DISCUSSION PAPER SERIES
Oct. 2013

No. 2013-10

Target behavior and lumpy investments

Masayo Shikimi
Katsumi Matsuura

Target behavior and lumpy investments
Masayo Shikimi*
Nagasaki University
Katsumi Matsuura†
Hiroshima University

Abstract

This study presents an empirical investigation whether lumpy investment behaviors by firms
affect their readjustment toward target leverage ratios. Using a data sample of Japanese listed

firms from 1978–2008, it is found that firm investment spikes have a larger effect on debt thanequity issuances. The positive effects vary with firms’ debt position s: firms with below-target
debt are more (less) likely to issue debt (equity) compared with those with above-target debt. It
is also found that financially constrain ed firms, with above-target debt, are more responsive toinvestment spikes than their financially unconstrain ed counterparts.

Keywords: Capital structure, information asymmetry* Associate Professor, Faculty of Economics, Nagasaki University, 4 -2-1, Katafuchi, Nagasaki 850-8506,

Japan. Phone: +81-95 -820-6323; Fax: +81-95-820-6370; E -mail: mshikimi@nagasaki-u.ac.jp† Professor, Faculty of Economics, Hiroshima University, 1-1-89, Higashisenda-cho, Naka-ku, Hiroshima

730 -0053 , Japan. E-mail: k matsuur@hiroshima-u.ac.jp

1 Introduction
How firms determine their capital structure and when and how they change it are one of the mostimportant topics in corporate finance. According to the trade-off theory, firms determine theiroptimal capital structure to balance the marginal benefits and cost of debt. Many empirical studies
support the trade-off theory that firms adjust their capital structure toward the target debt ratio.
Moreover, recent studies have concluded that the speed of this adjustment differs depending onwhether firms have a financial deficit or surplus, suggesting the influence on the target behavior byother factors, such as the asymmetric information costs of external financing (Byoun 2008;
Faulkender et al. 2011). A faster adjustment is enabled among firms in case of a financial deficit(surplus) because the adjustment costs are lower when shared with other transaction costs.
Earlier studies employ a partial adjustment model, which assumes a constant and continuous
adjustment. However, if an adjustment cost function is non-convex and a fixed cost, then adjustment
is expected to be infrequent and lumpy. Moreover, most of these studies also assume that investment
is continuous. However, recent studies on investment have found that firm investment behavior is
lumpy,1 not continuous; therefore, a firm’s capital structure adjustment is expected mostly during
investment spikes.
This study investigates how firms’ investment activities influence their debt and equity issuance1

See Caballero et al. (1995).

1

decisions and their corresponding rebalancing behavior toward a target debt level. We test whether
firms move toward or away from their debt target during large investments. We also analyze whether
the impact of large investments differ among firms with heterogeneous characteristics.
This study differs from previous studies in two ways. First, we investigate the effects of large
investments on financial decisions of debt and equity issues. Using financing decisions as dependent
variables, we avoid the mechanical mean reversion problems associated with the use of the debt ratio
as the dependent variable (Chen and Zhao 2007; Chang and Dasgupta 2009). Second, we focus on
the influence of firms’ lumpy investment behaviors instead of continuous investment behaviors.
Using the data on Japanese listed firms, we find that lumpy investments positively affect debt andequity issuances; however, this effect varies depending on a firm’s debt position and firm
characteristics. Firms with below-target debt are more likely to issue debt to move toward the target;
however, firms with above-target debt also issue debt to move away from the target. On the other
hand, the effects of spikes on equity issues are consistent with the target behavior that firms withbelow-target debt are less likely to issue equity. The effects of spikes on debt issues are found to varywith firm characteristics. Financially constrained firms are more sensitive to spikes, suggesting
greater benefits of adjustment during spikes. Mature firms with blow-target debt issue debt more,while those with above-target debt issue less than growing firms. In contrast, the effects of spikes on
equity do not vary with firm characteristics.
2

The remainder of the paper is organized as follows. Section 2 reviews previous empirical studies onchanges in capital structure and highlight their shortcomings. Section 3 describes our sample data
and the basic estimation strategy. Section 4 presents the estimation results of the effect of lumpy
investments on debt (equity) issuance and firm target behavior. Section 5 discusses the results andpresents the study conclusions.

