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This note was prepared by Susan Chaplinsky, Associate Professor of Business Administration, and Robert S. Harris, Professor of Business Administration. It was written as a basis for class discussion rather than to illustrate effective or ineffective handling of an administrative situation. Copyright 1996 by the University of Virginia Darden School Foundation, Charlottesville, VA. All rights reserved. To order copies, send an e-mail to sales@dardenpublishing.com. No part of this publication may be reproduced, stored in a retrieval system, used in a spreadsheet, or transmitted in any form or by any meanselectronic, mechanical, photocopying, recording, or otherwisewithout the permission of the Darden School Foundation.

CAPITAL STRUCTURE THEORY: A CURRENT PERSPECTIVE A complex set of decisions creates a firms capital structure. Capital structure dictates the

funding sources tapped by the company and allocates risks and control rights to various parties. Pursued wisely, capital structure decisions should enhance value in financial markets. Key decisions include the overall mix of debt and equity, the forms, terms and maturity structure of debt, the allocation of voting control among equity classes, the timing of security issuance, and a host of issues about particular types of financial claims (including hybrids such as convertibles and debt substitutes such as leasing).

Finance scholars approach to capital structure issues reflects a progression of thought over time. The result is an eclectic set of, sometimes competing, theories dealing with many forces that shape financial decisions. This note provides an overview of the current state of capital structure theory. Classical Theory - Perfect Capital Markets

Early theory focused on capital structure as a way to carve up a fixed amount of operating cash flow. In this fixed pie view, the key choice was the best split between debt and equity to allocate these operating results. This view originated with the classic contribution of Modigliani and Miller (1958). They showed that in perfect capital markets a firms value is independent of capital structure: that is, any number of different mixes of debt and equity can result in the same firm value. While MMs policy conclusion is not particularly appealing, their work laid an important foundation. In particular, by spelling out the assumptions of perfect capital markets MM pointed the way to factors (relaxed assumptions) that help explain financial structure. The critical properties of perfect capital markets are:

1. No taxes, 2. No transactions or distress costs, 3. Common objectives among decision makers (value maximization), and 4. Perfect information available to all.

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The evolution of capital structure theory can be viewed as the exploration of relaxing each of these four assumptions. The first contributions noted that corporate tax benefits arise from the tax deductibility of interest, providing a powerful incentive for using debt. Coupled with this was the recognition that substantial transactions costs could emerge if the firm failed to meet its debt obligations resulting in costs of financial distress. A combination of these two forces led to what can be called the modern traditional theory of capital structure. The Modern Traditional Theory - a Partial Synthesis

The modern traditional view builds on MM theory but concludes that a firm can pick an optimal mix of debt and equity by focusing on the tradeoffs between the tax benefits of debt and the potential costs of financial distress. More debt exploits the tax deductibility of interest and keeps more money in private (versus public) hands, thereby increasing firm value.1 Eventually, however, debt tax benefits begin to be eroded because 1) the firm runs out of income to be shielded from taxes (perhaps due to other non-debt tax shields such as depletion or depreciation), or 2) the increased prospects and the potential costs of financial distress offset the incremental tax benefits of more debt. In essence, this tradeoff sees firms increasing their use of debt until either they run out of income to shelter or they run up against the threat of financial distress.2 The underlying assumption is that there is a fixed pie of operating cash flows coming into the firm (independent of its capital structure) and the capital structure choice is how to divide this cash flow between debt and equity with as little going to the government and to the costs of financial distress as possible. The tradeoff at the margin between tax advantages and the costs of financial distress still dominates most textbook treatments of capital structure and was the primary focus of First Year Finance.

This treatment of capital structure views debt and equity generically. The primary concern centers on the overall amount of debt and much less to said about other dimensions of capital structure. No attention is paid to the source of equity (e.g., whether equity is internally generated versus raised externally) or to the allocation of control rights. Further, transactions are assumed to be straight forward, uncomplicated, observable exchanges where there is little concern that one partys superior information may disadvantage other parties. Perhaps most importantly, individual decision makers act as price-takers who work to maximize firm value, a common goal, rather than pursue their own agenda.

