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Firm external
Firm external financing decisions: financing
explaining the role of risks decisions
Abdul Rashid
International Institute of Islamic Economics (IIIE), 97
International Islamic University, Islamabad, Pakistan
Received 28 February 2013
Revised 27 June 2013
Abstract 8 August 2013
Accepted 13 August 2013
Purpose The main purpose of this paper is to empirically examine how firm-specific (idiosyncratic)
and macroeconomic risks affect the external financing decisions of UK manufacturing firms. The
paper also explores the effect of both types of risk on firms debt versus equity choices.
Design/methodology/approach The paper uses a firm-level panel data covering the period
1981-2009 drawn from the Datastream. Multinomial logit and probit models are estimated to quantify
the impact of risks on the likelihood of firms decisions to issue and retire external capital and debt
versus equity choices, respectively.
Findings The results suggest that firms considerably take into account both firm-specific and
economic risk when making external financing decisions and debt-equity choices. Specifically, the
results from multinomial logit regressions indicate that firms are more (less) likely to do external
financing when firm-specific (macroeconomic) risk is high. The results of probit model reveal that the
propensity to debt versus equity issues substantially declines in uncertain times. However, firms are
more likely to pay back their outstanding debt rather than to repurchase existing equity when they
face either type of risk. Of the two types of risk, firm-specific risk appears to be more important
economically for firms external financing decisions.
Practical implications The findings of the paper are equally useful for corporate firms in making
value-maximizing financing decisions and authorities in designing effective fiscal and monetary
policies to stabilize macroeconomic conditions. Specifically, the findings emphasize on the stability of
the overall macroeconomic environment and firms sales/earnings, which would result stability in
firms capital structure that help smooth firms investments and production.
Originality/value Unlike prior empirical studies that mainly focus on examining the impact of
risk on target leverage, this paper attempts to examine the influence of firm-specific and
macroeconomic risk on firms external financing decisions and debt-equity choices.
Keywords Capital structure, Corporate finance, Firm-specific risk, Macroeconomic risk,
External financing, Debt-equity choices
Paper type Research paper

1. Introduction
This paper contributes to the existing literature of risk-leverage relationship by
exploring the influence of risk associated with firms earnings (firm-specific risk) and
macroeconomic conditions (macroeconomic risk) on firms decisions to issue and retire
external capital. The paper also examines the impact of both types of risk on firms
debt versus equity choices. How does firm-specific (idiosyncratic) risk affect the capital
structure decisions of firms? Capital structure theories provide alternative answers to Managerial Finance
Vol. 40 No. 1, 2014
this question. Specifically, according to the trade-off theory of capital structure, pp. 97-116
firm-specific risk is expected to be negatively related to the target level of firms q Emerald Group Publishing Limited
0307-4358
leverage (Castanias, 1983; Bradley et al., 1984). On the other hand, according to another DOI 10.1108/MF-02-2013-0049
MF theory of capital structure, namely agency costs, there is a positive relationship
40,1 between firm-specific risk and a firms use of debt (Myers, 1977).
Recent theoretical research, however, has attempted to relate firms financing
decisions to macroeconomic risk. Broadly speaking, this new line of research inquires
into the response of firm leverage decisions to unpredictable variations in
macroeconomic conditions and predicts that firm leverage is pro-cyclically related to
98 the state of macroeconomy. In particular, Hackbarth et al. (2006) posit that the
borrowing decisions of firms are pro-cyclical. They also argue that both the pace and the
size of capital structure changes are significantly conditioned by macroeconomic
conditions. Similarly, other studies, such as Levy and Hennessy (2007), Chen (2010),
Korteweg (2010), and Bhamra et al. (2010), postulate that firms have tendency to reduce
their outstanding debt in times of unfavorable macroeconomic conditions. Specifically,
Chen (2010) and Bhamra et al. (2010) show that unforeseen variations in macroeconomic
conditions reduce tax benefits associated with debt financing by both increasing
discount rates and deteriorating expected future cash flows. The diminutions in tax
benefits of debt make debt financing unattractive for corporate firms. Hence, they
reduce the use of debt in their capital structure.
Despite researchers have successfully formulated theoretical interlinkages between
firms leverage decisions and the risk associated with macroeconomic conditions, we
have limited empirical evidence on this issue. There are a few prior studies that
empirically examine the response of firms leverage decisions to macroeconomic risk
(Hatzinikolaou et al., 2002; Baum et al., 2009; Caglayan and Rashid, 2013). These studies
broadly document that macroeconomic risk has a significant and negative impact on
firm leverage. Concerning idiosyncratic risk effects, several prior studies have
empirically examined the impact of firm-specific risk on firms leverage decisions.
However, the findings of these studies are inconclusive at best. For instance, studies
including Titman and Wessels (1988), MacKie-Mason (1990), Lemmon et al. (2008),
Antoniou et al. (2008), Baum et al. (2009), and Caglayan and Rashid (2013) provide
evidence that idiosyncratic risk affects firm leverage negatively. In contrast, some
studies, such as Toy et al. (1974), Kim and Sorensen (1986), Kale et al. (1991), Chu et al.
(1992), and Mueller (2008), document evidence indicating a positive impact of firm-
specific risk on firm leverage. However, the findings of Flath and Knoeber (1980), Wald
(1999), and Cassar and Holmes (2003) indicate that the effects of firm-specific risk on the
leverage decisions of firms are insignificant statistically.
Reviewing the existing literature we observe that in explaining the role of risk in
firms capital structure decisions, most of prior empirical studies have mainly focused
on the impacts of firm-specific risk on target leverage rather than on the security
issuance and repurchase decisions of firms. Another gap left by the existing literature is
that the previous empirical studies, such as Korajczyk and Levy (2003), Covas and
Den Haan (2007), and Korteweg (2010), which consider macroeconomic conditions, have
largely examined corporate security issuance decisions over the business cycle, instead
of the effects of risk associated with the overall state of the economy. Therefore,
empirical evidence on the impact of firm-specific and macroeconomic risk on corporate
decisions to issue and repurchase external capital (debt borrowing and equity financing)
as well as on firms choice of financial instruments (i.e. debt versus equity) is rather
scanty. Consequently, our understanding of how idiosyncratic and macroeconomic risk
affects firms financing policies is incomplete.
 However, answering the question as to the whether firm-specific and Firm external
macroeconomic risks have an important role to play in firms security issuance and financing
repurchase decisions is of great significance to firm managers and policymakers.
If various costs and benefits associated with firms financing options (retentions, debt decisions
borrowing, and equity financing) are affected by risk, so does the security issuance and
repurchase decisions of firms. This implies that firms are likely to alter their financing
decisions when they face risk, which yield changes in firms capital structure, in turn, 99
impacting the value of the firms. Therefore, the effects of risk on firms security
issuance and repurchase decisions may worth exploring.
Departing from the existing literature on the relationship between risk and firm
leverage, this paper examines the effects of firm-specific and macroeconomic risk on
firms decisions to issue and retire external capital. The paper also explores the impact
of both types of risk on firms debt versus equity choices. We conjecture that since risk
associated with a firms earnings and macroeconomic conditions influences various
costs and benefits related to different financing options available to the firm, the firm
would alter its financing decisions when there are changes in the risk structure within
which the firm operates. To test this hypothesis, we use a panel dataset of UK
manufacturing firms extracted from the Datastream for the period 1981-2009. We begin
the empirical analysis by exploring the impact of risk related to firms earnings and
macroeconomic conditions on firms target leverage. Similar to the existing literature
(Lemmon et al., 2008; Antoniou et al., 2008; Baum et al., 2009; Caglayan and Rashid,
2013), we find that firms are likely to reduce their leverage targets when either type of
risk is high.
We next study how firm-specific and macroeconomic risk affects the firms decision
to raise new external capital and retire existing external capital. In particular, we
examine the effects of risk on the likelihood of issuing and retiring external capital
against the case of firms that neither issue nor retire their external capital[1]. The
results suggest that firms tend to design propassive (proactive) external financing
policies during periods of high macroeconomic volatility (firm-specific risk).
Specifically, the results reveal that firms are less likely to use capital markets when
macroeconomic risks are high, whereas, they tend to rely more on external financing
when firm-specific risk is high. The results also indicate that firms are less likely to
issue debt versus equity, yet they are more likely to repurchase debt than equity, in
periods when either type of risk is high. These findings appear to be robust to the
inclusion of several firm-specific variables into the model.
The outline for the rest of the paper is as follows. Section 2 describes data and
explains construction of the variables used in the empirical section. Section 3 presents
the theoretical rationales for the risk sensitivity of firms external financing decisions.
Section 4 discusses the estimation methods. Section 5 presents the empirical results.
Section 6 concludes the paper.