2 Capital structure adjustments toward the target: theory and evidenceThis section reviews previous theoretical and empirical studies on capital structure adjustments.
Many studies have tested the dynamic trade-off theory, which predicts that firms adjust their capital
structure toward their debt target, and have found supporting evidence by estimation, using thepartial adjustment model. However, since the estimated adjustment speed is very slow (Fama andFrench 2002), some recent studies have explored its reasons. One of the impediments for adjustment
toward the debt target is the high transaction cost. Leary and Roberts (2005) found that theadjustment speed of firms is slow when the non-convex adjustment cost functions are assumed. With
fixed costs for adjustments, firms do not adjust their capital structure continuously, but periodically;
therefore, the observed adjustments are lumpy over time.
Some other studies have explored the possibility of asymmetric adjustment cost. With
informational asymmetry costs, the issue of equity is more costly than debt due to adverse selection3

(Majluf and Myers 1984). Therefore, to minimize these transaction costs, firms find it optimal toadjust their capital structure at the time of investments. Byoun (2008) found that adjustment is fasterfor over-leveraged (under-leveraged) firms with financial surplus (deficit) compared toover-leveraged firms (under -leveraged) with financial deficit (surplus). Faulkender et al. (2012)
found that firms with larger cash flows adjust faster than those with smaller cash flows. They argue
that adjustment costs are low during investments because transaction costs are shared between thebenefits of approaching the target and funding investments. Dudley (2012) also found evidence thatfirms move toward the target when they invest. On the other hand, DeAngelo et al. (2011) argue thatfirms temporarily move away from their target when the investment benefits are greater than thecosts of deviation from the target. Using data from Japanese listed firms, Shikimi (2013) findings are
consistent with those of DeAngelo et al. (2011).
Together, these findings imply that the functional form of adjustment costs and asymmetry inadjustment costs result in slower adjustments, on average. However, studies exploring real
investment effects estimate the partial adjustment model and do not consider the possibility thatlumpy real investment patterns result in lumpy capital structure adjustments. Given this disparity inthe literature, this present study investigates the effect of lumpy investments on firms’ financing
decisions regarding the issuance of debt and equity.

4

3 Data and empirical specification
3.1 Empirical specification
We assume that firms’ financing decisions can be described as follows:

Yit*   Debtit -1 – Targetit*   Sit  X it γ  mi  uit ,Yit  1 if Y  0, 0 otherwize,
*
it

(1)

,

where Yit is the financing decision of firm i in year t . Debtit 1 is the firm’s debt ratio, definedas the sum of short-term and long-term debts divided by the sum of short-term debt, long-term debt,*

and capital. Targetit is the firm’s target debt ratio, Sit is an investment spike, X it is a vector ofcontrol variables, and mi is a measure of the firm’s heterogeneity. We assume that the firm’sheterogeneity is correlated with the firm’s average of observable characteristic variables, and employ
the Mundlak probit model to obtain estimators (Wooldridge 2010). The expected sign of  isnegative for the issue of debt and is positive for that of equity.  is expected to be positive.

3.2 Data
Our sample comprises non-financial firms listed on the first and second sections of Japanese stock
markets from 1978 to 2008. We restrict our sample to those firms that have been listed for at least
five consecutive years, and obtain accounting and stock price data from Firm Financial Statement
Data Bank, supplied by the Development Bank of Japan. We exclude the electricity, gas, and water5

supply industries because they tend to be heavily regulated. Firms whose book debt-asset ratio
exceed one or take a negative value and those with missing stock price information are eliminatedfrom the sample. Firms whose growth rate of total assets is more than 100% or less than −100% arealso eliminated, since their involvement in a merger, acquisition, or large asset sale is likely. The
lower and upper 0.5% tails of the distribution of financial variables are trimmed to eliminate outliers.
Variables are deflated by the consumer price index. Summary statistics are presented in Table 1.

