17.4Dynamic Capital Structure Considerations

Up to this point, we have discussed the capital structure decision within a simple, static

context. The discussion assumed that firms initially would choose their preferred cap-

ital structure and later would bear the consequences. If the firm’s overall business

¹⁸Chevalier,

Judy, and David Scharfstein. “Capital Markets, Imperfections and Countercyclical

Markups: Theory and Evidence,” American Economic Review86 (1996), pp. 703–725.

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subsequently did well, the managers who took on a large amount of debt would be

pleased with this decision because the firm would enjoy the tax benefits of debt and

probably would avoid the negative aspects of debt financing. However, if the firm’s

business did very poorly, its managers, unable to use the tax benefits of debt and faced

with the financial distress costs of debt, would regret being highly levered. According

to the staticcapital structure theory, which assumes that capital structures are opti-

mized period byperiod, firms weigh the costs of having too much debt when they are

doing poorly against the tax benefits of debt when they are doing well to arrive at their

optimal capital structures.

Section 17.5 presents some empirical evidence which supports the various static

theories of capital structure presented up to this point in the text. Before these tests can

be discussed, however, we must consider that managers do not, in reality, optimize their

capital structures period by period as these theories suggest, but determine their capi-

tal structures as the result of a dynamic process that accounts for the costs associated

with capital structure adjustments. Hence, at any given point in time, a firm may devi-

ate from its long-term optimal or target debt ratio.

The Pecking Order of Financing Choices

Dynamic capital structure theory, the dynamic process that governs the capital struc-

ture choice, is still not well understood by financial economists. As a starting point in

our explanation of what is understood, consider again (see also Chapter 15) what

Donaldson (1961) called the pecking order of financing choices, which describes how

managers make their financing decisions. Asummary of this pecking order includes the

following observations:

1.Firms prefer to finance investments with retained earnings rather than external

sources of funds.

2.Because of their preference to finance investment from retained earnings, firms

adapt their dividend policies to reflect their anticipated investment needs.

3.Because of a reluctance to substantially change their dividend policy and

because of fluctuations in their cash flows and investment requirements,

retained earnings may be more or less than a firm’s investment needs. If the

firm has excess cash, it will tend to pay off its debt prior to repurchasing

shares. If external financing is required, firms tend to issue the safest security

first. They begin with straight debt, next issue convertible bonds, and issue

equity only as a last resort.

Asubstantial amount of empirical evidence verifies Donaldson’s behavioral

description. Most notably, extremely profitable firms tend to use a substantial amount

of their excess profits to pay down debt rather than to repurchase equity. In addition,

less profitable firms that need outside capital tend to use debt to fund their invest-

ment needs. As a result, firms that were profitable in the past have relatively low

debt ratios while those that were relatively less profitable in the past have relatively

high debt ratios. The main difference between what one might expect to observe from

the static trade-off models and what is observed is that firms generally do not issue

equity when they are having financial difficulties. The reluctance of firms to issue

equity, as Donaldson observed, appears to be greatest when firms need the equity

capital the most.

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Anumber of explanations are offered for this pecking order behavior, including:

1.Taxes and transaction costs favor funding new investment with retained

earnings and debt over issuing new equity (see Chapter 15).

2.Managers generally can raise debt capital without the approval of the board of

directors. However, issuing equity generally requires board approval and

hence more outside scrutiny (see Chapter 18).

3.Issuing equity conveys negative information to investors (see Chapter 19).

4.Afirm having financial difficulties may want to maintain a high leverage ratio

in the hope of gaining concessions from its employees and suppliers (see

Section 17.2).

5.The debt overhang problem makes stock issues less attractive for a financially

distressed firm (see Chapter 16).

We believe that a combination of all of the preceding reasons explains this observed

pecking order behavior. The first reason was discussed in detail in Chapter 15; the

others are described in more detail below.

