Barclay and Smith –
2005 – The Capital Structure Puzzle: The Evidence Revisit

Barclay and Smith investigated company’s capital structure
and the optimal way of dividing a company’s capital base between debt and
equity. There are different opinions about this structure. Miller and
Modigliani argue that both capital structure and dividend policy are mostly
“irrelevant” because they have no effects on corporate market values. Another
view is that corporate managers balance the tax advantages of greater debt
against large costs when going default, including those arising from corporate
underinvestment. On the other hand, too little debt leads to overinvestment and
low returns on capital. Others argue that managers are concerned about the
response of the environment when making a decision. Myers argues that a
company’s capital structure is the unplanned outcome of managers decisions.
This is in line with the pecking order theory, a rule that states: retained
pecking order earnings are systematically preferred to outside financing, and
debt is preferred to equity when outside capital funds are required. Myers
argues that managers in general do not think about future target debt-to-equity
ratio, but take the easiest path and generally prefer debt, not taking into
account the future consequences. These contradicting views are referred to as
the capital structure puzzle.

Researchers began to develop models to predict the value of
traded financial assets as a function of other variables. Unfortunately, empirical
methods in corporate ?nance are less developed for several reasons. First, the
models of capital structure decisions are less precise than asset pricing
models. Second, most theories of the optimal capital structure are not mutually
exclusive. Third, many of the variables that might affect the optimal capital
structure are dif?cult to measure. Current theories can be grouped into three
categories: taxes, contracting costs, and information costs.

Taxes: Interest payments are tax-deductible while dividends
are not, so adding debt to a company’s capital structure lowers its tax
liability and increases its after-tax cash flow.

Contracting costs: A higher debt-to-equity ratio has a
greater probability and higher expected costs of ?nancial distress. In this
view, the optimal capital structure is one in which the advantage of tax of the
next dollar of debt outweighs the increase in the expected costs of ?nancial
distress. For many companies, the most important indirect cost is the loss in
value that results from cutbacks in promising investment when the ?rm gets into
?nancial distress.

Information costs: Insiders often have better information
about the value of their companies than outside investors. Recognition of this
information “gap” between managers and investors has led to the formulation of
three theories of ?nancing decisions: market timing, signalling and pecking

Market timing: Interest payments to bondholders are fixed
and stockholders will receive the residuals. Therefore, stock prices are more
sensitive than bond prices to any proprietary information about the ?rm’s
future performance. This well-known propensity of companies to “time” their
stock offerings is called market timing.

Signalling: This model assumes that corporate ?nancing
decisions are designed primarily to communicate managers’ con?dence in the ?rm’s
prospects and, in cases where management thinks the company is undervalued, to
increase the value of the shares.

Pecking order: companies maximize value by choosing to ?nance
new investments with the cheapest available source of funds. Managers prefer
internal funding (retained earnings) to external funding , but if necessary, debt
to equity is preferred because of the lower information costs associated with

To test the contracting cost argument, they attempted to
determine the extent to which corporate leverage and dividend choices could be
explained by differences in companies’ investment opportunities. They find that
growth companies tended to have less long-term debt as a percentage of total
debt than companies with limited investment opportunities. Also consistent with
the contracting-cost hypothesis, they found that the debt issued by growth ?rms
was more concentrated among high-priority classes.

Croci et al. – 2011 –
Family Control and Financing Decisions

These researchers investigate the role of family control in
corporate financing decisions. Since family firms are usually controlled by
large shareholders, financing decisions are likely to be influenced by this dominant
shareholder’s incentives than those of diversified outside shareholders. This
fear of losing control can encourage family firms to invest in less risky
projects and prefer debt financing. A prior study found that US family firms
have a higher debt level than non-family firms. Another research showed that
family firms have higher leverage ratios in countries with high investor
protection. Croci et al. investigated European firms and found that family firms
prefer debt financing and are less enthusiastic to raise capital by equity
financing. Their explanation is the agency conflict: the interests of
controlling shareholders will be conflicting with the family firm. Bond owners
therefore feel that family ownership protects their interests. The reason that
a family firm prefers equity financing, is because family firms are considered
risk averse. Therefore, they tend to avoid debt financing to reduce
firm-specific risk. however, this study shows that family firms invest less
than non-family firms in high-risk, research and development (R)
projects, suggesting that fear of control loss in family firms outweighs the
risk-taking perspective. This is consistent with an earlier paper, arguing that
poor corporate governance can lead to taking less risky investments and greater
debt financing.

