THE CAPITAL STRUCTURE PUZZLE

The Theories
This paper first of all looks at different Theories of optimal Capital structure and then tries to prove/disprove theories based on empirical evidence and research in real world. How do you divide a companys capital base between debt and equity to maximise firm value ? Schools of thought include; 1 Are capital structure and dividend policy irrelevant in deciding corporate market value 2 Corporate funding choices reflect an attempt by corporate managers to balance tax shields of greater debt against potentially large costs of financial distress including those arising from corporate underinvestment. 3 Are corporate managers concerned primarily about signalling effect of decisions causing stock prices to fall in response to announcements of common stock offerings 4 Pecking order theory where retained earnings are preferred to outside financing, and debt is preferred to equity when outside funding is required. Good Models exist predicting value of traded financial assets, but modelling of corporate finance still far behind because; (a)Models of capital structure decisions less precise than asset pricing models. (b)Different Theories of optimal capital structure are not mutually exclusive. Variables affecting optimal capital structure are different to measure

Three broad categories of Theories (or Views) of Corporate Financial Policy 1 Taxes - 2 Contracting Costs3 Information Costs Taxes Adding debt to a firms capital structure lowers its expected tax liability, and increases its after tax cash flow. But this has the knock on effect of raising investors tax bills which must be countered by higher yields. However leaving debt out of the capital structure equation leaves value on the table. Contracting Costs Whatever the tax benefits of higher leverage, they must be set against the greater probability and higher expected costs of financial distress. In this view the optimal capital structure is one in which the next dollar of debt is expected to provide an additional tax subsidy that just offsets the resulting increase in the expected costs of financial distress. Two main contracting costs;

1 Costs of financial distress ( or the underinvestment problem) 2 Benefit of debt in controlling overinvestment

1 Costs of financial distress ( or the underinvestment problem) Indirect costs of bankruptcy can be substantial especially loss in value that results from cutbacks in promised investment when firm gets into trouble. Bankruptcy judge effectively assumes control of corporate investment policy and probably is not focussed on maximising value. Even where situation is not as extreme as bankruptcy; Highly leveraged companies are more likely than their low debt counterpart to pass up valuable investment opportunities. Tendancy to underinvest when facing financial difficulty leading to Cutbacks in R&D, advertising, training, maintenance will erode future profits. Value of such a firm is heavily dependant on its ability to carry out long term investment plans and generally needs an infusion of equity, but problem is that cost of new equity is usually so high that managers might rationall forgo both the capital and investment opportunities. This is the Underinvestment Problem where growth(and some old line manufacturing) companies will generally avoid debt to limit theit greater potential loss in value from underinvestment, and mature companies will have higher leverage (debt) ratios than high growth firms 2 Benefit of debt in controlling overinvestment Just as too much debt can lead to underinvestment, too little debt can lead to overinvestment. Large mature companies often have free cash flowwhich cannot be reinvested profitably within the firm, but natural inclination of corporate managers is to overinvest in core business, or worse by diversifying into acquisition of unfamiliar businesses. Maximising firm value means that this free cash should be distributed to investors Raise the dividend, Substitute debt for equity through leveraged stock purchases Debt financing can add value by forcing managers to be more critical in evaluating capital spending plans Use of debt reduces the Agency costs of equity- reduction in firm value that arises from the separation of ownership and control in large public companies with widely dispersed shareholders. However In mature industries with limited capital requirements, heavy debt financing has the added benefit of facilitating the concentrating of equity ownership.

