Potential Issues in Ratio Analysis

Potential Issues in Ratio Analysis
As your text describes, ratio analysis is a common technique in financial analysis. One of your colleagues states that a thorough ratio analysis is all that is needed in considering the financial health of a company. Although you agree that ratio analysis is a helpful guide, there may be some potential pitfalls in ratio analysis.

Discuss at least three potential issues in utilizing ratio analysis that you would share with your colleague. In addition, calculate a liquidity, profitability, and efficiency ratio from your Week Six company to demonstrate your observations.

Develop a 200 – 300 word explanation supporting your findings.
Learning Objectives

After studying this chapter, you should be able to:

• Describe the characteristics of perfect capital markets and how they relate to capital structure.

• Identify the characteristics that make capital markets imperfect, and explain how they relate to capital structure.

• Explain how the trade-off theory components are used to determine target capital structure.

• Identify other factors that affect a firm’s debt capacity.


Capital Structure: Right-Hand-Side Decisions and the Value of the Firm

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CHAPTER 9Introduction


Figure 9.0: Chapter 9 in focus

Company Operations

The Financial Balance Sheet






Managers must choose the sources of capital with which to finance the corporation’s assets. Chapter 9 discusses the factors managers need to consider as they decide on the appropriate mix of debt and equity for their company.

Managers choose products and services that create value for shareholders. Chapters 6, 7, and 8 discussed how these investment decisions, reflected on the left-hand side of the financial balance sheet, affect shareholders’ wealth. Recall that investing in positive NPV projects adds to the wealth of shareholders, whereas investing in negative NPV projects detracts from it. In this chapter, we examine how managers choose the mix of financing required to support these investment decisions. We call this the capital structure decision. As we turn our attention to the right-hand side of the balance sheet, we assume that capi- tal budgeting decisions have been made. Our concern is with choosing the mix of debt and equity used to fund the firm’s assets, and whether this capital structure choice will affect shareholders’ wealth.

You might think that there is a standard proportion of debt that most firms use—a finan- cial rule-of-thumb—but the debt-equity mix varies enormously across companies. Some, such as young high-tech or biotech firms use little or no debt, whereas public utilities use high levels of debt. Even private equity firms, such as Bain, KKR, the Blackstone Group and Warburg Pincus, often finance their purchases of companies with 60% or even 80% debt.

Why do debt ratios vary so much from company to company? It all comes back to the financial goal of the corporation: Management chooses a specific capital structure in the belief that its choice will maximize the firm’s worth, and ultimately shareholder wealth. How each of these decisions can be optimal yet so different is explained in this chapter as we explore the link between capital structure and firm value.

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CHAPTER 9Section 9.1 Perfect Capital Markets and Capital Structure


1. In perfect capital markets, firm value is unaffected by leverage. a. True b. False

2. All else being equal, debt will tend to increase firm value by lowering agency costs because of the disciplining effect of debt.

a. True b. False

3. The target capital structure of a firm includes less debt if taxes are high, all else being equal.

a. True b. False

4. According to the pecking order theory, a company should issue safe debt before using any other form of capital.

a. True b. False

Answers 1. a. True. The answer can be found in Section 9.1. 2. a. True. The answer can be found in Section 9.2. 3. b. False. The answer can be found in Section 9.3. 4. b. False. The answer can be found in Section 9.4.

9.1 Perfect Capital Markets and Capital Structure

Our discussion of the debt-equity mix begins with the assumption that capital mar-kets are perfect. Perfect capital markets are an ideal and do not reflect the real world, but they are very useful for developing an understanding of capital struc- ture’s impact on share value and also in understanding dividend policy, which will be covered in Chapter 10. Under the very strict (and unrealistic) assumptions of perfect mar- kets, we will see that capital structure has no impact on value. That is, right-hand-side decisions are irrelevant to shareholders under perfect market conditions, so any mix of debt and equity results in the same overall value of the firm. Also, in perfect capital mar- kets, the cost of borrowing is assumed to be the same for both investors and companies (which is not the case in actual capital markets). It may seem like a poor use of time to study something that is irrelevant to firm value, but this model gives us insights about why capital structure may matter in the real world. As we relax the assumptions of per- fect capital markets, we will begin to identify the factors that help determine a company’s optimal capital structure.

Perfect capital markets may be characterized as

• being strong-form efficient, • having no information asymmetry, • having no leakages such as taxes or transaction costs.

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CHAPTER 9Section 9.1 Perfect Capital Markets and Capital Structure

Strong-form efficiency defines a market in which security prices reflect all pertinent infor- mation. Prices in such markets are unbiased estimates of value, fully reflecting the cash flows and risk expected to accrue to security holders. In strong-form efficient markets, securities offering the same cash flows with equal risk will be equally priced.

As strong-form efficiency suggests, the information reflected in prices includes both insider and outsider information. This is a natural outcome of the second characteristic of perfect markets, their lack of information asymmetry. Because everyone has the same information, no distinction between insiders and outsiders is necessary in perfect capital markets. Furthermore, there is no agency problem in these markets. If, for example, man- agers were underperforming or granting themselves excessive perquisites, their employ- ers, the shareholders, would observe these actions. Shareholders, in turn, would correct such inappropriate behavior—possibly firing the managers. In this perfect market, man- agers would foresee this shareholder response and would not act inappropriately in the first place.

The third characteristic of perfect capital markets is that no leakages occur as cash flows move between the firm and capital suppliers. Examples of leakages include taxes (where a portion of the cash that otherwise would flow to security holders is paid to the govern- ment) and transaction costs (cash paid to investment bankers as part of the firm’s capital acquisition). Figure 9.1 illustrates some common leakages.

Figure 9.1: The financial balance sheet, illustrating some leakages

Fees to investment bank

Corporate income taxes




$ $

Product and service markets

Investments made by the firm


Services Claims on cash flow

Capital markets

This figure illustrates where leakages may impact the financial balance sheet.

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CHAPTER 9Section 9.1 Perfect Capital Markets and Capital Structure

Because such leakages do not exist in perfect capital markets, these markets are sometimes characterized as being friction- less. In physics, friction refers to resistance as objects are moved. The more friction there is, the more energy it takes to move an object. Thus, it is easier to push a heavy box across a smooth tile floor than across a carpeted floor. The analogy to economic friction is straightforward: As cash or securities move from the claimants to the firm, between claimants, or from the firm to claimants, there is no loss of value in a frictionless mar- ket. Anyone who has sold a house for $150,000 yet nets only $135,000 after commissions, lawyer’s fees, and taxes can attest to the frictions that exist in most markets.

Next we will look at capital structure in perfect capital markets.

The Irrelevance of Capital Structure in Perfect Markets In perfect capital markets, the mix of financing used to fund investment decisions is con- sidered irrelevant to shareholders. We illustrate capital structure’s irrelevance by develop- ing a simple example that assumes capital markets are perfect and the firm’s investments are identified. Suppose the firm in our example is a small, closely held corporation that does business as a donut shop. Further suppose that you are the sole owner of the shop, providing 100% of the corporation’s capital. All of the shop’s capital is provided via stock, so its capital structure is all equity, and you own all the shares.

In the perfect markets we have described, the value of the donut shop is unaffected by the fact that you have chosen to finance it using only equity. Had you decided to loan the company half of its capital and provided the other half in the form of equity, then the total value of your investment would be unchanged. Why doesn’t capital structure matter? Capital structure is irrelevant because it does not affect the cash flows that the shop gener- ates or their riskiness, and it is these characteristics of the shop that determine its value. To see this, ask yourself whether customers care about a donut shop’s capital structure when they choose to make a purchase. No, they care about price, flavor, cleanliness, selection, service, and convenience. These shop characteristics are independent of the proportion of debt and equity the business chooses to use as sources of capital. Customers are interested in the shop’s menu, not its balance sheet.

