Capital structures can be the proxy of ownership, hence equity and creditor has a distinct influences on the firms' business cycles as during good economic conditions creditors is more favorable in contrast to equity ownership where dividend is retained during the crisis. The advantage of creditors is that it is alot cheaper to fund firms' capital using interest rate paymeny compared to dividend payment to equity holders. The only problem is that creditors has the right by law to declare companies bankrupt if they failed to pay the interest rate and principal as specified in the contract. So it is subject to the performance of macroeconomics conditions in determining the capital structure.

Business cycles get manifested in many economic forms such as leading to monetary policy restriction. The attached paper suggest that under restrictive monetary restrictions dividend payout of companies reduces and hence debt equity ratio gets affected. Also, the low credit rated companies are able to raise less debt during recession and difficult economic situations. Best 

Article Dividend Behaviour of Indian Companies Under Monetary Policy...

Empirical findings have shown a market timing behavior of debt issuance where firms will issue more debt when term spread and risk premia decline.  From the equity side, there is also empirical evidence of market timing where firms are issuing equity when market valuation exceeds intrinsic value and repurchasing during market turndown. Pulvino 1998 JF Fire Sales, will be of particular interest to you. Firms with capital capacity increase buying activity when asset prices are depressed during downturns - capital constrained firms are more likely to liquidate assets at discount. A number of studies since Pulvino's 1998 JF document that in downturns firms greatly resist asset divestiture in illiquid markets to avoid a "fire sale" and lenders are likely to agree to a debt workout to avoid joint wealth loss.

 Dear William R Pratt, 

Thank you so much for the shedding light on the question. Based on your insight and few other papers, i infer that we can link the changing capital structure to Tobin's Q ratio. To have a broader view of the market as a whole. so that when Q is greater than 1 firms with less restriction and less agency problems will issue equity while in phases where Q is less than 1 firms will opt for debt in general. It would be great if you could comment on this. 

Blundell et provides a good starting point for relating Q to investment decisions -  a link to the paper has been attached.

http://www.ucl.ac.uk/~uctp39a/Qpaper_joe1992.pdf

Thank you so much Pratt. It helps a lot.

Business cycles are mostly impacted by economic cycles as said by previous scholars monetary policy, cost of funds, expansion plans of industry are all interlinked, so business cycle will surely have impact on capital structure decions. Hope u find my answer useful.

Based on the comments of above scholars and some papers i infer the following

In recovery period the less restrained firms will replace equity for debt. this will increase the level of their market capitalization and will reduce the leverage.

on the contrary in the periods of market downturn less restricted firms will shows sharp increase in leverage.  

so in recovery it is most probable to observe low debt ratio while in downturns higher debt ratio ..

Looking forward to comments ... Thank you so much

Hi,

I think that market timing is one the relevant point of your subject.CEOs issue stocks when the market is brisk, and debt when it is bearish. Moreover, there may be also a potential mean-reverting process in financial leverage (is a target ratio of debt to equity  existing?) Here are two papers that could be of some help:

M Baker  J Wurgler (2002) "Market timing and capital structure", Journal of Finance, N°57(1) , p1-32.

S Byoun, (2008) "How and when do firms adjust their capital structures towards targets?, Journal of Finance 63, p 3068 -396

Best regards.

Thank you so much Partrick Navatte. Your comments are interesting and the paper seems relevant . it will definitely help me. 

Dear  Muhammad,

If you look at reorganisation literature, you will come across the tendency to substitute outstanding debt by equity instruments. Thus interest payments can be saved, principal payments can be avoided and the creditors receive ownership status in the struggling company to give them voice and more power to influence the company's affairs as compared to their previous status. So, if we assume that companies struggle during an economic downturn, it can be argued that equity becomes the financing source of choice in recession.

Paul      

We have been working on this subject and used the Dickinson (2011) model to distinguish the life cycle stages in which firms can be classified. It has advantages and drawbacks. If you are interested, you can consult the following references available through Researchgate and/or directly in the web page of the Juornal:

- CASTRO, P., TASCÓN, M.T., AMOR, B. and DE MIGUEL, A. (2016). Target leverage and speed of adjustment along the life cycle of European listed firms, Business Research Quarterly, 19(3), July-September, 188-205.

- CASTRO, P., TASCÓN, M.T., and AMOR-TAPIA, B. (2015). Dynamic analysis of capital structure in technological firms based on their life cycle stages. Spanish Journal of Finance and Accounting, Vol. 44, nº 4, 458-486

- CASTRO, P., TASCÓN, M.T. y AMOR-TAPIA, B. (2014). The role of life cycle on the firm’s capital structure. Pecvnia. Revista de la Facultad de Ciencias Económicas y Empresariales de León, nº 19, julio-diciembre, 131-155.

I hope you find them useful.

Maria T. Tascon

Thank you so much Maria T Tascon. Sure i will read your papers. For now can you share your experience regarding the general behavior of firms. Like if economy is in recovery stage what can we expect in term of total debt and total equity. Which one is expected to increase and which one is expected to decrease? Thank you so much in advance for your comments

The product of the firm has relationship with the capital structure. The firm that provides essential products say food and transportation can afford to increase both equity and debt if potential market exist. The capital structure of choice for any firm rests on the philosophy and objectives a firm has set for itself. Under normal condition equity financing wins. When accelerated expansion is desired debt financing complements. 

Hi,

there is a new one in JFE that may be of interest to you:

Michael Halling, Jin Yu, Josef Zechner, "Leverage dynamics over the business cycle", Journal of Financial Economics, October 2016, 122, N°1, p 21 -41.

Best regards 

Thank you so much Patrick navatte