2. Data and variable definitions

2.1 Selecting the sample
The firm-level data for the UK are drawn from Datastream for the years 1981-2009.
Since financial firms and regulated utilities have different financial structure, we
exclude these firms from the sample. The effective sample contains a total of 1,025
firms. In order to purge the effects of heterogeneity across firms, we scale all the
MF firm-specific variables dividing them by the book value of total assets. We trim all
40,1 variables that are in ratio forms by one percentile from both tails of the distribution to
mitigate the influence of outliers.

2.2 Identifying the issuance and reduction of external financing

External capital issuances and reductions are identified by observing the change in
100 total external financing (net debt plus net equity financing) from year t 2 1 to t. The
net equity issued (repurchased) is the ratio of the positive (negative) change in book
equity less the change in retained earnings to the book value of total assets. The net
debt issued (retired) is defined as the positive (negative) change in total assets to total
assets less the sum of net equity issued and newly retained earnings divided by total
assets. Firms are defined as issuing (repurchasing) a security if the net amount of
issued (repurchased) is equal to or greater than 5 percent of the book value of total
assets. The net external capital issued (retired) is the sum of net equity and net debt
issued (repurchased). Firms are defined as issuing (repurchasing) external capital
when the net amount of issued (repurchased) is equal to or greater than 5 percent of the
book value of total assets[2].

2.3 Defining variables

Following prior studies including Kayhan and Titman (2007), Huang and Ritter (2009),
and Caglayan and Rashid (2013), book leverage is the ratio of the book value of total
debt to the book value of total assets. The market-to-book value is equal to total book
assets less book value of equity plus market value of equity divided by total book
assets. The two-year stock returns are defined as the difference between share prices at
time t and share prices at time t 2 2. Profitability is the ratio of earnings before
interest, taxes and depreciation to total assets. Tangible assets ratio is defined as
(net plant, property, and equipment)/total assets. Firm size is the log of net sales
normalized by consumer price index (CPI).
Following Leary and Roberts (2010) and Lemmon et al. (2008), the Z-score is
measured as (3.3*pre-tax income 1.0*sales 1.4*retained earnings 1.2*(current
assets 2 current liabilities))/total assets. Following Kayhan and Titman (2007) and
Byoun (2008), financial deficits are defined as follows:

FinancialDeficit it Investment it DWorkingCapital it Dividendsit 2 CashFlowit 1

The negative value of FinancialDeficitit implies a financial surplus (i.e. the firm invests
less than it internally generates cash). The positive value of FinancialDeficitit implies a
financial deficit (i.e. the firm invests more than it internally generates cash). To examine
the asymmetric effects of financing gaps, we separate the negative and positive values
of financial deficit variable. The financing deficit (surplus) is defined as the total
financing deficit (surplus) interacted with a dummy variable that takes the value 1
when the financing deficit is positive (negative) and 0 otherwise.

2.4 Generating risk proxies

Various statistical methods, such as moving standard deviations, autoregressive (AR)
specifications, ARCH/GARCH modelling, stochastic volatility models, and
survey-based methods, have been used in the literature to generate measures of risk.
For example, Driver et al. (2005) and Baum et al. (2009) use the conditional variance
obtained from the estimation of GARCH specifications for manufacturing output and Firm external
the index of leading macroeconomic indicators, respectively, to gauge macroeconomic financing
uncertainty. Analogously, Aizenman and Marion (1999) also utilize the conditional
variance obtained by estimating a GARCH model for government expenditure, the decisions
nominal money supply, and the real exchange rate to construct a proxy for
macroeconomic risk. However, Caglayan and Rashid (2013) and Rashid (2013) use the
conditional variance by estimating an ARCH model for quarterly real UK GDP to 101
generate a proxy for macroeconomic risk. Ghosal and Loungani (2000) use the moving
standard deviation of the federal funds rate (FFR) and energy prices as a proxy for
macroeconomic risks. Kaufmann et al. (2005) and Graham and Harvey (2001) use
survey-based methods based on the dispersion of forecast to proxy macroeconomic risk.
We estimate an ARCH model for seasonally adjusted quarterly real GDP over the
period 1975-2009 to generate a proxy for macroeconomic risk[3]. The quarterly
conditional variance obtained from the ARCH estimation is annualized by taking a
four-quarter average and used as a proxy for macroeconomic risk in our empirical
analysis. The estimated coefficient of the ARCH term (0.781) is less than one and
appears statistically significant. The diagnostic test statistics indicate that there are no
remaining ARCH effects left in the standardized residuals[4].
To generate a measure of idiosyncratic risk, following Bo (2002), Cagayan and
Rashid (2013), and Rashid (2011, 2013), we first estimate an autoregressive (AR) order
one model for each firm over the period under investigation. Next, for each firm, we store
one-period-ahead residuals (errors) from the estimated model. Finally, we compute the
recursive variance of the residuals using a one-year window for each firm included in the
sample over the examined period. The square root of the estimated recursive variance is
then used as a proxy for idiosyncratic risk. To examine the interdependence between
firm-specific and macroeconomic risk, we estimate the correlation between the two. The
coefficient of correlation (0.02) is very small and not statistically different from zero,
suggesting that both forms of risk are independent and cover a different aspect of the
risk faced by firms.