Information Costs Corporate executives often have better information about the value of their company than outside investors. Recognition of this gap between managers and investors has led to the formulation of 3 distinct but related theories of financing decisions;ie 1 Market Timing 1 Market Timing Stock prices are more sensitive than Bond prices to any proprietary information about the firms performance Companies who have favourable information about performance know that the release of such information will cause a larger increase in stock prices than in Bond prices, and will result in the stock appearing undervalued. Companies who have profitable use for more capital but believe that their shares are undervalued will generally chose to issue debt rather than equity. Conversely managers who think that their companies are overvalued are more likely to issue equity, or make stock for stock acquisitions. Some companies issue overvalued securities, debt or equity even if they have no current profitable use for the capital. Investors realise that the managers know more than they do and understand managements propensity to issue overvalued rather than undervalue securities. A considerable body of studies has shown that investors mark down the shares of issuing foirms by 3% on average. By contrast the average reaction to new debt offerings is not significantly different to zero. Important for management to realise that market will mark down but for overvalued companies the real cost is less to the shareholders than undervalued or fairly valued firms, diluting the effective value of shareholders interest. This cost is known as the Information Cost of raising outside capital. Signalling Signalling is premised on the idea that managers have better information than investors.In contrast to Market Timing (viewed attempt to raise cheap capital), signalling model assumes that communication of firms prospects is managers intention, and in cases where management think firm is undervalued, to increase the value of the shares. 2 Signalling 3 Pecking Order

Challenge for managers is to find a credible signalling mechanism- Increasing Leverage has been suggested as one potentially effective signalling device.

The Pecking Order Theory

The Pecking Order Theory suggests that the Dilution associated with issuing securities is so large that it dominates all other considerations and companies maximise value by systematically choosing to finance new investments with the cheapest source of funds. Managers prefer internally generated funds(retained earnings) to external funding and if outside funds are necessary they prefer debt to equity, because of lower information costs. Companies are said to issueequity only as a last resort when their debt capacity has been exhausted. Pecking order theory predicts that companies withfew investment opportunities or substantial free cash flow will have low (or even negative) debt ratios because the cash will be used to pay down the debt. It also suggests that firms with higher growth opportunitieswith lower operating cash flows will have high debt ratios because of theirv reluctance to raise new equity. Pecking order theory therefore offers predictions that are exactly the opposite of those offered by the Tax and Contracting Costs theories.

THE CAPITAL STRUCTURE PUZZLE

The Empirical Evidence

Evidence on Contracting Costs Reviewing the evidence of the applicability of the different theories of Capital Structure,
there are clear differences in the average debt to (book) asset ratios of companies in different industries, as well as a tendency of companies in the same industry to cluster around their industry average. Industry averages negatively correlated with R&D spending and other Corporate Growth proxies, with mature and asset intensive industries shown to be highly leveraged, and newer high growth industries with low debt ratios. Corporate debt to (book) asset ratios negatively related to R&D ,Operating Earnings volatility and advertising. Research on debt to asset ratios in 8800 companies supports the Contracting Costs hypothesis

Evidence on Debt Maturity and Priority. Not all debt is the same, with ssome differing in maturity, priority, convertability, call provsions, covenant restrictions, and whether privately placed or held by public investors. Each of these features affects potential underinvestment problem, in high growth firms. For example Debt financed companies with more opportunities would prefer to have debt with shorter maturities,, less restrictive covenants, more convertability options and a smaller group of private investors rather than public bondholders. Research shows that high growth companies have significantly less long term debt as a % of debt of companies with limited investment opportunities. Companies with high markrt to book ratios had higher porportions of secured and senior debt, with little subordinated debt.

Evidence on information costs is inconsistent with signalling cost theory. Evidence to support Pecking order theory not found. Evidence on Taxes found that Taxes play a modest role only in Corporate financing and Capital Structure decisions Implications for Dividends and other Corporate policies In conjunction with evidence on leverage high dividends and high leverage tend to be complementary strategies driven by common factors and considerations. Corporate compensation policy, hedging and leasing policies are similar, Integration of stocks and flows The key to reconciling the different theories and understanding the Capital Structure Puzzle lies in achieving a better understanding of the relations between corporate financing stocks and flows. CFOs need to develop a sensible approach to targeted capital structure in terms of a ratio of debt to totalcapital that is expected to minimise taxes and contracting costs (while paying some attention to information costs). CFO should adjust firms capital structure whenever the costs of adjustment are less than deviating from the target. Findings are that companies adjust at 30% per annum, and smaller firms will deviate more from their capital structure targets than larger companies. Larger adjustment costs will lead to larger deviations from target before firms readjust.