The Capital Structure Puzzle

Firms holding valuable intangible assets or growth opportunities tend to borrow less than firms holding mostly tangible assets.

“Firms holding valuable intangible assets or growth opportunities tend to borrow less than firms holding mostly tangible assets.”

• cites Long and Malitz [21] 21. Long, M. S., and E. B. Malitz, "Investment Patterns and Financial Leverage," Working Paper, National Bureau of Economic Research, 1983. sourceSupported
• cites Williamson [41] 41. Williamson, S., "The Moral Hazard Theory of Corporate Financial Structure: An Empirical Test," Unpublished Ph.D. Dissertation, MIT, 1981.Not matched

  Couldn’t be matched to a paper in Crossref, so it can’t be checked.

In Miller's theory, personal income taxes on interest payments would exactly offset the corporate interest tax shield, provided the firm pays the full statutory tax rate.

“In Miller's theory, the personal income taxes on interest payments would exactly offset the corporate interest tax shield, provided that the firm pays the full statutory tax rate.”

• cites [27] 27. Miller, M., "Debt and Taxes," Journal of Finance, 32 (May 1977), 261-275. sourcePartly supported

  In “Market Equilibrium and the Behavior of Firms and Individuals” (page unavailable), Miller says personal taxes on bond interest can offset the corporate benefit of deductible interest, and that the offset is one-for-one when the relevant tax rates satisfy a specified relationship. Paying the full statutory corporate tax rate alone does not establish that relationship; the personal tax rates on bond and stock income also matter. (LLM, conf=0.87)

  Experimental — accuracy not yet measured

In Miller's model, since the equilibrium only determines aggregates, debt policy should not matter for any single taxpaying firm.

“However, since the equilibrium only determines aggregates, debt policy should not matter for any single taxpaying firm.”

• cites [27] 27. Miller, M., "Debt and Taxes," Journal of Finance, 32 (May 1977), 261-275. sourceSupported

Risky firms tend to borrow less, other things equal.

“Risky firms tend to borrow less, other things equal.For example, both Long and Malitz [21] and Williamson [41] found significant negative relationships between unlevered betas and the level of borrowing.”

• cites Long and Malitz [21] 21. Long, M. S., and E. B. Malitz, "Investment Patterns and Financial Leverage," Working Paper, National Bureau of Economic Research, 1983. sourcePartly supported

  Table 6 reports a negative coefficient for unlevered beta (−0.099, t-statistic 7.62), and the Empirical Results section says its effect on leverage is negative. But that section also reports a significant positive relationship between total risk and leverage, so the broader claim that risky firms generally borrow less is not supported without specifying the risk measure. (LLM, conf=0.89)

  Experimental — accuracy not yet measured
• cites Williamson [41] 41. Williamson, S., "The Moral Hazard Theory of Corporate Financial Structure: An Empirical Test," Unpublished Ph.D. Dissertation, MIT, 1981.Not matched

  Couldn’t be matched to a paper in Crossref, so it can’t be checked.

If adjustment costs are small and firms stay near their target debt ratios, the observed diversity of capital structures across firms that seem similar in a static tradeoff framework is hard to understand.

“Then if adjustment costs are small, and firms stay near their target debt ratios, I find it hard to understand the observed diversity of capital structures across firms that seem similar in a static tradeoff framework.”

Extensive trading of depreciation tax shields and investment tax credits through financial leases and other devices proves that plenty of firms face low marginal rates.

“The extensive trading of depreciation tax shields and investment tax credits, through financial leases and other devices, proves that plenty of firms face low marginal rates.”

Miller's model allows explaining the dispersion of actual debt policies without introducing non-value-maximizing managers.

“Thus Miller's model allows us to explain the dispersion of actual debt policies without having to introduce non-value-maximizing managers.”

Firms cannot immediately offset random events that bump them away from the optimum, so there should be cross-sectional dispersion of actual debt ratios across a sample of firms having the same target ratio.

“Firms can not immediately offset the random events that bump them away from the optimum, so there should be some cross-sectional dispersion of actual debt ratios across a sample of firms having the same target ratio.”

The assumption that all firms face approximately the same marginal tax rate can be immediately rejected.

“and that is an assumption we can immediately reject.”

Miller's explanation works only if all firms face approximately the same marginal tax rate.

