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Capital Structure Volatility in Europe

Journal: International Review of Financial Analysis

Date: 20180101

Author: Campbell, Gareth; Rogers, Meeghan

Abstract:
Contrary to the predictions of the trade-off theory, we find that many companies in Europe had substantial variation in their capital structures between 2006 and 2016. We show that this pattern occurred across countries. Companies with the most volatile debt ratios tended to be smaller, and were less profitable. Their high debt volatility was partly due to high volatility in operating and investing activities, and partly due to a reduced propensity to let cash balances and equity payouts absorb the fluctuations.

Link: Google Scholar

Background and Context

Study Scope

Research examines capital structure volatility in European companies between 2006-2016, analyzing firms from the UK, Germany, France and PIIGS countries (Portugal, Italy, Ireland, Greece, Spain).

Research Question

Investigates why many companies deviate from the traditional trade-off theory which suggests firms should maintain stable debt ratios.

Methodology

Analyzes cash flow statements and balance sheets of 1,422 non-financial companies to examine debt ratios, volatility patterns, and corporate finance policies.

Average Debt Ratios Show Significant Country Variations

  • Shows stark differences in debt levels between European countries over time
  • Greece experienced steady increase in debt ratios from 30.9% to 42.6%
  • UK and France maintained relatively stable debt ratios around 16-22%

Smaller Companies Have Higher Debt Volatility

  • Companies with highest debt volatility had average assets of €2.56 billion
  • Companies with lowest debt volatility had average assets of €5.47 billion
  • Shows smaller firms tend to have less stable capital structures

Profitability Impacts Debt Stability

  • Companies with highest debt volatility had negative average returns (-1.00%)
  • Companies with lowest debt volatility had positive returns (2.42%)
  • Demonstrates that profitability helps maintain stable capital structures

Investment Drives Debt Changes

  • Companies with largest debt increases spent more on all types of investments
  • Fixed asset investment difference was 2.4% of assets between groups
  • Shows investment needs drive debt policy changes

Cash Flow Volatility Components

  • High debt volatility firms have higher operating cash flow variance (2.2% vs 1.0%)
  • Cash balance and equity payout variances show smaller differences
  • Demonstrates operational volatility drives debt instability

Contribution and Implications

  • Challenges traditional trade-off theory by showing many European firms have substantial capital structure volatility
  • Introduces "Corporate Finance Trilemma" concept explaining why firms cannot simultaneously optimize debt, cash holdings, and equity payouts
  • Provides practical insights for understanding how firm size, profitability and investment needs influence capital structure stability

Data Sources

  • Country debt ratios visualization based on Table 1 in the article
  • Size comparison chart constructed using data from Table 5
  • Profitability comparison based on Panel B of Table 5
  • Investment comparison created using data from Table 9
  • Cash flow volatility components from Table 12