The Capital Structure Puzzle: Another Look at the Evidence Team 3

Capital Structure: Premise Given the level of total capital required to support a company’s activities; is there an optimal debt to equity ratio that maximizes the firms current value? Challenges: Anecdotal approaches vs. empirical studies Test design

The Theories Taxes Contracting Cost (Underinvestment Problem) Basic corporate profit taxes allow the deduction of interest payments but not dividend payments from the calculation of taxable income. Therefore adding interest liability lowers the companies overall tax liability and increases its after tax cash flow. Contracting Cost (Underinvestment Problem) Combines setting leverage targets by balancing the tax benefits of higher debt with the increasing probability of incurring financial distress because of it. If financial distress occurs, companies tend to underinvest in their future value, or ability to generate future cash flows from revenues. Therefore companies with multiple investment opportunities will tend to have low debt, to avoid the underinvestment problem, were mature companies will have few profitable investments and higher leverage ratios.

The Theories Information Cost Signaling: Corporate executives typically have better information about the value of company’s than the market. But how to share this information in a way that it is believed and understood by the market. Taking on debt contracts obligates the companies future cash flows towards its repayments, so it has become a good way to signal the market about the confidence of its managers on their ability to make the payments. For this reason the signaling theory suggest that managers who believe their firm is under valued will issue debt, and those who believe they are overvalued with issue equity. The Pecking Order: Suggest that the information cost associated with issuing securities are so high that they should be avoided. According to the theory companies maximize value by systematically finding the “cheapest” method: 1) internal (retained earnings); 2) debt; 3)equity.

The Evidence on Contracting Cost To test the contracting cost theory; the authors used the market-to-book value ratio (the higher the market to book value ratio, the more investment/growth opportunities the market is seeing for the company). Once the type of company is established growth vs. mature, the leverage ratio can be examined and the theory supported or refuted. Companies with High market-to-book ratios had significantly lower leverage ratios than companies with Low market-to-book ratios. This evidence is also consistent with the tax hypothesis: Companies with low growth prospect and low distress cost have the greatest need of tax shields, hence they tend to have higher debt ratios.

The Evidence on Debt Maturity & Priority Companies with high growth/investment opportunities should use short term debt (or at least call provisions). By doing this they avoid the underinvestment cost that could result from committing long term cash flows to service interest debt and paying higher interest rates from higher investor risk. The researchers found that growth companies tended to have a lot less debt with maturity greater than three years than mature companies. Additionally, these high growth firms issued significantly more high priority debt than lower. The rational is that should the company fall into hardship it is easier to negotiate with less creditors with higher priority than with a multitude of creditors with different priorities to debt repayment.

The Evidence on Information Cost Several studies have looked at the signaling theory and the pecking order theory and found that it generally holds true. However the explanation that managers do not have a leverage ratio goal and will simply act to either signal the market or to avoid debt all together if internal resources allow (pecking order) is not the only conclusion that can be drawn from those studies. The authors found in their research that many companies indeed have targets but that the economies of scale in issuing debt or securities create a deviation from their leverage ratio goals. Compensating for these deviations in itself has a cost and companies only do so, every few years. When the maturity and priority of debt is also considered the authors did not find a connection between their data and the prediction of the model

The Evidence on Taxes The evidence suggest that taxes play a less significant role in debt decisions than the Tax theory would predict. However, these studies have to be taken lightly because the tax rate proxies are related to other financial decisions, so they may not be too accurate.

Toward a Unified Theory of Corporate Finance Policy The contracting cost theory provides the closest proximity to a unified framework for analyzing the capital structure framework. The next step in the evolution of a unified theory should also help explain a broader range of issues: dividend, payments, compensation, hedging and leasing policies. The evidence suggest companies pick coherent packages of these policies. Small, high-growth firms tend to have low leverage ratios and simple capital structures but low dividend payouts and considerable stock-base incentives for management compensations. The key is to reconcile both the level of debt vs. equity (stock) and the cost of issuing one or the other (flows) as both of these factors play a part in the managers decision.