Reading: Lesson 4 - Capital Structure Evidence and Implications

12.4.A - Capital Structure Evidence and Implications

1. Capital Structure Evidence and Implications

1. There have been hundreds, perhaps even thousands, of papers testing the capital structure theories described in the previous section. We can cover only the highlights here, beginning with the empirical evidence.
   
2. Recent studies by Professors Van Binsbergen, Graham, and Yang and by Professor Korteweg suggest that the average net benefits of leverage (i.e., the value of the tax shield less the expected cost of financial distress) make up about 3% to 6% of a levered firm’s value.18 To put this into perspective, let’s look at the impact of debt on an average company’s value. The average company is financed with about 25% to 35% debt, so let’s suppose that the company has $25 debt and $75 of equity, just to keep the arithmetic simple. The total net benefit of debt would be about $5, based on the recent research. This implies that each dollar of debt added (on average) about $0.20 of value ($5/$25 = 0.2) to the company. The first dollar of debt adds a bigger net benefit because bankruptcy risk is low when debt is low. By the time the 25th dollar of debt is added, its incremental net benefit was close to zero—the incremental expected costs of financial distress were about equal to the incremental expected tax shield.
   
3. These studies also showed that the net benefits of debt increase slowly until reaching the optimal level, but decline rapidly thereafter. In other words, it isn’t very costly to be somewhat below the optimal level of debt, but it is costly to exceed it.
   
4. A particularly interesting study by Professors Mehotra, Mikkelson, and Partch examined the capital structure of firms that were spun off from their parent companies. The financing choices of existing firms might be influenced by their past financing choices and by the costs of moving from one capital structure to another, but because spin-offs are newly created companies, managers can choose a capital structure without regard to these issues. The study found that more profitable firms (which have a lower expected probability of bankruptcy) and more asset-intensive firms (which have better collateral and thus a lower cost of bankruptcy should one occur) have higher levels of debt. These findings support the trade-off theory.
   
5. However, there is also evidence that is inconsistent with the static optimal target capital structure implied by the trade-off theory. For example, stock prices are volatile, which frequently causes a firm’s actual market-based debt ratio to deviate from its target. However, such deviations don’t cause firms to immediately return to their target by issuing or repurchasing securities. Instead, Professors Flannery and Rangan show that firms tend to make a partial adjustment each year, moving about 30% of the way toward their target capital structure. In a more recent study, Professors Faulkender, Flannery, Hankins, and Smith show that the speed of adjustment depends on a company’s cash flows—companies with high cash flows adjust by about 50%. This effect is even more pronounced if the company’s leverage exceeds its target—high cash flow companies in this situation have a 70% speed of adjustment. This is consistent with the idea that it is more costly to exceed the target debt ratio than to be lower than the target.
   
6. If a stock price has a big run-up, which reduces the debt ratio, then the trade-off theory suggests that the firm should issue debt to return to its target. However, firms tend to do the opposite, issuing stock after big run-ups. This is much more consistent with the market timing theory, with managers trying to time the market by issuing stock when they perceive the market to be overvalued. Furthermore, firms tend to issue debt when stock prices and interest rates are low. The maturity of the issued debt seems to reflect an attempt to time interest rates: Firms tend to issue short-term debt if the term structure is upward sloping but long-term debt if the term structure is flat. Again, these facts suggest that managers try to time the market.
   
7. Firms issue equity much less frequently than debt. On the surface, this seems to support both the pecking order hypothesis and the signaling hypothesis. The pecking order hypothesis predicts that firms with a high level of informational asymmetry, which causes equity issuances to be costly, should issue debt before issuing equity. Yet we often see the opposite, with high-growth firms (which usually have greater informational asymmetry) issuing more equity than debt. Also, many highly profitable firms could afford to issue debt (which comes before equity in the pecking order) but instead choose to issue equity. With respect to the signaling hypothesis, consider the case of firms that have large increases in earnings that were unanticipated by the market. If managers have superior information, then they will anticipate these upcoming performance improvements and issue debt before the increase. Such firms do, in fact, tend to issue debt slightly more frequently than other firms, but the difference isn’t economically meaningful.
   
8. Many firms have less debt than might be expected, and many have large amounts of short- term investments. This is especially true for firms with high market/book ratios (which indicate many growth options as well as informational asymmetry). This behavior is consistent with the hypothesis that investment opportunities influence attempts to maintain reserve borrowing capacity. It is also consistent with tax considerations, because low-growth firms (which have more debt) are more likely to benefit from the tax shield. This behavior is not consistent with the pecking order hypothesis, where low-growth firms (which often have high free cash flow) would be able to avoid issuing debt by raising funds internally.
   
9. To summarize these results, it appears that firms try to capture debt’s tax benefits while avoiding financial distress costs. However, they also allow their debt ratios to deviate from the static optimal target ratio implied by the trade-off theory. In fact, Professors DeAngelo, DeAngelo, and Whited extend the dynamic trade-off model by showing that firms often deliberately issue debt to take advantage of unexpected investment opportunities, even if this causes them to exceed their target debt ratio. Firms often maintain reserve borrowing capacity, especially firms with many growth opportunities or problems with informational asymmetry. There is a little evidence that firms follow a pecking order and use security issuances as signals, but there is some evidence in support of the market timing theory.
   

2. Implications for Managers

1. Managers should explicitly consider tax benefits when making capital structure decisions. Tax benefits obviously are more valuable for firms with high tax rates. Firms can utilize tax loss carryforwards and carrybacks, but the time value of money means that tax benefits are more valuable for firms with stable, positive pre-tax income. Therefore, a firm whose sales are relatively stable can safely take on more debt and incur higher fixed charges than a company with volatile sales. Other things being equal, a firm with less operating leverage is better able to employ financial leverage because it will have less business risk and less volatile earnings.
   
2. Managers should also consider the expected cost of financial distress, which depends on the probability and cost of distress. Notice that stable sales and lower operating leverage provide tax benefits but also reduce the probability of financial distress. One cost of financial distress comes from lost investment opportunities. Firms with profitable investment opportunities need to be able to fund them, either by holding higher levels of marketable securities or by maintaining excess borrowing capacity.
   
3. Another cost of financial distress is the possibility of being forced to sell assets to meet liquidity needs. General-purpose assets that can be used by many businesses are relatively liquid and make good collateral, in contrast to special-purpose assets. Thus, real estate companies are usually highly leveraged, whereas companies involved in technological research are not.
   
4. Asymmetric information also has a bearing on capital structure decisions. For example, suppose a firm has just successfully completed an R&D program, and it forecasts higher earnings in the immediate future. However, the new earnings are not yet anticipated by investors and hence are not reflected in the stock price. This company should not issue stock—it should finance with debt until the higher earnings materialize and are reflected in the stock price. Then it could issue common stock, retire the debt, and return to its target capital structure.
   
5. Managers should consider conditions in the stock and bond markets. For example, during a recent credit crunch, the junk bond market dried up and there was simply no market at a “reasonable” interest rate for any new long-term bonds rated below BBB. Therefore, low-rated companies in need of capital were forced to go to the stock market or to the short-term debt market, regardless of their target capital structures. When conditions eased, however, these companies sold bonds to get their capital structures back on target.
   
6. Finally, managers should always consider lenders’ and rating agencies’ attitudes. For example, Moody’s and Standard & Poor’s recently told one large utility that its bonds would be downgraded if it issued more debt. This influenced the utility’s decision to finance its expansion with common equity. This doesn’t mean that managers should never increase debt if it will cause their bond rating to fall, but managers should always factor this into their decision making.