17.6 Summary and Conclusions

The previous chapters examined a variety of costs and ben-tractive terms. Such firms also are likely to generate highefits of debt financing that firms must consider when theytaxable earnings because they usually have minimal taxmake their financing decisions. The discussion has sug-shields and, as a result, can fully utilize their interest taxgested which firms should be financed more heavily withdeductions.

debt and which should include very little debt in their cap-Producers of high-technology durable goods (for exam-ital structures. For example, producers of nondurableple, computers and other scientific equipment) generallygoods (for example, tobacco or cookies) that do little re-are not highly leveraged. These firms have the highestsearch and development generally have relatively highcosts associated with financial distress because their stake-debt ratios. These firms are likely to have low costs associ-holders are very concerned about their long-term viability.ated with financial distress because their customers andIn addition, the potential for taking on risky projects isother stakeholders are not likely to be especially concernedpresent for such firms, making lenders reluctant to supplyabout their long-run viability. The potential for such firmslarge amounts of debt capital. These firms also have lowerto substantially increase the risk of their investments is alsotaxable earnings, relative to their values, and hence canlimited, so that borrowers are willing to lend to them at at-utilize only limited amounts of debt tax shields.

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618Part IVCapital Structure

Although the types of products a firm sells and other as-pects of its overall strategy have an important influence onits financial structure, a firm’s capital structure is also de-termined by its history. Firms that are profitable often usesome of their profit to repay debt, and, as a result, reducetheir leverage ratio over time. In contrast, firms that suffersubstantial losses generally accumulate debt; as a result,they become highly leveraged.

Bankruptcy rates would be substantially lower if firmsissued equity instead of debt subsequent to incurring sub-stantial losses. This chapter has provided several explana-tions for why firms do not do this. For example, issuing eq-uity in these situations can result in a substantial transfer ofwealth from the firm’s equity holders to its debt holders. Inaddition, issuing equity might make it more difficult for thefirm to bargain effectively with its employees and suppli-ers; perhaps by keeping the threat of bankruptcy high, em-ployees and suppliers will make concessions that make thefirm more competitive. Additional explanations based onmanagerial incentives and information considerations willbe discussed in more detail in Part V.

This chapter completes Part IV, which was devoted ex-clusively to issues of capital structure and dividend policy.The chapters in this part provided a fairly thorough discus-sion of how financial managers make capital structurechoices in an ideal world where shareholders and managersare equally informed about the prospects of their firms andagree that the objective of the firm is to maximize share-holder value. While this provides a useful framework forthinking about how one should choose the optimal financ-ing mix for a firm, it provides an incomplete description ofhow these decisions are made in practice.

In reality, top managers may have an incentive tofinance their firms in ways that do not maximize the valueof their stock. For example, managers may choose conser-vative financial structures because of personal aversionstoplacing their firms in financial distress. In other cases,managers may choose high debt ratios to convey favorableinformation to their shareholders; that is, they signal theirconfidence in the firm’s ability to generate sufficientearnings to repay the debt. These issues are addressed inPart V.

Key Concepts

Result 17.1:Afirm’s liquidation choice and itsfirms should have relatively more debt in

decisions relating to the quality of itstheir capital structures.

product and fairness to employees andResult 17.2:Financial distress can benefit some firms

suppliers depend on its financial condition.by improving their bargaining positions

As a result, a firm’s financial condition canwith their stakeholders.

affect how it is perceived in terms of being

Result 17.3:Leverage affects the competitive dynamics

a reliable supplier, customer, and employer.

of an industry. In some situations,

Financial distress is especially costly for

leverage makes firms more aggressive

firms with:

competitors, in others less aggressive.

•Products with quality that isResult 17.4:If the costs of changing a firm’s capital

important yet unobservable.structure are sufficiently high, a firm’s

•Products that require future servicing.capital structure is determined in part by

its past history. This means that:

•Employees and suppliers who require

specialized capital or training.•Very profitable firms are likely to

experience increased equity values

These types of firms should have

and thus lower leverage ratios.

relatively less debt in their capital structures.