1 As Miller (1977) points out, the true tax advantage of debt must also account for any personal tax

disadvantage if bond income is taxed at a higher rate than share income. 2 Recent work has provided a closer look at the costs of financial distress. For instance, the degree to which

assets have alternative uses and well-developed secondary markets exist for the assets can result in lower liquidation costs (Shleifer and Vishny (1992). Greater liquidation values enhance debt capacity and can affect both the amount and structure (e.g., collateralized versus debenture issues) of debt. The theories have also broadened the scope of the effects* of financial distress to include not only explicit costs (e.g., attorneys fees) but also other more subtle costs that arise as a firm approaches financial difficulty. Some of these more subtle costs are explored in the following discussion.

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Recent Developments in Theory

Recent advances result from two strands of literature reexamining the third and fourth properties of perfect capital markets. The first set of contributions come from agency theory which focuses on the particular incentives and behavior of individuals (e.g., managers and investors) who make decisions (Jensen and Meckling (1976)). The second strand of theory recognizes that imperfect information is the norm. Different people have different knowledge (Leland and Pyle (1977), Ross (1977), Myers and Majhif (1984)) and costs arise from these imbalances in information.

More recent thought has broadened the scope of inquiry. Now the fundamental question is: How does capital structure affect other decisions? That is, how big is the pie? Important decisions include investment choices by managers, purchasing decisions by customers, and investor reactions to corporate decisions. Newer theories require consideration of how capital structure affects the total cash flow generated by the firm; no longer is it sufficient to simply allocate a fixed cash flow stream Brennan (1995)). In this size of the pie approach, attention is paid to how capital structure will affect decision makers incentives and actions. The operative assumption is that individual decision makers act in self-interested ways. Capital structure is therefore seen as a complicated nexus of contracts where different parties contributing capital have diverse and potentially conflicting interests. Reducing the potential for conflict among capital providers enhances the firms ability to operate efficiently. Additionally, the allocation of control rights, distinctions between internal and external financing, and interactions between financial policy and business results all come to the foreground.

Imperfect information interacts with agency theory as individuals act based on their own information. To appreciate how imperfect information and agency costs interact, consider the following everyday life situation described in Milgrom and Roberts (1992) where a driver (decision maker) must delegate some task to an agent (the mechanic) but the decision maker is not fully informed.

Suppose that you are traveling along a highway when a dashboard light comes on indicating that your car is overheating. There is a service station nearby, so you drive your car there. The traditional analysis of this market situation is simple: There is some price to be paid to repair the problem; either you pay it and the car is fixed, or you decide to take your chances and decline to get the car serviced.

That account might reflect what would happen, but there are other possibilities. After beginning to work on the car, the mechanic might say, Your radiator is shot. A new one will cost $500. If you are like most drivers, you have no idea whether the mechanic is being truthful or not. After all, it may be in the mechanics interest to sell you a radiator, especially at that price. You face the same problem that decision makers in organizations frequently face: When those with critical information have interests different from those of the decision maker, they may fail to report completely and accurately, the information needed to make good decisions. If the mechanic is lying to you, then both your interests and societys interest in efficiency are

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harmed. Your interests are harmed because the mechanic is profiting at your expense, and societys interests are harmed because productive resources have been wasted: A radiator that could have been repaired has instead been discarded.

Suppose that you agree to buy the radiator, wait an hour while it is installed, and then proceed down the highway another 100 miles toward your destination. You notice the overheating indicator on your dashboard lighting up again. Pulling into another service station, you learn that the new radiator was not installed correctly and it will cost you another $35 and another hour of waiting to have the job done right. When buyers cannot easily monitor the quality of the goods or services that they receive, there is a tendency for some suppliers to substitute poor quality goods or to exercise too little effort, care, or diligence in providing the services. Once again, both you and society are harmed. You, because you paid and waited twice for the same service, and society, because resources were wasted.

Notice that the above problems arise because the agent may choose to pursue his or her private interests at others expense. The possibility of this sort of behavior is ruled out by the perfect market assumptions of MM. Of course, if one could costlessly write and enforce contracts that anticipate and prevent all aspects of self interested behavior (by costlessly monitoring an agents actions), agency costs could be eliminated. Since this prospect is in reality unachievable, agency costs are a pervasive influence on corporate decision making.

