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Theory of Capital Structure - A Review

Stein Frydenberg April 29, 2004

ABSTRACT This paper is a review of the central theoretical literature. The most important arguments for what could determine capital structure is the pecking order theory and the static trade off theory. These two theories are reviewed, but neither of them provides a complete description of the situation and why some rms prefer equity and others debt under different circumstances. The paper is ended by a summary where the option price paradigm is proposed as a comprehensible model that can augment most partial arguments. The capital structure and corporate nance literature is lled with different models, but few, if any give a complete picture.

JEL classication: G32

University College, Department of business administration, Jonsvannsvn. 82, 7004 Trondheim, Norway. E-mail: stein.frydenberg@toh.hist.no.


Electronic copy available at: http://ssrn.com/abstract=556631

The view that capital structure is literally irrelevant or that nothing matters in corporate nance, though still sometimes attributed to us,...is far from what we ever actually said about the real-world applications of our theoretical propositions. Miller (1988)

I. Introduction
The paper introduces the reader to two main theories of capital structure, which is the static trade-off theory, and the pecking-order theory. Underlying these theories are the assumptions of the irrelevance theorem of Miller and Modigliani. Since the irrelevance theorem is indeed a theorem, the assumptions of the theorem, has to be broken before capital structure can have any bearing on the value of the rm. If the assumptions of the irrelevance theorem are justied, the theorem follows as a necessary consequence.

II. The Irrelevance Proposition

In complete and perfect capital markets, research has shown that total rm value is independent of its capital structure. An optimal capital structure does not exist when capital markets are perfect. Taxes and other market imperfections are essential to building or proving a positive theory of capital structure. Changes in capital structure benet only stockholders and then if and only if the value of the rm increases. An expropriation of wealth from the bondholders would in a rational expectations equilibrium be expected by the bondholders, and the stockholders would ultimately carry the costs of the expropriation. Miller and Modigliani (1958b) wrote the seminal article in this eld of research, using an arbitrage argument. If a rm can change its market value by a pure nancial operation, the investors in the rm can take actions that replicate the resulting debt position of the rm. These transactions would merely change the weights of a portfolio and should, in a perfect capital market, give zero prot. If the market were efcient enough to eliminate the prots for the investors, any prot for the rm would be

Electronic copy available at: http://ssrn.com/abstract=556631

eliminated too. Modigliani and Miller in their original articles Miller and Modigliani (1958b) and Miller and Modigliani (1958a) assume several strict constraints.

First, capital markets are assumed to be without transaction costs and there are no bankruptcy costs. All rms are in the same risk class. Corporate taxes are the only government burden. No growth is allowed since all cash ows are perpetuities. Firms issue only two types of claims, risk free debt and risky equity. All bonds (including any debts issued by households for the purpose of carrying stocks) are assumed to yield a constant income per unit of time, and the income is regarded as certain by all traders regardless of the issuer Miller and Modigliani (1958b)

Information is symmetric across insider and outsider investors. Managers are loyal stewards of owners and always maximize stockholders wealth. Copeland and Weston (1988)

Later, others such as Stiglitz (1974) and Merton (1990) have removed the assumption of risk class. Myers (1984) said that lifting these restrictions, one at a time, start possible causes for the capital structure puzzle. The theoretical models of capital structure in a world in which capital markets are not perfect relates capital structure to several measurable and nonmeasurable attributes of a rm. The irrelevance proposition provides conditions under which the capital structure of a rm is irrelevant to total rm value. Turning the irrelevance proposition around, the proposition also tells us which factors that may be the causes of corporate capital structure. The assumptions giving irrelevance as a result may cause relevance if they are broken. The question is, do they, and if so to what extent? And what if several imperfections exist simultaneously? Besides the irrelevance hypothesis of Modigliani and Miller there are several other theories relevant to capital structure. These are the asset substitution hypothesis, under-investment hypothesis, the free-cash ow hypothesis, the signaling hypothesis and product markets arguments. 3

.1. Value Additive Model of Capital Structure State preference models have been used extensively in the nance literature as a general framework for explanation of the irrelevance hypothesis. Both Lewellen and Mauer (1988), Kraus and Litzenberger (1973), Stiglitz (1969) and Hirshleifer (1966) have used this approach.