An Explanation Based on Management Incentives

The second reason is based on the idea that managers personally benefit from having

their firms relatively unlevered. As discussed earlier, one reason managers might pre-

fer lower debt ratios is that less levered firms can more easily raise investment capital

than can highly levered firms, creating greater opportunities for the managers. There-

fore, managers prefer to retain rather than pay out earnings and probably would prefer

to issue equity as well, except that an equity issue requires the approval of the board

of directors and thus leads to more scrutiny.¹⁹

An Explanation Based on Managers Having More Information Than Investors

The third explanation of Donaldson’s observation of the pecking order is based on

Myers and Majluf’s (1984) information-based model. The basic idea is that managers

are reluctant to issue stock when they believe their shares are undervalued.²⁰Because

of this, investors often see an equity issue as an indication that managers believe the

company’s stock is overvalued, which in turn implies that the stock price will fall when

the company announces it will issue new shares. The negative stock market reaction to

an equity issue may deter firms from issuing equity, even when they believe the mar-

ket’s perception that the firm’s equity is overvalued is incorrect.

An Explanation Based on the Stakeholder Theory

In general, most nonfinancial stakeholders are pleased to see the firm issue equity. For

example, employees will find their jobs more secure and their bargaining power

improved if the firm has less leverage. However, that does not necessarily mean that the

19

Zweibel (1996) presents a theoretical argument similar to this discussion.

²⁰This

topic is explained in detail in Chapter 19.

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614Part IVCapital Structure

stockholders will find that issuing equity is in their interest. More profitable firms may

anticipate expanding and, as a result, will want to maintain low debt ratios to attract the

best employees and to appear as attractive as possible to potential strategic partners. Less

profitable firms may plan on shrinking in size and could do so more efficiently with a

higher leverage ratio. When a firm is shrinking, it might want to renegotiate contracts

with suppliers and employees; and as discussed earlier, the firm may be in a better posi-

tion to ask for concessions if it is highly leveraged and is having financial difficulties.

An Explanation Based on Debt Holder=Equity Holder Conflicts

The firm’s financial claimants (that is, debt holders and equity holders) also may dis-

agree about the attractiveness of issuing equity. Chapter 16 noted that a firm with a

substantial amount of long-term debt may have little incentive to issue equity after a

series of losses. If bankruptcy costs are borne primarily by the firm’s debt holders, the

equity holders benefit little from an infusion of new equity. Indeed, share prices will

decline when firms replace debt with equity because decreasing the firm’s leverage

increases the value of existing debt and transfers wealth from the equity holders to the

debt holders. An exception to this general rule occurs when reducing leverage signifi-

cantly cuts the costs of financial distress and thus significantly increases the total value

of the firm. We discuss this possibility in more detail below.

In extreme cases, a financially distressed firm may be unable to raise equity capi-

tal. For example, during the 1980s, Kent Steel Corporation saw the value of its assets

fall by 70 percent. It required a $50 million capital infusion for maintenance costs in

order to remain in business for another year. While Kent Steel’s managers would have

preferred to issue equity, the firm was simply too far gone. The firm had debt obliga-

tions with a face value of $120 million; however, with a market value of less than $70

million for the entire firm, the debt was selling at a large discount.

In cases like Kent Steel, the firm cannot get out of financial distress simply by

issuing equity. As Example 17.6 illustrates, avoiding financial distress requires that the

lenders either forgive some of their debt or provide the firm with an additional infu-

sion of cash.

Example 17.6:Can Financially Distressed Firms Issue Equity?

Gentry, Inc., is having financial difficulties and although it has not yet defaulted, its bonds

are selling at 50 percent of their face values.The current value of the firm is $600 million,

which consists of $50 million in equity and $550 million (market value) in zero-coupon bonds.

These bonds have an aggregate face value of $1.1 billion, with one class of bonds, having

a face value of$100 million, due in six months, and another class with $1 billion due in two

years.Can Gentry issue stock within the next six months to raise the funds needed to meet

its $100 million near-term debt obligation, assuming that the aggregate value of all classes

of bonds would increase by 10 percent as a result of this equity infusion?

