Capital Structure Puzzle
A seminal paper by Stewart C. Myers first published in 1984, discusses capital structure theories in great detail.
When the paper was initially published questions like, ‘How did firms choose their capital structure decisions’ were a great puzzle and something which researchers were scratching their heads hard to figure out. The question remained: how were firms choosing amongst debt, equity, and hybrid securities?
What is more interesting: that there existed a theory by Modigliani and Miller (1958) which said that capital structure didn’t matter! So, well why bother with the specifics? Recent evidence had however discovered that changes in the capital structure were informational to investors and hence they mattered!
So, then how do firms make this choice?
There were two competing theories at that time:
- The static trade-off theory believes in an optimal debt structure which can be arrived by offsetting the costs and benefits of tax shield and financial distress. Thus one of the considerations of this theory is there exists a target debt ratio which the firm would aim to achieve.
- On the other hand, the pecking order theory states that there is no target debt structure in mind for firms while making financing decisions. Firm use the available set of investment opportunities to make decisions. Thus, if a new investment comes along, then it uses internal funds to finance it, or otherwise, it would go to the debt route and equity as a last resort.
Discussions of Static Tradeoff theory
Adjustment costs
Given a target debt ratio, a firm would want to move closer to it. While making these adjustments there could be two scenarios:
- No adjustment costs or small adjustment costs: each firm’s observed debt ratio should be the target ratio or close to it, so why do we see such variation in debt ratios?
- When adjustment costs are large, then the firms would take time to fully adjust to this debt ratio which can cause large variations in actual debt ratios.
Thus asking questions about these adjustment costs can help us to understand the diversity in debt ratios.
Tax and tax shields
Tax shields are supposed to be the advantages which a firm considers while making the debt ratio decision. Given that debt comes with a tax shield, it provides motivation for firms to raise debt, however, why don’t we see firms awash with debt to take advantage of these tax shields?
- A firm might have other sources of tax shield — depreciation tax shields, investment tax credits, so marginal tax rate might be different for different firms.
So variation in debt ratios might come about due to variations in marginal tax rates of firms: ‘the tax side of the static tradeoff theory predicts that IBM should borrow more than Bethlehem Steel, other things equal, and that General Motors’ debt- to-value ratio should be more than Chrysler’s.’
Financial distress
The costs of bankruptcy are the cost which is associated with the source of debt as financing. So firms which are risky firms should borrow less to prevent bankruptcy, ‘where the risk would be defined as the variance rate of the market value of the firm’s assets’, while safer firms safe would be borrowing more. Another factor could be tangibility of assets, thus firms which are borrowing more might have more tangible assets which could be having an active market for sale.
Hence the static trade-off theory gives the above predictions as to which firms would be borrowing more and which firms would withhold from borrowing.
Discussions of the Pecking-order Theory
Though few companies would go so far as to rule out a sale of common under any circumstances, the large majority had not had such a sale in the past 20 years and did not anticipate one in the foreseeable future. This was particularly remarkable in view of the very high Price‐Earnings ratios of recent years. Several financial officers showed that they were well aware that this had been a good time to sell common, but the reluctance still persisted. ( Donaldsons (1961)).
Why do firms rely on internal funds and debt?
Asymmetric information
- Asymmetric information leads to a cost: that the firm chooses not to issue from outside and hence given an investment it would pass it up. Thus, when there exists underpricing of securities, a firm might not raise money, give up good projects and then internal funds would come in handy.
- Why debt over equity: If a manager has greater information than the outsiders, the managers have an incentive to issue equity when they think that equity is overvalued by the market. However, the market would see through this and would penalize this information disadvantage by giving lower valuations to firms who would issue equity. This thus sends a ‘negative signal’ to the market. Given the above, a firm with good assets would not want to raise equity but would want to go to the debt route. Thus, firms would raise debt rather than go to the market for lower valuations.
If you know the firm will issue equity only when it is overpriced, and debt otherwise, you will refuse to buy equity unless the firm has already exhausted its “debt capacity” — that is, unless the firm has issued so much debt already that it would face substantial additional costs in issuing more. Thus investors would effectively force the firm to follow a pecking order.
Corporate Finance Behaviour of Firms — Explained through the two theories
1. Internal and External Equity
Empirical observation — Most of the investment outlays are financed by debt and internal funds than equity.
Static trade-off theory — can be explained if you add transaction costs to raising equity and tax treatment of capital gains relative to dividends. External equity is costly — so avoidance of regular stock issues. Thus, if the target<actual debt ratio — would not go to equity markets to buy-back debt but would remain overleveraged.
However, what about repurchasing shares?
‘It is hard to explain extended excursions below a firm’s debt target by an augmented static tradeoff theory — the firm could quickly issue debt and buy back shares. Moreover, if personal income taxes are important in explaining firms’ apparent preferences for internal equity, then it’s difficult to explain why external equity is not strongly negative — that is, why most firms haven’t gradually moved to materially lower target payout ratios and used the released cash to repurchase shares.’
Pecking order- This is what the theory states!
2. Timing of Security Issues
Empirical observation — Firms try to time stock issues when security prices are high.
Static trade-off theory-Cannot explain it, as the firm value rises — fall in debt to value ratio which means firms should raise debt, not equity to rebalance. Pecking order theory-Cannot explain it as information should not be much more favorable to managers when prices are high, and even it was, investors would understand it and interpret the decision of a firm accordingly.
(This is the third theory of capital structure — Market timing)
3. Exchange offers
Empirical observation-stock price rises when firms offer debt for equity and fall when they exchange equity to debt
Static trade-off theory- firms above their target debt ratio would make such swaps and doing this would make them move closer to their target debt ratio. Similar would happen in the other case, then why is there a difference in price movement associated with them? Debt to equity swap signals increased debt capacity which means decreased risk and good news, while the other would mean bad news. Does the story about the target debt ratio matter here? Would it not be only a story with conveying information about the firm’s risk?
5. Issue or repurchase of shares
Empirical observation-Stock price falls when a stock issue is announced and rises when an announcement of the stock buyback is made
Static trade-off theory- hard to explain
Pecking order theory- predicts it!
In conclusion, this might be the case:
Think of an unusually profitable firm in an industry generating relatively slow growth. That firm will end up with an unusually low debt ratio compared to its industry’s average, and it won’t do much of anything about it. It won’t go out of its way to issue debt and retire equity to achieve a more normal debt ratio. An unprofitable firm in the same industry will end up with a relatively high debt ratio. If it is high enough to create significant costs of financial distress, the firm may rebalance its capital structure by issuing equity. On the other hand, it may not. The same asymmetric information problems which sometimes prevent a firm from issuing stock to finance real investment will sometimes also block issuing stock to retire debt
All quotes are taken from the paper by Stewart C. Myers. Link to the paper is: Myers 1984
References:
Donaldson, G. (1961). Corporate debt capacity: A study of corporate debt policy and the determination of corporate debt capacity. Boston: Division of Research, Graduate School of Business Administration, Harvard University
Modigliani, F., & Miller, M. (1958). The Cost of Capital, Corporation Finance and the Theory of Investment. The American Economic Review, 48(3), 261–297.
MYERS, S. C. (1984), The Capital Structure Puzzle. The Journal of Finance, 39: 574–592.