“Trouble is, this explanation works only if we assume that all firms face approximately the same marginal tax rate”

The pecking order theory performs at least as well as the static tradeoff theory in explaining actual financing choices and their average impacts on stock prices.

“I will argue that this theory performs at least as well as the static tradeoff theory in explaining what we know about actual financing choices and their average impacts on stock prices.”

The firm may choose to reduce these costs by issuing stock now even if new equity is not needed immediately to finance real investment, just to move the firm down the pecking order.

“The firm may choose to reduce these costs by issuing stock now even if new equity is not needed immediately to finance real investment, just to move the firm down the pecking order.”

The firm won't go out of its way to issue debt and retire equity to achieve a more normal debt ratio.

“It won't go out of its way to issue debt and retire equity to achieve a more normal debt ratio.”

Recent work based on asymmetric information gives predictions roughly in line with the pecking order theory.

“However, recent work based on asymmetric information gives predictions roughly in line with the pecking order theory.”

• cites [34] 34. Myers, S., and N. Majluf, "Corporate Financing and Investment Decisions When Firms Have Information Investors Do Not Have," Journal of Financial Economics, forthcoming.Not matched

  Couldn’t be matched to a paper in Crossref, so it can’t be checked.

The bulk of required external financing came from borrowing.

“The bulk of required external financing came from borrowing.”

• cites [7] 7. Brealey, R. A. and S. C. Myers, Principles of Corporate Finance, 2nd Ed., McGraw-Hill Book Co., New York, 1984.Not matched

  Couldn’t be matched to a paper in Crossref, so it can’t be checked.

The average stock price impact of high-grade debt issues will be small relative to the average impact of stock issues.

“it seems reasonable to predict that the average stock price impact of high-grade debt issues will be small relative to the average impact of stock issues.”

If the pecking order story is right, average debt ratios will vary from industry to industry because asset risk, asset type, and requirements for external funds vary by industry.

“If this story is right, average debt ratios will vary from industry to industry, because asset risk, asset type, and requirements for external funds also vary by industry.”

Williamson found that the higher a firm's proxy for intangibles and growth opportunities, the less the firm's debt-to-value ratio.

“His proxy for a firm's intangibles and growth opportunities was the difference between the market value of its debt and equity securities and the replacement cost of its tangible assets.The higher this proxy, he found, the less the firm's debt-to-value ratio.”

• cites Williamson [41] 41. Williamson, S., "The Moral Hazard Theory of Corporate Financial Structure: An Empirical Test," Unpublished Ph.D. Dissertation, MIT, 1981.Not matched

  Couldn’t be matched to a paper in Crossref, so it can’t be checked.

The firm may rationally issue stock to acquire financial slack.

“In other words, financial slack (liquid assets or reserve borrowing power) is valuable, and the firm may rationally issue stock to acquire it.”

Financial slack (liquid assets or reserve borrowing power) is valuable.

“In other words, financial slack (liquid assets or reserve borrowing power) is valuable, and the firm may rationally issue stock to acquire it.”

Firms holding tangible assets-in-place having active second-hand markets will borrow less than firms holding specialized, intangible assets or valuable growth opportunities.

“Firms holding tangible assets-in-place having active second-hand markets will borrow less than firms holding specialized, intangible assets or valuable growth opportunities.”

The simple asymmetric information model used to motivate the pecking order hypothesis predicts that the announcement of a stock issue will cause stock price to fall.

“The simple asymmetric information model I used to motivate the pecking order hypothesis does predict that the announcement of a stock issue will cause stock price to fall.”

• AssumptionThe authors state this as an assumption: Managers have special information that investors do not have.

Net new stock issues were never more than 6 percent of external financing.

“Net new stock issues were never more than 6 percent of external financing.”

• cites [7] 7. Brealey, R. A. and S. C. Myers, Principles of Corporate Finance, 2nd Ed., McGraw-Hill Book Co., New York, 1984.Not matched

  Couldn’t be matched to a paper in Crossref, so it can’t be checked.

Specialized, intangible assets or growth opportunities are more likely to lose value in financial distress.

“Specialized, intangible assets or growth opportunities are more likely to lose value in financial distress.”

The simple asymmetric information model predicts that stock price should not fall, other things equal, if default-risk debt is issued.

