Firms initially would choose their preferred capital structure and later would bear the consequences. If the firm’s overall business subsequently did well, the managers who took on a large amount of debt would be pleased with this decision because the firm would enjoy the tax benefits of debt and probably would avoid the negative aspects of debt financing. However, if the firm’s business did very poorly, its managers, unable to use the tax benefits of debt and faced with the financial distress costs of debt, would regret being highly levered. According to the static capital structure theory, which assumes that capital structures are optimized period by period, firms weigh the costs of having too much debt when they are doing poorly against the tax benefits of debt when they are doing well to arrive at their optimal capital structures.
There are some empirical evidence which supports the various static theories of capital structure. Before these tests can be discussed, however, we must consider that managers do not, in reality, optimize their capital structures period by period as these theories suggest, but determine their capital structures as the result of a dynamic process that accounts for the costs associated with capital structure adjustments. Hence, at any given point in time, a firm may deviate from its long-term optimal or target debt ratio.
The Pecking Order of Financing Choices
Dynamic capital structure theory, the dynamic process that governs the capital structure choice, is still not well understood by financial economists. As a starting point in our explanation of what is understood, consider what Donaldson (1961) called the pecking order of financing choices, which describes how managers make their financing decisions. Donaldson observed that firms prefer first to finance investment with retained earnings; then, when they need outside funding, they prefer to issue debt instead of equity . The adverse selection theory explains the reluctance of firms to issue equity and, in addition, suggests that firms prefer to use their retained earnings to finance investment expenditures because this allows them to retain the capacity to borrow in the future. A summary of this pecking order includes the following observations:
- Firms prefer to finance investments with retained earnings rather than external sources of funds.
- Because of their preference to finance investment from retained earnings, firms adapt their dividend policies to reflect their anticipated investment
- Because of a reluctance to substantially change their dividend policy and because of fluctuations in their cash flows and investment requirements, retained earnings may be more or less than a firm’s investment needs. If the firm has excess cash, it will tend to pay off its debt prior to repurchasing shares. If external financing is required, firms tend to issue the safest security first. They begin with straight debt, next issue convertible bonds, and issue equity only as a last
A substantial amount of empirical evidence verifies Donaldson’s behavioral description. Most notably, extremely profitable firms tend to use a substantial amount of their excess profits to pay down debt rather than to repurchase equity. In addition, less profitable firms that need outside capital tend to use debt to fund their investment needs. As a result, firms that were profitable in the past have relatively low debt ratios while those that were relatively less profitable in the past have relatively high debt ratios. The main difference between what one might expect to observe from the static trade-off models and what is observed is that firms generally do not issue equity when they are having financial difficulties. The reluctance of firms to issue equity, as Donaldson observed, appears to be greatest when firms need the equity capital the most.
A number of explanations are offered for this pecking order behavior, including:
- Taxes and transaction costs favor funding new investment with retained earnings and debt over issuing new
- Managers generally can raise debt capital without the approval of the board of directors. However, issuing equity generally requires board approval and hence more outside scrutiny.
- Issuing equity conveys negative information to
- A firm having financial difficulties may want to maintain a high leverage ratio in the hope of gaining concessions from its employees and
- The debt overhang problem makes stock issues less attractive for a financially distressed firm.
We believe that a combination of all of the preceding reasons explains this observed pecking order behavior.
An Explanation Based on Management Incentives
The second reason is based on the idea that managers personally benefit from having their firms relatively unlevered. As discussed earlier, one reason managers might prefer lower debt ratios is that less levered firms can more easily raise investment capital than can highly levered firms, creating greater opportunities for the managers. Therefore, managers prefer to retain rather than pay out earnings and probably would prefer to issue equity as well, except that an equity issue requires the approval of the board of directors and thus leads to more scrutiny .
An Explanation Based on Managers Having More Information than Investors
The third explanation of Donaldson’s observation of the pecking order is based on Myers and Majluf’s (1984) information-based model. The basic idea is that managers are reluctant to issue stock when they believe their shares are undervalued. Because of this, investors often see an equity issue as an indication that managers believe the company’s stock is overvalued, which in turn implies that the stock price will fall when the company announces it will issue new shares. The negative stock market reaction to an equity issue may deter firms from issuing equity, even when they believe the market’s perception that the firm’s equity is overvalued is incorrect.
