California State University, San Bernardino CSUSB ScholarWorks Theses Digitization Project John M. Pfau Library 2003 The capital structure puzzle: On the existence of an optimal capital structure Mohamed Lahiani Follow this and additional works at: https://scholarworks.edu/etd-project Part of the Corporate Finance Commons Recommended Citation Lahiani, Mohamed, "The capital structure puzzle: On the existence of an optimal capital structure" (2003). Theses Digitization Project.edu/etd-project/2350 This Project is brought to you for free and open access by the John M. Pfau Library at CSUSB ScholarWorks.
It has been accepted for inclusion in Theses Digitization Project by an authorized administrator of CSUSB ScholarWorks. For more information, please contact scholarworks@csusb. THE CAPITAL STRUCTURE PUZZLE: ON THE EXISTENCE OF AN OPTIMAL CAPITAL STRUCTURE A Proj ect Presented to the Faculty of California State University, San Bernardino In Partial Fulfillment of the Requirements for the Degree Master of Business Administration by Mohamed Lahiani September 2003 THE CAPITAL STRUCTURE PUZZLE: ON THE EXISTENCE OF AN OPTIMAL CAPITAL STRUCTURE A Project Presented to the Faculty of California State University, San Bernardino by Mohamed Lahiani September 2003 Approved by: 7/A Date Dr. Taewon Yang Dr.
Otto Chang, Department CJ Accounting & Finance 1 © 2003 Mohamed Lahiani ABSTRACT A perennial debate in corporate finance concerns the question of optimal capital structure: given the level of total capital necessary to support a company's activities, is there a way of dividing up that capital into debt and equity that maximizes current firm value? And, if so, what are the critical factors in setting the leverage ratio for a given company? Corporate finance researchers have long been puzzled by low corporate debt ratios given debt's corporate tax advantage. What makes the capital structure debate especially intriguing is that the different theories represent such different, and in some ways almost diametrically opposed, decision-making processes. For instance, some researchers defend Miller and Modigliani by arguing that both capital structure and dividend policy are largely "irrelevant" in the sense that they have no significant, predictable effects on corporate financing. However, another school of thought holds that corporate financing choices reflect an attempt by corporate managers to balance the tax shields of greater debt against the increased probability and costs of financial distress, including those arising from corporate underinvestment.
But if too much debt can destroy value by causing iii financial distress and underinvestment, other schools of thought have argued that too little debt, at least in large, mature companies- can lead to overinvestment and low returns on capital. The purpose of this paper is to present a literature survey about the Capital structure puzzle theories and studies by different schools of thoughts over the past half a century. My concern is to illustrate the findings of capital structure studies and to present their contributions to the corporate finance literature, and to give my personal opinion about these results concluding by my estimation of the optimal capital structure. Thus, I am going to emphasize the role of corporate finance in supporting an interior optimum capital structure.
iv ACKNOWLEDGMENTS I am deeply grateful to my advisor, Dr. Dong Man Kim, for abundant help and encourage along the way. This thesis would not have come to fruition without his insightful and thought-provoking inputs. I am also indebted to Dr.
Taewon Yang for his continuous assistance and help during various stages of my dissertation effort. I would like to genuinely thank my parents Mokhtar and Souad Lahiani for their assistance in all my studying stages and unlimited encouragements throughout my academic carrier groundwork. This, as well al my sisters Hanene, Raja and Nouha for their persistent support to myself and to my studies and works throughout all the previous years; it is thanks to their generously provided insights and contributions that I was able to finish up my master degree and thesis project. Finally, many thanks to all my MBA friends and colleagues who helped make out MBA program such a great learning and working place.
v TABLE OF CONTENTS ABSTRACT. V LIST OF FIGURES. viii CHAPTER ONE: INTRODUCTION. 1 CHAPTER TWO: THE CAPITAL STRUCTURE PUZZLE.
6 The Static Tradeoff Hypothesis. 8 The Pecking Order Theory. 11 Discussion of the Theory and its Evidence. 16 Internal versus External Equity.
17 Timing of Security Issues. 18 Borrowing against Intangibles and Growth Opportunities. 20 Issue or Repurchase of Shares. 22 The Use of Debt in the Capital Structure.
27 CHAPTER THREE: NECESSITY AND ADVANTAGE OF THE USE OF DEBT IN THE CAPITAL STRUCTURE Inside versus Outside Debt. 38 How Big is the Advantage of Debt. 56 Maturity and Priority. 69 The Role of Bank Loans Raising Capital and Optimizing Capital Structure.
70 vi Some Restatements of Modigliani and Miller Proposition I. 77 Another Restatement of Modigliani and Miller I. 78 Leverage and Returns. 79 The Bottom Line.
82 Costs of Financial Distress. 83 What are the Costs of Financial Distress?. 83 CHAPTER FOUR: CONCLUSION. LIST OF FIGURES Figure 1.
Investment/Return Chart for Investments 1 and 2. Investment/Return Chart for Investments 3 and 4. Firm U/Firm L Tax Shields Chart. Firm U/Firm L Income After Tax.
82 viii CHAPTER ONE INTRODUCTION Financing policy of firms requires managers to identify ways of finding new investment. The managers have three main alternatives; use retained earnings, borrow through debt instruments, or issue new equity shares. Hence, the standard capital structure of a firm includes equity (including retained earnings), and debt; these components of capital structure reflect firm ownership structure in the sense that the first component reflects ownership by shareholders while the second component represents ownership by debt holders. This pattern is found in developing and developed countries alike.
