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Capital Structure
“... (now 55) years and hundreds of
papers after Modigliani and Miller’s
seminal work, what do we really know
about corporate capital structure choice?”
Consequences
• Financing and Investment
– Debt ratios and investment are negatively correlated.
• Does debt impede investment or do firms with modest
investment opportunities choose higher debt?
– Lang, Ofek, and Stulz 1996 look at noncore divisions of
large firms and find the same result.
• This is compelling evidence that leverage influences
investment. The firm’s leverage is likely to be exogenous for
noncore divisions in a firm. Said another way, it is unlikely
that the nature of the investment opportunities of a noncore
division heavily influenced the firm’s capital structure
decision.
Consequences
• Financing and Workers
– Leverage and wages are negatively correlated, high
leverage firms also provide less job security in
downturns and fund pensions less aggressively.
• Sharpe 1994
– Does leverage or size affect a firm’s tendency to “hoard labor”
during downturns.
– Employment should be affected by current and expected sales
growth. Sales growth is endogenous and may depend on
employment.
– Control endogeneity problem with 2SLS
– Results are consistent with the idea that firms with more flexible
labor forces use more debt.
Consequences
• Financing and Customers
– There is a negative relation between leverage and
performance. Opler and Titman 1994
• Industry shocks are used as exogenous variation in sales
and the authors find that highly leveraged firms
experience larger declines in sales than low leveraged
firms.
• It is possible that high leverage simply proxies for
operating inefficiency and it is not a surprise that
poorly run firms fail quickly in an industry decline.
Consequences
• Financing and Suppliers/Stakeholders
– Do firms that depend on a single
supplier/customer choose lower leverage?
• Banerjee, Dasgupta, Kim 2008 say yes.
• Consistent with a cost of distress story. Firms with low
leverage are a more attractive partner than are highly
leveraged firms.
• Possibly leverage is a by-product. Firms with
entrenched CEOs are attractive partners. Entrenched
CEOs prefer low leverage.
Theory
• We all know about taxes.
– “Horse and rabbit stew”
– Add personal taxes and it becomes unclear.
– Graham’s marginal tax rates and underleverage.
Theory
• Agency Cost Stories:
– Manager/Shareholder conflict derived from fact
that managers (decision makers) do not own
100% of the residual claim.
• The issue is mitigated as the decision maker owns more
of the equity. Holding manager’s investment constant,
debt financing increases their equity share.
• Mitigation of the manager/shareholder conflict is a
benefit of debt in agency cost models.
• The transfer of control in default also serves to control
incentives.
Theory
• Agency Cost Stories
– Shareholder/Bondholder conflicts derive from the
payoff structure of levered equity (over- and
under-investment incentives).
• These incentives are priced into debt ex ante, however
there is no way for shareholders to commit.
• Features that control such behavior, like debt covenants
are not perfect.
• The incentive distortions represent a cost of debt in
many of these models.
Theory
• Asymmetric Information Stories
– Investment/Financing Interactions
• Myers and Majluf is a leading example in this area.
• The benefit of debt is its relative informational
insensitivity and, in this story, there is no cost of debt
which necessitates an exogenous debt capacity to make
the pecking order “work” as a theory of financing.
• The big ticket prediction here is the negative stock price
reaction at the announcement of equity issues and
positive reaction to announcements of debt issues.
Theory
• Asymmetric Information Stories
– Signaling quality with debt
• Ross 77 is the first example in this area. Debt can signal firm
quality as managers face a cost in bankruptcy which is less likely
(for a given level of debt) the higher is the quality of the firm.
• Leland and Pyle use managerial risk aversion as the cost of the
signal. Increased leverage allows managers to retain a larger
fraction of the equity which via the risk aversion signals higher
quality.
– Gale and Stiglitz extend this to allow secondary market trading (dumping)
by managers. Show that if the aftermarket pricing is precise the
manager’s stake can retain its signaling quality. If not, signaling is
impossible.
– Courteau allows commitment to one period or two period holding. If
aftermarket pricing is very imprecise all commit to two period holding to
avoid market breakdown as in Gale and Stiglitz. When it is more precise,
the high types commit to two period holding while lower types choose
one period. When it is very precise all choose one period holding.
Theory
• Product market interactions with capital structure.
– Debt influences competitors strategies
• Brander/Lewis 1986 oligopolistic competitors use debt as a
commitment device. The “taste for risk” of levered equity
commits firm to a more aggressive output policy in a Cournot
game. Result is over-production relative to the Cournot
equilibrium (zero debt) in a sort of prisoner’s dilemma with
respect to capital structure.
– Product or market characteristics influence debt
• Titman 1984 - extent to which product is specialized. Liquidation
is a tension between shareholders and customers as firm does not
take customers costs into account in liquidation decision. Capital
structure choice allows firm to structure outcome efficiently.
Some Facts
• Event studies have told us the following:
– Abnormal returns associated with announcements of common
stock issues are about -3%
– Convertible bonds or convertible preferred: more negative than
the associated non-convertible security
– Straight debt or preferred stock: insignificantly different from 0
– Issues by utilities are less negative than issues by industrial firms
(of the same security)
– Firms are more likely to issue long-term debt when their
leverage is below a past average level
– Firms are more likely to issue equity after a period of positive
abnormal returns
– Equity issues are clustered after earnings announcements
Some Facts
• Masulis studied exchange offers (a pure financing
change!??):
– Debt issued in exchange for common stock results in a
14% abnormal return
– Preferred exchanged for common stock: 8.3%
– Debt exchanged for preferred stock: 2.2%
– Common stock exchanged for preferred: -2.6%
– Common stock exchanged for debt: -9.9%
– Preferred stock exchanged for debt: -7.7%
• Earnings and earnings forecasts have been found
to react consistently with these price responses.
Firm/Industry Characteristics
• With respect to capital structure choices, firms
within an industry are more similar than those
in different industries.
• Furthermore, industries tend to retain their
relative leverage rankings over time. (Bradley,
Jarrell, Kim 84 & Bowen, Daly, Huber 82)
– Low: Drugs, Cosmetics, Instruments, Metal Mining
– High: Steel, Telephone, Electric and Gas Utilities,
Airlines
Rajan and Zingales 1995
• Evidence from international data
– Independent samples to test the standard results.
– Also requires corrections necessary so that
measures of leverage are comparable.
– Institutional differences allow deeper tests of the
alternative theories.
• Leverage levels are relatively consistent across
countries with England being a low leveraged country.
• Overall the marginal effects are quite consistent across
countries with one exception.
Frank and Goyal 2009
• What factors are reliably related to leverage.
– Largely a statistical exercise.
LRZ
• A very simple message:
– The data suggests that corporate leverage has
both a permanent component and a transitory
component.
– Further that existing models of leverage do not do
a good job of capturing either feature of the
leverage data generating process.
• But one with important implications for how
empirical models of capital structure should
be approached.
LRZ
• The paper illustrates these basic points in a
variety of ways.
• There has been a lot of “push back” from a
variety of authors against what they think the
paper is about.
First Look
A Potential Concern