“It also predicts that stock price should not fall, other things equal, if default-risk debt is issued.”

• AssumptionThe authors state this as an assumption: Managers have special information that investors do not have.

Safe firms ought to be able to borrow more before expected costs of financial distress offset the tax advantages of borrowing.

“Since costs of financial distress are caused by threatened or actual default, safe firms ought to be able to borrow more before expected costs of financial distress offset the tax advantages of borrowing.”

A long-run industry average debt ratio will not be a meaningful target for individual firms in that industry.

“But a long-run industry average will not be a meaningful target for individual firms in that industry.”

Actual debt ratios vary widely across apparently similar firms.

“Actual debt ratios vary widely across apparently similar firms.”

Sticky dividend policies, plus unpredictable fluctuations in profitability and investment opportunities, mean that internally-generated cash flow may be more or less than investment outlays.

“Sticky dividend policies, plus unpredictable fluctuations in profitability and investment opportunities, mean that internally-generated cash flow may be more or less than investment outlays.”

Since target dividend payout ratios are sticky and investment opportunities fluctuate relative to internal cash flow, the firm will from time to time exhaust its ability to issue safe debt.

“Since target dividend payout ratios are sticky, and investment opportunities fluctuate relative to internal cash flow, the firm will from time to time exhaust its ability to issue safe debt.”

Given that external finance was needed, managers rarely thought of issuing stock.

“Given that external finance was needed, managers rarely thought of issuing stock:”

• cites [13] 13. Donaldson, G., Corporate Debt Capacity: A Study of Corporate Debt Policy and the Determination of Corporate Debt Capacity, Boston, Division of Research, Harvard Graduate School of Business Administration, 1961.Not matched

  Couldn’t be matched to a paper in Crossref, so it can’t be checked.

The evidence on exchanges hardly builds confidence in the static tradeoff theory as a description of financing behavior.

“The evidence on exchanges hardly builds confidence in the static tradeoff theory as a description of financing behavior.”

If management acts this way, its decision to issue will signal bad news to both old and new shareholders.

“But if management acts this way, its decision to issue will signal bad news to both old and new shareholders.”

• AssumptionThe authors state this as an assumption: The firm's manager knows x and y, while investors in capital markets do not and see only a joint distribution of possible values (x, y).
• AssumptionThe authors state this as an assumption: Aside from the information asymmetry, capital markets are perfect and semi-strong form efficient.
• AssumptionThe authors state this as an assumption: MM's Proposition I holds in the sense that the stock of debt relative to real assets is irrelevant if information available to investors is held constant.
• AssumptionThe authors state this as an assumption: The information asymmetry is taken as given.

The manager will issue and invest when y is greater than or equal to ΔN.

“Then the manager will issue and invest when y 2 AN.”

• AssumptionThe authors state this as an assumption: The firm's manager knows x and y, while investors in capital markets do not and see only a joint distribution of possible values (x, y).
• AssumptionThe authors state this as an assumption: Aside from the information asymmetry, capital markets are perfect and semi-strong form efficient.
• AssumptionThe authors state this as an assumption: MM's Proposition I holds in the sense that the stock of debt relative to real assets is irrelevant if information available to investors is held constant.
• AssumptionThe authors state this as an assumption: The information asymmetry is taken as given.

There is plenty of indirect evidence indicating that the level of borrowing is determined not just by the value and risk of the firm's assets, but also by the type of assets it holds.

“There is plenty of indirect evidence indicating that the level of borrowing is determined not just by the value and risk of the firm's assets, but also by the type of assets it holds.”

If the manager with superior information acts to maximize the intrinsic value of existing shares, then the announcement of a stock issue should be bad news, other things equal, because stock issues will be more likely when the manager receives bad news.

“If the manager with superior information acts to maximize the intrinsic value of existing shares, then the announcement of a stock issue should be bad news, other things equal, because stock issues will be more likely when the manager receives bad news.”

• AssumptionThe authors state this as an assumption: Managers have special information that investors do not have.

Costs of financial distress exist.

“We know these costs exist, although we may debate their magnitude.”

Dann and Mikkleson find that the average stock price impact of high-grade debt issues is small relative to the average impact of stock issues.

“This is what Dann and Mikkleson [10] find.”