Answer:Probably not.Although Gentry is close to bankruptcy, its equity still retains some

value because investors believe that there is a slight chance that the firm can be turned around.

In this case, the equity should be thought of as an out-of-the-money option that will probably

expire worthless.While there is a sizable upside if the firm does manage to survive for the

next two years, this does not mean that the firm can issue new stock at the current stock price.

The $100 million equity infusion, which would pay the near-term debt obligation, increases

the value of the firm by $100 million, since paying off debt is a zero-NPVinvestment.This

infusion makes the bonds more valuable because it increases the likelihood that they will

berepaid in full.Since the bonds gain $55 million in value as a result of this infusion, the

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post-issue value of all of the firm’s equity must be only $95 million.Hence, investors will not

be willing to put up an additional $100 million in equity.

Example 17.6 describes a firm that is unable to issue new equity because debt

holders capture a large part of the gain associated with the recapitalization. If the

recapitalization does not make the firm more valuable, then an equity infusion hurts

equity holders by transferring value from them to the debt holders. In many cases,

however, a financially distressed firm does become more valuable after a recapital-

ization, in which case both equity holders and debt holders can benefit. This will hap-

pen, for example, when a firm is unable to sell its products or is losing key employ-

ees because of its financial difficulties. Since financial distress reduces the current cash

flows to equity holders, it provides an incentive for a firm to issue new stock, which

can increase the value of the firm’s existing equity as well as its debt. Example 17.7

illustrates this point.

Example 17.7:Issuing Equity to Improve CustomerConfidence

Consider again the case of Gentry, Inc., but now assume that one reason for its low value

is that its customers have lost faith in the firm’s ability to produce quality products because

of its financial distress.Although the assets of the firm are currently valued at $600 million,

the equity infusion will restore customer confidence and Gentry’s asset value (before the

$100 million debt payment) will increase to $900 million.Under this scenario, is it possible

for the firm to issue $100 million in equity?

Answer:Yes.The proceeds from the issue are not fully dissipated by an improvement in

the value of the firm’s debt.If the debt increases in value by less than $200 million as a

result of the equity infusion and restored customer confidence, it follows that the post-issue

equity value of the firm will exceed $150 million, implying that the stock can be issued and

that the original stockholders will benefit from the recapitalization.

Example 17.6 shows that when there are high costs associated with financial dis-

tress, equity holders have an incentive to recapitalize. However, if it is costly to repur-

chase or issue debt or equity, firms that have relatively low financial distress costs will

have their leverage ratios determined to a large extent by their past history. That is, we

expect a firm’s current debt-to-equity ratio to be low if its past earnings were high, and

its leverage ratio to be substantially higher if its past earnings were negative. This argu-

ment suggests the following result.

Result 17.4

If the costs of changing a firm’s capital structure are sufficiently high, a firm’s capital struc-ture is determined in part by its past history. This means that:

•	Very profitable firms are likely to experience increased equity values and thus lowerleverage ratios.
•	Unprofitable firms may experience lower equity values and perhaps increased debt,and thus higher leverage ratios.

In summary, we believe that firms deviate from their target or long-term optimal

capital structure because of transation costs and the debt overhang problem and are

more likely to take actions that move them toward their optimal ratio when financial

distress costs are high. As we will discuss in more detail in Chapter 18, managerial

incentives are also likely to play an important role in determining how a firm’s capi-

tal structure changes over time.

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616	Part IVCapital Structure

17.5	Empirical Evidence on the Capital Structure Choice

Chapters 14 through 17 discuss a variety of theories about the costs and benefits of

debt financing. Taken together, these theories help explain why firms select the capital

structures that they do. In sum, the theories suggest a trade-off between the tax benefits

of debt and a variety of costs as well as some benefits of incurring financial distress.

This section examines some of the empirical tests of these theories.