In our example, all of the cash flows to you, the owner, whether it is an all-equity firm or a 50% debt–50% equity firm. You receive the same cash flow stream whether all the cash

Just as friction hinders our ability to push a cart of boxes, so too does friction impede the movement of funds in a capital market.

Christie & Cole/Corbis

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CHAPTER 9Section 9.1 Perfect Capital Markets and Capital Structure

As levers are used in mechanics to amplify strength, finance also uses the concept of levers to demonstrate the strength of good and bad cash flows.


comes in the form of dividends or part of the return is dividend income and part is inter- est income. Since there are no taxes or transaction costs, you see no advantage in receiving interest income or dividend income. As the sole owner you receive identical cash flow and bear identical risk with either capital structure; therefore, your business will have the same value with either structure. To put it another way, the components of value (the size and riskiness of expected cash flows) are determined by the left-hand side of the financial balance sheet and are reflected in the values of the right-hand-side claims. Thus, the left- hand side is critical to a firm’s valuation.

It follows that in a perfect capital market, capital structure has no impact on value. This is the irrelevance proposition we referred to at the beginning of this section. It means that when capital markets are perfect, managers need not waste their time worrying about right-hand side decisions. One capital structure is as good as another, and they all result in the same value for owners.

Irrelevance is probably best understood by recognizing that both cash and risk flow from the left-hand side of the balance sheet (from assets and the products those assets pro- duce) to the right-hand side of the balance sheet (to financial claims such as debt and equity). Capital structure simply determines how these cash flows and risk are distributed to claimants. A pie is a good analogy: A firm’s capital budgeting determines the size of the pie, and capital structure determines who gets the pieces of the pie. In a perfect world, capital structure has no impact on the size of the pie (i.e., the value of the firm).

Leverage and the Risk of Common Stock in Perfect Markets The term financial leverage describes the proportion of debt used in a firm’s capital struc- ture. The presence of debt in a firm’s capital structure has a magnifying effect on financial performance; just as a lever in physics magnifies strength, financial leverage can make good cash flows to shareholders even better (and poor cash flows to shareholders even

worse). An all-equity firm is considered unlevered because it does not use debt to finance its investment decisions. To dem- onstrate this property of lever- age, we extend the donut shop example.

Suppose your donut company, The Whole Donut, Inc., required $1,000,000 in financing. The firm can be financed either using half debt and half equity or all equity. The company can borrow $500,000 at an interest rate of 6%. As you consider the two financ- ing alternatives, your market research consultant has identi- fied three possible cash flow scenarios for the coming year: a

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CHAPTER 9Section 9.1 Perfect Capital Markets and Capital Structure

best case of $170,000; an expected level of cash flows of $100,000; and a worst-case sce- nario, when cash flows total only $30,000. Table 9.1 shows the returns to shareholders on the common-stock investment for both the unlevered (all-equity) financial structure and the leveraged firm financed with $500,000 of debt and $500,000 of equity.

Table 9.1: The effect of financial leverage

Worst case Expected Best case

A. Total investment $1,000,000 $1,000,000 $1,000,000

B. Operating cash flows $30,000 $100,000 $170,000

C. Return on total investment (B/A)

3% 10% 17%

All equity

D. Payments on fixed claims

$0 $0 $0

E. Total residual cash flow (B – D)

$30,000 $100,000 $170,000

F. Equity investment $1,000,000 $1,000,000 $1,000,000

G. Return on equity (E/F)

3% 10% 17%

Leveraged firm

H. Payments to fixed claims (6% of $500,000)

$30,000 $30,000 $30,000

I. Residual cash flow (B – H)

$0 $70,000 $140,000

J. Equity investment $500,000 $500,000 $500,000

K. Return on equity (I/J) 0% 14% 28%

First, let’s look at the rows labeled D through G in Table 9.1. For the all-equity financed firm the ROE (return on equity) ranges from 3% under the worst-case scenario to 17% for the best case, with an expected ROE of 10%. Now, let’s look at the leveraged firm; rows H through K show results for the same firm when financed with a mix of debt and equity. For the leveraged company, the ROE ranges from 0% under the worst-case scenario to 28% for the best case, with an expected ROE of 14%. The leveraged firm has a higher expected ROE, but twice the range of possible ROEs compared to the all-equity firm. The table demonstrates the trade-off between risk and return when using financial leverage. All else being equal, shareholders have a higher expected return with debt financing, but they also have a higher return variability.

This is in line with what we have already learned about risk and investment: risk-averse investors require a higher expected return if they anticipate exposure to more risk or vari- ability. In our example, the 4% increase in the expected ROE will compensate investors for the greater risk created by leverage, but stock prices (and thereby firm value) will remain unchanged.

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CHAPTER 9Section 9.2 Imperfect Capital Markets and Capital Structure

This section has shown that capital structure is irrelevant in perfect capital markets. But markets in the real world are not perfect. Therefore, in the following section, we relax the perfect market assumptions to better reflect reality.

9.2 Imperfect Capital Markets and Capital Structure

To better reflect capital structure’s effect on the firm in the real world, we will relax the perfect market assumptions made in Section 9.1. In this section, we introduce imperfections into our model of capital markets, creating an environment that is more complicated and realistic. As with any real-world decision that involves uncertainty, capital structure choice will involve pros and cons, or trade-offs between the potential benefits of leverage and its potential adverse effects. Let’s begin by relaxing the assump- tion of no leakages.

Leakages In the real world, claimants do not always receive the full cash flows; frictions, such as leakages, interfere. Just as friction lowers our ability to do physical labor, frictions in capi- tal markets lower the cash flows to investors. The first leakage we will discuss is taxes.

Taxes Let us return to the donut shop example to illustrate how tax functions as a leakage. Table 9.2 shows cash flows to claimholders of The Whole Donut Inc. when the firm is unle- vered and when it is leveraged with $500,000 of debt bearing a 6% interest rate. We have assumed a 30% corporate tax rate. As Table 9.2 shows, the unlevered firm pays $30,000 in taxes to the government, whereas the levered firm pays only $21,000. With debt financing, the leakage to the government is $9,000 less, and cash flows to investors are $9,000 greater compared to the unlevered financing model. The $9,000 is the tax savings resulting from the interest being a tax-deductible expense. We could compute the interest tax savings directly as the interest expense times the tax rate ($9,000 5 $30,000 3 0.30).

Table 9.2: The effect of taxes on cash flows

Cash flow Unlevered $500,000 of 6% debt

A. Expected operating cash flow before taxes $100,000 $100,000

B. Interest payments to debtholders (6%) $0 $30,000

C. Cash flow after interest payments (A – B) $100,000 $70,000

D. Corporate taxes (30% of C) -$30,000 –$21,000

E. Cash flow to residual claims (C – D) $70,000 $49,000

F. Total cash flows to all claimants (B 1 E) $70,000 $79,000

So, why is there a tax difference between leveraged and unlevered firms? Interest payments made by the corporation are paid before corporate income taxes, whereas dividend payments are paid after. Thus, a firm may reduce taxes paid to the government by using more debt in

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CHAPTER 9Section 9.2 Imperfect Capital Markets and Capital Structure

its capital structure. Conceptually, a corporation could avoid taxes altogether by financing exclusively with debt. If all cash flows were distributed to claimants in the form of interest payments, the government would collect no corporate taxes because all interest would be paid before taxes. On the other hand, a corporation financed solely with equity would pay taxes before any distributions could be made to its suppliers of capital because dividends would be paid after taxes. Few firms are all-equity financed, and none are all-debt financed. The Internal Revenue Service would probably claim that an all-debt financing scheme was a tax-avoidance strategy and would impose taxes on that portion of the debt they felt was de facto equity. Normally, corporations have a mix of debt and equity.