In Corporate Financings, we encounter agency costs most frequently in the context of the firms capital raising efforts. Agency theory here refers to the incentives of various parties to pursue their own interests ahead of the shareholders or organizations interests. Agency theory attempts to reduce the potential for conflicts among the firms capital providers by recognizing (and avoiding) the circumstances in which managers, shareholders, and debtholders interests are most likely to diverge. Special attention is paid to the design of specific securities. What is the role of covenants? of convertible features? of security? The motivation behind security design is to lower monitoring costs, curtail opportunistic behavior by agents, and hence reduce agency costs.

There are several agency problems that are frequently encountered by firms in establishing an optimal financing policy. These are the: (1) the agency costs of equity, and (2) the agency costs of debt (see Jensen and Meckling (1976), Harris and Raviv (1991), and Milgrom and Roberts (1992)). We discuss each in turn. Agency Costs of Equity

One primary task of capital structure is the allocation of voting and control rights. Agency costs of using equity may arise if such usage creates a wedge between the decisions made by managers and the interests of shareholders. It is often claimed that managers interests (e.g. for security and personal reward) may not coincide with those of shareholders. Suppose an entrepreneur/manager owns 100% of the equity of a firm. Suppose further that he or she is

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considering the purchase of an oriental carpet for the office or by analogy any other perquisite such as corporate jets, empire building or overpaying subordinates. If the carpet is purchased, lets assume firm value would drop by $10,000, the full cost of which is absorbed by the entrepreneur. Now suppose instead that managements ownership stake had been 50%. If management refrains from consuming perquisites, firm value will be $10,000 higher than if the carpet is purchased. But notice that a managers gain from behaving him or herself is only $5,000. Alternatively stated, management can gain a resource it values at $10,000 (managements private valuation of the carpet) for only $5,000. Accordingly, as managements share of the equity falls, there is less and less incentive for managers to refrain from these value destroying investments.

The wedge between managers and shareholders interests gives managers incentives to over invest in perquisites beyond the level that would maximize firm value. Several courses of action have been proposed to reduce the agency costs of equity, or the costs that stem from the separation of ownership and control. First, one solution is to increase the fraction of the firms equity owned by the manager. This aligns a managers interests more directly with shareholders interests. Alternatively, the board of directors and other outside investors (including corporate raiders) may monitor managers to reduce their incentives to pursue their own interests ahead of the shareholders. Finally, Jensen (1986) suggests that high levels of debt impose a strict discipline on managers.3 Since debt commits the firm to pay out cash, it reduces the amount of free cash flow available to managers to engage in self interested behavior. In addition, holding constant the dollar size of a managers equity holdings, greater use of leverage increases the managers percentage control rights,4 thereby mitigating the potential conflict between managers and shareholders. Agency Costs of Debt

The above suggests that firms may benefit from additional debt because it reduces the

agency costs of equity. However, before one concludes that the firm should rely more on debt, we must recognize that greater debt usage creates the potential for additional conflicts of interest that do not arise in an all-equity financed firm. Debt usage can give rise to conflicts between the interests of shareholders (perhaps including management) and those of creditors. Conflicts between debtholders and equityholders arise because the debt contract gives equityholders an incentive to invest suboptimally. There are two ways in particular that debt contracts can result in suboptimal investment. In the literature these are described as the asset substitution problem and the debt-overhang problem.

3 High leverage may be more appropriate in situations in which the firm has substantial free cash flow over which management has discretion and few promising investment opportunities.

4 Consider an example where an entrepreneur holds $100 of equity and all other outside claims ($50) are in outside equity and there is no debt. In this case, managerial control rights are 67% (1001150). If leverage is increased to 33% (501150) by the substitution of debt for all outside equity, managerial control rights increase to 100%.

