Question

Assume that you are interested in examining the effect of earnings volatility (uncertainty) on firms’ target capital structure using a panel data of firms listed on Palestine Exchange between 2012 and 2019. In light of your study of capital structure decisions, you think that earnings volatility is a determinant factor of capital structure. Moreover, you reason that earnings volatility effect on leverage targets is greater than the impact of firm size, market-to-book ratio, assets tangibility, R&D intensity, ..., and it is the most critical among all time-varying determinants of leverage targets. Further, you think that high level of uncertainty decreases debt tax shields, increases potential financial distress costs, and exacerbates debtholder–shareholder conflicts, thereby leading to a lower optimal target of capital structure.

1. What should be your testable hypotheses?

Answer 1

Yes. Earnings in volatility have a huge effect on Leverage, as the company's long-term life and the company's short-term debt repayment in terms of liquidity risk will result in financial distress, and the longterm debt will solve to see ifthe business has a good earning stability or fluctuates in earnings with regard to economic development.Thus, in an adverse economic scenario, a company is likely to fail and such companies should always aim to ensure earningstability and a debtreturn structure to have enough income to cover the debt, as there would be much financial distress  and there will be an increasing conflict between shareholders and lower optimum target of capital structure.

In my testable hypothesis Time earning ratio (TIE) would be included. In order to avoid default risks and liquidity risk, it will be useful to estimate the overall effect of earnings and the ability of the company to repay debt in the short term.

In my testable hypothesis, liquidity ratios such as the current ratio and the quick ratio would also be used so that there is enough cash to repay the debt in a longer time.

My testable hypothesis would also include the historical mean of company earning stability in different periods, so as to forecast the company's repayment ability so as to proactivate debt capital management, and hence my testable hypothesis will include all such measures in order to check firm's ability towards debt repayment and periodic repayment structure inorder to reduce the risk