As we have shown, increasing leverage reduces taxes, which increases the cash flows available to investors, thereby increasing the value of the firm. Let’s return to the pie anal- ogy to further explore this concept. When taxes (or other leakages) are introduced into otherwise perfect markets, a piece of the cash flow pie is effectively given to a third party. By avoiding taxes through debt financing, less of the pie is distributed to third parties, leaving more cash flows available for distribution to the capital suppliers. In either case, levered or unlevered, the corporation’s risk is entirely borne by these capital suppliers, so firm value will be directly linked to the amount of cash security holders can claim. Mini- mizing taxes will increase cash flows, thereby increasing the value of the company. Figure 9.2 illustrates this impact of debt on a firm’s value.

Figure 9.2: Firm value with debt

Irrelevance of leverage in perfect markets with no taxes

Firm value if interest were paid after taxes

Financial leverage (debt/equity)

Fi rm

v al

u e

Impact of taxes on value

Debt’s tax shield

Firm value with interest paid before taxes

This figure shows the decreasing relevance of leverage as the firm’s tax rate goes to zero (perfect markets).

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CHAPTER 9Section 9.2 Imperfect Capital Markets and Capital Structure

The upper horizontal line in Figure 9.2 represents the irrelevance of leverage when capital markets are perfect. Regardless of the debt-equity mix that the corporation chooses for its capital structure, firm value remains unchanged. The upward-sloping line shows the ben- efits of leverage. As more debt is incorporated into the firm’s capital structure, a greater proportion of operating cash flows is distributed before taxes are paid. The deductibility of interest payments allows the firm to distribute more of its cash flows, a characteristic known as the tax shield of debt. This benefit increases firm value as the firm uses more debt.

By studying Figure 9.2, we conclude that a firm should use almost no equity in its capital structure. Indeed, in the 1980s some firms did leverage themselves to such an extent that debt represented 70%, 80%, and even 90% or more of their capital. Yet the majority of cor- porations did not follow the lessons of Figure 9.2, choosing instead to keep a more moder- ate level of debt in their financing mix. Why didn’t they take full advantage of the debt tax shield? We answer that question next, as we study a second leakage, bankruptcy costs.

Bankruptcy Costs As more and more debt is added to a firm’s capital structure, that debt becomes riskier because interest payments are fixed. If a company performs poorly, it may decide not to pay dividends to stockholders, but it must pay interest to debtholders. Bonds and loans are contractual agreements, so if these claimants are not paid on time and in full they can bring legal action against the company. As debt levels rise, smaller variations in per- formance can leave a company unable to service its debt. The possibility of default on mandatory debt service payments increases with debt levels. A default that cannot be corrected or negotiated can lead to bankruptcy. Therefore, the probability of bankruptcy increases as debt increases.

Figure 9.3 is a stylized graph showing cash flows for The Whole Donut, Inc. under dif- ferent economic conditions. Figure 9.3a shows our firm with $500,000 of debt, which car- ries a 6% interest rate and requires $30,000 of annual interest payments. These required payments are represented by the dotted horizontal line. Because the cash flows never dip below that line, we know the firm can make its interest payments regardless of the future economic scenario. Thus, at this level of leverage, our firm’s debt is riskless.

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CHAPTER 9Section 9.2 Imperfect Capital Markets and Capital Structure

Figure 9.3: Bankruptcy risk with increasing debt

Economic conditions



Required interest

payment (a) $500,000 debt at 6% yields $30,000 interest payment

Cash flow

Debt is riskless because cash flows never fall below $30,000.

$30,000 interest $30,000

Economic conditions



Required interest

payment (b) $700,000 debt at 6% yields $42,000 interest payment

Cash flow

Potential financial distress; thus, debt is not risk free and lenders won’t lend at 6%

$42,000 interest $30,000

Economic conditions



Required interest

payment (c) $700,000 debt at 8% yields $56,000 interest payment

Cash flow

Risky debt results in higher rate of interest

$56,000 interest $30,000

This figure shows how the likelihood of bankruptcy changes as more debt is introduced into a firm’s capital structure.

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CHAPTER 9Section 9.2 Imperfect Capital Markets and Capital Structure

In a perfect market, even repossessing a car due to a borrower’s bankruptcy does not have a negative impact on the bank, but in reality, markets are far from perfect.

McClatchy-Tribune/Getty Images

Now, suppose that the firm chooses to take greater advantage of debt’s tax-shielding bene- fits by borrowing a greater proportion of its capital. Suppose the firm borrows $700,000, as illustrated in Figure 9.3b. At that level of debt, the loan would no longer be riskless. Even at a 6% interest rate, lenders stand the chance of not being paid under certain economic conditions because the cash flow curve falls below the $42,000 threshold. The shaded areas illustrate potential cash shortfalls when conditions are poor for our firm’s business. Knowing this, lenders will require a higher interest rate to compensate them for this risk, say 8%. Figure 9.3c shows the interest payment threshold of $56,000 when $700,000 is bor- rowed at 8%.

If the economy turns sour and cash flows are insufficient to cover interest payments, The Whole Donut, Inc. stands a chance of being unable to pay its contractual interest (or other fixed obligations). Firms unable to meet their fixed claims are in default, and this may lead to bankruptcy. Some firms may avoid default during these shortfalls by keeping a cash reserve on hand or having other sources of capital that can be accessed to meet these obligations. They may choose to borrow funds to make the payments, or even sell more stock. However, if the shortfall is extreme, the firm may be unable to raise more cash and could be forced into bankruptcy.

Bankruptcy has many forms, but for our purposes it may be characterized as the transfer of control of assets from the residual claimants (i.e., shareholders) to fixed claimants (i.e., lenders). A simple example will help illustrate bankruptcy and its impact. Suppose a bank lends someone the cash to purchase an automobile. The bank is a fixed claimant, and the borrower is the owner of the car. Let’s say the owner is unable to make the payments the loan requires and is in default. This is like bankruptcy in that the borrower must transfer ownership of the vehicle to the fixed claimant (to the bank). If this is done without friction, as in a perfect market setting, there is no loss in the value of the automobile or the bank’s claim.

However, in an imperfect mar- ket, the bank incurs some costs when repossessing a car. It pays lawyers to do the legal paper- work, the state charges fees to transfer the car’s title, and so on. These are the direct costs of this transfer. Additionally, the car’s owner may have neglected to maintain the vehicle in an effort to conserve cash and avoid default. Once the bank has pos- session of the car, this deferred maintenance must be done at a cost to the bank. Bank officers will also spend considerable time doing in-house paperwork, making phone calls, and so on in order to take possession of the car. It must also absorb the

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CHAPTER 9Section 9.2 Imperfect Capital Markets and Capital Structure

advertising costs associated with selling the automobile. These activities are costly and represent the indirect costs of the transaction. Both the direct and indirect costs of transfer- ring ownership of the car represent frictions in this transaction, and they effectively lower the value of the car to the bank.

Similarly, corporate bankruptcies are characterized by frictions. Residual claimants will not costlessly transfer their ownership rights to fixed claimants once they recognize that the firm cannot meet its fixed claims. There are costs inherent to the bankruptcy procedure.