One of the earliest empirical findings was that firms in the same industry tend to

choose similar capital structures. In the United States, for example, financial services

firms tend to have high leverage ratios while makers of scientific equipment tend to

have low leverage ratios. These findings provide evidence that the optimal capital struc-

tures of firms vary from industry to industry, reflecting the differential costs and ben-

efits of debt which presumably are related to a firm’s line of business. This evidence,

however, is consistent with any theory that proposes a trade-off between the costs and

benefits of debt financing, and it may even be consistent with capital structure irrele-

vance. In essence, the evidence may simply indicate that firms like to use industry

norms to select their debt ratios. Because the use of industry norms is not harmful to

firm value if capital structure is irrelevant, there is no reason to rule it out.

Anumber of empirical studies have documented evidence more supportive of the

trade-off theories.²¹

The evidence indicates that debt ratios are systematically linked to

variables related to the costs of bankruptcy and financial distress (see Exhibit 17.2). Past

research finds that observed debt ratios are negatively related to the firms’past prof-

itability, research and development expenditures, and advertising and selling expenses. In

addition, firms in industries that produce durable goods, like machines and equipment, are

usually less leveraged than firms that produce nondurables; and more unionized firms are

usually more leveraged than less unionized firms. Small firms use about the same amount

of long-term debt as larger firms, but small firms use significantly more short-term debt.

The negative relation between operating profit and leverage is found in numerous

studies and holds in many countries outside of the United States.²²This relation reflects

the pecking order of financing behavior. When firms generate substantial amounts of

cash from their operations, they tend to pay down debt before paying out dividends

and repurchasing shares. When firms generate insufficient cash to cover investment

needs, they tend to borrow rather than issue stock to cover the shortfall.

There are a number of explanations for the negative relation of R&D and selling

expenses to leverage. First, firms with large R&D and selling expenses may have little

taxable earnings and hence, may only be able to utilize rarely, if at all, debt tax shields

(see Chapter 14). In addition, firms with high R&D and selling expenses are likely to

be growth firms that produce specialized products. To the extent that these are indeed

growth firms, these firms are not likely to have access to sizable amounts of debt

financing because of the debt holder–equity holder conflicts described in Chapter 16.

The tendency of these growth firms to borrow short term provides further support for

this idea because short-term debt creates fewer conflicts than long-term debt. Moreover,

since firms with high R&D and selling expenses produce more specialized products,

their nonfinancial stakeholders are more likely to require investments in specialized

human and physical capital. Hence, the stakeholder theory also suggests that these firms

should have low leverage ratios. For similar reasons, firms that produce machines and

equipment requiring future maintenance tend to have relatively low leverage ratios.

²¹See

Bradley, Jarrell, and Kim (1984); Long and Malitz (1985); and Titman and Wessels (1988).

International evidence is presented by Rajan and Zingales (1995).

²²See

Rajan and Zingales (1995).

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EXHIBIT17.2Summary of Empirical Evidence on the Capital Structure Choice

Variables

Relation to Leverage Ratio

Explanation

EBIT/total assets	Strong negative relation.	Pecking order description.
(profitability)

R&D/sales

Strong negative relation.

•Tax reasons.

Selling	expenses/sales	•	Specialized assets and
Market	value/book value		products imply greater
			stakeholder costs and
			potentially more conflicts
			between debt holders and
			equity holders.

Machines and equipment	Less highly leveraged.	Customer avoidance of
producers (dummy		purchasing durable
variable)		goods of distressed firms.
Unionizationa	Highly unionized	Leverage increases the
	industries are more	firm’s bargaining power.
	leveraged.

Size	Small firms use more	•Transaction costs of
	short-term debt.	issuing long-term debt.

•	Adverse incentive costs associated with long-term debt.b

^aSee Bronars and Deere (1991).

^bThis explanation was discussed in Chapter 16.

The fact that unionized firms are more highly leveraged relates to our earlier dis-

cussion (see Section 17.2) about how committed stakeholders generate an environment

of bilateral monopoly, characterized by negotiation. As we discussed earlier, unionized

firms may prefer to take on more debt because it allows them to bargain more effec-

tively with their unions.