The MM Proposition 1 Assume perfect capital markets and no taxes on corporate income. An equilibrium in the capital market requires that the value of the rm, Vt , should be independent of the proportions of debt and equity in the rms capital structure.


VB t VE t


Let V be the total market value of the rm debt and equity. VB = market value debt VE = market value equity Dene a set of possible future states of nature, assumed to be nite and exhaustive. Given that a state of nature occurs, all relevant future events are known with certainty. I do not, however, know which state that will occur. The return to an investor depends on which state of nature actually occurs. An investor thus has a bundle of state contingent returns. A security that returns one dollar, if a certain state occurs and zero otherwise is called a primitive security. The price of this primitive security is called a state-price and is the price today for one dollar tomorrow given that a particular state occurs. A complex security i.e. a stock or bond will thus be composed of several primitive securities, one or more for each state in which the stock gives dividend. In states where the stock pays more than one dollar, say ten dollars, the stock must contain ten primitive securities. In the states where the stock does not give dividend, for instance if bankruptcy occurs, the primitive security for this state is not included in the 4

stocks bundle of primitive securities. The value to the investor of any particular bundle is derived from the value to him of a marginal increase in his wealth in a given state. The value now of any future contingent claim is dependent on the probability that the state will occur, the investors preferences for a wealth increase in this state based on a representative agents utility and the time preferences represented by the risk free rate of return. Three assumptions are made before I proceed with the multi-period state preference model. These assumptions are: Assumption 1: The rms investment strategies are given - in particular, although specic investment decisions are not known, the rules governing those decisions are known. These rules are consistent with maximization of the wealth of the security holder. In other words, I am assuming that nancing and investment decisions are not connected. Assumption 2: Perfect capital markets without transaction cost, informational asymmetry or bankruptcy costs. Assumption 3: No taxes at either corporate or personal level. An un-leveraged rms time t market value Vt is expressed as eq. 2. According to Lewellen and Mauer (1988), the levered and un-levered rm total values coincide and the irrelevance proposition can be justied by the following statements:


V t 1 dPt 1


where V t 1 is total rm value in state at time t 1, = All the possible states of nature. = State i of nature that the economy may have in time t , i = 1..n Bt 1 = Market value of debt in state at time t 1, E t 1 = Market value of stocks in state at time t 1. Pt 1 = The distribution of corresponding state prices. Rt 1 = Interest payment promised to bondholders at time t 1, which is state-independent.

A leveraged rms time t market value is expressed as the sum of debt and equity value. V t E t Bt (3)

How the total rm value will be divided between stockholders and bondholders depend upon when there is a default on debt obligations. There will be a default and consequently bankruptcy when Rt 1 or when Rt 1 Bt V t 1 (5) E t 1 (4)

At the point of maturity, the bondholders claim will be worth: V B t 1 min Rt 1 Bt 1 V t 1 (6)

At the point of maturity, the equity holders claim will be worth: V E t 1 max V t 1 Rt 1 Bt 1 0 max E t 1 Rt 1 0 (7) (8)

V E t 1

The value of the equity holders claim is equivalent to a call option on either E t 1 with exercise price Rt 1 , or on V t 1 with exercise price Rt 1 Bt 1 . In a risk neutral evaluation, all cash ows are certain, given that a specic state occurs. The time t values of equity and debt in the levered rm can then be written as: Equity : E t Debt: Bt

VE t 1 dPt 1


VB t 1dPt 1


Given the linearity of the operator, I can add together equity and bond values. Due to the nature of the pay off of debt and equity investment, the total rm value can be written as max V t 1 Rt 1 Bt 1 0 CASE 1 VE t 1
Rt 1 Bt 1 min

Rt 1 Bt 1 V t 1


(12) (13)

eq 11 V t 1 CASE 2 VE t 1
Rt 1 Bt 1

(14) (15)

eq 11 V t 1 The value of the leveraged rm is E t Bt VE t 1 VB t 1 dPt 1 V t 1


With the assumptions above, I have showed that the values of the unleveraged and leveraged rm are equal. The original irrelevance proposition of Miller and Modigliani were based on the notion of risk -classes, but these risk - classes are not necessary. As Stiglitz (1969) and Kraus and Litzenberger (1973) have shown, the irrelevance proposition hold in a more general time-state framework.