The direct costs of bankruptcy include attorney’s fees and court fees. Indirect bankruptcy costs include management’s time spent on paperwork, phone calls, meetings, and so on, which could otherwise be spent on more productive activities. Furthermore, some key employees may conclude that, given the firm’s financial distress, now is a good time to take another job, which is also costly to the corporation. Customers may stay away from the firm’s products because they fear that the firm’s guarantees will not be honored as a result of the bankruptcy. Distressed airlines, for example, often find demand for their ser- vices declines as customers worry about deferred aircraft maintenance or canceled flights. These represent bankruptcy’s indirect costs.

All costs, direct or indirect, lower the firm’s cash flows in the event of bankruptcy. Return- ing to our earlier example, imagine that The Whole Donut, Inc. began experiencing finan- cial distress because of difficulty in making interest payments. It is possible that the shop would try to conserve cash by reducing labor costs. The money saved could be used to meet interest payments on the firm’s debt. However, the shop’s regular customers may begin to notice that they must wait longer to be served, that the shop isn’t as clean as it used to be, and that employees aren’t as friendly due to overwork. The Whole Donut, Inc. could lose business, lowering cash flows, as a result of the cost-cutting strategy brought on by financial distress. Had the company foregone leverage in its capital structure, these financial difficulties and their accompanying negative impact on firm value might have been avoided.

Figure 9.4 is similar to Figure 9.3, but it shows the reduction of cash flows in the event of bankruptcy. It is important to note that the expected cash flow for the firm is no longer $100,000. The friction caused by financial distress lowers the cash available to claimants in several potential economic conditions. Recognizing this, investors incorporate these costly outcomes into their cash flow estimates, lowering their estimate of the firm’s expected cash flow. They may also require a higher return because of the greater variability of cash flows given potential bankruptcy costs. The value of the firm must decline since expected cash flows are lower and/or risk is higher.

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CHAPTER 9Section 9.2 Imperfect Capital Markets and Capital Structure

Figure 9.4: Bankruptcy costs

“Old” expected cash flow of $100,000

“New” expected cash payment

$56,000 required interest payment

Worst case = $30,000

Best case = $170,000 Expected cash

flow is reduced by the introduction of bankruptcy costs.

Cost of bankruptcy

The figure shows forecasted cash flows across economic conditions, highlighting the impact of potential bankruptcy costs.

The expected cash flows are reduced by the expected costs of bankruptcy. Expected bank- ruptcy costs are calculated by multiplying the likelihood of bankruptcy times the poten- tial costs. If there is very little or no debt in the firm’s capital structure, the corporation will not be in danger of default, and no potential bankruptcy costs will be included when investors value the firm. This occurs because the probability of bankruptcy is zero or close to zero. Yet, as more debt is added, the likelihood that these costs will be incurred becomes greater, and the expected value of bankruptcy costs rise, lowering firm value. Figure 9.5 shows the impact of bankruptcy costs on firm value as leverage increases.

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CHAPTER 9Section 9.2 Imperfect Capital Markets and Capital Structure

Figure 9.5: Leverage and firm value

Leverage’s impact with taxes

Leverage’s impact with taxes and bankruptcy costs


Fi rm

v al

u e

Impact of taxes on value

Debt’s tax shield

Expected bankruptcy costs

This figure highlights leverage’s effect on firm value, taking into account taxes and bankruptcy costs.

The lesson here is that as leverage increases, so does the likelihood of incurring bank- ruptcy costs or costs associated with financial distress. These potential costs reduce firm value, partially offsetting the tax benefit of debt. This is the first trade-off mentioned ear- lier: Managers must balance the tax advantage of debt against the potential for costly bankruptcy. Leveraging the firm reduces the leakages to the government (lowers taxes), while increasing potential leakages to third parties in the form of bankruptcy proceedings or financial distress (lawyers’ fees, court costs, customers lost to competitors, etc). The role of leverage and bankruptcy costs is an important topic. But what happens when corpo- rate managers know more about the firm’s activities than do most corporate owners? We address this issue, information asymmetry, next.

Information Asymmetry When capital markets are perfect, no information gap exists between corporate insid- ers and outsiders. This means that all market participants have the same, or symmetric, information. In such conditions no agency problem would exist because investors would observe the problem (excessive perquisite consumption, growth for growth’s sake, shirk- ing behavior, etc.) and take remedial action. When we drop the assumption of symmetric information, we get a much more realistic view of how corporations conduct their affairs. Next, we discuss an issue related to the information asymmetry present in an imperfect market: agency costs.

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CHAPTER 9Section 9.2 Imperfect Capital Markets and Capital Structure

Agency cost problems are especially troublesome in industries like tobacco and oil. What are your thoughts about creating debt in order to reduce agency costs?


Agency Costs Asymmetric information means that corporate managers know more about many of the firm’s activities than do most corporate owners—the outside shareholders. Under these conditions, agency problems can arise and be quite costly. How does leverage affect agency problems? The answer lies in the discipline of debt.

To understand the discipline of debt, first consider the nature of the manager–stockholder agency problem. Managers control corporate expenditures and oversee their own efforts. They may choose to invest cash in wasteful purchases—unneeded corporate jets, luxury offices, and so on—and they may choose to play a lot of golf or take two-hour lunches on company time. These resources, corporate cash and managerial effort, could be put to better, wealth-producing use. In sum, agency problems can be costly for the corporation. Now, consider bankruptcy, the likelihood of which increases with leverage. In the event of bankruptcy, or financial distress that could lead to bankruptcy, managers are often fired, demoted, or retired early. These consequences of bankruptcy are especially costly to man- agers who have most of their “wealth” linked to their jobs (e.g., their human capital and financial capital). Shareholders, who also suffer from bankruptcy’s costs, are not affected to the same degree as managers are because investors’ portfolios are diversified. With so much depending on their careers, managers are highly motivated to avoid bankruptcy.

But what happens to agency costs when a firm’s leverage increases? Leverage increases the likelihood of financial dis- tress, threatening management’s job security. Management’s fear of bankruptcy causes them to become more frugal, conserving cash to minimize the chances of a default. In order to accomplish this, managers of highly lever- aged firms work hard to cut wasteful pursuits. As a result, agency costs are reduced, and firm value increases. They may play less golf during business hours and work harder to avoid financial distress. In essence, they waste less money, and they waste less time. This is the disci- pline of debt. The discipline of

debt argument asserts that firms become more efficient and therefore more valuable as leverage increases.

Some industries may be more susceptible to agency costs than others. Michael Jensen developed the discipline of debt theory, arguing that the agency cost problem would be particularly severe in companies with large cash flows and limited growth or invest- ment opportunities. Such companies have excessive funds for managers to spend but few value-creating investments to make. Industries that fit this description include the tobacco or cigarette industry and, when oil prices are high, the oil and gas industry. Debt reduces

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CHAPTER 9Section 9.2 Imperfect Capital Markets and Capital Structure

the cash available to managers to spend by requiring it be paid to lenders. Dividends do not function in the same way as debt; being somewhat discretionary, they usually don’t have the same agency cost-reducing effect that debt has.

Figure 9.6 illustrates the effect of debt’s discipline on firm value.

Figure 9.6: Leverage and firm value, with agency costs


Fi rm

v al

u e

4. With taxes, bankruptcy costs, and the discipline of debt

1. Irrelevance in a perfect market

2. W ith

deb t’s t

ax shie


Expected bankruptcy costs increase with leverage, lowering value.

3. With tax and costs of bankruptcy

The discipline of debt increases cash flows as waste is cut, increasing firm value.

Interest payments, being tax deductible, lower taxes and therefore increase firm value.

Taxes lower cash flows and thus lower firm value.

