1 Survey evidence on some of the factors that affect the decision to issue debt. The survey is based on the responses of 392 CFOs, conducted by John Graham and Campbell Harvey. (Paper is enclosed as an optional reading.) How Firms Establish Capital Structure

2 Tradeoff or Pecking Order? 1.Financial flexibility. Can be argued both ways. If you view flexibility as a room for avoiding equity financing for fear of bad “signalling,”— pecking order. If you view it as a benefit/cost consideration, tradeoff 2.Credit rating. Here you worry about default probability/costs. tradeoff. 3.Earnings/cashflow volatility. Volatile cashflows lead to higher default probability. Tradeoff 4.Insufficient internal funds. Literally from pecking order theory 5.Level of interest rate. This relates to cost of debt. Tradeoff 6.Interest tax saving. Tradeoff (on class slides) 7.Transaction costs and fees. Pecking order. In pecking order, you want to avoid those costs. 8.Equity under/over valuation. Pecking order. This stems from information asymmetry—whether you believe your equity is overvalued or not and how investors perceive it in turn. 9.Comparable firm debt level. Target leverage ratio. Tradeoff 10.Bankruptcy costs. Tradeoff (from slide) 11.Customer/supplier satisfaction. Can be one cost of debt. Tradeoff.

3 Review Questions Does the following increase or decrease the use of debt: 1.Agency costs of debt A: From the perspective of bondholders, foreseeing these agency costs and the increased risk, they will ask for higher returns  debt costs increase  less debt 2. Governments often step in to protect large companies that get into financial trouble and bail them out. If this were an accepted practice, what effect would you expect it to have on the debt ratios of firms? Why? A: Effectively reduces bankruptcy costs. Debt ratio goes up.