3. Theoretical backgrounds and prior empirical evidence

Under the tax shelter-bankruptcy cost (TS-BC) hypothesis of the trade-off theory of
capital structure, firm leverage is likely to be negatively affected by an increase in
firm-level risk (Castanias, 1983). Given positive costs of bankruptcy and given that
debt increases the probability of bankruptcy, risky firms are prone to decline the use of
debt in their capital structure. Firms do so to reduce the likelihood of financial distress.
Along the same lines, Bradley et al. (1984) present a single period corporate capital
structure model and show the presence of an inverse relation between a firms optimal
level of debt and its earnings volatility. Likewise, Brealey and Myers (1981) argue that
financial distress is costly regardless of the presence or the absence of bankruptcy
costs. Firms therefore generally have a tendency to repress the probability of distress;
hence, risky firms use less debt in their capital structure than the others.
Empirically, several earlier studies including Baxter (1967), Ferri and Jones (1979),
Friend and Lang (1988), Titman and Wessels (1988), Crutchley and Hansen (1989), and
MacKie-Mason (1990) have provided evidence of a negative impact of cash
flow/earnings volatility on firms leverage decisions. Recent empirical studies also
document negative effects of firm-specific risk. Specifically, Baum et al. (2009) find that
MF idiosyncratic risk has a significant and negative effect on the optimal short-term
40,1 leverage for US firms. Similarly, Antoniou et al. (2008) and Lemmon et al. (2008) show
that the leverage decisions of firms are negatively related to firm-specific risk. More
recently, Caglayan and Rashid (2013) also present evidence of a significant and
negative impact of idiosyncratic risk on the leverage decisions of both UK public and
non-public manufacturing firms.
102 On the flip side, Myers (1977) predicts a positive relation of target leverage with
firm-specific risk. In this regard, Myers argues that higher business risk may cause to
decline the debt-related agency costs and thus, it, in turn, may induce firms to increase the
use of debt. Some empirical studies, such as Toy et al. (1974), Jaffe and Westerfield (1987),
Kim and Sorensen (1986), Chu et al. (1992), and Michaelas et al. (1999) confirm the Myers
predictions, providing evidence of positive effects of firm-specific risk on leverage.
Moreover, Mueller (2008) provides evidence that firms exposures to firm-specific risk
increasing the cost of equity capital make debt financing more attractive. Thus, firms
increase their leverage when they experience variations in their earnings.
Unlike the firm-specific risk, the existing theories of capital structure do not lay
greater stress on how firm capital structure relates to unpredictable variations in
macroeconomic conditions. Gertler and Hubbard (1993) argue that in spite of the fact
that firms can mitigate the adverse effects of firm-specific risks, they are not able to
overcome macroeconomic risk exposures. Therefore, firms have tendency to prefer
equity financing to debt in order to share at least some of the business-cycle risk with
their outside investors when they face higher macroeconomic risk. However, recent
theoretical studies, such as Hackbarth et al. (2006), Levy and Hennessy (2007),
Baum et al. (2009) Bhamra et al. (2010), and Chen (2010), posit that macroeconomic
fluctuations have a significant impact on firms financing decisions. In particular,
Baum et al. (2009) develop a dynamic partial equilibrium model of a firms optimal
target leverage based on the standard Q model of investment and predict a negative
relationship between macroeconomic uncertainty and debt/assets ratio. Bhamra et al.
(2010) and Chen (2010) use a dynamic capital structure framework and show that firms
financing policies are significantly related to variations in macroeconomic conditions.
Empirical evidence concerning the effects of macroeconomic risk on firms capital
structure is also limited. Only few studies have empirically examined the effects of
macroeconomic risk on leverage decisions (Hatzinikolaou et al., 2002; Baum et al., 2009;
Caglayan and Rashid, 2013). A common finding emerging from these studies is that
macroeconomic risk has a negative impact on firm leverage.
Overall, the literature review reveals that empirical findings on the effect of
firm-specific risk on leverage are inconclusive. Further, prior studies estimating the
effect of risk on capital structure have mainly emphasized on relating the target
leverage to risk. This paper differs significantly from these studies as it examines the
effects of firm-specific and macroeconomic risk on firms decisions to issue and pay off
external capital and the choice of firms between bank borrowing and equity financing.
To the best of my knowledge, none of the existing study examines the effects of risk on
corporate capital structure in this spirit.

4. Estimation process
In order to estimate the effects of risk related to firms own business activities and
macroeconomic conditions on firms target leverage, we follow previous studies of
capital structure that study the determinants of firm leverage and model the effects of Firm external
risk on leverage as follows: financing
Leverageit a X it21 b Qit21 c mit 2 decisions
where Leverageit is the ratio of the book value of total debt to the book value of total
assets. Xit is a vector of firm-specific explanatory variables, which includes
market-to-book value, stock return, profitability, tangibility, firm size, Z-score,
103
financial surplus and deficit, and industry leverage. Qit is a vector of risk proxies, which
includes time-varying idiosyncratic (firm-specific) risk and time-varying
macroeconomic risk. mit is white-noise error term.
After estimating the target level of leverage for each firm included in the sample, we
examine how risk affects firms external capital issuance and retirement decisions[5].
Specifically, a multinomial regression model is estimated in the following form:

C*it a Z it21 b Qit21 c hit 3

The dependent variable, C*it , in equation (3) is a latent variable, which measures the
propensity to issue new external capital or to retire existing external capital versus no
action for firm i in year t. The observable counter part of C*it , Cit, is set to 1 for
observations where firms issue new external capital, to 2 for observations where firms
act to retire existing external capital, and 0 otherwise, the base case where firms neither
issue nor retire external capital (no action case). Here, Zit is a vector of firm-specific
variables, while Qit is a vector of risk measures: the time-varying firm-specific risk and
the time-varying macroeconomic risk. hit is white-noise error term[6]. The model is
estimated using full-information maximum likelihood approach. In all regressions,
standard errors are corrected for the presence of heteroskedasticity across firms and
serial correlation across firm-year observations for a given firm.

