Interest rate effects on capital structure in publicly traded firms: - An empirical analysis –

Abstract: In this paper we investigate if publicly traded firms change their capital structure as an effect of the interest rate. We do this with data from stocks listed on the major indices in France, Germany, Japan, the Nordic region, United Kingdom and the United States, spanning over the years 1987-2007. Our results show no sign of a negative relationship between debt levels and interest rates, in contradiction to both the market timing and the trade off theory. A large reason for not seeing this relationship is related to the use of book value of debt instead of market value of debt. There are also firm specific reasons for why firms do not change their capital structure, including that firms keep a constant leverage ratio instead of an interest coverage ratio and investment opportunities and interest rates are often negatively related. Only the most profitable firms, measured in EBITDA margin, show the expected negative relationship. As these firms have the largest abilities to switch their leverage, one would also expect these results.