This figure shows four scenarios where leverage impacts a firm’s value:(1) markets are perfect, (2) taxes are introduced, (3) bankruptcy costs are included, and (4) the discipline of debt is also considered.

Now that we have discussed how information asymmetry can lead to agency cost prob- lems, and how those problems can be addressed, we can discuss another factor related to information asymmetry in imperfect markets: debt signaling.

Signaling With Debt Knowing that leverage may lead to financial distress and possibly the loss of their jobs, you might ask why a manager would ever take on more debt financing. With informa- tion asymmetry, outside stockholders must estimate firm value without all the informa- tion that inside managers have. Rational investors will typically assign at best an average value (but more likely a lower value) to aspects of a business about which they are uncer- tain. Managers don’t want their companies undervalued (they own stock in the company, and their performance is often related to share price). Issuing debt helps address this undervaluation problem.

Debt may be viewed as management’s signal of the firm’s future cash flow prospects. When firms take on greater leverage, the managers, whose decision it was to increase

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CHAPTER 9Section 9.3 Determining Target Capital Structure: Trade-Off Theory

leverage, must believe that the firm’s future cash flows are sufficiently large and steady enough to make higher interest payments. Thus, such leveraging decisions signal man- agement’s faith in the corporation’s cash flow–producing capabilities. Because leverage is increasing, the signal to outsiders is that the firm has a greater capacity for servicing its debt, meaning cash flows are expected to increase in management’s view. Therefore, the corporation’s value will increase in the opinion of outsiders, based on the signal from management.

But why don’t managers simply announce that cash flow prospects have improved? An announcement would convey the same information as the leveraging signal, so why opt for the riskier option? The answer lies in the faith outsiders put in the information; that is, increasing leverage is a more credible signal than an announcement from management. Positive announcements carry little weight with outsiders, as managers generally suf- fer few penalties for misrepresenting a company’s future cash flow prospects. Negative announcements, however, are usually taken seriously because they are usually made only when a situation is so severe that there is no “glossing it over.” In contrast, a leveraging signal is credible because of the potential penalty for managers—loss of their job if the firm can’t meet its debt payments.

Consider the opposite signal, increasing the equity base. Suppose a firm issued and sold additional stock using the funds to pay off debt. Such action reduces fixed claims on cash flows, thereby reducing the likelihood of financial distress. Perhaps management feels the firm’s future cash flows may be more variable or at a lower level than they have been in the past. In order to reduce the chance of default, management reduces leverage, signal- ing to stockholders that the firm has less value. Perhaps instead, management sold the stock to raise funds because, with their inside information, they feel the stock’s value is currently too high. In this case, the firm realizes it is wise to sell some stock to raise funds before the market discovers its error and lowers equity’s price. In both cases, the signal is clear: Firm value is too high in light of management’s information. Leverage, therefore, may be a credible signal of management’s superior information about firm value: Increas- ing leverage signals increasing value and vice versa.

Clearly, there are trade-offs to consider when deciding which capital structure should be used to finance the firms’ investments in an imperfect market. Tax benefits are partially offset by bankruptcy costs, which tend to be offset by the discipline of debt. Debt may also be viewed as a signal of the firms’ future prospects, given the inside information of man- agement. Note that there are no formulas in this chapter that let us solve for the optimal degree of leverage. Instead, managers must evaluate the characteristics of the firm and its environment in order to arrive at the best estimate of the firm’s optimal capital structure. The next section outlines factors that should be considered in making that decision.

9.3 Determining Target Capital Structure: Trade-Off Theory

So far we have discussed what is often called the trade-off theory of capital structure. The trade-off theory argues that companies have an optimal level of debt (a mix of debt and equity that maximizes value). This optimum point is a trade-off between the tax and agency cost reduction benefits of debt and its bankruptcy costs. This optimum

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CHAPTER 9Section 9.3 Determining Target Capital Structure: Trade-Off Theory

point becomes the target capital structure that companies strive to maintain. Another way to look at the target capital structure is as the company’s debt capacity, or the maximum amount of debt that can be safely serviced. Debt capacity implies that debt is a valuable resource and that a company that does not utilize its capacity to borrow may not be maxi- mizing value for shareholders. In this section, we discuss the characteristics that deter- mine a company’s debt capacity, as suggested by the trade-off theory: taxes, potential bankruptcy costs, agency costs, and signaling.

Taxes As we have shown, taxes function as a leakage that can negatively impact the value of a firm. Tax rates can vary between states, countries, and even industries. Fortunately, there are options for shielding a firm from taxes, with some firms seeing more of a benefit from these options than others. The higher the tax bracket a firm finds itself in, the greater the tax-shielding benefit of debt will be for that corporation, and the more leverage the firm should employ in its capital structure. On the other hand, firms with large tax-loss carry- forwards or high depreciation expense will garner less benefit from leverage’s tax shield and will choose lower levels of debt. This is also true for start-up firms that have not yet reached profitability and therefore pay no taxes. When determining target capital struc- ture, managers must weigh a firm’s tax burden against its ability to carry debt. Without proper consideration, a firm may find itself in danger of bankruptcy.

Bankruptcy Two considerations must be given to bankruptcy when determining debt capacity: the likelihood of default and the costs of bankruptcy. We will look at each of these consider- ations in turn, starting with what determines a firm’s likelihood of default.

Likelihood of Default To estimate the likelihood of default, a firm must estimate the level of expected cash flows and their variability. To illustrate this, we will compare three firms’ future cash flows, as shown in Table 9.3, using a sine-wave model in Figure 9.7.

Table 9.3: Estimated cash flows, Firms A–C

Cash flow Firm A Firm B Firm C

Expected cash flow $200,000 $125,000 $125,000

Estimated minimum cash flow

$75,000 $30,000 -$50,000

As you can see, Firm A has a greater debt capacity than either Firm B or Firm C. Given the estimated minimum level of cash flow, Firm A could take on fixed obligations of $75,000 per year that would be virtually riskless. This is not the case for Firms B and C. Firm B could carry more debt than Firm C because its cash flows are less variable. Any amount of debt taken on by Firm C would carry a risk premium because in some economic condi- tions the firm would produce a cash flow deficit, which increases its likelihood of default.

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CHAPTER 9Section 9.3 Determining Target Capital Structure: Trade-Off Theory

Figure 9.7: Debt capacity, Firms A–C

Economic conditions

Economic conditions

Firm A: Highest debt capacity

Cash flow

Expected cash flow of


Minimum $75,000

Economic conditions

Firm B: Debt capacity higher than Firm C but lower than Firm A

Cash flow

Expected cash flow of


Minimum $30,000

Firm C: Lowest debt capacity

Cash flow

Expected cash flow of




This figure illustrates forecasted cash flows and debt capacities for Firms A–C across varying economic conditions.

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CHAPTER 9Section 9.3 Determining Target Capital Structure: Trade-Off Theory

The product market in which a firm competes plays a key role in determining its cash flow characteristics. For example, utilities operate in markets where product demand is relatively price- inelastic; that is, price has little impact on demand for the product. Consumers and businesses use a certain level of energy, regardless of the economic climate. This relatively stable demand enables providers to use high degrees of leverage in their capital structure. Extremely cyclical businesses, like home construction, would be more uncertain of their level of future cash flows, and produc- ers of nonessential luxury goods may find that product demand varies radically with economic conditions. Such firms would carry lower propor- tions of debt than utilities with their more stable cash flows.