Fan et al. – 2012 –
An International Comparison of Capital Structure and Debt Maturity Choices

This study examines how the institutional environment
in?uences capital structure and debt maturity choices of ?rms. The country a
firm operates in is an important determinant of how the firm is financed, even
more than its industry affiliation. Differences in country-level institutional
factors are likely to have a first order on the capital structure choice. The
country-level factors that explain a significant part of the variation in
leverage and debt maturity ratios are a country’s legal and tax system,
corruption, and the preferences of capital suppliers. Firms tend to use more
debt in countries with a greater tax gain from leverage. Three main tax
categories are used in this research: The classical tax system in which
dividend payments are taxed at both the corporate and personal levels and
interest payments are tax-deductible. Second is dividend relief tax system,
where dividend payments are taxed at a reduced rate at the personal level and third
is the dividend imputation tax system, where corporations can deduct interest
payments, but where the domestic shareholders of a company receive a tax credit
for the company’s paid taxes. Firms in countries with a higher level of
corruption and those with weaker laws tend to use more debt. When there are explicit
bankruptcy codes to minimize corruption, this is associated with higher
leverage and more long-term debt. They find that debt maturity is positively
related to the common law countries. Common law countries tend to have lower
corruption and stronger investor protection, encouraging the use of long-term
debt ?nancing, which supports the earlier finding of the influence of
corruption on a company’s capital structure. The preferences of the suppliers
of capital in?uence capital structure choices. The suppliers of capital
investigated in this study are banks, pension funds, and insurance companies.
Banks tend to have short-term liabilities and have a comparative advantage
holding short-term debt. On the other hand, pension funds have long-term
liabilities, and therefore a preference for holding long-term assets. Relatively
more equity is used. Likewise, insurance companies tend to hold longer-term

Myers – 2001 –
Capital Structure

There are several theories about a company’s capital
structure: the trade-off theory, the pecking order theory, free cash flow
theory and the irrelevance theory. Starting with the irrelevance theory of
Modigliani and Miller, that financing doesn’t matter in perfect capital markets,
this theory is explained further. This theory suggests that the weighted
average cost of capital is a constant and tax is fixed and permanent. Debt has
a first claim when it comes to a company’s assets and earnings, so the cost of
debt is always less than the cost of equity. This theory suggests perfect
capital markets exists, for regulators and policymakers this theory is the
ideal end result. However, the firm’s value actually depends on spreading of
assets, cash flows and growth opportunities and how they are available as debt
and equity claims to investors. Corporate income is taxed in the US, but interest
paid is tax-deductible. Therefore, financing with debt increases total
after-tax return to debt and equity investors, and should increase firm value.

The trade-off theory says that the firm will have debt until
the marginal value of tax shields on additional debt balances out by the
increase of possible costs of financial distress. This theory predicts moderate
borrowing by tax-paying firms.

The pecking order theory assumes perfect financial markets,
except for the fact that investors are not aware of the real value of the
existing assets or the upcoming opportunity. Investors are not able to value
the exact securities issued to finance the upcoming investment. The firm will
not issue equity but borrow when internally capital is not enough to fund and
external capital is necessary. The amount of debt is a firm’s need for external

A prior study tested the trade-off theory against the
pecking order theory. They found significant support for both the theories. Since
this is quite unlikely, other research found that the pecking order theory had
statistical power relative to the trade-off theory. the pecking order was the
best explanation in the financing decision of companies. Still, there is
something wrong with the pecking order theory. The theory is unable to explain
why financing tactics are not developed to avoid the financing results of
managers having more superior information than shareholders. The pecking order
suggests that the managers act in the interests of the shareholders, but this
research does not who why managers should take this into account is a new stock
issue is over- or undervalued. Perfect alignment between shareholders and
managers is not possible. Managers will act in their own interest, that can be
redirected by share ownership or compensation scheme, but there is never a
perfect alignment between shareholders and managers. The free cash flow theory
argues that high debt levels will increase value, even though there is a risk
of financial distress. This theory is for more mature firms, which have a lower
risk of financial distress. Each theory may work in different circumstances.

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