1. 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

2. 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

3. 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

4. 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

5. 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

6. 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

7. 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

8. 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

9. 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

10. 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

11. 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

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