Chapter 13
Capital Structure
Decisions
Copyright  2009 McGraw-Hill Australia Pty Ltd
PPTs t/a Business Finance 10e by Peirson
Slides prepared by Farida Akhtar and Barry Oliver, Australian National University
13-1
Learning Objectives
• Outline empirical evidence from recent studies
on capital structure.
• Assess the implications of the evidence for the
trade-off, pecking order and free cash flow
theories.
• Explain how financing can be viewed as a
marketing problem.
• Outline the main factors that financial managers
should consider when determining a company’s
financing strategy.
Copyright  2009 McGraw-Hill Australia Pty Ltd
PPTs t/a Business Finance 10e by Peirson
Slides prepared by Farida Akhtar and Barry Oliver, Australian National University
13-2
Introduction
• Modigliani and Miller (MM) analysis is useful in
showing that if capital structure is important, the
reasons must relate to factors that MM excluded
by their assumptions.
• Four main theories of capital structure:
– MM leverage irrelevance — company value depends on
investment rather than financing decisions.
– Trade-off theory — emphasises tax benefits of debt.
– Pecking order theory — information on projects is
asymmetric, and internal finance is highest in pecking
order.
– Free cash flow theory — emphasises agency costs with
the discipline of debt reducing unprofitable investment.
Copyright  2009 McGraw-Hill Australia Pty Ltd
PPTs t/a Business Finance 10e by Peirson
Slides prepared by Farida Akhtar and Barry Oliver, Australian National University
13-3
Company Financing: Some Initial Facts
• In the US, most investment by non-financial
companies is financed from internal cash flows,
followed by external debt finance, and then by
equity.
• The pattern in Australia is similar, with more
than 50% of finance coming from internal equity
between 2000–04.
• High-growth companies have investment
needs that exceed cash flow and, as a result,
these high-growth companies depend heavily on
share issues (equity finance).
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PPTs t/a Business Finance 10e by Peirson
Slides prepared by Farida Akhtar and Barry Oliver, Australian National University
13-4
Company Financing: Some Initial Facts
(cont.)
• Relationships between industry characteristics and
capital structure have been reported in several
studies.
– Paper, steel and airline companies typically have high
leverage.
– Pharmaceutical and electronics companies typically
have low leverage.
– MacKay and Phillips (2005) study found that financial
leverage is higher in concentrated industries than in
competitive industries.
• These observations suggest that capital structure
decisions are important.
Copyright  2009 McGraw-Hill Australia Pty Ltd
PPTs t/a Business Finance 10e by Peirson
Slides prepared by Farida Akhtar and Barry Oliver, Australian National University
13-5
Evidence on Capital Structure: Taxes
• Effects of personal and company tax tend to be
offsetting:
– Deductions for interest on debt reduce company tax.
– However, at the investor level, interest is taxed more
heavily than dividends and capital gains.
• However, managers may view non-debt tax
shields, such as investment tax credits or tax
losses being carried forward, as substitutes for
interest deductions.
• Evidence of any significant relationship between
leverage and taxes is sparse.
• MacKie–Mason (1990) argue that this is because
most studies have tested for average rather than
marginal effects.
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Slides prepared by Farida Akhtar and Barry Oliver, Australian National University
13-6
Evidence on Capital Structure: Taxes
(cont.)
• Examining individual financing decisions on a
marginal basis for companies near the point of tax
exhaustion, MacKie–Mason (1990) found strong
evidence that taxes do influence financing decisions.
• Evidence for the US shows that high tax rate
companies borrow more heavily than those with low
tax rates.
• Evidence on imputation tax systems for Canada,
New Zealand and Australia suggests that imputation
removes the tax advantages of debt financing.
• Imputation reduces corporate financial leverage.
Copyright  2009 McGraw-Hill Australia Pty Ltd
PPTs t/a Business Finance 10e by Peirson
Slides prepared by Farida Akhtar and Barry Oliver, Australian National University
13-7
Evidence on Capital Structure:
Financial Distress
• Trade-off theory — financial distress is the
negative to be offset against tax benefits of debt.
• Direct costs of financial distress are small, but
companies likely to fail incur indirect costs.
• Loss of sales occurs due to uncertainty, with
company management focusing on aversion of
failure rather than operations.
• Indirect costs of financial distress seem much
larger than direct costs but are very difficult to
measure.
Copyright  2009 McGraw-Hill Australia Pty Ltd
PPTs t/a Business Finance 10e by Peirson
Slides prepared by Farida Akhtar and Barry Oliver, Australian National University
13-8
Evidence on Capital Structure:
Financial Distress (cont.)