Financing policy, capital structure and firm ownership are all strongly linked in explaining how economic agents form and modify their asset acquisition behavior through firms and capital markets, and thereby influence their incomes and returns to asset holdings, whether in the form of direct remuneration, capital gains or dividends. Corporate capital structure has been one of the most popular issues in financial economics. Many theoretical and empirical studies have been done to examine the effects of corporate capital structure determinants 1 including taxes, profitability, firm size; type of assets, volatility, and business risk on the firm's financing decision. Two competing theories have been raised to explain corporate capital structure: The trade-off hypothesis and the pecking order theory.
In the trade-off hypothesis, firms choose their optimal debt ratio by weighing the.benefits (tax of interest payment) and costs (potential bankruptcy costs) of debt financing. In this model, taxes are regarded as a potentially important factor. Since interest payments can be deducted in determining corporate taxable income, an incentive exists for the firm to use debt financing even if this incentive is reduced by the tax disadvantage of personal income taxes paid by the recipient on the interest payments.' The trade-off hypothesis focuses on the tax advantage of debt, thus, implying a positive relationship between a firm's value and its debt ratio. Moreover, every firm has its own optimal leverage target that maximizes its firm value, and a firm's actual leverage is expected to revert towards the target leverage.
In the pecking order theory, firms finance new investments in a specific order: First, with retained earnings, then with safe debt, then with risky debt, and 2 i finally with equity to minimize asymmetric information 1 ! costs. Compared to the trade-off hypothesis, the pecking I order theory focuses on the profitability, implying a I ' negative relationship between a firm's value and its debt ! ratio. Moreover, in this model, there is no optimal or i | target leverage. ; Some writers argue that corporate managers making I financing decisions are concerned primarily with the.
"signaling" effects of such decisions-for example, the I I tendency of stock prices to fall significantly in response I j to common stock offerings (which can make such offerings [ very expensive for existing shareholders) and to rise in jresponse to leverage increasing recapitalizations. I ■Building on this signaling argument, Stewart Myers has I j suggested that corporate capital structures are simply the I cumulative result of individual financing decisions in 'which managers follow a financial pecking order-one in which retained earnings are preferred to outside financing, and debt is preferred to equity when outside funding is required. According to Myers, corporate managers making financing decisions are not really thinking about an optimal capital structure that is, a long-run targeted !debt-to-equity ratio they eventually want to achieve. 3 Instead, they simply take the "path of least resistance" and choose what then appears to be the low-cost financing vehicle-generally debt-with little thought about the future consequences of these choices.
The purpose of this study is to find the optimal corporate capital structure for firms. What is the optimal capital structure of a company? What factors make a company prefer debt financing to equity financing? 4 CHAPTER TWO THE CAPITAL STRUCTURE PUZZLE A firm consists of assets which produce a stream of cash flows. The capital structure decision determines how those assets will be paid for, and thus how the cash flows will be allocated among different claims (debt, equity, etc. The best way to think about an optimal firm structure is that the current owners of a firm are thinking about II how to sell their firm today (Welch, 1996).
Their goal is i I to design a corporate charter that maximizes the total 1I |market-value of their firm today, that is the price that i lnew investors will be willing to pay to acquire the firm ifrom the old investors. The corporate charter must not I I only specify the voting rules, the procedure to replace j incumbent managers and how the charter can be changed in 'the future, but also how future earnings are to be split among different owners (such as bondholders and stockholders) and stakeholders (such as customers, workers, and suppliers). The agreement how to split up future earnings-either explicitly outlined or implicitly allowed to be changed in the future-is the firm's financial structure: rules that specify who receives the 5 proceeds of (possibly uncertain) future cash-flows (Welch, 1996). Historically, corporations have been using bonds and stocks (equity).
In general, bonds ("financial leverage") are like loans, promising certain payoffs. Equity is like ownership, receiving whatever is left over after the promises to bondholders have been honored. In addition, modern corporations can use a variety of financial instruments that promise different future payoffs to various buyers under various scenarios: convertible debt, equity, warrants, derivatives, leases and trade credit. Firms can also collateralize assets and/or borrow from banks.
Our discussion will focus mostly on the choice between simple debt and equity, although the purpose of this study is to provide the necessary intuition to understand why other financial instruments can be useful. Theory The capital structure puzzle is intended to remind analysts about the Dividend puzzle and Fischer Black's well known saying: "What should the corporation do about dividend policy? We don't know. Myers, in his article entitled: "The Capital Structure Puzzle," started his argument by asking: "How do firms choose their capital 6 structure?" Again, the very usual answer is, "We don't know." Researchers and analysts know more about the dividend policy puzzle than they do know about the capital structure one. John Lintner's model of how firms set dividends dates back to 1956, and it still seems to work in Stewart C.
We know that stock prices are extremely sensitive to any unexpected dividend changes; this makes clear that dividends have information content; this information dates back at least to Miller and Modigliani, 1961. Myers argues that we do not know whether high dividend yield increases the expected return required by investors, as adding taxes to the Miller and Modigliani proof of dividend irrelevance suggests, but financial analysts are at least investigating and advancing at this concern. We do not know that much about capital structure.