• cites Dann and Mikkleson [10] 10. Dann, L. Y. and W. H. Mikkleson, "Convertible Debt Issuance, Capital Structure Change and Financing-Related Information: Some New Evidence," Working Paper, Amos Tuck School of Business Administration, 1983. sourceNot checked — no full text of the source

Firms prefer internal finance.

“Firms prefer internal finance.”

• cites [13] 13. Donaldson, G., Corporate Debt Capacity: A Study of Corporate Debt Policy and the Determination of Corporate Debt Capacity, Boston, Division of Research, Harvard Graduate School of Business Administration, 1961.Not matched

  Couldn’t be matched to a paper in Crossref, so it can’t be checked.

If the inside information is favorable, the firm may pass up a positive-NPV investment opportunity rather than issue undervalued shares.

“If the inside information is favorable, however, the firm may pass up a positive-NPV investment opportunity rather than issue undervalued shares.”

• AssumptionThe authors state this as an assumption: The firm's manager knows x and y, while investors in capital markets do not and see only a joint distribution of possible values (x, y).
• AssumptionThe authors state this as an assumption: Aside from the information asymmetry, capital markets are perfect and semi-strong form efficient.
• AssumptionThe authors state this as an assumption: MM's Proposition I holds in the sense that the stock of debt relative to real assets is irrelevant if information available to investors is held constant.
• AssumptionThe authors state this as an assumption: The information asymmetry is taken as given.

Risky firms ought to borrow less, other things equal.

“Risky firms ought to borrow less, other things equal.”

Each firm's observed debt ratio reflects its cumulative requirements for external finance.

“Each firm's observed debt ratio reflects its cumulative requirements for external finance.”

If internally-generated cash flow is less than investment outlays, the firm first draws down its cash balance or marketable securities portfolio.

“If it is less, the firm first draws down its cash balance or marketable securities portfolio.”

• cites [13] 13. Donaldson, G., Corporate Debt Capacity: A Study of Corporate Debt Policy and the Determination of Corporate Debt Capacity, Boston, Division of Research, Harvard Graduate School of Business Administration, 1961.Not matched

  Couldn’t be matched to a paper in Crossref, so it can’t be checked.

When the firm exhausts its ability to issue safe debt, it turns to less risky securities first, for example, risky debt or convertibles before common stock.

“When this happens, the firm turns to less risky securities first-for example, risky debt or convertibles before common stock.”

In the modified pecking order story, observed debt ratios reflect the cumulative requirement for external financing, cumulated over an extended period.

“The crucial difference between this and the static tradeoff story is that, in the modified pecking order story, observed debt ratios will reflect the cumulative requirement for external financing-a requirement cumulated over an extended period.”

In the pecking order story, there is no well-defined target debt-equity mix, because there are two kinds of equity, internal and external, one at the top of the pecking order and one at the bottom.

“In this story, there is no well-defined target debt-equity mix, because there are two kinds of equity, internal and external, one at the top of the pecking order and one at the bottom.”

Firms set target dividend payout ratios so that normal rates of equity investment can be met by internally generated funds.

“They set target dividend payout ratios so that normal rates of equity investment can be met by internally generated funds.”

Marsh and Taggart have found some evidence that firms adjust towards a target debt-to-value ratio.

“Marsh [22] and Taggart [39] have found some evidence that firms adjust towards a target debt-to-value ratio.”

• cites Marsh [22] 22. Marsh, P. R., "The Choice Between Equity and Debt: An Empirical Study," Journal of Finance, 37 (March 1982), 121-144.Not matched

  Couldn’t be matched to a paper in Crossref, so it can’t be checked.

• cites Taggart [39] 39. Taggart, R., "A Model of Corporate Financing Decisions," Journal of Finance, 32 (December 1977), 1467-1484. sourceNot checked — no full text of the source

The firm may plan to cover part of normal investment outlays with new borrowing, but it tries to restrain itself enough to keep the debt safe, that is, reasonably close to default-risk free.

“The firm may also plan to cover part of normal investment outlays with new borrowing, but it tries to restrain itself enough to keep the debt safe-that is, reasonably close to default-risk free.”

An unprofitable firm in the same industry will end up with a relatively high debt ratio.

“An unprofitable firm in the same industry will end up with a relatively high debt ratio.”

