Hu - Financing Decision I Topics 12. The Capital Structure Puzzle Michael F. Barclay and Clifford W. Smith, Jr. 2019/2/2 Hu - Financing Decision I

The Capital Structure Puzzle Theories - Taxes Corporate income taxes Interest expenses deduction Tc: Corporate tax tc: corporate tax rate EBIT: Earnings before interest and tax I: Interest expense 2019/2/2 Hu - Financing Decision I

The Capital Structure Puzzle Theories - Taxes Corporate income taxes EBIT-Tc (distribute to bondholders and stockholders) is higher when I is larger 2019/2/2 Hu - Financing Decision I

The Capital Structure Puzzle Theories - Taxes Individual income tax If individuals are both shareholder and bondholder, personal income before tax will be I + (EBIT-I-Tc) = I + (1-tc) (EBIT-I)。 Personal tax will be： Tp is personal tax, tD is tax rate for interest income, tE is tax rate for income as stockholder 2019/2/2 Hu - Financing Decision I

The Capital Structure Puzzle Theories - Taxes Individual income tax Personal income after tax: (1-tD)I + (1-tC)(1-tE)(EBIT-I)。 To get $1 as a bondholder, income after tax is (1-tD) To get $1 as a stockholder, income after tax is (1- tC)(1-tE) 2019/2/2 Hu - Financing Decision I

The Capital Structure Puzzle Theories - Contracting issues Cost of financial distress Underinvestment because benefit will go to someone else Especially for growth firms Growth firms should use less debt 2019/2/2 Hu - Financing Decision I

The Capital Structure Puzzle Theories - Contracting issues Benefit of debt financing Control agency cost of overinvestment Especially for mature firms Mature firms should use more debt 2019/2/2 Hu - Financing Decision I

The Capital Structure Puzzle Theories – Information costs Signalling of future cash flow How can it be credible? Issue debt commits the firm to pay future cash flow Issue debt conveys good information 2019/2/2 Hu - Financing Decision I

The Capital Structure Puzzle Theories – Information costs Issue equity conveys bad information When a firm is overvalued, equity is more overvalued than debt, company will sell equity Therefore, stock price will drop when a company issues equity 2019/2/2 Hu - Financing Decision I

The Capital Structure Puzzle Theories – Information costs The information cost is the highest when issue equity Pecking order 1st priority is to use internal funds 2nd priority is to issue debt Last priority is to issue stock 2019/2/2 Hu - Financing Decision I

The Capital Structure Puzzle Evidence High leveraged firms are mature and asset-intensive Cement, Steel, Paper, Textiles, Petroleum refining Low leveraged firms are growth industries Cosmetics, drugs 2019/2/2 Hu - Financing Decision I

The Capital Structure Puzzle Evidence Growth companies use less long-term debt, use more high-priority securities 2019/2/2 Hu - Financing Decision I