Capital Structure Theories and Evidence Advanced Corporate Finance 25 September 2007

Is there an “optimal” capital structure for a firm? Adding corporate taxes to the Modigliani and Miller framework suggests firms should be “all-debt”. What keeps firms from this type of capital structure? Costly financial distress Value of levered firm = Value of unlevered firm + tax benefits – expected costs of distress

Trade-off theory of capital structure Firms trade off tax benefits of debt against financial distress costs. Equation 15.67 presents one such model. Figure 15.10 shows a graphical representation. Empirical implications of trade-off theory Higher marginal tax rates, higher debt ratios. Greater expected costs of distress, lower debt ratios. In general, very non-specific!

What are distress costs? Include both “direct” and “indirect” costs. Direct Costs paid by firm as part of bankruptcy proceedings. Will vary by economic regime based on law. Indirect Business disruption costs. Value lost because of underinvestment. Value lost because of asset fire sales.

How big are financial distress costs? First evidence from Warner (1977): direct costs only from railroad bankruptcies. More recent evidence from highly-leveraged transactions that become financially distressed analyzed by Andrade and Kaplan (1998): 10 – 20% of pre-distress firm value. Evidence from asset fire sales by Pulvino (1998): 14 – 30% discounts on aircraft sold by distressed airlines. Overall, not a lot of quantifiable evidence!

More on the tax benefits of debt Are the tax benefits of debt really defined by corporate tax rate? Miller (1977) Missing piece: tax rates faced by investors. Tax rate paid by investors on equity income is positive, but tax rate on interest income is typically much higher. Reduces tax benefit of debt. See definition of “G” in equation 15.24. Tax code could be defined to deter debt (by making tax rate on interest income sufficiently high relative to corporate tax rates). Graham (2000) estimates the value of debt tax shield after accounting for personal taxes to be about 4 – 7% of firm value.

Capital structure puzzle How do firms choose their capital structures? Answer according to Myers (1984): “We don’t know.” The answer is not really that bleak. It was just that existing theory did not do a very good job of explaining observed capital structures. An alternative to trade-off theory is proposed by Myers: pecking order.

Pecking order Firms prefer internal financing Adapt target dividend payout to investment opportunities. Sticky dividend plus unpredictable fluctuations in profitability and investment opportunities create need for financing (or surplus of financing). If new financing is required, firms issue debt first with new equity as last resort. Observed debt ratio reflects cumulative need for financing over time.

Basic example of pecking order Myers and Majluf (1984) basic example: Two equally likely states of the world: High value Low value Value of assets in place: High = 150 Low = 50 NPV of investment opportunity costing 100: High = 20 Low = 10

Basic Example (cont’d) In absence of information asymmetry: Value = 115 (expected value of existing assets + expected NPV) Assume that managers learn which state occurs ahead of outside investors: Value of existing shareholders’ stake if high value occurs: Issue & invest = 144.42 (115/215 * 270) Don’t invest = 150 Value of existing shareholders’ stake if low value occurs: Issue & invest = 85.58 (115/215 * 160) Don’t invest = 50

Basic example (cont’d) Equilibrium strategy is that firm’s managers refuse to invest in positive NPV project in “good” state. Equilibrium value to existing shareholders: If high value occurs, don’t invest Value of existing shares = 150 If low value occurs, issue & invest Value of existing shares = 60 Issuing new capital signals bad news If firm has internal capital available, firm invests regardless of outcome (no underinvestment).

Does pecking order really explain financing choice better than trade-off theory? Shyam-Sunder and Myers (1999) Yes Change in debt is better correlated with the financing deficit (as compared to correlation with difference between lagged “target” debt ratio and lagged actual debt ratio Frank and Goyal (2003) No Net equity issues track financing deficit more closely than do net debt issues. Small, high-growth firms are less likely to follow pecking order.

Agency costs of free cash flow Jensen (1986) Free cash flow: cash flow in excess of that required to fund all valuable projects. After-tax operating cash flow is easily observable, BUT Valuable investment opportunities are NOT easily observable. Free cash flow can be used by managers for non-value-adding purposes. Paying cash flow to shareholders (i.e., more dividends and/or repurchases) is “weak” commitment. More debt = binding commitment to pay out excess free cash flow (more interest). Greater commitments to pay debtholders might create additional motivation for managers to maximize efficiency of business.

Other arguments Firms may “time” the market: Old argument that gained new traction in recent years. Issue equity when it’s overpriced. Issue debt when cheap. Capital structure reflects cumulative effect of these issuance decisions: Baker and Wurgler (2002). Firms may choose lower debt ratios if high debt puts it at disadvantage to product market competitors: Campello (2003).

Summary of capital structure theory “Optimal” capital structure is a complex decision. No single theory adequately describes how firms set capital structure, but all have merit. Trade-off theory is very difficult to empirically test properly. Pecking order and market timing theories describe how firms make financing choices only (not capital structure choice). Product market theories are nice recent add-on to our understanding of capital structure (but more to be done).

How should managers choose capital structure? Tax benefits should be considered, but avoid overestimating. Probability of financial distress does not equate to costs of distress. Firms with high costs of distress should optimally choose lower debt in capital structure. Managers should make the effort to understand types and magnitudes of distress costs faced if distress occurs. How likely is distress? Following the pecking order to finance new investment should not stop managers from periodically evaluating whether it’s value-adding to restructure debt/equity mix.

References Andrade, G., and S.N. Kaplan, 1998, “How costly is financial (not economic) distress? Evidence from highly leveraged transactions that became distressed,” Journal of Finance 53, 1443 – 1493. Baker, M., and J. Wurgler, 2002, “Market timing and capital structure,” Journal of Finance 57, 1 – 32. Campello, M., 2003, “Capital structure and product markets interactions: Evidence from business cycles,” Journal of Financial Economics 68, 353 – 378. Frank, M., and V. Goyal, 2003, “Testing the pecking order theory of capital structure,” Journal of Financial Economics 67, 217 – 248. Graham, J.R., 2000, “How big are the tax benefits of debt?” Journal of Finance 55, 1901 – 1941. Jensen, M.C., 1986, “Agency costs of free cash flow, corporate finance, and takeovers,” American Economic Review 76, 323 – 329. Miller, M.H., 1977, “Debt and taxes,” Journal of Finance 32, 261 – 275. Myers, S. C., 1984, “The capital structure puzzle,” Journal of Finance 39, 575 – 592. Myers, S.C., and N. Majluf, 1984, “Corporate financing and investment decisions when firms have information that investors do not have,” Journal of Financial Economics 13, 187 – 221. Pulvino, T.C., 1998, “Do asset fire sales exist? An empirical investigation of commercial aircraft transactions,” Journal of Finance 53, 939 – 978. Shyam-Sunder, L., and S.C. Myers, 1999, “Testing static tradeoff against pecking order models of capital structure,” Journal of Financial Economics 51, 219 – 244. Warner, J., 1977, “Bankruptcy, absolute priority, and the pricing of risky debt claims,” Journal of Financial Economics 4, 239 – 276.