A second factor that impacts a firm’s likelihood of default is its mix of operational fixed costs and variable costs. This is known as the company’s operating leverage. Fixed costs do not vary with pro- duction; these are costs such as rent or salaried workers. Variable costs are dependent on the firm’s activity; these include raw materials, labor, and sales commissions. Fixed costs increase a firm’s potential for financial distress in an economic downturn; as fixed costs increase, so does the likelihood of default. On the other hand, we see the opposite effect during good economic times, with fixed costs benefiting the firm when activity increases. Often, firms may substitute fixed costs for variable costs in their operating structure in the same way they might sub- stitute debt for equity in their capital structure. Just as added debt increases financial leverage, more fixed operating costs increase operating leverage. Both types of leverage tend to magnify the firm’s performance and risk: Leverage makes good times better and makes bad times worse.

To illustrate operating leverage, consider the operating costs for two retail clothing stores, as represented in Table 9.4. Store A pays its salesperson a 50% commission on sales, (a variable cost), while Store B pays its salesperson a salary of $2,000 a month (a fixed cost). Now, consider two possible economic environments: good and poor. In poor times, both firms sell $1,000 worth of goods in a month; in good times both stores sell $5,000 worth of goods in a month. Which store has more operating leverage? Which is more likely to default on its payments to its sales staff? Which can maintain a higher degree of financial leverage? In this example, the store with lower operating leverage (lower fixed costs) has greater debt capacity.

During tough economic times, luxury goods shops like jewelry stores are especially impacted. When economies improve, do you think people are likely to re-indulge in luxury goods or stay practical?

Associated Press

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CHAPTER 9Section 9.3 Determining Target Capital Structure: Trade-Off Theory

Table 9.4: The effect of operating leverage on profitability

Good economic times Poor economic times

Store A Salary $0 $0

Commissions $2,500 $500

Operating profit (or loss)

$,2500 $500

Store B Salary $2,000 $2,000

Commissions $0 $0

Operating profit (or loss)

$3,000 ($1,000)

Now that we have covered the factors that impact a firm’s likelihood of default, we can move on to the other aspect of bankruptcy that should be considered when establishing debt capacity: bankruptcy costs.

Cost of Bankruptcy The costs of bankruptcy are another determinant of corporate borrowing capacity. Recall from Section 9.2 that bankruptcy is essentially the transfer of asset ownership from residual claimants to fixed claimants. The frictions associated with such a transfer are somewhat predictable. For example, the liquidity of the firm’s assets affects the level of expected bankruptcy costs.

Characteristics of the assets themselves can impact the ease of transfer, thereby affecting bankruptcy costs. As a general rule, tangible assets are more easily sold (more liquid) than intangible assets. This means that businesses whose assets are primarily land, buildings, and equipment would have lower bankruptcy costs than those whose value depends on intangibles, such as the firm’s reputation or the brand value of its products. Cash and mar- ketable securities are easily (almost costlessly) transferred from owner to owner, while work-in-progress inventory is often sold in financial distress yielding $0.50 or less per dollar invested. Asset specificity adds to cost of transfer, lowering liquidity and increas- ing expected bankruptcy costs. For example, an abandoned nuclear power plant, despite its tangible nature, has almost no alternative use—thus it is considered a highly specific asset. This plant may have cost billions of dollars to construct, but almost no one would be willing to receive it as a gift—free of charge. In fact, most would require compensation just for accepting such a gift. In a bankruptcy, such an asset would have a very high transfer cost. On the other hand, a delivery truck can be more easily sold because it can be used in a variety of ways. The vehicle’s use is not highly specific, a characteristic that enhances its marketability and helps contribute to lower bankruptcy costs.

To summarize, bankruptcy’s impact on leverage depends on the likelihood of its occur- rence and the costs associated with the procedure, should it occur. Evaluation of these considerations involves analysis of the firm’s capacity to generate future cash flows and of the nature of the assets underlying the business. This explains why lenders look at two factors when considering the debt capacity of a borrower: (1) the primary source of

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CHAPTER 9Section 9.3 Determining Target Capital Structure: Trade-Off Theory

Field Trip: Small Business Lending

To see small business lending in action, visit: http://www.bankrate.com/calculators/index-of-small-business-calculators.aspx

There are many useful links on this page for a small business owner, including free access links to cal- culate current ratios, quick ratios, debt-to-asset ratios, return on assets, gross profit margin, and oper- ating profit percentage.

Suppose you own a florist shop and want to track your gross profit margin and operating profit per- centage over the course of a year. How will these figures fluctuate from season to season? What fac- tors might impact these numbers?

repayment (cash flow) and (2) the collateral (the assets backing the loan) that could be sold as a secondary source of repayment. As a result, firms (or individuals) with high and steady cash flows who hold assets easily marketed for their full value can borrow more than those without these characteristics. By borrowing more, they are able to take greater advantage of debt’s tax-shielding benefit.

Next, we discuss how agency cost problems play into determining target capital structure.

Agency Problems We covered agency cost problems in detail in Section 9.2. As you recall, mature companies with high cash flows and few positive NPV investment projects often find themselves with excess cash on hand. Firms that are flush with free cash flow (cash not needed to fund promising projects) have a higher potential for wasted money and time than those still in their formative stage. Additionally, managers of widely owned companies are less likely to be held accountable for costly activities because no single stockholder owns sufficient stock to present a threat to incumbent management. When combined, free cash flow and widely dispersed ownership are ingredients that foster wasted resources. These firms may benefit from the discipline of debt because leveraging upward puts more pressure on management to perform effectively and efficiently. As fixed claims increase, free cash flow is paid out, reducing the possibility for discretionary expenditures, like excessive perqui- sites. If the potential for costly agency problems exists within the firm, incorporating debt into the target capital structure can add value.

Signaling Another consideration in determining target capital structure is the use of leverage as a signal to outside shareholders and analysts. If, for example, managers are confident that the firm’s performance is improving, then a strong signal would be to borrow funds and use the proceeds to repurchase some shares. By taking on more debt, management is sig- naling the firm’s ability to meet a higher level of fixed claims. Additionally, insiders might direct the firm to repurchase shares when the share price is below its value—in other words, when buying one’s own shares is a positive NPV investment. When determining debt capacity, managers must decide if the conditions are right for debt signaling, and how their signal will be interpreted by firm outsiders.

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CHAPTER 9Section 9.4 Determining Target Capital Structure: Looking Beyond the Trade-off Theory

Now that we have covered how the components of trade-off theory play into determining capital structure, we will look at other factors management may consider when establish- ing debt capacity.

9.4 Determining Target Capital Structure: Looking Beyond the Trade-off Theory

The empirical evidence doesn’t support the notion that companies constantly fine-tune their capital structure to be at or near their optimal mix of debt and equity. Observers see companies going years between security issues that would bring them back toward their historical debt ratios. How can this slow response be explained? In this section, we look beyond trade-off theory, at other factors that also appear important to companies when determining debt capacity.

Transaction Costs Transaction costs may help explain the delayed response some companies have shown in issuing securities. Also known as issuance costs, transaction costs are the costs associated with issuing securities in the public capital markets. There are two types of transaction costs: direct and indirect. Direct costs are the fees paid to lawyers, accountants, and invest- ment bankers; listing fees paid to exchanges, printing, advertising and marketing costs; and management time spent on the issuance process rather than other activities. Indirect costs include underpricing of security issues by underwriters and any reactions in the price of existing securities to the announcement of a new issue. Table 9.5 shows the direct costs for various sizes and types of securities.

Table 9.5: Sample transaction costs for corporate securities

Amount issued (in millions)

New equity IPO Seasoned equity Convertible bonds

Straight bonds

.$40 12.2% 8.8% 7.4% 2.9%

$40–$100 8.5% 5.5% 3.5% 2.1%

.$100 6.8% 4.0% 2.6% 2.2%

Weighted average 11.0% 7.1% 3.8% 2.2%

Source: Lee, Lochhead, Ritter, & Zhao (1996).