III. The Trade-off Theory

In this section I will review literature that suggest that debt has a central role in rm nancing. Jensen (1986) argues that debt is an efcient means by which to reduce the agency costs associated with equity. Klaus and Litzenberger show that with the tax advantages of debt, optimal capital structure includes debt nancing. Ross (1977) and Leland and Pyle (1977) argue that 7

debt can be valuable as a device for signaling rm value. The three main hypotheses that are used to explain differences in capital structure between companies are the transaction-cost hypothesis, the asymmetric information hypothesis and the tax hypothesis. According to Harris and Raviv (1991), leverage increases with xed assets, non-debt tax shields, investment opportunities, and rm size and decreases with volatility, advertising expenditure, the probability of bankruptcy, protability and uniqueness of the product. This theory claims that a rms optimal debt ratio is determined by a trade-off between the losses and gains of borrowing, holding the rms assets and investment plans constant. The rm substitutes debt for equity, or equity for debt until the value of the rm is maximized. The gain of debt is primarily the tax-shelter effect, which arises when paid interest on debt is deductible on the prot and loss account. The costs of debt are mainly direct and indirect bankruptcy costs. The original static trade-off theory is actually a sub theory of the general theory of capital structure because there are only two assumptions that are broken here, the no tax incentive assumption and the no bankruptcy cost assumption. In the more general tradeoff theory several other arguments are used for why rms might try to adjust their capital structure to some target. Leverage also depends on restrictions in the debt-contracts, takeover possibilities and the reputation of management. A negative correlation between debt and monitoring costs is proposed by Harris and Raviv (1990). Diamond (1989) suggest that vintage rms with a long history of credits will have relatively low default probability and lower agency costs using debt nancing than newly established rms. A common factor for all these rm characteristics are that they are proxies meant to measure some form of costs related to a principal-agent problem. There may simultaneously be several principal-agent problems between the different classes of securities in the rm or between stockholders and managers in the rm. This multiplicity of problems can easily confuse the analyst and lend an air of incomprehensibility to the eld of corporate nance. A construction of a positive theory of debt nancing, builds on arguments on the advantages and disadvantages of debt. First, debt is a factor of the ownership structure that disciplines managers. Limiting control to a few

agents that control the common stock, while the rest of the capital is raised through bond sale, can reduce agency cost of management. Second, debt is a useful signaling device, used to inform investors a message of the rms degree of excellence. Third, debt can also reduce excessive consumption of perquisites because creditors demand annual payments on the outstanding loans. Debt also has its disadvantages. First, there is the problem of agency cost of debt that includes risk substitution and under investment. Second, debt also increases bankruptcy possibility by increasing the nancial risk of the rm. I will discuss this reasoning in the following sections.

A. The Theoretical Tax Incentive

Taxes The hypothesis is that an increase in tax rate will increase value of rm tax-shield.

The rm reduces income by deducting paid interest on debt and thereby reducing their tax liabilities. An increase in tax rates should hence increase leverage. Tax systems currently adopted by most industrial countries can be classied into classical systems and imputation systems. In the classical systems, interest payments are deductible at the corporate level, but dividends are not. At the personal level dividends and interest are deductibles. Imputation systems reduce or eliminate taxation of dividends by granting a tax credit to recipients of dividends, equal to some fraction of the corporate tax paid on earnings used for dividends. The tax incentive is a part of the static trade off theory that contends that a manager balance increased nancial risk and tax deductions. In Norway this is not necessarily true since the tax system is and has been neutral towards debt and equity. After the tax reform in 1992, dividends are not taxed as income for the investor, while interest income is. The rm pays the dividends out of taxed earnings while interests on debts are tax deductible in the rms income statement. So, in Norway, dividend and interest rate taxation should be neutral regarding which nancial instrument, debt or equity, rms have an incentive to issue. Norway have had deferred taxation after the tax reform of 1992. Taxation, which, owing to tax legislation results in timing differences, i.e., differences between incomes computed for taxation purposes