Financing decisions
Debt and equity issuances are the two types of financial decisions to be considered here. Debt
issuance includes public debt and bank loan debt. Following Chang and Dasgupta (2009), net debt
issue and net equity issue are defined as follows: Net equity issue is a change in book capital minus achange in retained earnings, whereas net debt issue is a change in total assets minus a change inretained earnings. Net debt (equity) issues are divided by total assets at the beginning of the year.
Following Hovakimin et al. (2001), Hovakimin (2004), and Leary and Roberts (2005), a firm thathas a net debt (equity) issuance divided by total assets exceeding 5% is defined to issue debt
(equity).

Investment spikes
6Following Caballero et al. (1995), an investment spike is defined as follows:

Spike  1 if (( I it  I i ) / σiI )  1.5 ,I

where I it is firm i ’s investment rate at time t , I i is the firm’s mean of investment rate, and σ i isthe firm-level standard deviation. Following Shima (2005), the investment rate is defined as anincrease in fixed tangible assets minus depreciation divided by capital stock at the beginning of theyear. Figure 1 plots the number of firms that have issued debt (equity) and have experienced
investment spikes during the period from1978 to 2008.

Determinants of target capital structure
Target capital structure is described as follows:

Targetit*  Wit 1δ  fi   t   it ,where Wit 1 is a vector of firm characteristics, such as firm size, growth, profitability, and collateral(Rajan and Zingales 1995; Hovakimian et al. 2001; Frank and Goyal 2008; Lemmon et al. 2008).

f i is firm fixed effects,  t denotes the year dummy to control for macroeconomic shocks such as
the inflation rate. For firm size, we use the ln(sales) as a proxy. For firm growth, we use themarket-to-book ratio as a proxy. EBITA / total assets and tangible fixed assets / total assets,
respectively, are used as proxies for profitability and collateral. Industry median debt ratios are also
included to control for variations across industries. We regress firm observable debt ratio on those7

determinants, and obtain fitted values as target debt ratio. The firm fixed effects are also included in
the fitted values. We divide the timeframe into three financial periods: 1976–1986, 1987–1995, and1996–2008 to consider the possibility that a firm’s decisions regarding its target capital structure
might be affected by financial regulations.2 Table 2 tabulates the estimation results.

Other variables
To control for other factors explained by the pecking-order hypothesis and market timing
hypothesis, cash plus marketable securities divided by total assets and the price-to-earnings ratio areincluded. We expect the cash ratio to have negative effects for both issues. The price-to-earnings
ratio is expected to have a positive effect on the issue of equity. The shareholdings ratio for the top
10 shareholders, banks, and foreigners is also included to control for the effect of the agency
problem. To control for industry variation and macroeconomic shocks, industry and year dummies
are included, respectively.

4 Debt (equity) issue and real investments
4.1 Base model

2

Regulations on bond issuances were gradually relaxed after 1987. Equity issue at market price wasbanned during 1990–1995.

