How Does Industry Affect Firm Financial
Structure?
Peter MacKay
Hong Kong University of Science and Technology
Gordon M. Phillips
University of Maryland and NBER
We examine the importance of industry to firm-level financial and real decisions. We
find that in addition to standard industry fixed effects, financial structure also
depends on a firm’s position within its industry. In competitive industries, a firm’s
financial leverage depends on its natural hedge (its proximity to the median industry
capital–labor ratio), the actions of other firms in the industry, and its status as
entrant, incumbent, or exiting firm. Financial leverage is higher and less dispersed
in concentrated industries, where strategic debt interactions are also stronger, but a
firm’s natural hedge is not significant. Our results show that financial structure,
technology, and risk are jointly determined within industries. These findings are
consistent with recent industry equilibrium models of financial structure.
Despite extensive financial structure research since Myers (1984) and
Harris and Raviv (1991) surveyed the literature, important questions
remain about how financial structure is related to industry and about
how real and financial decisions are related.
1
Although it is widely held
that industry factors are important to firm financial structure, empirical
evidence shows that there is wide variation in financial structure even
after controlling for industries.
2
Researchers routinely remove industry
fixed effects by including dummy variables or sweeping out industry
This paper was previously circulated under the title: ‘‘Is There an Optimal Industry Financial Structure?’’.
MacKay is from the Edwin L. Cox School of Business, SouthernMethodist University and Phillips is from
the Robert H. Smith School of Business, University of Maryland. We wish to thank Murray Frank,
Gerald Garvey, Mike Long, Robert McDonald, Vojislav Maksimovic, Dave Mauer, Nagpurnanand
Prabhala, Alexander Reisz, Michael Roberts, Antoinette Schoar, Harry Turtle, Toni Whited, two anon-
ymous referees, and seminar participants at the American Finance Association, the Atlanta Finance
Consortium, the Northern Finance Association, the Rutgers Conference on Capital Structure, MIT,
Southern Methodist University, the University of Delaware, the University of Kentucky, and the Uni-
versity of British Columbia for helpful comments. MacKay can be reached at pmackay@ust.hk, homepage
http://www.bm.ust.hk/fina/staff/pmackay.html. Phillips can be reached at gphillips@rhsmith.umd.edu,
homepage www.rhsmith.umd.edu/Finance/gphillips/. The authors alone are responsible for the work
and any errors or omissions.
1
Recent empirical papers on financial structure examine static trade-off and pecking-order theories
(Shyam-Sunder and Myers, 1999, Fama and French, 2002, Frank and Goyal, 2003), taxes (Graham,
1996, 2000), managerial fixed effects (Bertrand and Schoar, 2002), technology (MacKay, 2003), and stock
returns (Welch, 2004).
2
Bradley, Jarrell, and Kim (1984), Chaplinsky (1983), and Remmers et al. (1974).
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doi:10.1093/rfs/hhi032 Advance Access publication August 31, 2005

means and using the remaining variation to test how firm characteristics
affect financial policy. Yet, this approach does not tell us how industry
affects firm financial structure, nor why financial structure and real-side
characteristics vary so widely across firms within a given industry. In
addition, theoretical models such as Dammon and Senbet (1988) and
Leland (1998) stress the jointness of real and financial decisions—yet little
is known about the empirical relevance of the simultaneity of these
decisions. We thus examine these two unresolved but related questions:
How important are industry factors to firm financial structure? Can indus-
try equilibrium forces explain how firms distribute within industries—both
along real-side and financial dimensions?
We address these questions by examining how intra-industry variation in
financial structure relates to industry factors and whether real and financial
decisions are jointly determined within industries. We base our analysis on
models of competitive-industry equilibrium (Maksimovic and Zechner,
1991, Williams, 1995, and Fries, Miller, and Perraudin, 1997).
3
Similar to
Miller’s (1977) irrelevance result, these models illustrate how conclusions
reached in a partial-equilibrium framework are fundamentally altered, even
reversed, as the equilibrium setting is aggregated to the level of an industry.
Our research therefore goes beyond tests of static trade-off and pecking-
order theories to examine whether the decisions of individual firms are
related to those of industry peers. We also investigate the impact of
endogeneity, both as an empirical matter and as an implication of recent
theory, by contrasting single- and simultaneous-equation regressions for
financial leverage, capital–labor ratios, and cash-flow volatility.
We precede our examination of industry equilibrium models with a
broader investigation of inter- and intra-industry variation in financial
structure. We document extensive cross-sectional variation in financial
leverage in our sample of 315 competitive manufacturing industries.
Regressing firm-level financial leverage on industry-level medians, we
find that most of the variation in financial structure arises within indus-
tries rather than between industries. Specifically, we find that industry
fixed effects account for only 13% of variation in financial structure. In
contrast, firm fixed effects explain 54% of variation in financial structure,
and the remaining 33% is within-firm variation.
Given the relative unimportance of industry fixed effects in explaining
financial structure, we examine whether other industry-related factors can
account for some of the wide variation observed within industries. Our
empirical strategy is to construct various measures of a firm’s industry
position inspired from industry equilibrium models and test whether these
3
Chevalier (1995), Phillips (1995), and Kovenock and Phillips (1995, 1997) show that financial structure
conditions real decisions in imperfectly competitive industries. Opler and Titman (1994) show that highly
leveraged firms lose market share in concentrated industries after negative industry shocks.
The Review of Financial Studies / v 18 n 4 2005
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