•Unprofitable firms may experience

Financial distress should be less costly

lower equity values and perhaps

for firms that sell nondurable goods and

increased debt, and thus higher

services, that are less specialized, and

leverage ratios.

whose quality can easily be assessed. These

Key Terms

bilateral monopolies605		predation609
dynamic capital structure theory	612	stakeholder theory597
nonfinancial stakeholders596		static capital structure theory	612

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Chapter 17

Capital Structure and Corporate Strategy

619

Exercises

17.1.What are the differences between direct and17.7.Comparing the indirect costs of bankruptcy,

indirect bankruptcy costs? Who bears these costs?explain why Apple includes very little debt in its

Explain your answer by referring to a realcapital structure while Marriott International uses

situation from the recent past.a fairly large amount of debt.

17.2.As a potential employee, why might you be17.8.Describe the trade-offs involved when firms

interested in the employer’s capital structure?decide how to price their products. What are the17.3.Compare qualitatively the indirect bankruptcycosts and benefits of raising prices? How do

costs of operating a franchised hotel to that ofinterest rates affect the decision? How do leverage

running a high-tech start-up computer firm.ratios affect the decision?

17.4.You are the manager of a company that produces17.9.Weston Tractor is a cyclical business that is

automobiles. Aunion contract will come up forforced to lay off workers during downturns. The

renegotiation in two months and you wish toCEO estimates that they saved $50 million during

increase your firm’s bargaining power prior tothe last recession by laying off excess labor.

hearing the union’s initial demands. The union isHowever, the company had additional expenses

likely to ask for a 25 percent increase fromof $70 million three years later when it had to

existing wage levels of $20 per hour for the 1,000retrain the new workers. The firm is currently

workers at your company. Workers typically workfacing a similar situation. The risk-free rate is 10

2000 hours per year. The firm has $100 million ofpercent, but Weston’s current borrowing rate is

debt outstanding at an interest rate of 10 percent16percent. Should Weston lay off the workers?

annually, and an equity market value of $200IfWeston was less highly leveraged, it would be

million. Income before interest is $20 million perable to borrow at 11 percent. How would this

year. Assume no taxes.affect the firm’s decision? Discuss how a

What specific financing strategies would youprospective employee would react on learning

implement and why?that Weston was substantially increasing its

leverage.

17.5.BCD Manufacturing is considering repurchasing

40 percent of its common stock. Management17.10.Compass Computers has suffered an unexpected

estimates the tax savings from such a move to beloss and is currently having financial difficulties.

$48 million, based on the addition of $1 billion ofExplain why Compass may choose not to issue

debt at a rate of 12 percent with a 40 percentequity to solve its financial problems. If Compass

marginal tax rate. However, the company’sdoes not issue equity, should it change its product

suppliers are unhappy with the decision and aremarket strategy to account for the firm’s weaker

threatening to revoke the company’s net-30 dayfinancial health?

credit terms, which will cost the firm an additional17.11.As the CEO of Mega Corp., which do you prefer:

2 percent on its $1.5 billion inventory. Shoulda competitor with high leverage or one with low

management go ahead with the repurchase? Whyleverage? Under what conditions will you act

or why not?more or less aggressively if your competitor is17.6.Carcinogens-R-Us and Lung Decay, two cigarettehighly leveraged?

producers of comparable size, are struggling for17.12.Compton Industries currently has 2 million shares

market share in a declining market. Carcinogens-outstanding at $3 per share. Because the company

R-Us has just undergone a leveraged buyout andis having financial difficulties, it also has $50

is able to meet its fixed expenses with its existingmillion in face value of long-term outstanding

market share, but it may be forced into bankruptcydebt that is selling at only 60 percent of its face

if it loses market share. As a manager of Lungvalue. As Compton’s CEO, you estimate that you

Decay, how would you establish your pricingwill need a cash inflow of $10 million within six

policy? If Carcinogens-R-Us enters bankruptcy, itmonths to meet your payroll. Since covenants in

would either (a) be forced to liquidate, (b) losethe existing debt preclude further debt financing,

market share because of customer concerns, or (c)you are forced to consider an equity offering. Is

emerge recapitalized with no harm to marketsuch an offering possible, assuming the equity

share. How would these three possibilities affectissue would result in a 20 percent increase in the

your decision?value of the debt? Explain why.

