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Unraveling the Capital Structure Puzzle: Insights & Strategies

Delve into the complexities of capital structure decisions, from tax implications to contracting issues and information costs, to optimize corporate financing strategies effectively. Explore evidence-backed insights on leveraged vs. growth industries.

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Unraveling the Capital Structure Puzzle: Insights & Strategies

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  1. Topics • 12. The Capital Structure Puzzle Michael F. Barclay and Clifford W. Smith, Jr. Hu - Financing Decision I

  2. The Capital Structure PuzzleTheories - Taxes • Corporate income taxes • Interest expenses deduction • Tc: Corporate tax • tc: corporate tax rate • EBIT: Earnings before interest and tax • I: Interest expense Hu - Financing Decision I

  3. The Capital Structure PuzzleTheories - Taxes • Corporate income taxes • EBIT-Tc (distribute to bondholders and stockholders) is higher when I is larger Hu - Financing Decision I

  4. The Capital Structure PuzzleTheories - 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 Hu - Financing Decision I

  5. The Capital Structure PuzzleTheories - 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) Hu - Financing Decision I

  6. The Capital Structure PuzzleTheories - Contracting issues • Cost of financial distress • Underinvestment because benefit will go to someone else • Especially for growth firms • Growth firms should use less debt Hu - Financing Decision I

  7. The Capital Structure PuzzleTheories - Contracting issues • Benefit of debt financing • Control agency cost of overinvestment • Especially for mature firms • Mature firms should use more debt Hu - Financing Decision I

  8. The Capital Structure PuzzleTheories – 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 Hu - Financing Decision I

  9. The Capital Structure PuzzleTheories – 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 Hu - Financing Decision I

  10. The Capital Structure PuzzleTheories – 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 Hu - Financing Decision I

  11. The Capital Structure PuzzleEvidence • High leveraged firms are mature and asset-intensive • Cement, Steel, Paper, Textiles, Petroleum refining • Low leveraged firms are growth industries • Cosmetics, drugs Hu - Financing Decision I

  12. The Capital Structure PuzzleEvidence • Growth companies use less long-term debt, use more high-priority securities Hu - Financing Decision I

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