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Asset Substitution and Incentives for Over-Investment

A well known feature of debt contracts is that they have limited upside potential. If the firms investments pay off more than what is promised to the debtholders, equityholders capture most of the gain. On the other hand, if the investment fails, debtholders bear the consequences. Thus debtholders and equityholders have different incentives to bear risk which affect their preferences for the type of investments firms should make. The potential for conflict is greatest when the firm is near or in financial distress. In this circumstance equityholders may favor investing in very risky projects that are value-decreasing (i.e., negative net present value.) Consider a firm that has to pay $50 to debtholders in two years and has resources consisting of $50 cash and a investment project requiring $50 in capital today. For simplicity assume that the firm has no other assets or interim cash flows. If no investment is made, equityholders claims are worthless. However, if there exists a risky project with even a remote chance of realizing a good outcome (i.e., a payoff well above $50 in two years), shareholders will favor this project.

Shareholders can favor this project even if the expected net present value based on an expected value of all possible outcomes [e.g., good, average, bad] is negative. If the project achieves a good outcome, equityholders receive all of the benefits but debt holders are paid only what they are promised (no more than they would have received in the absence of the project). If the project results in anything other than a good outcome (average or bad), equity claims are likely to remain worthless but debtholders lose the capital ($50) invested in the project. For a given expected net present value, the parties interests are in direct conflict. Debtholders instincts are to preserve capital at all costs, whereas equityholders are to spend it on high risk projects (the equivalent of lottery tickets.) The adoption of these bad projects causes the firms (and debts) value to erode. However, if managers are assumed to work in shareholders interests, bad investments are still made because the loss in equity value from the bad investment is outweighed by the gain in equity value captured at the expense of debtholders. That is to say, equityholders can gain more from the potential wealth transfer from debtholders than they lose from the negative NPV of the project.5 Thus, this agency conflict results in an incentive to over-invest in excessively risky projects.

Of course, one might think that these problems could be anticipated. To the extent that they are foreseeable, the amount creditors will lend will be less or the return they demand will be higher. For example, if debtholders perceive these problems to be a concern, equityholders will realize less for the sale of debt securities than they otherwise would. Higher interest expense paid to debtholders reduces cash flow to equity and, in turn, the value of equity. In these ways, equityholders bear the anticipated costs of their incentives to pursue suboptimal investment which is created by the use of debt. Consequently, equity holders have incentives to find ways to credibly limit their undertaking of risky investments. An example of this are covenants placed in the debt contract to limit capital expenditures. While these actions may prove helpful in lowering an issuers cost, the larger point remains: the capital markets exact a toll for these potential conflicts and these costs must be factored into the firms decision to seek external capital.

5 The legal term for these wealth transfers is appropriation of capital.

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Debt Overhang and Incentives for Under-Investment

A second problem arises when the firm has excessive levels of debt relative to its assets but also has profitable investment opportunities (Myers (1977)) (as opposed to the above case of unprofitable projects.) Consider the following situation where a firm has assets worth $140 and outstanding debt of $160 million. Currently the firm has a project which it could undertake that costs $10 million and would produce a certain net present value of $15 million. If the firm could find financing for the project, asset value would rise to $165. But who would be willing to supply the necessary funds? Suppose a new lender agrees to provide the $10 million. If the firm decides to liquidate and existing debtholders must be paid first, then $20 of the $25 projects gross value and all of the NPV will accrue to the old debtholders. The project is not profitable to a new lender who receives only $5 million on a $10 million investment. In this example, new debtholders provide the full cost of the investment, but the returns are captured mainly by the old debtholders. Thus, new lenders have no incentive to supply needed funds to the firm and the profitable investment is foregone with a resulting loss in value.6

Notice that if new lenders have little incentive to supply additional capital to the firm, equityliolders have even less. Infusions of equity at this point work only to insure the claims of debtholders without necessarily supplying any return to the equityliolder (the coinsurance problem.) That is, the projects success will simply reduce bondholder losses rather than accrue as shareholder gains. As in the case of excessive risk taking, the under-investment problem can be more severe when more of a firms value is based on future growth opportunities (linked to future decisions) rather than to assets already currently in place. Because the interests of old debtholders and new capital providers are potentially so divergent, distressed firms virtually impossible to raise additional capital through private market channels.

