Testing Alternative Theories of Capital Structure in the US Electric Industry
Keywords:
Capital Structure, regulationAbstract
Capital structure choices are somewhat mysterious. This mystery has prompted many different stories concerning a firm’s choice of leverage. The traditional trade-off theory holds that firms balance the tax advantages of debt with the costs of financial distress to minimize overall financing costs. More sophisticated theories, such as the pecking-order theory and managerial prerogative theories, incorporate notions of asymmetric information between shareholders and managers and predict that leverage choice is used to address the asymmetry of information. Electric utilities, however, operate in a different business environment than do unregulated firms. Financial decisions are scrutinized publicly before a regulatory body which generally has the authority over the firm’s prices. Moreover, public utilities are charged with providing service at the lowest possible cost. This paper explores two alternative theories of capital structure: the trade-off theory and the pecking order theory. Following Shyam-Sunder and Myers (1999), we use data from FERC Form 1 to evaluate different theories of capital structure for the period 1988 through 2014 in the electric industry. We find that the POT tests do not characterize the electric industry through we do find that the TOT tests appear to provide some explanatory power.
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