8

Estimation results for Equation (1) are presented in Table 3. The coefficients of deviation from thetarget have the expected signs and have highly significant effects on debt (equity) issue, suggestingthat firms are more likely to adjust their capital structure in case of higher deviation. Although theinvestment spikes have a positive effect at the 1% level for both debt and equity, their effect isgreater for debt than for equity. When firms make large investments, firms’ probabilities of debt
issuance increases by 15.6%; whereas, equity issuance increases by 1.1%. Cash divided by total
assets have a negative effect on debt (equity) issue, suggesting that firms with more internal funds
are less likely to use external financing; this is consistent with the pecking-order hypothesis. The
coefficients of the price-to-earnings ratio are positive and significant at the 1% level for both debt
and equity issuance. None of shareholding ratio variables are significant for debt issue. On the other
hand, shareholding by the top 10 (foreigners) has a negative (positive) effect on equity (debt) issue atthe 5% (1%) significance level, suggesting that cross-shareholding weakens shareholder discipline;
however, the presence of foreign shareholders lowers the agency costs.
To further evaluate the effects of investment spikes on financing decisions, Figure 2 plots theaverage marginal effects of investment spikes at the firm’s debt position. Firms are more likely toissue debt when actual debt is below-target; however, they are also observed to do so when it isabove-target. On the other hand, firms are likely to issue equity when their debt is above-target, but
not when it is below-target.
9

4.2 Target behavior and investment by firm characteristics
In this section, we examine whether the effect of investment spikes vary with firm characteristics
and market conditions. We split the sample according to firm characteristics, such as financial
constraints, investment opportunities, earnings volatility, profitability, and their market-to-book ratio,
and compare their target behaviors and the effects of spikes in those samples.

A. Financial constraints
Financially constrained firms have greater difficulty in issuing debt or equity compared withfinancially unconstrained firms, due to high transaction costs. Therefore, we expect financiallyconstrained firms to be less likely to adjust their capital structure and issue debt (equity) comparedwith unconstrained firms (Korajczyk and Levy 2003). On the other hand, financially constrained
firms are expected to make less frequent lumpy adjustments since the fixed costs of adjustment andtransaction are relatively higher compared with financially unconstrained firms. Therefore, theopportunity costs of forgoing investments and the timing of adjustment are higher for financiallyconstrained firms, and thus they are expected to be more responsive to investment spikes. Samples
are divided into financially constrained and financially unconstrained firms. Firms whose total assets
are less (greater) than the 30th (70th) percentile are defined as financially constrained10(unconstrained) firms. The estimation results are presented in Panel A of Table 4. Other variables
used in Table 3 are also included (not reported due to space constraints). Deviations from target andinvestment spikes have the expected sign, demonstrating highly significant effects on debt issuanceby financially constrained and unconstrained firms. It is also noteworthy that those effects differ
between the two groups. On the other hand, although deviations from targets have a 1% positiveeffect on equity issue for both groups, investment spikes matter only for financially constrained
firms. A comparison of the average marginal effects on both groups is illustrated in Panels A and B
of Figure 3. Panel A of Figure 3 shows that financially constrained firms are more sensitive to spikes,
suggesting that the benefits of financing investments are greater, and due to limited internal funds
they are more likely to depend on external funds. On the other hand, large financially unconstrained
firms can fund investments with internal funds and are less likely to issue debt or equity.

B. Investment opportunities
Firms whose market-to-book ratio is greater (less) than one are classified as firms with high (low)investment opportunities. Panel B of Table 4 shows the estimation results. Deviations from target
and investment spikes have the expected signs and are significant at the 1% level for the issue ofboth debt and equity. The test statistics of equal coefficients for two groups are also significant at the
1% level, suggesting that firms’ target behaviors differ between growing and mature firms. The
11

effects of investment spikes are shown in Panels A and B of Figure 4. Panel A of Figure 4 shows thatmature firms with below-target debt are more likely to issue debt compared with growing firms.
Moreover, it reveals that debt issues by growth firms with above-target debt are more sensitive tospikes compared with mature firms with above-target debt, suggesting that the benefits of financing
investments by debt issue are greater for growing firms with above-target debt compared withmature firms with above-target debt, despite deviating further from the target. In other words, theopportunity costs of forgoing the investment opportunities are greater for growing firms comparedwith mature firms with above-target debt.

