Do Firms ’ Financing Decisions Affect One Another ?

Our study highlights the interdependent nature of corporate financial policies: firms do not make financing decisions in isolation of one another as often assumed in theories of corporate capital structure. Using an instrumental variables approach, we show that firms’ industry peers play an important role in shaping corporate financial policies. A one standard deviation shift in peer firms’ leverage ratios is associated with a 9% change in own firm leverage ratios — a marginal effect that is significantly larger than that of any other observable determinant. Driving this leverage effect is a linkage among firms’ security (debt and equity) issuance decisions. We also show that these effects are driven largely by the efforts of younger, less successful firms to learn from industry leaders. Do firms’ financing decisions affect one another? Most research on corporate capital structure focuses on traditional hypotheses, such as tradeoff and pecking order, which ignore interactions among firms’ financial policies. However, there are several reasons to believe that firms do not make financing decisions in isolation of one another. For example, interactions in the product markets can generate interactions among financial policies. Alternatively, learning motives may link firms’ financial policies, as can herding behavior to avoid any negative consequences associated with a separating equilibrium. Empirically, firms in the same industry tend to have similar capital structures. Median or average industry leverage is an important, if not the most important, capital structure determinant. Further, survey evidence indicates that CFOs often consider the financing decisions of other firms in their industry when setting financial policy. While well motivated and empirically important, peer firm financial policy and its link to corporate capital structure does not have a unique interpretation because of the reflection problem (Manski (1993)). The reflection problem refers to a specific endogeneity problem that arises when trying to infer whether the behavior of a group influences the behavior of the individuals that comprise the group. In our context, this problem is created by using a measure of peer firm financial policy, such as industry median leverage, as an explanatory variable for individual firm financial policy. In particular, any observed similarity in financing behavior among the firms within an industry — or any other peer group — can be attributed to three potential explanations. The first explanation is that firms in the same industry have similar firm characteristics or face similar institutional environments, such as production technologies and investment opportunities. The second explanation is that firms are responding to the characteristics of other firms in the industry, or the context in which they operate. This explanation is referred to as a contextual effect. For example, firms whose competitors are more financially sound may face lower liquidation costs (Shleifer and Vishny (1992)), leading to higher optimal debt ratios. The last explanation, and the focus of our study, is that a true peer effect exists, in which the decisions of firms’ peers directly affect the decisions of each firm. The goal of this paper is to disentangle these explanations to better understand See studies by Brander and Lewis (1986) and Maksimovic and Zechner (1991) (product market competition), Conlisk (1980) (Learning), and Ross (1977) (Signalling). Studies by Bradley, Jarrell, and Kim (1984), Frank and Goyal (2007), Lemmon, Roberts, and Zender (2008) all show that industry effects have the most economically important impact on leverage among observable leverage determinants. Graham and Harvey (2001) show that almost one quarter of surveyed CFOs identify the behavior of competitors as an important input into their financial decision making.