Using the probability of default as the determinant of firms' capital structure : empirical study in G7 nations

Abstract

This paper studies the effect of credit rating and probability of default, by implying Merton’s model, on firms’ capital structure in G7 nations. The time horizon is 10 year including year 1997 to 2006. Total observations are 6070 observations. More over, this paper study the above variables further with the capital structure theories which are Pecking order theory, Trade off theory, and Market timing theory. The results show that using credit rating to determine firms’ capital structure is decrease in its explanatory power. When test together with the capital structure theories, Trade off theory is able to explain the capital structure while credit rating is unable to explain. Oppositely, Probability of default can be used to explain the capital structure together with Trade off theory. This paper will be the first that use probability of default to observe the signal of securities issuance and will be alternative determinant of firms’ capital structure. Furthermore, this paper motivates future study of applying Merton’s model and probability of default in to other field of financial study.