5. Regression results
5.1 Determinants of target leverage: the role of risk
Table I presents three sets of results from ordinary least square approach where
standard errors are adjusted for clustering heteroskedasticity across firms on pooled
firm-year observations. The first set of results is based on the results obtained for the full
sample. Focusing first on the role of risks we observe that both types of risk measures
exert a negative impact on firms target leverage. The negative response of the target
leverage to firm-specific risk is in line with the fact that risky firms are likely to reduce
the use of debt in their capital structure and thus, their target leverage ratio declines.
Alternatively, given that the probability of default increases with firm-level risk, it is
likely that banks and other lending institutes may hesitate to lend risky firms. Hence,
firms with high business risk would not be able to raise sufficient external funds and,
thus, they may have to use either internally generated funds or issue equity, which, in
both cases, would result in a decline in target leverage. Another rationale for this inverse
relationship between leverage and firm-specific risk is that high firm-specific risk,
the vulnerability of expected cash flows, makes firms uncertain to fully harvest the
tax-shield benefits associated with interest payments and, therefore, increases the
expected costs of bankruptcy. Thus, risky firms are likely to reduce the level of debt in
their capital structure[7].
MF
All firms Active firms Passive firms
40,1 Regressors Coefficient SE Coefficient SE Coefficient SE

Market-to-book value 20.016 * * * 0.003 20.015 * * * 0.004 20.019 * * * 0.003

Stock returns 20.015 * * * 0.002 20.014 * * * 0.003 20.018 * * * 0.004
Profitability 20.532 * * * 0.060 20.402 * * * 0.070 20.705 * * * 0.038
104 Tangible assets 0.166 * * * 0.020 0.130 * * * 0.023 0.195 * * * 0.019
Firm size 0.021 * * * 0.001 0.020 * * * 0.002 0.018 * * * 0.001
Z-score 20.147 * * * 0.017 20.114 * * * 0.020 20.202 * * * 0.008
Financing surplus 0.001 0.033 0.007 0.036 0.054 0.044
Financing deficit 0.114 * * * 0.023 0.099 * * * 0.026 0.189 * * * 0.035
Industry leverage 0.345 * * * 0.051 0.371 * * * 0.055 0.272 * * * 0.053
Firm-specific risk 20.027 * * 0.011 20.028 * * 0.013 20.034 * * 0.014
Macroeconomic risk 20.006 * * * 0.001 20.007 * * * 0.001 20.003 * * * 0.001
R2 0.506 0.404 0.686
Observations 8,809 5,414 3,395
Notes: Significantly different from zero at: *10, * *5, and * * *1 percent levels; this table reports the
results for the determinants of target leverage; the market-to-book value is defined as total book assets
less book value of equity plus market value of equity divided by total book assets; the two-year stock
returns are the difference between share prices at time t and share prices at times t 2 2; profitability is
the ratio of earnings before interest, taxes, and depreciation to total assets; tangible assets ratio is
defined as (net plant, property, and equipment)/total assets; firm size is the log of net sales normalized
by CPI; firm-specific risk is drawn from sales of firms; the Z-score is measured as (3.3*pre-tax
income 1.0*sales 1.4*retained earnings 1.2*(current assets 2 current liabilities))/total assets;
the financing deficit is the ratio of (the change in working capital plus investment expenditure plus
dividends less net cash flows) to the book value of total assets; the financing deficit (surplus) is defined
as the total financing deficit (surplus) interacted with a dummy variable that takes the value 1 when
financing deficit is positive (negative) and 0 otherwise; industry leverage is the mean of industry
leverage; firm-specific risk is drawn from sales of firms; macroeconomic risk is proxied by the
conditional variance of UK real GDP over the period under investigation; all regressors are lagged one
Table I. period; business cycle and industry-specific effects are accounted for via year-specific and industry-
Determinants of target specific intercepts (not reported), respectively; the sample consists of listed UK manufacturing firms
leverage over the period 1981-2009; the date source is the Datastream database

The coefficient estimate for macroeconomic risk also reflects that during uncertain
states of the economy, firms are likely to reduce their target leverage ratio. This
negative estimate is in line with the fact that during uncertain times, firms are likely to
be more cautious about bankruptcy and thus, they reduce their use of debt financing as
the higher the level of outstanding debt, the higher the likelihood of bankruptcy. This
finding is also in support of the idea that since debt makes firms more exposed to
macroeconomic risk; firms tend to have less debt in their capital structure during
unstable and uncertain state of the economy. A possible explanation for this finding is
that more uncertain macroeconomic environment may deteriorate the potential cash
flows of firms, which increases the costs of financial distress, which deters firms to use
debt in their capital structure. In times of high macroeconomic risk, therefore, firms
tend to decline their debt/assets (leverage) ratios[8].
When estimating the effects of risk on firm leverage we include several firm-specific
explanatory variables into the specification. The estimates of these variables suggest
that the leverage of firms increases with tangibility, firm size, financial deficits, and the
industry mean leverage. However, the estimates indicate that firms target leverage Firm external
declines in response to an increase in the market-to-book value, stock returns, financing
profitability, and firms financial soundness. The negative estimate of profitability is
consistent with the pecking order theory. Costs that arise due to asymmetric decisions
information problems cause firms to use internal funds (retained earnings) rather than
external financing. Thus, firms with high profitability have tendency to use less debt in
their capital structure. The positive coefficient on financial deficits provides support to 105
the view that firms tend to prefer debt over equity financing when they seek external
sources to finance financial deficits (Shyam-Sunder and Myers, 1999).
Regarding firm size we observe a significant and positive coefficient. This is
reasonable as large firms are less likely to face debt-related agency costs. Further, an
increase in firm size may lead to lower default risk as a percentage of total assets or
total debt. Hence, larger firms have tendency to have higher target leverage. The
inverse relation between leverage and stock returns confirms the prediction of pecking
order theory that firms are likely to issue net equity when their share are overvalued.
The results also suggest that tangibility affects target leverage positively. The
positive impact on firm leverage of the firms tangibility is rationalized in line with the
trade-off theory. Firms with higher tangibility are well collateralized and risk of
lending to them is lower, and thus, they can do easily debt financing. In addition,
tangibility reduces the chance for shareholders to engage in substitution of high-risk
assets with low-risky ones and hence results in lower agency costs. Lower debt-related
agency costs prompt firms to borrow more, suggesting a positive relation of leverage
with the tangibility of assets.
Finally, the estimates reveal that there is a negative impact of market-to book value
on target leverage, which is consistent with predictions of the trade-off theory.
Specifically, the trade-off theory posits that growth lowers free cash flow problems,
exacerbates debt-related agency problems, and increases costs of financial distress,
which forcing firms to use less debt in their capital structure.
Table I also reports the results for a sample of active firms (firms that issue or pay
off their external financing) and for a sample of passive firms (firms that neither issue
new securities nor repurchase the existing ones). This set of results is presented to
ensure that the negative effects of risk on firm leverage that we documented here are
not driven by the group of firms that actively involved in issuing and repurchasing
securities. The coefficient of both types of risk are negative and statistically significant,
indicating that the target leverage of firms is negatively related to firm-specific risk
and variation in macroeconomic conditions regardless of whether firms are involved in
the issuance and repurchase of securities or not. This piece of evidence suggests that
passive firms decline their leverage by increasing the use of internally generated funds
when they experience firm-specific and macroeconomic risk. The results related to
other firm-specific variables are also remaining unchanged in terms of both their signs
and statistical significance across these two groups of firms.