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620Part IVCapital Structure

17.13.You have been hired by Dell Computer17.14.In 1999 Chrysler had close to $10 billion in cash

Corporation to advise it on its capital structure.on its balance sheet invested in short-term

This $75 billion company would like to raise ansecurities. Kerkorian, Chrysler’s largest

additional $25 billion to acquire the assets of oneshareholder, wanted Chrysler to use the cash to

of its competitors. It currently has very little debt,buy back shares. At the very least, Kerkorian

but it is considering borrowing the entire $25thought that the cash, which yields about 4

billion. In order to make your recommendation,percent, should be used to repurchase the

you have asked the following questions:company’s outstanding bonds, which yield 7

a.Is Michael Dell planning on reducing his stakepercent. How can you justify holding cash

in the business?yielding 4 percent when the firm has bonds that

b.Do Dell computers require specially trainedcan be retired that yield 7 percent?

Dell technicians for servicing, or can the17.15.Explain why grocery store prices tended to

service be acquired from a variety of sources?increase in markets where one or more of the main

c.Does Dell expect to be generating significantcompetitors initiated an LBO. (Hint:Think of

amounts of cash in excess of its investmentmarket share as an investment.)

needs in the future, or is it likely to require

17.16.Over the past 20 years, the transaction costs

additional external capital in the future?

associated with issuing and repurchasing debt and

Explain how the answers to these questions wouldequity securities have declined. What effect do

affect your advice.you think this change has had on capital structure

choices?

References and Additional Readings

Asquith, Paul; Robert Gertner; and David Scharfstein.

“Anatomy of Financial Distress: An Examination of

Junk-Bond Issuers.” Quarterly Journal of Economics

109, no. 3 (1994), pp. 625–58.

Barclay, Michael J., and Clifford W. Smith, Jr. “The

Maturity Structure of Corporate Debt.” Journal of

Finance50, no. 2 (1995), pp. 609–31.

Bolton, Patrick, and David Scharfstein. “ATheory of

Predation Based on Agency Problems in Financial

Contracting.” American Economic Review80 (1990),

pp. 93–106.

Bradley, Michael; Gregory Jarrell; and E. Han Kim. “On

the Existence of an Optimal Capital Structure:

Theory and Evidence.” Journal of Finance39, no. 3

(1984), pp. 857–78.

Brander, James A., and Tracy R. Lewis. “Oligopoly and

Financial Structure: The Limited Liability Effect.”

American Economic Review76 (1986), pp. 956–70.Bronars, Stephen G., and D. R. Deere. “The Threat of

Unionization, the Use of Debt, and the Preservation

of Shareholder Wealth.” Quarterly Journal of

Economics106, no. 1 (1991), pp. 231–54.

Chevalier, Judith A. “Capital Structure and Product

Market Competition: An Empirical Study of

Supermarket LBOs.” American Economic Review85

(1995a), pp. 206–56.

———. “Do LBO Supermarkets Charge More? An

Empirical Analysis of the Effects of LBOs on

Supermarket Pricing.” Journal of Finance50

(1995b), pp. 1095-1112.

Chevalier, Judy, and David Scharfstein. “Capital Markets,

Imperfections and Countercyclical Markups: Theory

and Evidence.” American Economic Review86

(1996), pp. 703–26.

Cornell, Bradford, and Alan Shapiro. “Corporate

Stakeholders and Corporate Finance.” Financial

Management16 (1987), pp. 5–14.

Cutler, David M., and Lawrence H. Summers. “The Costs

of Conflict Resolution and Financial Distress:

Evidence from the Texaco-Pennzoil Litigation.”

Rand Journal of Economics19 (1988), pp. 157–72.

Dasgupta, Sudipto, and Kunal Sengupta. “Sunk

Investment, Bargaining, and Choice of Capital

Structure.” International Economic Review34, no. 1

(1993), pp. 203–20.

Dasgupta, Sudipto, and Sheridan Titman. “Pricing

Strategy and Financial Policy.” The Review of

Financial Studies11 (1998), pp. 705–737.

Donaldson, Gordon. Corporate Debt Capacity: AStudy of

Corporate Debt Policy and the Determination of

Corporate Debt Capacity.Boston: Harvard Graduate

School of Business Administration, 1961.

Fischer, Edwin O.; Robert Heinkel; and Josef Zechner.

“Dynamic Capital Structure Choice: Theory and

Tests.” Journal of Finance44 (1989), pp. 19–40.Hanka, Gordon. “Debt and the Terms of Employment,”

Journal of Financial Economics48 (1998),

pp. 245–282.

Harris, Milton, and Arthur Raviv. “The Theory of Capital

Structure.” Journal of Finance46 (1991), pp. 297–356.