• The costs associated with financial distress can
reduce company value, but are they large enough
to have an economically significant effect?
• Direct bankruptcy costs appear to be small.
• Indirect bankruptcy costs found to be significant.
– Andrade and Kaplan (1998) — say that there is a need
to separate economic and financial distress.
– Based on their study of economically sound firms,
Andrade and Kaplan found that net costs of financial
distress are between 10–20% of firm value.
Copyright  2009 McGraw-Hill Australia Pty Ltd
PPTs t/a Business Finance 10e by Peirson
Slides prepared by Farida Akhtar and Barry Oliver, Australian National University
13-9
Evidence on Capital Structure:
Agency Costs
• Debt and underinvestment:
– High-growth companies with intangible assets will find
debt expensive and difficult to obtain.
– Companies that borrow and struggle to service debt will
find it difficult to pursue other investments.
– Debt will lead to underinvestment.
• Debt and overinvestment:
– Mature companies with high free cash flows may pursue
unprofitable investments.
– Increased debt acts to discipline managers, curbing
the inclination to overinvest: Jensen (1986).
Copyright  2009 McGraw-Hill Australia Pty Ltd
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Slides prepared by Farida Akhtar and Barry Oliver, Australian National University
13-10
Evidence on Capital Structure: Agency
Costs (cont.)
• Leverage is generally negatively correlated with
a company’s investment opportunities.
• Barclay, Smith and Watts (1995) (BSW), found
evidence to confirm that a company’s investment
opportunities are an important determinant of
leverage.
• BSW’s results are opposite to those predicted by
the pecking order theory.
Copyright  2009 McGraw-Hill Australia Pty Ltd
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Slides prepared by Farida Akhtar and Barry Oliver, Australian National University
13-11
Evidence on Capital Structure:
Agency Costs (cont.)
• Maturity and priority of debt:
– Previous discussion has implicitly assumed that all debt
is the same.
– However, debt can have many different features
(maturity, security, priority, etc.).
– Managers must not only decide how much debt to use
but also what type of debt to use.
• Growth companies tend to use debt of shorter
maturity and higher priority rather than mature
companies.
Copyright  2009 McGraw-Hill Australia Pty Ltd
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Slides prepared by Farida Akhtar and Barry Oliver, Australian National University
13-12
Evidence on Capital Structure:
Information Costs and Pecking Order
Theory
• Pecking order theory:
– Managers prefer internal finance.
– Managers adapt target dividend payout ratios to their
company’s investment opportunities (but dividends are
‘sticky’).
– If internally generated cash flows are inadequate, the
company draws first on its cash and marketable securities.
– If external finance is required, the company issues debt
first, then hybrids, and finally, equity.
Copyright  2009 McGraw-Hill Australia Pty Ltd
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13-13
Evidence on Capital Structure:
Information Costs and Pecking Order
Theory (cont.)
• The pecking order theory predicts that the announcement
of a new share issue will cause the company’s share
price to fall.
– Pilotte (1992) found that the share price response to new
financing, while negative, depends on the company’s
investment opportunities and is not related only to the type
of security being issued.
– Price falls were larger for mature companies relative to
growth companies.
• Pecking order theory implies that a company’s leverage
depends on the difference between operating cash flows
and investment needs over time.
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13-14
Evidence on Capital Structure:
Information Costs and Pecking Order
Theory (cont.)
• Pecking order theory suggests that leverage
is negatively related to profitability.
• Several studies over different time periods and
in different countries confirm this prediction —
–
–
–
–
–
–
Jarrell and Kim (1984)
Titman and Wessels (1988)
Ranjan and Zingales (1995)
Wald (1999)
Graham (2000)
Graham and Harvey (2001)
Copyright  2009 McGraw-Hill Australia Pty Ltd
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13-15
Evidence on Capital Structure:
Information Costs and Pecking Order
Theory (cont.)
• Testing pecking order and trade-off theories:
– Trade-off theory predicts a target adjustment
behaviour of a company’s debt levels.
– Pecking order theory predicts actual debt ratios will
vary depending on need for external finance.
– Shyam-Sunder and Myers (1999) compared the
theories — and found that it is hard to distinguish
statistically, but evidence supports pecking order theory.
Copyright  2009 McGraw-Hill Australia Pty Ltd
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13-16
Evidence on Capital Structure:
Information Costs and Pecking Order
Theory (cont.)
– Fama and French (2002) — trade-off theory is unable to
explain negative link between profitability and leverage.
Small growth companies with low leverage depend on
equity issues — which is inconsistent with the pecking
order theory — and expect more dependence on debt.
