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
managers 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 firms 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 firms
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
years 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.
Thomsons SDC Platinum database to get data of CEOs personal portfolios held and their selling of
shares as well as their exercising of stock options.