Grinblatt1254Titman: Financial	IV. Capital Structure	17. Capital Structure and	© The McGraw1254Hill
Markets and Corporate		Corporate Strategy	Companies, 2002
Strategy, Second Edition

Chapter 17

Capital Structure and Corporate Strategy

621

Jensen, Michael, and William Meckling. “The Theory of

the Firm: Managerial Behavior, Agency Costs and

Ownership Structure.” Journal of Financial

Economics3 (1976), pp. 305–60.

Khanna, Naveen, and Sheri Tice. “Strategic Responses of

Incumbents to New Entry: The Effect of Ownership

Structure, Capital Structure and Focus.” The Review

of Financial Studies13 (2000), pp. 749–779.Lang, Larry H.; Annette Poulsen; and René M. Stulz.

“Asset Sales, Firm Performance, and the Agency

Costs of Managerial Discretion.” Journal of

Financial Economics37, no. 1 (1995), pp. 3–37.

Long, Michael, and Ileen Malitz. “The Investment-

Financing Nexus: Some Empirical Evidence.”

Midland Corporate Finance Journal3 (Spring

1985), pp. 53–59.

———. “Investment Patterns and Financial Leverage.” In

Corporate Capital Structure in the United States.

Benjamin Friedman, ed., Chicago: University of

Chicago Press, 1985.

Mackie-Mason, Jeffrey K. “Do Taxes Affect Corporate

Financing Decisions?” Journal of Finance45 (1990),

pp. 1471–95.

Maksimovic, Vojislav. Optimal Capital Structure in

Oligopolies.Ph.D. dissertation, Harvard University,

1986.

Maksimovic, Vojislav, and Sheridan Titman. “Financial

Reputation and Reputation for Product Quality.”

Review of Financial Studies2 (1991), pp. 175–200.Miller, Merton. “Debt and Taxes.” Journal of Finance32

(1977), pp. 261–75.

Myers, Stewart C. “The Capital Structure Puzzle.”

Journal of Finance39 (1984), pp. 575–92.

Myers, Stewart C., and Nicholas Majluf. “Corporate

Financing and Investment Decisions When Firms

Have Information that Investors Do Not Have.”

Journal of Financial Economics13 (1984),

pp. 187–221.

Opler, Tim, and Sheridan Titman. “Financial Distress and

Corporate Performance.” Journal of Finance49

(1994), pp. 1015–40.

Perotti, Enrico, and Kathy E. Spier. “Capital Structure as

a Bargaining Tool: The Role of Leverage in Contract

Renegotiation.” American Economic Review83,

no. 5 (1994), pp. 1131–41.

Phillips, Gordon M. “Increased Debt and Industry Product

Markets.” Journal of Financial Economics37, no. 2

(1995), pp. 189–238.

Rajan, Raghuram G., and Luigi Zingales. “What Do We

Know about Capital Structure? Some Evidence from

International Data.” Journal of Finance50, no. 5

(1995), pp. 1421–60.

Shapiro, Alan, and Sheridan Titman. “An Integrated

Approach to Corporate Risk Management.” Midland

Corporate Finance Journal3 (Summer 1985),

pp. 41–56.

Sharpe, Steven. “Financial Market Imperfections, Firm

Leverage, and the Cyclicality of Employment.”

American Economic Review84 (1995), pp. 1060–74.

Titman, Sheridan. “The Effect of Capital Structure on the

Firm’s Liquidation Decision.” Journal of Financial

Economics13 (1984), pp. 137–52.

Titman, Sheridan, and Roberto Wessels. “The

Determinants of Capital Structure Choice.” Journal

of Finance43 (1988), pp. 1–20.

Zingales, Luigi. “Survival of the Fittest or Fattest: Exit

and Financing in the Trucking Industry.” Journal of

Finance53 (1998), pp. 905–938.

Zweibel, Jeffrey. “Dynamic Capital Structure under

Managerial Entrenchment.” American Economic

Review86 (1996), pp. 1197–1215.