5.2 Effects of risk on firms financing decisions/choices

5.2.1 Risk affecting decisions to issue or retire external capital. To examine the impact of
risk on the issuance and retirement of external capital, we model the firms external
financing decisions in a multinomial logit framework, as equation (3) depicts[9]. Firms
that neither issue nor retire securities are used as the base alternative in all multinomial
MF logit regressions. For each regression, standard errors are adjusted for clustering and
40,1 heteroskedasticity across individual firms. To gauge economic significance, we also
report the change in probability of the underlying alternative (e.g. capital issuance)
versus the base alternative (hereafter DProb.) for each explanatory variable. We
compute DProb. for a given explanatory variable by changing the particular variable
from 2 1 standard deviation to 1 standard deviation around its sample mean value,
106 holding all other explanatory variables fixed at their respective mean values.
Table II presents the results[10]. The estimates indicate that both types of risk
significantly affect firms external capital issuance and repurchase decisions.
In particular, the results indicate that firm-specific risk appears with a positive sign
in both the issuance and repurchase of external capital regressions. This suggests that
firms are more likely to engage in altering their capital structure by issuing and
retiring external capital when they face high idiosyncratic risk. Firms managers do
this perhaps to correct the deviations from the target capital structure or to attain a
particular capital structure, which may provide shield against the unfavorable effects
of unexpected variations in their earnings.
The positive relation of firm-specific risk with the likelihood of the issuance of new
external capital is consistent with the idea that firms with high variation in their
expected cash flow stream are likely to rely more on external resources to financing
their capital needs than firms that are relatively certain about their potential cash flow
stream. However, one should note that although the probability of both issuing and
retiring external capital increases with firm-specific risk, the change in probability is
larger for the former than the later case. This implies that the sensitively of the firms
decision to raise new external capital to firm-level risk is higher than the sensitively of
the firms decision to retire the existing external capital.
The estimates related to macroeconomic risk effects indicate that while firms
probability of issuing new external capital decreases, the probability of retiring external
capital increases with a rise in macroeconomic volatility. The negative and statistically
significant estimated coefficient for the issuance of external capital implies that the
probability of issuing external capital is lower relative to the probability of doing
nothing in times when the overall macroeconomic environment is uncertain. In other
words, in times of high macroeconomic risk, firms are less likely to issue external
finance. In contrast to this, the coefficient of macroeconomic risk appears statistically
significant with a positive sign for firms capital retirement decisions, implying that
firms are more likely to pay off their external capital when macroeconomic conditions
are uncertain. These observations suggest that firms have a smaller tendency to finance
their needs through external resources when the overall macroeconomic conditions are
more volatile. That is, firms appear to design passive financing policies during a
unstable and uncertain state of the economy.
Looking at the economic significance of macroeconomic risk, we find that the
change in probability in response to a two-standard-deviation change in the extent of
risk is considerably higher in the issuance decision (DProb. 2 3.3 percent) than in
the reduction decision (DProb. 2.5 percent). However, comparing the economic
significance of risk across firms financing decisions one can see that the economic
effects of both types of risk are more profound in the issuance decisions. Overall, the
estimates on the effects of risk suggest that firms take into consideration both
 Firm external
Issue versus no action Retire versus no action
Regressors Coefficient SE DProb. Coefficient SE DProb. financing
Leverage deficit 0.609 * * * 0.233 0.051 22.517 * * * 0.365 2 0.339
decisions
Market-to-book value 0.243 * * * 0.036 0.064 20.210 * * 0.055 2 0.036
Stock returns 0.216 * * * 0.041 0.068 20.261 * * * 0.047 2 0.056
Profitability 20.137 0.244 20.084 0.708 * * * 0.273 0.119 107
Tangible assets 20.361 * * * 0.151 20.008 21.189 * * * 0.153 2 0.155
Firm size 0.027 * * 0.014 0.002 0.053 * * * 0.016 0.006
Z-score 20.004 0.032 20.019 20.270 * * * 0.047 2 0.041
Financing deficit 0.959 * * * 0.328 0.145 0.955 * * * 0.361 0.074
Financing surplus 21.694 * * 0.504 20.035 21.600 * * * 0.536 2 0.193
Issue size 0.530 * * * 0.174 0.144 20.318 * * 0.167 2 0.089
Industry leverage 2.072 * * * 0.458 0.357 1.485 * * * 0.523 0.072
Firm-specific risk 0.478 * * * 0.154 0.063 0.595 * * * 0.193 0.055
Macroeconomic risk 20.140 * * * 0.023 20.033 0.125 * * * 0.023 0.025
Pseudo-R 2 0.052
Observations 7,737
Notes: Significantly different from zero at: *10, * *5, and * * *1 percent levels; this table reports the
results of multinomial logit models; standard errors are corrected for the presence of heteroskedasticity
across firms and serial correlation across firm-year observations for a given firm; the net equity issued
(repurchased) is the ratio of the positive (negative) change in book equity less the change in retained
earnings to book value of total assets; the net debt issued (retired) is defined as the positive (negative)
change in total assets to total assets less the sum of net equity issued and newly retained earnings/total
assets; the net external capital issued (retired) is the sum of net equity and net debt issued (repurchased);
firms are defined as issuing (repurchasing) external capital when the net amount of issued (repurchased)
is equal to or greater than 5 percent of the book value of total assets; the leverage deficit is the target
leverage minus actual leverage ratio, where the target leverage is estimated leverage ratio using firm-
specific determinants and risk measures as specified in equation (2); the market-to-book value is defined
as total book assets less the book value of equity plus the market value of equity divided by total book
assets; the two-year stock return is defined as the difference between share prices at time t and share
prices at time t 2 2; profitability is the ratio of earnings before interest, taxes, and depreciation to total
assets; tangible assets ratio is defined as (net plant, property, and equipment)/total assets; firm size is the
log of total book assets; the Z-score is measured as (3.3*pre-tax income 1.0*sales 1.4*retained
earnings 1.2*(current assets 2 current liabilities))/total assets; the issue size is the net external
capital issued; the financing deficit is the ratio of (change in working capital plus investment
expenditure plus dividends less net cash flows) to book value of total assets; the financing deficit
(surplus) is defined as the total financing deficit (surplus) interacted with a dummy variable that takes
the value 1 when financing deficit is positive (negative) and 0 otherwise; industry leverage is the mean of
industry leverage; firm-specific risk is drawn from sales of firm; macroeconomic risk is proxied by the
conditional variance of UK real GDP over the period under investigation; all regressors are lagged one Table II.
period; business cycle and industry-specific effects are accounted for via year-specific and industry- Risk and the decision
specific intercepts (not reported), respectively; the sample consists of listed UK manufacturing firms to raise or retire
over the period 1981-2009; the date source is the Datastream database external capital