Here we define the various securities listed in the table:

• New equity IPO is the very first issuance of stock for a company; the company’s ini- tial public offering. Determining the market value of an IPO is difficult, so under- writers and investors tend to severely underprice these issues. This leads to large indirect issuance costs in addition to the high direct costs. More on this below.

• Seasoned equity is an issue of more common stock being offered to the public by a company that already has publicly traded common stock outstanding. These new shares will dilute existing ownership, so some shares of stock have preemp- tive rights, which give existing shareholders the right to buy shares in any new

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CHAPTER 9Section 9.4 Determining Target Capital Structure: Looking Beyond the Trade-off Theory

stock issues to maintain their original proportional ownership. Most states do not require companies to include preemptive rights in their articles of incorporation, so this right is not guaranteed. Seasoned equity offerings are valued based on the market value of the existing shares, so underwriter underpricing is much less than in IPOs.

• Convertible bonds are bonds characterized by both a debt and equity component. While the debt portion is relatively easy to value the equity portion can be com- plex, increasing the cost of issuance.

• Straight bonds are also known as nonconvertible bonds. This debt is relatively easy to value. Once the bond issue is rated and a coupon rate set, it is a standard present value exercise.

Looking at Table 9.5, we observe some clear patterns. First, notice that smaller issues cost more than larger issues of the same security. This suggests higher fixed costs associated with the underwriting and issuance process. Second, the more difficult a security is to value, the higher the costs. Equity for a new firm is the most difficult to value because the company has a limited track record, may be offering a new product in a relatively new market, and may have untested managers (venture capital or private equity costs could be higher still, since those valuations would be more complex than for companies ready to go public). On the other hand, seasoned equity is simpler because there is an existing stock price, but the value of the stock (new and existing) ultimately depends on what the company plans to do with the proceeds. If investors believe that managers will make poor use of the money, they will push share prices down (increasing indirect issuance costs). Valuation, then, is more complex than setting the price at or near current market value; it must also include analysis of the firm’s intended use of the issuance’s proceeds.

As discussed earlier in this chapter, asymmetric information complicates the process of pricing equity (both new and seasoned). To illustrate, consider a company with a positive NPV project it wants to finance. The firm has the option of issuing either debt or equity. If the CEO works for the benefit of existing shareholders, she will offer only equity if it is fairly or overpriced. This means that investors may be paying too much for the new stock offerings. To combat this, investors will only buy new shares at a discount, so we see new shares selling below the price of the shares immediately before the new stock offering is announced. This is supported by the following facts:

• Offerings of seasoned equity generally occur the year following steady share price increases (consistent with the stock being over valued).

• Stock performance tends to be subpar for five years following the issuance of a seasoned equity offering.

With the high transaction costs related to issuing equity, companies must take careful consideration before incorporating security issues into their target capital structure. These costs have even led to the development of an alternative theory of how companies make the debt-equity decision: the pecking order theory.

The Pecking Order Theory So far, this chapter has argued that firm value can be maximized at some target amount of debt; that is, that companies have an optimal capital structure. The pecking order the- ory of capital structure takes an entirely different view of how companies choose their

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CHAPTER 9Section 9.4 Determining Target Capital Structure: Looking Beyond the Trade-off Theory

Considering the pecking order theory of capital structure, applying for a bank loan would rate toward the bottom of the ideal debt list for most companies.

Bloomberg/Getty Images

financing mix. This theory, developed by Stuart Myers of MIT, argues that the high costs of issuing securities in the capi- tal market drives companies to fund as much of their invest- ment as possible from internal sources (e.g., retained earnings). By using internal sources, com- panies hope to avoid the costs associated with issuing pricey securities (e.g., equity). When external funds must be used, companies will choose to use funds in order of their safety and cost effectiveness. First, they will issue safe debt. If more funds are needed for investment in productive assets, compa- nies will then issue risky debt. Finally, if the company doesn’t want to bear too much bankruptcy risk, they will issue equity. Figure 9.8 outlines the pecking order theory’s process of raising funds for investment.

Figure 9.8: Pecking order theory

Internal Resources (retained earnings)

External Resources (issue safe debt)

External Resources (issue risky debt)


The pecking order theory says that companies raise funds by first using internal resources, then safe debt, risky debt, and finally equity.

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CHAPTER 9Conclusion

Companies following the pecking order theory want to avoid issuing equity unless it is absolutely necessary, as the direct and indirect costs are very high. Debt issues— particularly highly rated or relatively safe debt—will have the absolute lowest costs of all sources of external finance. Retained earnings have no issuance costs whatsoever, and for this reason they are at the top of the pecking order. This model is significantly different than the trade-off theory, as it disregards a target debt level. Instead, compa- nies looking to invest in projects consider internally generated cash flow, their invest- ment opportunities, and the costs associated with security issuance.

Next, we look at how a firm’s financial flexibility plays into determining its optimal capi- tal structure.

Financial Flexibility Recent research points to the importance of financial flexibility as a driving force in capital structure and debt levels. For example, companies appear to have debt targets somewhat lower than expected. DeAngelo, DeAngelo, and Whited (2011) argue that this allows com- panies to maintain financial flexibility, or the ability to raise funds for investment (and paying dividends) during periods when cash generation is low. The notion of financial flexibility also explains why companies sometimes issue debt and exceed their estimated target debt levels and then slowly adjust back toward the target. In a survey of about 250 global companies, Servaes and Tufano (2006) find that financial flexibility (the ability to continue making investments and paying dividends) are the second and fourth ranked determinants of debt levels.

One important aspect of financial flexibility is maintaining a high credit rating. Having a high credit rating means companies are able to issue debt at a reasonable cost at any time. This helps support flexibility. The Servaes and Tufano survey found that corporate man- agers are very concerned with maintaining the firm’s credit rating.


As we said at the beginning of this chapter, debt acts like a lever in finance. When the firm is doing well, financial leverage increases the return to stockholders. When times are tough, it magnifies the negative effect on shareholders’ returns. The more leverage a company uses, the greater the magnifying effect. Thus, leverage can increase expected returns, but it also increases variability or risk. In perfect capital mar- kets, these two effects offset one another, leaving value unchanged.

In reality, there are market imperfections that complicate decisions regarding capital structure. The choice can be likened to a balancing act between the benefits of debt and its value-harming effects. Debt may increase cash flows to claimants by avoiding corporate taxes, by limiting agency problems, and by sending a positive signal to outsiders. On the other hand, added leverage increases the likelihood of a costly bankruptcy.

Although there is no precise method for finding the optimal capital structure of a firm, certain characteristics of corporations help to guide managers toward an appropriate

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CHAPTER 9Post-Test

target structure. First, firms with high taxable income operating in areas with high corpo- rate tax rates should consider higher leverage. Next, corporations with widely dispersed ownership and excess free cash flow may find that leverage lowers potentially wasteful cash expenditures. Leverage may also be used as a signal of the increased debt capacity of the borrower. Finally, firms may deviate from optimal target debt levels to maintain financial flexibility.

As firms raise new capital, they also consider the costs associated with different forms of financing. These costs can be direct, like the fees paid to banks and lawyers, or they may be indirect, like the underpricing of newly issued equity. The pecking order theory says firms will first attempt to raise capital from sources with the lowest transaction costs (e.g., retained earnings) before issuing securities associated with higher fees or risky mispricing as is often the case with issues of new equity.