Grinblatt1256Titman: Financial	IV. Capital Structure	17. Capital Structure and	© The McGraw1256Hill
Markets and Corporate		Corporate Strategy	Companies, 2002
Strategy, Second Edition

622	Part Part IVIV	Capital Structure
		Capital Structure

PRACTICALINSIGHTSFORPARTIV

Allocating Capital forReal Investment

•Investment projects that generate substantial nondebt

tax shields, like depreciation deductions, generally

contribute less to a firm’s debt capacity and, therefore,

require higher discount rates. (Section 14.5)

•For firms with taxable shareholders, investment projects

that can be financed from retained earnings require a

lower cost of capital than projects that require the

issuance of new equity. (Section 15.5)

•Managers who wish to maximize shareholder value, as

opposed to total firm value, will use higher discount

rates when their firms become more highly levered.

(Section 16.2)

•Because of potential incentive problems, firms that are

highly leveraged may not be able to borrow additional

money to fund positive net present value investment

projects. (Section 16.2)

•Because financial distress costs are higher in industries

that produce more specialized products that may

require future servicing, those industries use less debt

financing and, as a result, require higher costs of

capital. (Section 17.1)

Financing the Firm

•Since interest payments are tax deductible, corporate

taxes induce firms to use more debt financing than they

would use otherwise. In the absence of other

considerations, firms would include sufficient debt in

their capital structures to eliminate their corporate tax

liability. (Section 14.4)

•Personal tax considerations lead to lower debt ratios for

two reasons: First, part of the return to equity holders

comes in the form of capital gains which are more lightly

taxed than interest payments that are taxed as ordinary

income. Second, there is a tax disadvantage associated

with paying out retained earnings to shareholders, which

would increase leverage. (Sections 14.5 and 15.3)•Firms without taxable earnings, but which do not wish to

issue common stock, may obtain a lower cost of capital

by issuing preferred stock rather than debt. (Section 14.6)•If the personal tax rates of equity holders are higher

than corporate rates, retained earnings offers the

cheapest form of financing, debt offers the second

cheapest form of financing, and external equity

provides the most expensive capital. (Section 15.6)•Profitable firms might choose to be initially overlevered

and then use their profits to pay down their debt over

time. (Section 15.6)

•Shareholders with different marginal tax rates will

generally disagree about the firm’s optimal debt ratio

and dividend policy. (Sections 15.5 and 15.6)

•Taxable shareholders will prefer firms to distribute

earnings by repurchasing shares rather than by paying

dividends. (Section 15.3)

•Taxes play much less of a role in determining capital

structure and dividend choices in countries with

dividend imputation systems. (Section 15.3)

•Firms with substantial future investment opportunities

should use relatively less debt financing than more

mature companies whose values consist mainly of the

assets they currently have in place. (Section 16.2)

•The direct costs associated with bankruptcy as well as the

indirect costs associated with debt holder–equity holder

conflicts will be reflected in the firm’s required interest

payments on its debt. These costs should not be a

deterrent to using debt financing if lenders are willing to

provide debt at reasonable interest rates. (Section 16.2)•When there is a substantial potential for debt holder–

equity holder incentive problems, convertible debt,

short-term debt, and bank loans are better sources of

debt capital than straight long-term bonds. (Section 16.4)•Firms that sell specialized products that require future

servicing should be less levered than firms that sell

commodities. (Section 17.1)

•Holding all else equal, we expect that a less levered firm

will provide better future opportunities for employees

than a more highly levered firm. (Section 17.1)

Financial distress, and hence debt financing, may be•

beneficial if it allows firms to obtain concessions from

employees, suppliers, and governments. (Section 17.2)

Firms often lose market share subsequent to large

•

increases in their debt ratio. (Section 17.3)

•Financially distressed firms can sometimes reduce their

financial difficulties by issuing new equity. However,

issuing equity in these situations transfers wealth from

shareholders to long-term debt holders and puts the firm

in a worse bargaining position with employees and

suppliers. (Section 17.4)

Allocating Funds forFinancial Investments

•High tax bracket individuals should tilt their portfolio

toward stocks that pay low dividends and should hold

taxexempt municipal bonds. (Sections 14.5, 14.7, 15.3,

and 15.4)

•Tax-exempt investors should hold taxable bonds and stocks

with high dividend yields. (Sections 14.5, 15.3, and 15.4)

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Chapter 1

Chapter Title

623

•	Investors with high marginal tax rates should time their	ex dates. Tax-exempt investors should do just the
	transactions so that they purchase stocks just after the	opposite: buying just before the ex dates and selling just
	dividend ex dates and sell them just before the dividend	after the ex dates. (Section 15.4)

EXECUTIVEPERSPECTIVE

Roberts W. Brokaw III

My experience as an investment banker has brought meinto contact with senior company managers and theirfinancial advisors, who are quite sophisticated in effectingspecific transactions. However, these financial decisionmakers often are very deal-driven, which allows them tomiss the big view—the impact of the deal on the overallcapital structure of the firm. This shortfall occurs becauseof two basic realities: (1) a transaction’s direct conse-quences are easier to measure than its indirect ones; and(2) the good academic work on how debt and equity costsinteract is poorly understood or inconsistently applied.