Firms have good reasons to avoid having to finance real investment by issuing common stock or other risky securities.

“Firms have good reasons to avoid having to finance real investment by issuing common stock or other risky securities.”

For all non-financial corporations over the decade 1973-1982, internally generated cash covered, on average, 62 percent of capital expenditures, including investment in inventory and other current assets.

“For all non-financial corporations over the decade 1973-1982, internally generated cash covered, on average, 62 percent of capital expenditures, including investment in inventory and other current assets.”

• cites [7] 7. Brealey, R. A. and S. C. Myers, Principles of Corporate Finance, 2nd Ed., McGraw-Hill Book Co., New York, 1984.Not matched

  Couldn’t be matched to a paper in Crossref, so it can’t be checked.

The factors that make financial distress costly also make it difficult to escape.

“The factors that make financial distress costly also make it difficult to escape.”

This cost is avoided if the firm can retain enough internally-generated cash to cover its positive-NPV opportunities.

“This cost is avoided if the firm can retain enough internally-generated cash to cover its positive-NPV opportunities.”

Firms in financial distress often do not rebalance their capital structures.

“This is why firms in financial distress often do not rebalance their capital structures.”

The gain in firm value from rebalancing is highest when the firm has gotten into deep trouble and lenders have absorbed a significant capital loss.

“The gain in firm value from rebalancing is highest when the firm has gotten into deep trouble and lenders have absorbed a significant capital loss.”

New stock issues play a relatively small part in financing aggregate investment outlays.

“New stock issues play a relatively small part.”

• cites [7] 7. Brealey, R. A. and S. C. Myers, Principles of Corporate Finance, 2nd Ed., McGraw-Hill Book Co., New York, 1984.Not matched

  Couldn’t be matched to a paper in Crossref, so it can’t be checked.

Aggregate investment outlays are predominantly financed by debt issues and internally-generated funds.

“Aggregate investment outlays are predominantly financed by debt issues and internally-generated funds.”

• cites [7] 7. Brealey, R. A. and S. C. Myers, Principles of Corporate Finance, 2nd Ed., McGraw-Hill Book Co., New York, 1984.Not matched

  Couldn’t be matched to a paper in Crossref, so it can’t be checked.

Investors would effectively force the firm to follow a pecking order.

“Thus investors would effectively force the firm to follow a pecking order.”

The firm which borrows against intangibles or growth opportunities may end up reducing their value.

“But the firm which borrows against intangibles or growth opportunities may end up reducing their value.”

The securities of growth firms may be excellent collateral.

“The securities of growth firms may be excellent collateral.”

Asymmetric information creates the possibility of a different sort of cost: the possibility that the firm will choose not to issue, and will therefore pass up a positive-NPV investment.

“Asymmetric information creates the possibility of a different sort of cost: the possibility that the firm will choose not to issue, and will therefore pass up a positive-NPV investment.”

• AssumptionThe authors state this as an assumption: The firm's manager knows x and y, while investors in capital markets do not and see only a joint distribution of possible values (x, y).
• AssumptionThe authors state this as an assumption: Aside from the information asymmetry, capital markets are perfect and semi-strong form efficient.
• AssumptionThe authors state this as an assumption: MM's Proposition I holds in the sense that the stock of debt relative to real assets is irrelevant if information available to investors is held constant.
• AssumptionThe authors state this as an assumption: The information asymmetry is taken as given.

If the firm does seek external funds, it is better off issuing debt than equity securities.

“If the firm does seek external funds, it is better off issuing debt than equity securities.”

• AssumptionThe authors state this as an assumption: The firm's manager knows x and y, while investors in capital markets do not and see only a joint distribution of possible values (x, y).
• AssumptionThe authors state this as an assumption: Aside from the information asymmetry, capital markets are perfect and semi-strong form efficient.
• AssumptionThe authors state this as an assumption: MM's Proposition I holds in the sense that the stock of debt relative to real assets is irrelevant if information available to investors is held constant.
• AssumptionThe authors state this as an assumption: The information asymmetry is taken as given.

In that case, rebalancing gives lenders a windfall gain.

“In that case, rebalancing gives lenders a windfall gain.”

The problem is not that intangibles and growth opportunities are risky.

“The problem is not that intangibles and growth opportunities are risky.”