upon the argument of baker and Wurgler (2002), who is of the view about the inexistence of optimal capital structure of the organization, and this inexistence provide way to market timing to show its involvement in the capital structure.

Welch (2004) defines stock prices as first order determinants of debt ratios and explained the relationship between debt ratios and capital structure through omitted share prices variable.

Shefrin (2005) also argues that some firms simply value financial flexibility and will issue debt so as to hold enough cash especially in times of uncertainty. This might be interpreted from a behavioral finance perspective that management become overconfident about potential takeover prospects in the future, at some point when other firms might become distressed and consequently would potentially be targets for acquisitions.

However, behavioral bias like anchoring effect used in this study is also viewed from prospect theory, in which investor is indifference among capital gains and losses. The argument of prospect theory in this study is managers, CEO, insiders of the firm and VCs were satisfied when they realised a net wealth gain arising from the appreciation in value of their retained shares when the closing price of the share is higher.

This research adopts the overconfidence of managers as a bias to explain its effect on the capital structure. In this regard, Barros and Da Silveira (2007) study on Brazilian market is examined that focus on the managerial optimism and overconfidence on the basis of entrepreneurial nature of the managers. They are of the view that the firms managed or owned by the overconfident managers focus on more levered capital structures for their organizations. The market to book ratio as proxy of measurement of management behavioral perspective is also studied by focusing on the Oliver (2005) study, which uses consumer sentiment index in this regard and determines market-to-book ratio as a significant determinant of capital structure decisions.

Model and variables:

In our model, we employ different measures of leverage by using both the total debt and long-term debt scaled by the book value of assets. Total debt overestimates the borrowing capacity of the firm, while short term debt in the analysis may not capture correctly the true underlying determinants of a firm’s borrowing decisions, but longer term contractual obligations are likely to be qualitatively different compared to those that affect short-term borrowing. In this regard, both long and short term debts are used in this study.

Behavioral biases are measured through market-to-book ratios, personal sell off of shares held by managers, managers exercising of stock options, share buy-backs, book-to-market ratios, stock returns, bond yields, 52-week share price highs, share price at last equity issue, and share price at last debt issue.

Due to the natural lag inherent in the nature of this study, we use as a proxy the previous year’s share price as a measure of anchoring to determine whether managers decide to issue equity or debt in the current period.

In order to capture the managerial perspective regarding share prices, we considered the six months before expiration prices of options to better identify their trade off with the money value at expiration.

Data and Methodology:

The data used in this study was extracted from the Profit and Loss Accounts and Balance Sheets of all publicly listed US and Canadian firms from 1990 to 2007.

Thomson’s SDC Platinum database to get data of CEOs personal portfolios held and their selling of shares as well as their exercising of stock options.