and for nancial accounting purposes. Unlike permanent differences, timing differences are capable of being reversed in future periods. In the deferred tax model, deferred tax is a longterm liability. Depending on the direction of the difference, deferred taxes could be a liability as well as an asset. Discounting the deferred taxes is not presently accepted in any accounting standards. Deferred taxes are the tax rate (28%) multiplied with the difference in income between the nancial prot and loss account and the reported prot or loss for taxation purposes. If the deductions are higher in the tax report, deferred taxes are positive.1 The expense for taxes is shown in the prot and loss account/income statement. In the deferred tax model, the amount represents the total tax to be paid on the accounting prot for that year. In other models, just the amount to be paid is shown.

The 1992 tax-reform

The Norwegian Tax Codes was changed in the 1992 tax-reform.

Consequently, this has inspired us to test whether a tax incentive of debt nancing exist in Norway. The yearly regressions in Frydenberg (2001), display that the tax variable nondebt is signicant in 1991, 92 and 1999 and year 2000 for the interest carrying debt variable. According to Bhren and Michalsen (2001) page 261, these are the years, except for 1999, that the Norwegian tax system is not neutral! This is a new contribution, using the natural experiment in Norway, to show that the tax system matters for the debt ratio. Before the accounting reform in 1992, taxes presented in the accounts referred to taxes payable for the current year. After 1992, taxes include both payable taxes and changes in deferred taxes. Changes in deferred tax occur as a result of temporary differences between book value and tax book value, and tax loss carried forward. Sjo (1996) claims that the marginal tax rate could inuence the debt structure whenever the tax codes are not entirely neutral. A lower marginal tax rate should decrease leverage. With the tax-reform, dividend
This is common for accelerated depreciation. The depreciation percentage is 30 % for ofce equipment, which is considerable more than the 1/5 linear economic depreciation in the nancial statements. The 10% difference multiplied with the tax rate of 28% is considered a long-term liability. Sooner or later, here already after three years, the nancial linear depreciations are higher than the accelerated tax depreciations and the deferred taxes will be reduced with 28% of the difference between tax and nancial depreciations.


taxes were substantially reduced. Dividends are no longer double taxed. The investors taxes on dividends are reduced by the amount that is paid in the companies. This change would increase the attractiveness of being a stockholder in Norwegian rms. A change in incentives towards equity is a consequence of the tax-reform. Some authors have claimed that the rms serve as a nancial intermediary. Firms may not have a tax incentive to increase debt if both the investor and the rm are in a tax position. The rm pays the taxes on the equity return, while the investor pays the tax on the debt return. If the debt investor is not in a tax position, he may have other tax deductions and deferrals, which give him, zero taxable income, then the debt capital return is not taxed and there is an incentive to rely on debt nancing. The nancial intermediary argument also claims that rms may lend at more favorable terms than investors. The idea is that rms can make better use of the benets of debt nancing if they are in a tax position. The rm benets from a reduction of the taxes paid to the government. Interest rates paid to debt holders are deductible in the prot and loss account and hence reduces the tax burden. For private debt, this is clearly an advantage. The marginal tax advantage of interest deductibility is expected to sink as leverage increases when the marginal tax rate is progressive. The last amount of debt that is incurred does not invoke a very large tax effect since the marginal tax rate decreases as the income is reduced. For corporate debt, however, the marginal tax rate in Norway is 28% and constant for all prot levels. The tax incentive for debt nancing is therefore not marginally decreasing as the leverage increases when the corporate tax-rate is constant. The rm tax is a pure net-prot tax and where there is no prot, even the government tax collector has lost his claim. In his article Debt and taxes, Miller (1977) argues that the debt level is not dependent on tax rate when both personal and corporate taxes are considered. Thakor (1989) is also critical to the tax advantage of debt since debt was used prior to 1913 when there were no corporate taxes in the US. Preferred stock pays a xed dividend such as debt but the dividends are not tax-deductible. The issuance of such preferred stock also shows that the tax advantage of debt only partly can explain the usage of debt. 11