– Frank and Goyal (2003) — study shows that small firms in
the US do not follow pecking order theory, and even larger
firms’ support for the pecking order theory declines over
time.
– Evidence in support of pecking order theory is mixed —
negative relationship between leverage and profitability is
the strongest evidence. However, several explanations
consistent with trade-off theory are proposed in the
literature — and are open to empirical questioning.
Copyright  2009 McGraw-Hill Australia Pty Ltd
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13-17
Evidence on Capital Structure: Dual
Issues and Spin-Offs
• Hovakimian, Hovakimian and Tehranian (2004)
(HHT) study dual issues — companies that issue
both debt and equity in same year expecting clean
outcomes, i.e. debt ratio is more likely to be exactly
what management want.
• No relationship between profitability and leverage
after dual issue.
• Evidence supports hypothesis that firms have target
capital structures.
Copyright  2009 McGraw-Hill Australia Pty Ltd
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Evidence on Capital Structure: Dual
Issues and Spin-Offs (cont.)
• Mehrotra, Mikkelson and Partch (2003) (MMP) study
spin offs — new companies that are formed when
separated from existing companies — again, leverage
ratios of new companies can be chosen deliberately.
• MMP find that higher leverage is associated with higher
profitability, lower variability of industry operating incomes,
and greater proportion of tangible assets.
• No relationship between leverage and tax status.
• Apart from the absence of tax effect, MMP results are
consistent with trade-off theory.
Copyright  2009 McGraw-Hill Australia Pty Ltd
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13-19
Evidence on Capital Structure:
Evidence from Surveys
• An alternative to empirical testing is to ask CFOs about what
factors they consider when making capital structure decisions.
• Study by Brounen et. al. (2006) of 313 CFOs from UK, France,
Germany and the Netherlands were consistent with the study by
Graham and Harvey (2001) of 392 US CFOs.
• Consistent with trade-off theory is the fact that most CFOs
reported having some kind of target debt–equity ratio.
• In both surveys, the desire for financial flexibility was the most
important factor considered in debt decisions.
• Neither study found much evidence that CFOs considered
assets substitution, asymmetry information, free cash flows, or
personal tax as important factors.
Copyright  2009 McGraw-Hill Australia Pty Ltd
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Slides prepared by Farida Akhtar and Barry Oliver, Australian National University
13-20
Assessing Theories of Capital
Structure: Trade-Off Theory
• Trade-off theory says firms should borrow until the
marginal tax advantage of additional debt is offset
by the marginal expected costs of financial distress.
• Trade-off theory explains some of the differences
in capital structure of firms in different industries.
• Leverage is low when business risk is high and
when assets are intangible (and unable to be used
as security).
• Predicts leveraged buyout targets as mature
companies with stable cash flows, tangible assets,
and few growth opportunities.
Copyright  2009 McGraw-Hill Australia Pty Ltd
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Slides prepared by Farida Akhtar and Barry Oliver, Australian National University
13-21
Assessing Theories of Capital
Structure: Trade-Off Theory (cont.)
• Limitations of trade-off theory:
– Cannot explain why companies are generally conservative
in using debt finance.
– Cannot explain negative relationship between leverage
and profitability.
– Cannot explain similar leverage levels across countries
with different tax systems.
– Expects leverage to be higher in the US, where a classical
tax system applies.
Copyright  2009 McGraw-Hill Australia Pty Ltd
PPTs t/a Business Finance 10e by Peirson
Slides prepared by Farida Akhtar and Barry Oliver, Australian National University
13-22
Assessing Theories of Capital
Structure: Pecking Order Theory
• Pecking order theory explains the popularity of
internal financing, and that when external finance
is sought, it is usually debt.
• Also explains that less profitable firms need to
borrow more.
• Low leverage in hi-tech industries?
– Mostly intangible assets so borrowing is expensive.
– Problem of debt induces underinvestment.
• Suggests that firms should raise external equity
when all other sources are exhausted.
Copyright  2009 McGraw-Hill Australia Pty Ltd
PPTs t/a Business Finance 10e by Peirson
Slides prepared by Farida Akhtar and Barry Oliver, Australian National University
13-23
Assessing Theories of Capital
Structure: Free Cash Flow Theory
• Reflects conflict of interest between managers and
shareholders.
• Wants to prevent managers from investing in lowreturn projects.
• High leverage forces company to pay out cash and
adds value by preventing unprofitable investment.
• Primarily applicable to companies with high free
cash flows and poor investment opportunities —
typically ‘mature cash-cow firms’.
