1. The theory of firm financing suggests that corporations should use the cheapest methods of financing their activities first (i.e. the sources of funds that require payment of the lowest rates of return to investors) and switch to more expensive methods only when the cheaper sources have been exhausted. Helwege and Liang (1996) examine the pecking order hypothesis in the context of a set of US firms that had been newly listed on the stock market in 1983, with their additional funding decisions being tracked over the 1984-92 period. A core objective of the paper is to determine the factors that affect the probability of raising external financing. As such, the dependent variable will be binary - that is, a column of ones (firm raises funds externally) and zeros (firm does not raise any external funds) (a) Explain the term 'limited dependent variable! (b) Explain why a linear probability model is inappropriate for the analysis. (c) The table below documents the results from the logit regression (t-statistics are in parentheses). The explanatory variables are a set of firm characteristics that aim to capture the relative degree of information asymmetry and degree of riskiness of the firm. The variable 'deficit' measures (capital expenditures + acquisitions + dividends - earnings); assets' is used as a measure of firm size; 'industry asset growth' is the average rate of growth of assets in that firm's industry over the 1983-92 period; previous financing' is a dummy variable equal to 1 for firms that obtained external financing in the previous year. (1) Logit estimation of the probability of external financing Variable (2) Intercept -0.29 -0.72 (-3.42) (-7.05) Deficit 0.04 0.02 (0.34) (0.18) Assets 0.0004 0.0003 (1.99) (1.36) Industry asset growth -0.002 -0.002 (-1.70) (-1.35) Previous financing 0.79 (8.48) Descriptive statistics Variable Mean Std. dev. Deficit 0.10 0.40 Assets 80.91 231.52 Industry asset growth 50.86 33.04 Previous financing 0.40 0.01 Specify the logit model for regression (1). How can this model be estimated? (d) For logit regression (1) comment on the sign and the significance of the regression coefficients. (e) How is the probability of raising external financing affected by 1 unit increase in the firm's deficit? 1 unit increase in the firm's size? 1 unit increase in industry asset growth? Explain your calculations. (f) Explain how you would measure the goodness-of-fit for the regressions (1) and (2). (8) How does the interpretation of the intercept change in regression (2) compared to the regression (1)? (h) Compute the marginal effect of having external financing in the previous year on the probability to obtain financing this year (see regression model (2)). 1. The theory of firm financing suggests that corporations should use the cheapest methods of financing their activities first (i.e. the sources of funds that require payment of the lowest rates of return to investors) and switch to more expensive methods only when the cheaper sources have been exhausted. Helwege and Liang (1996) examine the pecking order hypothesis in the context of a set of US firms that had been newly listed on the stock market in 1983, with their additional funding decisions being tracked over the 1984-92 period. A core objective of the paper is to determine the factors that affect the probability of raising external financing. As such, the dependent variable will be binary - that is, a column of ones (firm raises funds externally) and zeros (firm does not raise any external funds) (a) Explain the term 'limited dependent variable! (b) Explain why a linear probability model is inappropriate for the analysis. (c) The table below documents the results from the logit regression (t-statistics are in parentheses). The explanatory variables are a set of firm characteristics that aim to capture the relative degree of information asymmetry and degree of riskiness of the firm. The variable 'deficit' measures (capital expenditures + acquisitions + dividends - earnings); assets' is used as a measure of firm size; 'industry asset growth' is the average rate of growth of assets in that firm's industry over the 1983-92 period; previous financing' is a dummy variable equal to 1 for firms that obtained external financing in the previous year. (1) Logit estimation of the probability of external financing Variable (2) Intercept -0.29 -0.72 (-3.42) (-7.05) Deficit 0.04 0.02 (0.34) (0.18) Assets 0.0004 0.0003 (1.99) (1.36) Industry asset growth -0.002 -0.002 (-1.70) (-1.35) Previous financing 0.79 (8.48) Descriptive statistics Variable Mean Std. dev. Deficit 0.10 0.40 Assets 80.91 231.52 Industry asset growth 50.86 33.04 Previous financing 0.40 0.01 Specify the logit model for regression (1). How can this model be estimated? (d) For logit regression (1) comment on the sign and the significance of the regression coefficients. (e) How is the probability of raising external financing affected by 1 unit increase in the firm's deficit? 1 unit increase in the firm's size? 1 unit increase in industry asset growth? Explain your calculations. (f) Explain how you would measure the goodness-of-fit for the regressions (1) and (2). (8) How does the interpretation of the intercept change in regression (2) compared to the regression (1)? (h) Compute the marginal effect of having external financing in the previous year on the probability to obtain financing this year (see regression model (2))