B. Bankruptcy Incentive
A bankruptcy without costs would not change the value of the rm. Stiglitz (1969) have shown that the value of a security is the same, regardless of whether a bankruptcy would occur or not under some specic conditions. There are, however, costs of nancial distress. These costs are divided into direct costs and indirect costs. Bankruptcy costs are expected to increase for all levels of leverage. Bankruptcy costs are not only the direct costs of transferring the assets to the new owners, lawyers fee and court fees, but there are also indirect costs of bankruptcy arising from the bankruptcy process itself. The bankruptcy trustee, as an agent of the court, has the authority to operate the rm. Warner (1977) said that it is not clear if this agency relation give the trustee any incentive to run the rm efciently and take decisions which are in fact value maximizing. The stockholders face the possibility that they may lose control of the rm when a nancial distress situation occurs. The option to receive dividends if the rm operates protably in the future is thereby lost for the current stockholders. Indirect costs arise when qualied employees that can pursue alternative opportunities quit the rm when bankruptcy is closing in. Unrest in the organization is often the result, and suppliers and customers that rely on continuous business relations may lose condence in the rm.

Risk shifting

Risk shifting is described in Section F but is worth mentioning here too be-

cause the gains and temptation to play this game is strongest when the odds of default are high. If the rm probably will go under anyway, why not make a nal bet that might salvage the rm. The stockholders and management is betting with the creditors money. The point in risk shifting is how stockholders of levered rms gain when business risk increase. This point can also be described with a Call option.

C. Dividends Payments and Claim Dilution Problem

Brealey and Myers (2000) describe this as the cash in and run problem; stockholders can take out the valuable assets, while bondholders are kept in the dark. Bonds are priced under the 12

assumption that dividend policy remains unchanged. Reducing the investments by increasing the dividends will reduce rm value, increase the risk of outstanding debt and harm the bondholders. The stockholders can pay out all the assets and leave the bondholders with an empty shell. As the rm approaches bankruptcy and nancial distress is more and more transparent for the rms stakeholders, management may chose to play games with the creditors. These games can be played all the time, but stakes are higher near bankruptcy.

C.1. Claim Dilution The stockholders can use the value of the assets as bait, and then switch to another strategy. Bonds are priced under the assumption that no new debt will be issued. When the rm issues new debt with the same or higher priority than the old debt, the claim of the old bondholders will be reduced. The reason is that the probability of default on the old debt increases. The rm starts with a conservative policy, issuing a limited amount of relatively safe debt. Then the rm suddenly switch and issue a lot more. That makes all the debt risky, imposing a capital loss on the old bondholders. Their capital loss is the stockholders gain.

D. Product Market Competition and Capital Structure

In his model, Titman (1984) postulate that a seller of a product enters contracts of service to a product. A seller who can credibly enter this kind of service contract can demand a higher price for his output product. If this service becomes too costly, he will renegade on the contract. Bankruptcy is a possible method to renegade a service contract. A higher debt-ratio increases the possibility of bankruptcy and consequently the mark-up - price the seller can demand, since the customers view the debt ratio as a signal of possible bankruptcy. Williams (1988) have also studied the capital structure problem when there are more than one rm in the model. An agency problem occurs where a rm has to choose between two technologies. One labor intensive and one capital intensive are the two available technologies.


If the entrepreneur invests in the labor-intensive technology, he may consume some of the investment proceeds from external nancing. The capital-intensive technology is assumed to give higher returns than the labor-intensive technology. Debt can then be used to control management incentives by setting the debt level so high that an investment in labor-intensive industry is not feasible. An important conclusion from the industrial equilibrium literature is that several nancing arrangements may coexist at the same time. Large capital-intensive rms with high debt levels may coexist with smaller and marginally protable rms that are having lower levels of debt. Williams (1988) model could therefore explain the large heterogeneity of debt ratios observed in the data.

