Cost Structure and Capital Structure – A Test of the Stakeholder Theory of Capital Structure

The stakeholder theory of capital structure proposed by Titman (1984) argues that firms will take into account the nonfinancial stakeholders’ preferences when making capital structure decisions. In particular, firms selling specialized products will choose a lower leverage ratio. We propose a cost structure measure to capture the uniqueness of products. We document that this single factor can explain about 16 to 23% of the cross-sectional variation in capital structure. A one standard deviation increase in the cost structure variable relates to an 8 to 10% decrease in the debt ratio. The association is stronger among firms with a higher expected default probability. The results are robust to using the instrumental variable (IV) method. We further discuss three underlying mechanisms: customers’ channel, suppliers’ channel and employees’ channel, through which the cost structure variable captures stakeholders’ concerns. We conclude that, consistent with the stakeholder theory, cost structure has a causal impact on a firm’s leverage choices and is one of the most important determinants of capital structure in the cross-section.