Chapters 14 through 17 provide a solid basis for reme-dying this shortfall. In other areas of finance, such as port-folio management, the structuring and valuation of com-plex securities, and arbitrage, theory has contributed muchto practice in recent years. However, while the capital mar-kets have shown an impressive ability to utilize “security-specific” theory, progress has been much slower in man-agement’s application of corporate finance theory to capi-tal structure.

Once the bankers have completed their part of a trans-action, companies are left to assess their optimal capitalstructure. Management has the continuing responsibility toweigh the many matters impacting this task, includingidentifying funding requirements, business risks andopportunities, certainty of operating forecasts, tax posi-tion, and potential changes in corporate strategy. Withinthis context, the decision maker must be knowledgeableabout a bewildering range of new financing vehicles andasset disposition alternatives, all in the context of ever-changing capital markets.

Exceptional value can be created for financial man-agers who understand and apply the concepts described inthis part of the book. These concepts might not lend them-selves to the same precision as, say, the 50 basis points thatcould be saved from using debt derivatives in a syntheticfixed-rate financing. But, that is just the point! Applying

lessons learned in these chapters can make 50 basis pointson one deal look like chump change.

Most nonfinancial companies’capital structuresinclude equity predominantly (as measured by marketvalue). An improved understanding of equity’s costdynamics is at the heart of the challenge to financial man-agers today. Equity is more expensive than debt; it servesas the main cushion that makes debt “cheap”; it can be atodds with lenders; and its cost is usually nondeductible fortax purposes. Here, there is an imperfect fit among theory,reality, and practice—a combination which assures thatmodest improvements toward optimizing the capital struc-ture will reap high marginal returns.

Grinblatt and Titman provide important techniques andguideposts by leading the reader through the basics, start-ing with the most easily understood concept—the taximpact of financings and distributions to shareholders.Next, they develop the idea of the inherent conflictbetween lenders and owners of an enterprise, as well as therelated consequences of financial distress. This emergingarea of theory has important implications, not only foroverall leverage, but also for the design of new issues andrepair of weakened balance sheets. Finally, the authorsreach beyond discussion of the securities themselves todescribe an important area affected by and impacting uponcapital structure—corporate strategy. This matter is at theheart of how a company is run and of the value it creates.Chapter 17 underscores the importance to a company ofhaving a consistent, disciplined, informed view of capitalstructure policy—one that is not discouraged by the com-plexity and relative imprecision of some of the tasks re-lated to its determination.

Mr. Brokaw is currently a senior managing director at Bear, Stearns &Co. In addition to his duties as an investment banker, Mr. Brokaw is alsoan adjunct professor of finance at New York University’s Stern School ofBusiness.

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Grinblatt1261Titman: Financial	V. Incentives, Information,	Introduction	© The McGraw1261Hill
Markets and Corporate	and Corporate Control		Companies, 2002
Strategy, Second Edition

PART	Incentives, Information, and
V	Corporate Control

U p to this point, we have explored financial strategies that firms can employ to

enhance the value of their shares. In reality, however, financial managers do not

always make the decisions that maximize the stock prices of their firms. To understand

how financial decisions actually are made,we have to understand how managerial

incentives can differ from shareholder incentives.

Part Vtakes a closer look at how managers actually make financial decisions.

Chapter 18 examines managerial incentives in detail, paying particular attention to the

general belief among managers that they must satisfy a broad constituency that includes

shareholders as only one of many relevant players. For example, managers generally

view their employees as important constituents, so typically they are somewhat averse

to making decisions that jeopardize their employees’jobs. They also are interested in

their own job security and future prospects; as a result, managers may take on negative

net present value investments that allow their firms to grow and may also include less

than the optimal amount of debt in their capital structures.