An Explanation Based on the Stakeholder Theory
In general, most nonfinancial stakeholders are pleased to see the firm issue equity. For example, employees will find their jobs more secure and their bargaining power improved if the firm has less leverage. However, that does not necessarily mean that the stockholders will find that issuing equity is in their interest. More profitable firms may anticipate expanding and, as a result, will want to maintain low debt ratios to attract the best employees and to appear as attractive as possible to potential strategic partners. Less profitable firms may plan on shrinking in size and could do so more efficiently with a higher leverage ratio. When a firm is shrinking, it might want to renegotiate contracts with suppliers and employees; and as discussed earlier, the firm may be in a better position to ask for concessions if it is highly leveraged and is having financial difficulties.
An Explanation Based on Debt Holder - Equity Holder Conflicts
The firm’s financial claimants (that is, debt holders and equity holders) also may disagree about the attractiveness of issuing equity. A firm with a substantial amount of long-term debt may have little incentive to issue equity after a series of losses. If bankruptcy costs are borne primarily by the firm’s debt holders, the equity holders benefit little from an infusion of new equity. Indeed, share prices will decline when firms replace debt with equity because decreasing the firm’s leverage increases the value of existing debt and transfers wealth from the equity holders to the debt holders. An exception to this general rule occurs when reducing leverage significantly cuts the costs of financial distress and thus significantly increases the total value of the firm.
In extreme cases, a financially distressed firm may be unable to raise equity capital .
For example, a corporation saw the value of its assets fall by 70 percent. It required a
$5 million capital infusion for maintenance costs in order to remain in business for another year. While managers would have preferred to issue equity, the firm was simply too far gone. The firm had debt obligations with a face value of $12 million; however, with a market value of less than $7 million for the entire firm, the debt was selling at a large discount.
In cases like this, the firm cannot get out of financial distress simply by issuing equity. Avoiding financial distress requires that the lenders either forgive some of their debt or provide the firm with an additional infusion of cash.
A firm that is unable to issue new equity because debt holders capture a large part of the gain associated with the recapitalization. If the recapitalization does not make the firm more valuable, then an equity infusion hurts equity holders by transferring value from them to the debt holders. In many cases, however, a financially distressed firm does become more valuable after a recapitalization, in which case both equity holders and debt holders can benefit. This will happen, for example, when a firm is unable to sell its products or is losing key employees because of its financial difficulties. Since financial distress reduces the current cash flows to equity holders, it provides an incentive for a firm to issue new stock, which can increase the value of the firm’s existing equity as well as its debt. When there are high costs associated with financial distress, equity holders have an incentive to recapitalize. However, if it is costly to repurchase or issue debt or equity, firms that have relatively low financial distress costs will have their leverage ratios determined to a large extent by their past history. That is, we expect a firm’s current debt-to-equity ratio to be low if its past earnings were high, and its leverage ratio to be substantially higher if its past earnings were negative. This argument suggests the following result.
If the costs of changing a firm’s capital structure are sufficiently high, a firm’s capital structure is determined in part by its past history. This means that:
- Very profitable firms are likely to experience increased equity values and thus lower leverage
- Unprofitable firms may experience lower equity values and perhaps increased debt, and thus higher leverage
In summary, we believe that firms deviate from their target or long-term optimal capital structure because of transition costs and the debt overhang problem and are more likely to take actions that move them toward their optimal ratio when financial distress costs are high. Managerial incentives are also likely to play an important role in determining how a firm’s capital structure changes over time.
The list of used literature:
- Chevalier, Judy, and David Scharfstein. “Capital Markets, Imperfections and Countercyclical Markups: Theory and Evidence,” American Economic Review 86 (1996), pp. 703–725
- Zweibel, Jeffrey. “Dynamic Capital Structure under Managerial ” American Economic Review 86 (1996), pp. 1197–1215.
- Mark Grinblatt, Sheridan Titman, «Financial Markets and Corporate Strategy» (2nd edition) McGraw-Hill/Irwin 2001
- Weston J. Fred; Kwang S. Chung; and Susan E. Hoag. Mergers, Restructuring, and Corporate Control. Englewood Cliffs, NJ: Prentice Hall, 1990