C. Earnings volatilities
Firms with high earnings volatility incur higher costs for issuing debt or equity; therefore, they areless likely to adjust their capital structure and less responsive to investment spikes. If the coefficientof variation of firms’ EBITA to assets is greater (less) than 70th (30th) percentile, they are classified
as high (low) volatile. In Panel C of Table 4, the coefficients of deviation from the target in theequity issue equation differ significantly between the two samples but not in the debt issue equation.
Expectedly, Panel A of Figure 5 indicates that the effect of investment spikes on debt issue is greater
for lower volatility firms with below-target debt, suggesting that high volatility firms have difficulty
attracting external financing investment.
12

D. Profitability
Profitable firms have more retained earnings and can rebalance their capital structure with internalfunds; therefore, they are less likely to issue debt when they have below-target debt. High (low)profitability firms are defined as firms with an EBITA-to-assets ratio greater (less) than the 70th
(30th) percentile. In Panel D of Table 4, the deviations from the target have the expected signs andare significant at the 1% level. Contrary to expectations, however, there are no significantly different
effects of deviation on debt issue between two groups. On the other hand, when the deviation
increases, the probability of equity issuance is higher for profitable firms than for their less profitablecounterparts, suggesting that adjustments can be made more easily because the transaction costs ofequity issue are lower for profitable firms. Regarding the effect of investment spikes, Panels A and B
of Figure 6 reveal no differences between the two groups.

E. Market timing
Following Faulkender et al. (2012), samples are divided into two groups based on whether a firm’s
market-to book-ratio is greater than the industry median or not. The results listed in Panel E of Table
4 indicate that target behavior does not differ among these two groups; indeed, the effect ofinvestment spikes on debt issuances is significantly greater for firms with lower market-to-book13

ratios than for firms with higher market-to-book ratios. Panel A in Figure 7 indicates that
under-leveraged firms with low market-to-book ratios are more likely to issue debt during
investment spikes compared with those firms with higher market-to-book ratios.

5 Conclusion
This study analyzes the effect of a firm’s real investments on their target behavior. Using data fromlisted Japanese companies in 1978–2008, we find that debt issue is more sensitive to deviation fromthe target compared to equity issue. Second, the effects of deviation are found to differ between
financially constrained and financially unconstrained firms, growth and non-growth firms, andhigh-leverage and low-leverage firms. As for the economic impact, the effects of deviation are foundto be relatively small compared to investment spikes. Moreover, we found asymmetry in the effectsof spikes. The positive effect of investments on debt issue is greater for firms with below-target debt
than for those with above-target debt, implying that firms with above-target debt might move awayfrom the target debt during large investments. On the other hand, the effect of investment on equity
issue is consistent with the trade-off theory.
Some studies on capital structure adjustment have found evidence that adjustment speed isasymmetric. This study finds that firms can move toward their target during large investments even
if the sensitivity of debt (equity) issuance to deviation is constant. Adjustment asymmetry is possibly
14

caused by either a variation in adjustment costs or the varying effects of investments, depending on
the firm’s debt position. An investigation in to which factors are dominant is left for future research.

Acknowledgements:
We thank the seminar participants at Hiroshima University.

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18Figure 1. Financing choice and investment spikes

800

600

500
debt issue

400

equity issue

300

investment spike

200
100
0
1978
1980
1982
1984
1986
1988
1990
1992
1994
1996
1998
2000
2002
2004
2006
2008

Number of firms

700

19

Figure 2. Average marginal effect of spikes on debt (equity) issue
Panel A: Effect of spike on debt issue

Panel B: Effect of spike on equity issue
Average Marginal Effects of spike with 95% CIs

.2
.15
.1

0

0

.05

.05

.1

.15

.2

Effects on Pr(Stock issue)

.25

.25

.3

.3

Average Marginal Effects of spike with 95% CIs

-.5

-.4

-.3

-.2

-.1
0
.1
.2
Deviation (Debt-Target)

.3

.4

.5

20

-.5

-.4

-.3

-.2

-.1
0
.1
.2
Deviation (Debt-Target)