The benefits of leverage must be balanced against the corporation’s potential bankruptcy costs. Firms with more volatile cash flows are in greater jeopardy of experiencing financial distress than firms with stable cash flows. Therefore, businesses should consider the stabil- ity of their income when targeting their debt level. Should a firm have financial difficulty, those with highly liquid or marketable assets should experience lower bankruptcy costs than those whose assets are unique or specific to their current use. Firms with illiquid, highly specific assets have higher potential bankruptcy costs and must carefully consider their levels of debt. In Chapter 10, we examine corporations’ dividend policy. As you will see, dividend policy and the capital structure decision share many of the same features.


1. In perfect capital markets, firm value is unaffected by leverage. a. True b. False

2. All else being equal, debt will tend to increase firm value by lowering agency costs because of the disciplining effect of debt.

a. True b. False

3. The target capital structure of a firm includes less debt if taxes are high, all else being equal.

a. True b. False

4. According to the pecking order theory, a company should issue safe debt before using any other form of capital.

a. True b. False

5. Which of the following is NOT characteristic of perfect capital markets? a. Strong-form efficiency b. Information asymmetry

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CHAPTER 9Key Ideas

c. No taxes d. No agency costs

6. Which of the following represent the indirect costs of bankruptcy and financial distress?

a. Deferred maintenance on the assets used as collateral b. Legal fees charged by bankruptcy lawyers c. Bankruptcy court costs d. Transfer of ownership fees

7. Potential bankruptcy costs tend to increase when the assets used as collateral are a. tangible. b. highly liquid. c. highly specific. d. cash or equivalents.

8. Which of the following is an indirect cost included in the issuing of securities? a. The underpricing of IPOs b. Legal fees c. Underwriting fees d. Marketing expenses

Answers 1. a. True. The answer can be found in Section 9.1. 2. a. True. The answer can be found in Section 9.2. 3. b. False. The answer can be found in Section 9.3. 4. b. False. The answer can be found in Section 9.4. 5. b. Information asymmetry. The answer can be found in Section 9.1. 6. a. Deferred maintenance on the assets used as collateral. The answer can be found in Section 9.2. 7. c. highly specific. The answer can be found in Section 9.3. 8. a. The underpricing of IPOs. The answer can be found in Section 9.4.

Key Ideas

• The mix of debt and equity used to finance the firm’s investments is known as its capital structure.

• The debt-equity decision is initially examined under the assumption of perfect capital markets. Under such conditions, it can be shown that firm value is unaf- fected by capital structure. The capital structure is said to be irrelevant because the mix of debt and equity financing has no impact on either the overall cash flows or their riskiness.

• The use of debt in a firm’s capital structure is called leverage. Just as a lever increases power, the use of debt increases the impact of good (and bad) operating results.

• Because interest is tax deductible, the use of debt protects cash flows from taxation.

• Bankruptcy costs represent a potential leakage of cash flows from the firm, caused by the use of debt in its capital structure.

• The capital structure decision involves balancing the benefits of debt, like its tax deductibility, against the potential costs associated with its use, including the potential for bankruptcy.

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CHAPTER 9Critical Thinking Questions

• The use of debt may be interpreted as a signal that the firm has improved prospects.

• A firm’s target capital structure is affected by taxation, potential bankruptcy costs, agency costs, and signaling.

Critical Thinking Questions

1. Explain why there is no agency problem when there is no information asymmetry.

2. Why does the Securities and Exchange Commission require firms with traded securities to have their financial statements audited by an outside accounting firm according to generally accepted accounting principles? (Hint: Think of infor- mation asymmetry.) Is the cost of having the firm’s financial statements audited an agency cost? Why or why not?

3. Do you think a corporation must actually declare bankruptcy to incur costs asso- ciated with financial distress? Could rumors of financial problems lead to costs? How would these costs lower firm value? Explain your answers.

4. Suppose two countries have identical economic environments except that Coun- try X allows interest payments to be deductible for corporate income tax pur- poses and Country Y allows only half of a firm’s interest expense to be deducted. Would you expect to see, on average, greater use of leverage by corporations in Country X or in Country Y?

5. Affiliated Industries Incorporated (AII) is a corporate giant. It is highly profit- able, producing cash flows far beyond those required to fund its new positive net present value projects because it is in a mature industry with few growth oppor- tunities. Yet AII has traditionally retained much of this residual cash rather than paying it out as dividends. Would you, as a stockholder, be pleased or displeased if AII announced an increase in leverage by using its cash to repurchase a large proportion of its stock? Explain using an agency-related rationale.

6. Total leverage describes a firm’s degree of operating leverage plus its degree of financial leverage. Consider two utility companies, each with 50% debt in their capital structure. Washington State Electric generates hydroelectric power at its dam across the Rapid River in the Pacific Northwest. Smokey Mesa Power is located in Arizona and generates its power at the coal-burning Black Cloud Power Plant. What are the raw materials for each electric generation process? Which utility is exposed to more price uncertainty regarding its cost of these raw materials? Which utility has more operating leverage? Which one has more total leverage?

7. Managers naturally want to protect their jobs. For them, the chance of a firm’s bankruptcy is more threatening than for the firm’s shareholders. Given this, do you think managers are biased against certain potential investment projects that have high risk? Assuming they are, is this bias in the best interest of sharehold- ers? What if the risky project has a positive NPV? Could this bias affect firm value, and, if so, will its affect get stronger as the firm takes on more debt? Is this type of agency cost a pro-leverage or anti-leverage argument?

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asset specificity The degree to which an asset’s value is tied to a particular, unique function.

bankruptcy costs The direct (attorney’s fees and court fees) and indirect (manage- ment’s time spent on paperwork, phone calls, meetings, and so on, that could otherwise be spent on more productive activities) costs of filing for bankruptcy.

capital structure The mix of debt and pre- ferred equity in a company’s portfolio.

debt capacity The maximum amount of debt that can safely be serviced by a firm.

discipline of debt Financial theory that asserts firms become more efficient and therefore more valuable as leverage increases.

financial flexibility The ability of a firm to raise funds for investment (and pay- ing dividends) during periods when cash generation is low.

pecking order theory Theory developed by Stuart Myers of MIT that argues that the costs of issuing securities in the capi- tal market is so high that companies will try to avoid these costs. Companies con- sider internally generated cash flow, their investment opportunities, and the costs associated with security issuance.

signal An outward measure of the finan- cial health of a company.

target capital structure The optimum mix of debt, preferred stock, and equity that maximizes firm value.

trade-off theory of capital structure Theory that argues that companies have an optimal level of debt (a mix of debt and equity that maximizes value). This opti- mum point is a trade-off between the tax and agency cost reduction benefits of debt and its bankruptcy costs.

Key Terms

Web Resources

For a step-by-step guide to the IPO process, see David Newton’s article, “The ABC’s of the IPO Process,” Entrepreneur Magazine: http://www.entrepreneur.com/article/75252

Find small business tax information at: http://www.sba.gov/content/learn-about-your-state-and-local-tax-obligations and http:// www.irs.gov/Businesses/Small-Businesses-&-Self-Employed

Capital structure irrelevance was proven for perfect markets by Franco Modigliani and Merton Miller in one of the most important articles ever written in economics. They have both received Nobel prizes, in part for their capital structure studies. Read “The Cost of Capital, Corporation Finance and the Theory of Investment,” American Economic Review, 48 (June 1958) here: https://www2.bc.edu/thomas-chemmanur/phdfincorp/MF891%20papers/MM1958.pdf

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Students interested in agency problems or corporate takeover battles are advised to read Barbarians at the Gate, the story of the battle for control of RJR-Nabisco, which led to one of the largest corporate takeovers in history. It was made into a movie, which can be viewed here: http://youtu.be/iPhF_YwWvoM

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