When firms forego profitable opportunities it also implies that there might be other arrangements that would make everyone better off if it were possible to renegotiate the contracts at this point. If the project is foregone, old debtholders lose $20 million. Suppose we can convince them to forgive $10 million of their claims. Since new lenders will now receive $15 million back on their $10 million investment, they will be willing to lend on the project. By taking the project old debtholders cut their losses to $10 million. The reality is that even though every one is better off, it is difficult to renegotiate the terms of the debt contracts at this point. Thus, perhaps the best course of action is to set limits on the amount of debt in relation to assets to reduce the probability of the firm finding itself in this situation. Other Agency Costs

A third source of agency costs concerns the relationships not only within the firm (among managers and investors) but between different firms and with customers. For instance, suppose a

6 The situation described provides a rationale for debtor-in-possession financing. To aid distressed firms in raising much needed capital, bankruptcy courts sometimes approve DIP financing which affords new creditors claims a higher priority than existing creditors claims.

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firms products involved an extensive need for maintenance and/or repair services. Current purchases of the product may depend on customers confidence that the firm will provide these services in the future. If such confidence is reduced by higher debt loads and the attendant possibility of financial distress, more debt may actually hurt the firms sales and operational performance (Titman (1984)). In this case, there is a direct link between the size of the pie to be divided and the choice of how to allocate returns. Such a linkage is in direct contrast to MMs underlying assumptions. The implication of this reasoning is that product characteristics and links to other firms will affect debt usage.

In sum, one can view each of the agency costs of debt articulated here as adding extra costs to the use of debt, increasing the true costs that may result from anticipated financial distress. Such costs include not only out-of-pocket costs of a bankruptcy proceeding but also costs due to suboptimal decision making and compromised business relationships. Connection with Imperfect Information

As noted earlier, agency problems are often exacerbated in the presence of imperfect information. Imperfect information increases the difficulty of the parties to verify and monitor their position vis-a-vis other capital holders, thereby increasing the costs of raising capital. The term asymmetric information refers to one party having superior information to another. Often, it is assumed that managers, who possess inside information, likely know more about the firm than investors, who possess only public information. In such a setting, capital structure and capital structure changes (e.g., security issues, repurchases, dividends) can reveal private information to financial markets and hence affect value (Ross (1997)).

In Myers and Majluf (1984), the firms announcement of a debt or equity security issue indirectly reveals (signals) managers view of the future outlook for the firm. If a firm announces an equity issue, investors must evaluate whether the firms need for capital is due to an abundance of profitable investment activities (good news) or is due to management acting opportunistically and issuing shares when they are over-valued (bad news). Unless shareholders can readily distinguish good from bad firms or management can credibly signal they are a good firm (bonding), investors must factor in some probability that the firm is issuing opportunistically and that stock price will fall following the offer. Thus, investors rationally discount the firms stock price when they learn of an equity offer. This explanation provides some rationale for why equity issues are typically accompanied by stock price declines. Debt issuance, on the other hand, does not elicit stock price decreases. Hence, relative to equity issues, debt issues convey more positive news (Smith (1986)). One explanation for the more neutral response of debt issues is that even if the firms stock price falls following the issue (likely because operating performance weakens), the value of debt could be largely unaffected by these events-especially if the debt is highly rated. The existence of asymmetric information and investors concerns that they will be adversely affected by what management knows and they dont raises the cost of obtaining outside capital. One can view the loss in stock value on the day that an equity issue is announced as an indirect cost of equity financing. A clear message is that

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management should spend time informing the market about company value and management plans to avoid unnecessary guessing games that may cause share price fluctuation. A key challenge is to develop a reputation so that management communication is credible. Because asymmetric information increases the transaction costs of raising outside capital, particularly equity capital, Myers (1984) posits a pecking order theory of capital structure. This theory predicts that firms rely, to the extent possible, on internally generated funds to finance new investment. After exhausting internal funds, the theory states that firms have a strong preference to issue safe debt first and only when absolutely necessary resort to riskier claims such as equity. Theoretically the pecking order results from the high transactions costs and important information asymmetries between managers and investors that make security issuance costly. By following this view firms avoid some of the distortions in investment incentives that arise in the presence of agency costs and imperfection information. Myers offers this view as broadly consistent with the observed financing patterns of U.S. firms.7 An implication of the pecking order is that firms not may have a long-term target mix of debt and equity but rather adjust episodically to the balance of funds generated and investment needs. Moreover, in contrast to the MM view, internal equity via returned earnings is a very different source of financing than new share issues. It also implies that building up financial slack (in the form of safe liquid assets) can be value enhancing.8 Pulling the Elements Together

