Cross-Country Variations in Capital Structures: The Role of Bankruptcy Codes

Abstract

We investigate the impact of bankruptcy codes on firms’ capital-structure choices. We develop a theoretical model to identify how firm characteristics may interact with the bankruptcy code in determining optimal capital structures. A novel and sharp empirical implication emerges from this model: that the difference in leverage choices under a relatively equity-friendly bankruptcy code (such as the US’s) and one that is relatively more debt-friendly (such as the UK’s) should be a decreasing function of the anticipated liquidation value of the firm’s assets. Using a large database of firms from the US and the UK over the period 1990 to 2002, we subject this prediction to extensive empirical testing, both parametric and non-parametric, using different proxies for liquidation values and different measures of leverage. We find strong support for the theory; that is, we find that our proxies for liquidation value are both statistically and economically significant in explaining leverage differences across the two countries. On the other hand, many of the other factors that are known to affect within-country leverage (e.g., size) cannot explain across-countries differences in leverage.