firm-specific risk and the vulnerability of macroeconomic environment while deciding

to raise new external capital or to reduce the existing external capital.
The comparison of the effects of both types of risk shows that an increase in
firm-specific risk increases the likelihood of issuing external capital, while an increase
in macroeconomic risk reduces the probability of going for external financing. Yet,
firms are more likely to retire their external capital in response to an increase in either
MF types of risk. These differential effects are explained as follows. The positive relation of
40,1 the propensity to issue external finance with firm-specific risk is perhaps due to as
banks find advantages to rollover a firms debts with new terms and conditions when
the firm faces high variability in its own internal cash flows rather than let the firm to
go for bankruptcy. Alternatively, in times of high variation in firms business activity
firms may prefer to issue equity to bring down their leverage ratio instead of paying
108 down debt as high leverage ratio exposes them to risk, which results in an increase in
their overall external capital. However, the overall uncertain macroeconomic
environment makes external financing relatively costly by deteriorating the market
value of equity and increasing the risk premium demanded by the outside lenders.
Thus, firms issue less external capital when macroeconomic risk is high.
Turning to the effects of firm-specific determinants of external financing, we
observe that the results are generally consistent with prior studies that examine the
determinants of capital issuance and reduction. Therefore, we briefly discuss some
observations. Consistent with the target adjustment hypothesis, firms are likely to
increase their external financing when they are under-levered relative to the target
leverage, while firms are prone to retire external financing when they are over-levered
relative to their targets.
Firms with high market-to-book values and stock returns are more (less) likely to
issue (retire) external capital. Comparing the economic significance of stock returns
and the market-to-book value ratio, one can see that both variables are more important
in the decision to issue external capital than to retire external capital. Holding all other
explanatory variables fixed at their means, if stock returns and the market-to-book
value are increased from 1 standard deviation below to 1 standard deviation above
their mean value, the probability of issuing external capital versus no action increases
by 6.8 and 6.4 percent, respectively, whereas, the probability of repurchasing external
capital decreases by 5.6 and 3.6 percent, respectively.
The probability of the reduction in external financing versus do nothing is
positively linked with profitability, suggesting that more profitable firms are more
likely to pay back their external financing. In contrast, the impact of profitability on the
likelihood of the issuance of capital is negative but it is statistically insignificant. Yet,
the economic effects of profitability are higher for the reduction decision than for the
issuance decision.
Consistent with the view that large firms are less likely to incur costs of financial
distress and bankruptcy, firm size takes positive and statistically significant
coefficient in issuance regression. This finding suggests that the larger firms are more
likely to raise external capital. The results also suggest that the probability of retiring
external capital relative to the base case increases with firm size. This observation is
consistent with the fact that large firms tend to enjoy economies of scale in cash
management and thus, they are more likely to pay down their indebtedness to outside
lenders. While the proxy for firms financial health (Z-score) does appear statistically
insignificant in the issuance decisions, the propensity to repurchase existing external
capital versus do nothing is significantly less for financially strong firms.
Consistent with the views of Shyam-Sunder and Myers (1999), firms are more likely
to finance their capital needs by issuing external capital when they have a financing
deficit, suggesting that firms only access external capital market when they need
external finance. This finding is also consistent with Brav (2009), who also empirically
shows that firms have a larger propensity to raise capital when they face a financial Firm external
deficit. On the other hand, the coefficient estimate for the negative financing deficit (the financing
financing surplus) is significantly negative in both the issuance and reduction
regressions. This suggests that firms with a financing surplus are not only less likely decisions
to issue external capital, but also less likely to retire existing external capital. This
implies that firms with excess cash flows may prefer to hold cash in hand rather than
to use it to reduce external capital. Further, issue size seems to affect firms decisions to 109
issue (retire) external capital positively (negatively), while the effects of industry mean
leverage are significantly positive for both the issuance and retirement decisions.
These results are generally consistent with Hovakimian et al. (2004).