Copyright  2009 McGraw-Hill Australia Pty Ltd
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Slides prepared by Farida Akhtar and Barry Oliver, Australian National University
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Financing as a Marketing Tool
• Choosing a capital structure is essentially
choosing a particular package of financial services
to supply to investors. The instruments differ in:
– Risk.
– Return.
– Taxation treatment.
– Voting rights.
– Priority in the event of liquidation.
• Differences also exist within categories.
Copyright  2009 McGraw-Hill Australia Pty Ltd
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Slides prepared by Farida Akhtar and Barry Oliver, Australian National University
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Determining a Financing Strategy
• Evidence indicates that financing decisions are
important and influenced by many factors.
• The financing strategy should complement the
investment strategy and take into consideration:
– Business risk.
– Asset characteristics.
– Tax position.
– Maintenance of reserve borrowing capacity.
– Other factors such as political and inflation risk.
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Slides prepared by Farida Akhtar and Barry Oliver, Australian National University
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Determining a Financing Strategy
(cont.)
• Business risk:
– Variability of net cash flows from a company’s assets
is typically taken as business risk.
– The greater the company’s business risk, the less it
can borrow without raising probability of bankruptcy.
– Thus, capital structure decisions and the optimal
capital structure will be affected by business risk.
Copyright  2009 McGraw-Hill Australia Pty Ltd
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Slides prepared by Farida Akhtar and Barry Oliver, Australian National University
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Determining a Financing Strategy
(cont.)
• Asset characteristics:
– Distinction between tangible and intangible assets is
important for ability to borrow.
– Similarly, distinction between company specific assets
and general purpose assets is also important in
determining ability to borrow.
– Issue is the value of these assets as security against
debt.
– Agency costs of debt are high for companies with high
levels of intangible assets — high monitoring costs mean
debt is expensive and, therefore, not used by firms with
high levels of intangibles.
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Determining a Financing Strategy
(cont.)
• Tax position:
– Tax savings associated with debt depend on tax
system in place in a particular country.
– Key point is that with an imputation system as we
have in Australia, the tax benefits associated with
debt as a form of finance are at least partly
neutralised.
– This neutrality does not apply to non-resident
shareholders of Australian companies — as a
consequence, various classes of shares are issued
to minimise the wastage of franking credits.
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Determining a Financing Strategy
(cont.)
• Maintenance of reserve borrowing capacity:
– Information asymmetry issues create problems when
seeking external equity finance to fund new projects —
associated bad signals.
– As a consequence, firms like to maintain reserve
borrowing capacity to easily fund investment
opportunities.
– Allen (2000) finds that 60% of Australian companies
retain reserve borrowing capacity or ‘financial slack’.
– While valuable, creates free cash flow problems and
may destroy shareholder value — Jensen (1986).
Copyright  2009 McGraw-Hill Australia Pty Ltd
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Slides prepared by Farida Akhtar and Barry Oliver, Australian National University
13-30
Determining a Financing Strategy
(cont.)
• Other factors: political and inflation risk
– Multinational companies will structure international
projects using little equity and high levels of debt raised
in the host country — this minimises political risk.
– Inflation has an impact on interest rates, so floating rate
borrowers need to consider inflation when deciding on
debt levels.
– Important to understand that cash flows and sales
revenues can increase in the case of inflation,
neutralising the problem.
Copyright  2009 McGraw-Hill Australia Pty Ltd
PPTs t/a Business Finance 10e by Peirson
Slides prepared by Farida Akhtar and Barry Oliver, Australian National University
13-31
Summary
• MM’s results imply that capital structure is not
important.
• Similarities within industries and differences
between industries suggest capital structure
does matter.
• Factors affecting capital structure include
taxes, costs of financial distress, companies’
investment opportunities, and free cash flows.
• Trade-off, pecking order and free cash flow
theories all have empirical support, suggesting
no one theory is right or wrong.
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Slides prepared by Farida Akhtar and Barry Oliver, Australian National University
13-32
Summary (cont.)
• Financing can be treated as a marketing problem.
• Firms need to offer investors instruments that
satisfy their tastes for risk–return trade-offs, tax
treatment and voting rights.
• Financing strategy should complement
investment strategy.
• Evidence from surveys of CFOs gives some
support to trade-off theory with both tax benefits
and financial distress receiving attention of CFOs.
• Need to consider business risk, asset
characteristics, tax position, political and inflation
risk, and the need for reserve borrowing capacity.
Copyright  2009 McGraw-Hill Australia Pty Ltd
PPTs t/a Business Finance 10e by Peirson
Slides prepared by Farida Akhtar and Barry Oliver, Australian National University
13-33