🔎 The Bottom Line

Tying the last two lectures together, we arrive at the “tradeoff theory” of capital structure, which helps us understand the relative proportions of equity financing and debt financing that a firm should have.

To help keep everything straight, I’ve organized everything we’ve covered during these two weeks into Four Steps. (Click on the red link to learn the four steps.) It is up to the management of the firm to weight the insights from the four steps and decide on the optimal capital structure, in consultation with their bankers.

The following summary, adapted from another version of our textbook, gives an overview of this process.

The most important insight regarding capital structure goes back to Modigliani and Miller (Step 1): With perfect capital markets, a firm’s security choice alters the risk of the firm’s equity, but it does not change its value or the amount it can raise from outside investors. Thus, the optimal capital structure depends on market imperfections, such as taxes, financial distress costs, agency costs, and asymmetric information.

Of all the different possible imperfections that drive capital structure, the most clear- cut, and possibly the most significant, is taxes. The interest tax shield (Step 2) allows firms to repay investors and avoid the corporate tax. Each dollar of permanent debt financing provides the firm with a tax shield worth T dollars, where T is the effective tax advantage of debt. For firms with consistent taxable income, this benefit of leverage is important to consider.

While firms should use leverage to shield their income from taxes, how much of their income should they shield? If leverage is too high, there is an increased risk that a firm may not be able to meet its debt obligations and will be forced to default. While the risk of default is not itself a problem, financial distress (Step 3) may lead to other consequences that reduce the value of the firm. Firms must, therefore, balance the tax benefits of debt against the costs of financial distress.

Agency costs (Step 4) and benefits of leverage are also important determinants of capital structure. Too much debt can motivate managers and equity holders to take excessive risks or under-invest in a firm. When free cash flows are high, too little leverage may encourage wasteful spending. This effect may be especially important for firms in countries lacking (49) strong protections for investors against self-interested managers. When agency costs are significant, short-term debt may be the most attractive form of external financing.

A firm must also consider the potential signaling and adverse selection (Step 4) consequences of its financing choice. Because bankruptcy is costly for managers, increasing leverage can signal managers’ confidence in the firm’s ability to meet its debt obligations. When managers have different views regarding the value of securities, managers can benefit current shareholders by issuing the most overpriced securities. However, new investors will respond to this incentive by lowering the price they are willing to pay for securities that the firm issues, leading to negative price reaction when a new issue is announced. This effect is most pronounced for equity issues, because the value of equity is most sensitive to the manager’s private information. To avoid this “lemons cost,” firms should rely first on retained earnings, then debt, and finally equity. This pecking order of financing alternatives will be most important when managers are likely to have a great deal of private information regarding the value of the firm.

Finally, it is important to recognize that because actively changing a firm’s capital structure (for example, by selling or repurchasing shares or bonds) entails transactions costs, firms may be unlikely to change their capital structures unless they depart significantly from the optimal level. As a result, most changes to a firm’s debt-equity ratio are likely to occur passively, as the market value of the firm’s equity fluctuates with changes in the (50) firm’s stock price.

Footnotes: 49 See J. Fan, S. Titman, and G. Twite, “An International Comparison of Capital Structure and Debt Maturity Choices,” Journal of Financial and Quantitative Analysis 47 (1) (2012):23—56. 50 See I. Strebulaev, “Do Tests of Capital Structure Theory Mean What They Say? ” Journal of Finance 62 (2007): 1747-1787.