.3

.4

.5

Panel B: Equity issue

.2
.1

0

0

.1

.2

Effects on Pr (equity issue).3.3

Panel A: Debt issue

-.5

-.4

-.3

-.2

-.1

0
.1
Debt-Target

Financially constrained

.2

.3

.4

.5

-.5

-.4

Financially unconstrained

-.3

-.2

-.1

0
.1
Debt-Target

Financially constrained

.2

.3

.4

.5

Financially unconstrained

Figure 4. Average marginal effect of spikes by investment opportunities
Panel B: Equity issue

.2
.1

.1

.2

Effects on Pr (equity issue).3.3

Panel A: Debt issue00

Effects on Pr (debt issue)

Effects on Pr (debt issue)

Figure 3. Average marginal effect of spikes by financial constraint

-.5

-.4

-.3

-.2

-.1

0
.1
Debt-Target

Market/book assets >= 1

.2

.3

.4

.5

Market/book assets < 1

21

-.5

-.4

-.3

-.2

-.1

0
.1
Debt-Target

Market/book assts >= 1

.2

.3

.4

Market/book assets < 1

.5

.2
.1
0

0

.1

.2

Effects on Pr (stock issue).3

Panel B: Equity issue.3

Panel A: Debt issue

-.5

-.4

-.3

-.2

-.1

0
.1
Debt-Target

High volatility of cash flow

.2

.3

.4

.5

-.5

Low volatility of cash flow

-.4

-.3

-.2

-.1

0
.1
Debt-Target

High volatility of cash flow

.2

.3

.4

.5

Low volatility of cash flow

Figure 6. Average marginal effect of spikes by profitability
Panel B: Equity issue

.2
.1

.1

.2

Effects on Pr (stock issue).3.3

Panel A: Debt issue00

Effects on Pr (debt issue)

Effects on Pr (debt issue)

Figure 5. Average marginal effect of spikes by volatility of cash flow

-.5

-.4

-.3

-.2

-.1

0
.1
Debt-Target

High profitability

.2

.3

.4

Low profitability

.5

-.5

-.4

-.3

-.2

-.1

0
.1
Debt-Target

High profitability

22

.2

.3

Low profitability.4.5

Figure 7. Average marginal effect of spikes by market timing

.2
.1

0

0

.1

.2

Effects on Pr (stock issue).3

Panel B: Equity issue.3

Panel A: Debt issue

-.5

-.4

-.3

-.2

-.1

0
.1
Debt-Target

MB ratio >= industry median MB

.2

.3

.4

.5

-.5

MB ratio < industry median MB

-.4

-.3

-.2

-.1

0
.1
Debt-Target

MB ratio >= industry median

23

.2

.3

.4

.5

MB ratio < industry medianTable 1. Summary statistics

24

Table 2. Estimation results of target capital structure

Note: The dependent variable is firm debt ratio, defined as the sum of short-term plus long-term
debts divided by sum of the shot-term debt, long-term debt, and capital. Robust standard errors are inparentheses. Significance at the 10%, 5%, and 1% level is denoted by *, **, and ***, respectively.

25

Table 3. Estimation results of debt (equity) issue and investment spikes

Note: Bootstrap standard errors for estimated coefficients, and Delta-method standard errors for average marginal
effects (AME) are in parentheses. Significance at the 10%, 5%, and 1% level is denoted by *, **, and ***,
respectively.

26

Table 4. Estimation results of debt (equity) issue by firm characteristics

27

Table 4. Estimation results of debt (equity) issue by firm characteristics (continued)

28

Table 4: Estimation results of debt (equity) issue by firm characteristics (continued)

Note: All the equations include all the other variables in Table 3. Bootstrap standard errors for estimatedcoefficients and Delta-method standard errors for AME are in parentheses. Significance at the 10%, 5%,
and 1% level is denoted by *, **, and ***, respectively.

29