Although these incentive issues probably cannot be eliminated, financial markets

have evolved in recent years in ways that lessen the more significant problems. In most

companies, for example, the debt-equity choice is a decision made at the board of direc-

tors’level. Hence, firms with active outside board members—that is, members of the

board of directors who are not employees of the company—can force managers to

select a debt ratio higher than that which the managers would personally prefer. In addi-

tion, outside board members might want to see the firm more highly leveraged than

would be optimal in the absence of managerial incentive problems, since the added

debt burden may mitigate the incentives of managers to overinvest.

Amore direct way to align the incentives of managers and shareholders, which is

also examined in Chapter 18, is to make the pay of managers more sensitive to the

performance of their stock prices. The threat of outside takeovers, examined in Chap-

ter 20, also helps to align the interests of managers and shareholders. As Chapter 19

notes, however, many types of performance-based compensation, such as executive

stock options and the threat of outside takeovers, can make managers overly concerned

about the current share prices of their firms. When this is the case, managers may take

actions that convey favorable information to investors that temporarily boosts share

prices at the expense of lowering the intrinsic or long-term values of their firms.

The incentives of managers to make financial decisions that convey favorable infor-

mation to investors are examined in Chapter 19. We argue, for example, that managers

625

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626Part VIncentives, Information, and Corporate Control

may want to distribute cash to shareholders, in the form of either dividends or share

repurchases, because cash distributions signal that firms are generating cash, thus result-

ing in favorable stock price responses. Similarly, leverage increases signal that man-

agers are confident that they can take advantage of the debt tax shield and are not overly

concerned about incurring the costs of financial distress. Hence, when firms announce

an increase in their debt ratios, stock prices generally respond favorably.

An important lesson of Chapter 19 is that the stock price response to the announce-

ment of a financial decision may provide misleading information about how investors

view the particular decision. For example, managers may believe that their sharehold-

ers prefer higher dividends because share prices reacts favorably to dividend increases.

In reality, however, shareholders may react favorably to dividend increases because of

the favorable information the decision conveys, even though investors dislike the tax

consequences of the higher dividends. Asecond important lesson of this chapter is that

there may be negative consequences associated with making managers overly concerned

about boosting the current stock price of their firm.

Chapter 20, which examines mergers and acquisitions and their effect on the con-

trol of firms, applies the material used throughout this text. For example, an under-

standing of the incentive and information issues examined in Chapters 18 and 19 is

particularly important for individuals who evaluate mergers and acquisitions. In some

cases, mergers and acquisitions mitigate the incentive and information problems; in

other cases, however, mergers can worsen these problems. In addition, many of the tax

issues discussed in Chapters 13 through 15 and the valuation techniques developed in

Part III prove to be important in the evaluation and structuring of merger and acquisi-

tion deals.

It should be noted that both risk aversion and the time value of money, which were

central to our analysis of asset pricing in the first half of this text, provide an unnec-

essary layer of complication to the analysis of how information and incentive problems

affect corporate behavior. Hence, unless specified otherwise, the discussion and exam-

ples in Part Vassume that investors are risk neutral and the interest rate is zero, or

equivalently, that the present value of a future cash flow equals its expected future

value.

Grinblatt1266Titman: Financial	V. Incentives, Information,	18. How Managerial	© The McGraw1266Hill
Markets and Corporate	and Corporate Control	Incentives Affect Financial	Companies, 2002
Strategy, Second Edition		Decisions

CHAPTER

How Managerial Incentives

18

Affect Financial Decisions

Learning Objectives

After reading this chapter, you should be able to:

1.Distinguish between managerial incentives and shareholder incentives.

2.Understand how the differences between manager and shareholder incentives

affect the ownership structure, capital structure, and investment policies of firms.

3.Describe ways to design compensation contracts that minimize manager-shareholder

incentive problems.

Armand Hammer founded and ran Occidental Petroleum until his death in 1990 at

the age of 92. Although he is generally credited with creating a highly successful oil

company, during the last decade of his life he pursued strategies that were widely

criticized and that resulted in dismal share price performance for Occidental while

the stocks of other oil companies tripled in value. Aparticularly visible example of

Hammer’s decision making that many stockholders opposed was the building of an

art museum for Hammer’s art collection at a cost of $120 million to shareholders.

