Capital Structure Theories and Evidence

1. Capital Structure Theories and Evidence Advanced Corporate Finance 25 September 2007

2. 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

3. 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!

4. 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.

5. 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!

6. 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.

7. 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.

8. 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.

9. 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

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

11. 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).

12. 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.

13. 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.

14. 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).

15. 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).

16. 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.

17. 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.