One perspective on capital structure choice is to view it as posing tradeoffs among five elements:

1. the tax benefits of financing, 2. the explicit costs of financial distress, 3. the agency costs of debt (including an array of indirect costs linked to financial distress), 4. the agency costs of equity, and 5. the signaling effect of security issuance.

The first two elements lead to the modem traditional tradeoff discussed earlier. The third and fourth build on agency theory and imperfect information and emphasize the individual incentives of decision makers. The fifth recognizes that the very act of issuing a security can convey new information to investors when there is imperfect information. These general strands of

7 Consider the well-known examples of highly profitable firms (American Home Products, Lilly, US Tobacco)

which use little debt. Given their strong cash flows, these firms would seem to have little probability of distress and great need for tax shields.

8 in some respects a pecking order story appears to run counter to some arguments based on control and agency costs of equity. For instance, in Myers story building up financial slack is desirable because it reduces the need to raise external capital. According to Jensens (1986) free cash flow view, more financial slack can be detrimental results of its managers interests supplanting those of shareholders. The key distinction is that Jensens view applies mainly to firms without strong investment opportunities.

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theoretical inquiry often overlap and each provides important new insights that supplement the traditional tax/financial distress tradeoff. These newer theories also provide a much richer array of insights into more detailed dimensions of financial policy, down to the structure of individual claims such as debt contracts, leases, and convertibles. The downside is that at present, there is no overarching synthesis of these theories. As a result, practical application requires careful identification of how any of these particular theories are relevant to the business, markets, and the situation at hand. Where Does This Leave Us?

Bringing together these strands yields a new synthesis in which optimal capital structure is viewed again as a trade off between leverage related benefits and costs. Now, however, these effects include agency costs and information effects supplementing the traditional view of tax features and explicit costs of financial distress. These new factors add the important implication that the firms business results may actually depend on capital structure. The size of the pie to be divided depends on how it is to be sliced. Furthermore, slices come in many sizes and shapes that are not covered by the simple distinction between debt and equity. Table 1 recaps some of the important features of this new synthesis. Table 2 lists some additional issues.

What are key implications of the new theories of capital structure? Firms and managers must recognize that the world is filled with potential conflicts of interest as different decision makers interact. The field of actors is wide (managers, employees, customers, investors, boards of directors), information is imperfect and financial policy decisions can affect decision makers incentives and information. Such effects feed into financing costs as well as into the underlying business results for the firm. Firms should take prudent steps to lower costs that arise from such conflicts through appropriate channels such as agreeing to covenants, purchasing productive assets that can be redeployed, understanding customer and supplier views about its risk, keeping a margin of reserve borrowing power, keeping markets informed of the firms performance, structuring incentive based employee contracts, and considering the structure of its board of directors. Newer theories of financial policy emphasize that capital structure is not a narrow decision about the level of debt but a broad look at the firm, its products, its markets and its governance.

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Table 1: A Summary of Key Factors to Consider in Capital Structure Policy

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Table 2: Other Dimensions of Capital Structure Policy

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Review 76, 323-339. Jensen, M. and W. Meckling, 1976, Theory of the firm: Managerial behavior, agency costs, and capital

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Journal of Finance 32, 371-388. Miller, M., 1977, Debt and taxes, Journal of Finance, 32, 261-275. Milgrom, P. and J. Roberts, Economics, Organization and Management (Prentice Hall, 1992). Modigliani, F. And M. Miller, 1958, The cost of capital, corporation finance, and the theory of

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Economics 8, 23-40. Shleifer, A. And R. Vishny, 1992, Liquidation values and debt capacity: A market equilibrium approach,

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