More about the work by Dan Law and his colleagues
How could this article contribute to our student's understanding of the topic? Capital structure (study of how companies used debt and equity to finance their operations) is a very important part of finance. Most of the fundamental theories regarding capital structure were developed over twenty-five years ago, and this tends to be the material covered in finance classes. Few fundamental changes have been proposed since. An assumption that has remained persistent over time is that owner characteristics do not influence the capital structure of firms, since the theory assumes that owners have well diversified personal portfolios (Modigliani and Miller (1958)). In this study, we demonstrate that individual characteristics can help better explain capital structure decisions.
Were there any sources that you used for this article that should be "must-reads" for our students? Yes, Modigliani and Miller (1958). Franco Modigliani and Merton Miller, two Nobel laureates, advanced arguments in the field of finance over 50 years ago that are still taught in the classroom today. Their basic argument suggests that it is completely irrelevant how a firm chooses to arrange its finances and that the firm's cost of capital is unaffected by its use of debt and equity.
How can a business person relate to the information presented in this article? What makes this article particularly important for people in organizations? We show that individual characteristics, when included with traditional capital structure determinants, account for 33% to 60% of the variation in the leverage ratios of firms. We also find that firm leverage is positively related to age, sophistication, business experience, and sales of the firm and is negatively related to the age of the firm and the ratio of return to assets. Given these findings, it may benefit organizations to analyze their operations in more depth, especially if the organization has a target or optimal leverage ratio. While additional debt provides for additional tax breaks, it also increases the probability of bankruptcy. Thus, the leverage ratio of any organization is a critical component that should be analyzed regularly.
Citation: Ang, James, Rebel Cole and Daniel Lawson, 2010, The Role of Owner in Capital Structure Decisions, currently under review at The Journal of Finance.