One event illustrates the extent to which Armand Hammer influenced the value

of Occidental Petroleum’s stock. When it became known, on November 10, 1989, that

Hammer had entered the intensive care unit of the UCLAMedical Center, the rumor

spread that the 91-year-old chairman was critically ill. Based on this rumor, the

price of Occidental stock increased from $28 to $31 per share, representing a total

gain in shareholder value of approximately $300 million. Given Hammer’s age, his

medical problems could not have been totally unexpected, so this $300 million

increase in market value probably underestimates the extent to which Hammer was

harming the company’s value. The following Monday, it was reported that Hammer

had gone into the hospital for a routine adjustment to his pacemaker. The price of

Occidental stock reacted to this information by falling $2 per share, giving up most

of its earlier gain.

Up to this point, we have presented a fairly simplistic view of how corporate deci-

sions are made. The previous chapters considered financial decisions within the

context of a firm whose shareholders know as much about the business as the managers

627

Grinblatt1268Titman: Financial	V. Incentives, Information,	18. How Managerial	© The McGraw1268Hill
Markets and Corporate	and Corporate Control	Incentives Affect Financial	Companies, 2002
Strategy, Second Edition		Decisions

628Part VIncentives, Information, and Corporate Control

and whose managers act in the interests of shareholders. In most cases, these assump-

tions provide a useful framework for understanding how investment and financing deci-

sions shouldbe made to create value for shareholders. However, given the conflicts of

interest between managers and shareholders, this framework does not provide a good

general description of how these financial decisions are actuallymade.

This chapter has two purposes. The first purpose is to provide a more realistic picture

of how financial decisions are actually madeby firms, taking into account the potential

incentive problems that can exist between managers and shareholders. The second

purpose is to reexamine how financial decisions should be madein this more realistic

setting, accounting for inherent manager-shareholder conflicts.

One can take two views as to why management decisions might deviate from those

that maximize firm values. The first, more cynical, view is that managers take

advantage of their positions and engage in actions that allow them to benefit person-

ally at the expense of shareholders. The chapter’s opening vignette, which described

Armand Hammer’s use of Occidental Petroleum’s funds to build a museum for his per-

sonal art collection, is an oft-cited example that might fit into this category. Although

the popular press has emphasized this cynical view of the management-shareholder con-

flict, we emphasize a different view: that managers view their positions as serving a

broader constituency than just shareholders.

The most important source of conflict between managers and shareholders arises

from the sense of loyalty most managers feel toward their employees and other stake-

holders. For example, managers generally find it unpleasant to lay off employees, and

similarly, find it rewarding to offer their employees good career opportunities. Indeed,

many Americans believe that taking care of employees—not maximizing stock

prices—should be the primary goal of U.S. corporations. Apoll taken by Yankelovich

in 1996 “showed that 51 percent of Americans think a corporation’s top obligation is

to its employees, while 17 percent think stockholders deserve highest priority.”¹

Perhaps the most important implication of both the cynical view and the stakeholder

view is that managers may choose investment and financing strategies that do not max-

imize the firm’s value. For example, to enhance their own opportunities as well as those

of their employees, managers may bias their investment and financing decisions in ways

that reduce risk and increase the firm’s growth rate. To accomplish these goals, a man-

ager may accept negative net present value projects that increase the size and diversity

of the firm and use less than the value-maximizing level of debt financing.

Since managers and shareholders do not always have the same interests, financial

decisions can be viewed from a number of perspectives. For example, the previous

chapters viewed financial decisions from the perspective of a firm run by value-

maximizing managers. This chapter views the financial decisions from two different

perspectives: (1) from the perspective of a manager who has complete control of the

firm and who may, for personal reasons, want less risk and more growth than share-

holders; and (2) from the perspective of a large shareholder, or perhaps a board mem-

ber, who can influence the firm’s overall strategy but cannot control the day-to-day

decisions made by the firm’s managers. These large outside shareholders may influence

a firm’s capital structure decision, since they can readily observe the capital structure

choice, but they may not be able to influence the firm’s investment choices.

This chapter addresses the question of how outside shareholders should exert their

influence on the capital structure choice in order to indirectlyinfluence the manager’s

1

The Wall Street Journal,May 21, 1996.

Grinblatt1270Titman: Financial	V. Incentives, Information,	18. How Managerial	© The McGraw1270Hill
Markets and Corporate	and Corporate Control	Incentives Affect Financial	Companies, 2002
Strategy, Second Edition		Decisions

Chapter 18

How Managerial Incentives Affect Financial Decisions

629

investment choice. This chapter also examines ways of compensating managers so that

these incentive problems are minimized.²