5.3 Effects of risk on firms debt-equity choice

In order to examine the effect of risk on the choice of financial instruments, we estimate
two probit regressions. We use equity issuers as the base alternative in the issuance
regression and equity repurchasers as the base alternative in the repurchase
regression. A firm is considered as issuing (repurchasing) a securing for a particular
year when the net amount of issued (repurchased) is equal to or greater than 5 percent
of the book value of total assets for a given firm and year. We exclude the cases
wherein the firm issues both debt and equity (dual issues) because such instances
cannot be classified as either a debt issuance or an equity issuance. Since the dual
issuance is only 9 percent of all capital issues in our sample, we do not think that this
exclusion can raise the possibility of bias selection of the sample.
Table III presents the results of two probit regressions for the choice between debt
and equity. In particular, the first regression quantifies the effect of risk on firms
propensity to issue new debt relative to issue new equity. The second regression
quantifies the effect of risk on firms, propensity to retire existing debt relative to
repurchase existing equity. We use the same set of firm-specific variables to control for
firm-specific effects in both the issuance and repurchase regressions. To gauge the
relative economic significance of both types of risk and other firm-specific explanatory
variables, we compute changes in the probability of issuing debt versus equity and
changes in the probability of retiring debt versus equity.
The results for risk measures are as follows. First, consistent with our prediction,
the coefficient estimate for firm-specific risk is significantly negative in the debt versus
equity issue regression. This suggests that the more risky the firm, the less likely the
firm will issue new debt. This result supports the view that risky firms are more likely
to finance their capital needs via new equity issues rather than by new debt issues to
avoid the high-risk premium and to limit the likelihood of bankruptcy. On the other
hand, the coefficient of firm-specific risk has a positive sign in debt versus equity
repurchase regression. This suggests that firms propensity to retire debt relative to
repurchase existing equity is relatively higher when firm-specific risk is high.
Collectively, one could consider these findings as being in line with the TS-BC
hypothesis, which states that given positive costs of bankruptcy, risky firms tend to
reduce the level of debt in their capital structure.
Observing the economic significance we find that firm-specific risk has a more
important role to play in the choice of issuing debt versus equity than the repurchasing
choice. For example, if firm-specific risk increases by one standard deviation above its
mean while all other explanatory variables remain unchanged at their respective
MF
Issue versus no action Retire versus no action
40,1 Regressors Coefficient SE DProb. Coefficient SE DProb.

Leverage deficit 1.275 * * * 0.337 0.144 21.835 * * * 0.383 2 0.272

Market-to-book value 20.077 * * 0.038 2 0.009 20.072 * * 0.034 2 0.011
Stock returns 0.162 * * * 0.049 0.018 0.001 0.075 0.000
110 Profitability 0.515 * * 0.254 0.058 20.256 0.284 2 0.038
Tangible assets 0.336 * * 0.138 0.038 0.069 0.224 0.010
Firm size 0.077 * * * 0.018 0.008 0.037 * * 0.019 0.005
Z-score 0.204 * * * 0.045 0.023 0.054 0.052 0.008
Financing deficit 0.565 * * 0.280 0.064 1.751 * * * 0.536 0.260
Financing surplus 0.139 0.440 0.015 21.900 * * * 0.781 2 0.282
Issue size 0.213 0.150 0.024 0.193 0.157 0.029
Industry leverage 1.020 * * 0.452 0.115 1.328 * * * 0.477 0.197
Firm-specific risk 20.054 * * 0.024 2 0.061 0.042 * * * 0.013 0.023
Macroeconomic risk 20.017 * * * 0.003 2 0.019 0.075 * * * 0.012 0.055
Pseudo-R 2 0.175 0.064
Observations 2,749 1,735
Notes: Significantly different from zero at: *10, * *5, and * * *1 percent levels; this table reports the
results estimated from probit models; standard errors are corrected for the presence of
heteroskedasticity across firms and serial correlation across firm-year observations for a given firm;
firms are defined as issuing (repurchasing) a security if the net amount of issued (repurchased) is equal
to or greater than 5 percent of the book value of total assets; the leverage deficit is the target leverage
minus actual leverage ratio, where the target leverage is estimated leverage ratio using firm-specific
determinants and risk measures as specified in equation (2); the market-to-book value is defined as total
book assets less the book value of equity plus the market value of equity divided by total book assets;
the two-year stock returns are defined as the difference between share prices at time t and share prices at
time t 2 2; profitability is the ratio of earnings before interest, taxes, and depreciation to total assets;
tangible assets ratio is defined as (net plant, property, and equipment)/total assets; firm size is the log of
net sales normalized by CPI; the Z-score is measured as (3.3*pre-tax income 1.0*sales 1.4*retained
earnings 1.2*(current assets 2 current liabilities))/total assets; the issue size is the net external
capital issued; the financing deficit is the ratio of (change in working capital plus investment
expenditure plus dividends less net cash flows) to book value of total assets; the financing deficit
(surplus) is defined as the total financing deficit (surplus) interacted with a dummy variable that takes
the value 1 when financing deficit is positive (negative) and 0 otherwise; industry leverage is the mean of
industry leverage; firm-specific risk is drawn from sales of firm; macroeconomic risk is proxied by the
conditional variance of UK real GDP over the period under investigation; all regressors are lagged one
Table III. period; business cycle and industry-specific effects are accounted for via year-specific and industry-
Risk and the debt-equity specific intercepts (not reported), respectively; the sample consists of listed UK manufacturing firms
choice over the period 1981-2009; the date source is the Datastream database

means, the propensity to retire existing debt versus to repurchase existing equity
increases by only 2.3 percent, whereas, the propensity to issue new debt versus equity
decreases by 6.1 percent.
With respect to the effect of macroeconomic risk, the results indicate that the odds
ratio of issuance of debt relative to the issuance decision for equity turns out to be
negatively related to the volatility of the macroeconomic environment. This suggests
that in periods when the overall macroeconomic environment is uncertain, firms are
less likely to issue debt relative to the base case of equity issues. In debt-equity
repurchase regression, the coefficient estimate for macroeconomic risk is positive and
statistically significant, indicating that firms are more likely to retire debt than Firm external
repurchase equity in periods when macroeconomic conditions are uncertain. Since financing
firms cannot mitigate the risk associated with overall macroeconomic activities, they
prefer the issuance of equity over debt financing to share, at least some, macroeconomic decisions
level risk with their outside lenders. In contrast, when firms act to reduce overall
external finance they are more likely to reduce their outstanding debts relative to equity
as high levels of debt make firms more exposed to aggregate risk. These observations, 111
on the whole, suggest that firms tend to reduce their target leverage in periods when
macroeconomic conditions exhibit unpredictable variations.
Overall, the results suggest that the economic effect of macroeconomic risk is larger
for firms choice between debt and equity repurchases as compared to firms choice
between debt and equity issues. The probability of retiring debt relative to equity
increases by 5.5 percent, while the probability of issuing debt relative to equity
decreases by 1.9 percent when macroeconomic risk increases by one standard deviation
below its mean to its value at the one standard deviation above its mean, holding all
other explanatory variables constant at their means. Comparing the economic effects of
both types of risk, one can see that relative to the impact of firm-specific risk, the effects
of macroeconomic risk are of secondary importance in the choice of debt and equity
issuing. However, when firms have to make a choice between debt reduction and equity
repurchase the economic significance of macroeconomic risk is higher than that of
firm-specific risk.
Other results in Table III are generally consistent with those presented in the
literature on corporate security issuance decisions[11]. The estimated coefficient
estimates for leverage deficit variable are statisticant and have expected signs in both
the issuance and repurchase regressions. Specifically, the coefficient of leverage deficit
is positive and statistically significant in the issuance regression, suggesting that
firms whose leverage deviates from the estimated target leverage ratio are more likely
to issue debt relative to equity. In the repurchase regression, the coefficient estimate
for leverage deficit is negative and statistically significant. This implies that the
deviation of observed leverage from the target leverage renders firms unwilling to
retire debt relative to repurchasing equity.
The market-to-book value enters with a negative sign in both debt-equity issuance
and reduction regressions. This implies that the probability of both issuing and retiring
debt versus equity is less for high-growth firms. These observations are in support of
hypothesis that growing firms are more likely to issue equity relative to debt. Profitable
firms are more likely to choose debt rather than equity while financing their capital
needs from external resources. This finding is in line with the target adjustment
hypothesis of the static trade-off theory, which states that the more profitable the firm,
the more likely the firm will issue debt versus equity.
Firms having more proportion of tangible assets relative to total assets are more
likely to issue new debt relative to equity. With respective to firm size, the estimated
coefficients suggest that large firms are more likely not only to issue debt but also to
retire debt as compared to equity. Both firm size and the asset tangibility seem
economically more important for the debt versus equity issue choice than for the debt
versus equity repurchase choice. The coefficient estimates for industry leverage suggest
that firms belong to high-levered industry are likely to choose debt rather than equity
when deciding on the issuance and repurchase securities.
MF The Z-score has a positive and significant impact on the debt-equity issue choice.
40,1 This suggests that firms facing a low probability of bankruptcy are more prone to
issue new debt than equity. Consistent with the pecking order theory of capital
structure, the coefficient estimate for financial deficit variable is positive and
statistically significant in debt versus equity issuance regression. We also find that
firms with financial deficits are also more likely to retire their debt relative to equity.
112 Firms doing so might tend to avoid fixed interest payments.

6. Conclusions
This paper focusing on the role of firm-specific and macroeconomic risk examines
external capital issuance and repurchase decisions as well as debt versus equity issues
and repurchases choices of UK manufacturing firms over the 1981-2009 period. Empirical
investigation shows that firms target leverage is negatively related to both firm-specific
and macroeconomic risk, even after controlling for several firm-specific effects. This
finding implies that firms are likely to have low leverage target in periods of high risk.
The results from multinomial logit models suggest that both firm-specific and
macroeconomic risks are significantly linked with the issuance and retirement
decisions of firms. Specifically, it turns out that the likelihood of both issuing and
retiring external financing is higher when firms face a greater volatility in their
earnings. Regarding the effects of macroeconomic risk, the results indicate that
propensity to issue external financing decreases when the risk is high, while the
propensity to retire existing external financing increases with macroeconomic risk.
Further, we find that the economic importance of the effects of both types of risk is
higher for the issuance of new external capital than for the retirement of existing
external capital. The results also suggest that there is a higher probability of raising
additional external financing for large firms, firms with high market-to-book ratios,
stock returns, and financing deficits, and for firms that raise external financing by
large amounts. On the other hand, the likelihood of issuing external capital is low for
firms having financing surpluses and more tangible assets relative to their total assets.
Finally, the paper provides evidence that firms preferences for debt versus equity
issues and repurchases are significantly influenced by both firm-specific and
macroeconomic risk. The propensity to issue debt relative to issue equity declines with
increases in risk regardless of the type of risk. The analysis also suggests that firms
are more likely to purchase debt instead equity in periods when they experience risks,
and thus, they in turn reduce their leverage ratios.
The findings of the paper help firm managers in making sound financing decisions,
having value maximization in mind. They are also useful for authorities in designing
effective fiscal and monetary policies to stabilize macroeconomic conditions.
In particular, the results presented in this paper suggest that stability in both firms
earnings (sales) and the overall macroeconomic environment is of significance to the
stability of firms capital structure, which would subsequently be conducive to stability
in their investments and production.

Notes
1. Firms that actively engage in issuance and retirement of external capital are categorized as
active firms, whereas, firms that neither issue new securities nor repurchase the existing
ones are referred as passive firms (denoted by no action).
 2. Prior studies, such as Hovakimian et al. (2001), Chen and Zhao (2003), Korajczyk and Levy Firm external
(2003), Leary and Roberts (2005), Hovakimian (2006), Huang and Ritter (2009), Brav (2009),
and Leary and Roberts (2010), also have identified debt and equity issuance in similar ways. financing
3. Although the sample period for this paper starts from 1981, following Baum et al. (2009), decisions
Caglayan and Rashid (2013), and Rashid (2011, 2013), the ARCH model is estimated for the
period 1975-2009 to get robust, unbiased, and smooth estimates.
4. We do not present the results for the ARCH estimation to economize the space but are 113
available from the author.
5. Estimated target leverage is then utilized to define leverage deficit, which is used as a
regressor variable in logit and probit regressions.
6. The vector Zit2 1 includes the variables similar to Xit in equation (2) except it includes the
leverage deficit as an additional firm-specific variable.
7. Our evidence on the negative effect of firm-specific risk on target leverage strongly supports
the findings of previous studies such as Caglayan and Rashid (2013), Baum et al. (2009),
Antoniou et al. (2008), Lemmon et al. (2008), and Titman and Wessels (1988).
8. Caglayan and Rashid (2013), Korteweg (2010), Baum et al. (2009), Covas and Den Haan
(2007), and Hatzinikolaou et al. (2002) have also documented negative effects of
macroeconomic uncertainty on firms target leverage.
9. The one key advantage of this approach is that since we assign the same value (1(2)) for
issuance (retirement) of capital regardless of whether its worth is equal to 5 or more than
5 percent of a firms book value of total assets, it effectively controls for the large influence of
a only few firms retiring or raising a larger amount of external capital.
10. The dependent variable is equal to one if the firm issues new external capital, two if the firm
does a reduction in existing external capital and zero if the firm does nothing. The positive
(negative) sign on the estimated estimate of the coefficient in the multinomial logit model
implies that the odds ratio of the indicated alternative relative to the reference case of doing
nothing increases (decreases) with an increase in the explanatory variable.
11. Studies of this genre include Marsh (1982), Hovakimian et al. (2001), Hovakimian et al. (2004),
Brav (2009), and Huang and Ritter (2009).

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Corresponding author
Abdul Rashid can be contacted at: abdulrashid@iiu.edu.pk

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