E. Optimal Contract and Corporate Governance Theory

In this section I explore three subjects that are often mentioned as possible causes of capital structure decisions. First, I consider the corporate governance problem. How should the rm be controlled? A tightly held rm where a majority or large shares of the stocks are controlled by an individual or a group is supposed to be a more efcient managed rm than the rm controlled by entrenched self-interested managers. Second, operating risk has to be shared by the owners of the rm and the debt-equity paradigm have shown remarkable ability to allocate risk to the people that has the residual control rights of the rm, the equity holders. Third, does transaction cost theory have anything to do with capital structure?

The corporate governance problem

Aghion and Bolton (1988) and also Zender (1991)

emphasize that contracts that grant control to one class of agents exclusively may not be efcient because they fail to give the controlling agent the incentives to make the rst best decisions. The intuition behind the existing nancial instruments equity and debt are that they are designed so that in each state the owner of the residual control rights own the residual cash ow. If this is not the case, there is a potential conict because owners of one of the securityclasses could expropriate wealth from owners of the other security class. The standard debt


contract (SDC) is an optimal contract and dominates all other types of contracts in the Costly State Verication(CSV) literature. A SDC minimizes the expected transfer of wealth from the entrepreneur to the outside investor. See Allen and Winton (1995) for a comprehensive review of the literature. The dening character of the CSV literature is that that the true cash ows of the rm are only observable to the manager or entrepreneur. The cash ows of the rm are only veriable at a cost in a bankruptcy process. The outside investor receives only a xed sum of money when the entrepreneur income is not veried and a strictly lower payment when income is veried. Ownership structure could be an important factor explaining the leverage structure. Firms that are tightly controlled by major stockholders will have less agency costs. Fama and Jensen (1983) argue that it makes sense to separate the nancial claims into only two types: a relatively low risk component, the debt capital, and a relatively high risk component, the equity capital. This is an optimal form of contracting because it reduces contracting costs and it lowers the cost of risk-bearing services. Stockholders and bondholders do not have to monitor one another. Only the bondholders must monitor the stockholders and not vice-versa. This one-way monitoring will help to reduce contracting costs.

Risk sharing Members of a syndicate are eager to regulate two main elements in the partnership. First, the payoffs from positive NPV-projects must be divided, and second, risk has to be shared. The risk stems from the time varying realization of payoffs and liability if bankruptcy occurs. In an equity-debt model, equity-owners carry almost all the risk, and receive all the pay-off if the rm reaches a certain prot-target. On the other hand, if prots are below target they get no pay off. The debt owners have practically no risk and xed pay-off structure unless losses incurred wipe out the equity. Neither equity nor debt owners can lose more than what they have invested, guarantees set aside. A rst best solution to this risk-sharing problem would be to give the risk-neutral investor all the risk and divide the pay-off accordingly. No risk results in a risk free return for the debt owners. A second best solution makes the risk averse investor carrying more risk than the optimal solution. This induces an excessive risk premium that can be attributed to the non-optimal risk sharing; the less risk averse investor should accept a larger risk. 15

Transaction cost theory

Coase (1937) suggested that the neo-classical literature of the rm

is consistent with there being one huge rm in the world and also that every division of a rm could be divested to single autonomous rm. Organizations emerged because of market failure, because of asymmetric information between agents. This asymmetric information between members give organizations their reasons for existence. Williamson (1981) claimed that other reasons for existence are transaction costs and economies of scale and scope. A general employment contract between the rm and the employee reduces the necessary details in a contract compared to contracts that specify exactly the content of the services provided by the employee. Instead the rm can order the employee to perform tasks within a broadly dened area. The organizations are not markets and they are not individuals. The literature of rm nancing, views rms as something between. Firm nancing can be seen as a set of contracts between people that cooperate towards a common goal while they are pursuing their self-interest. Financing the investments of these organizations requires a trade off between costs and benets of security and loan contracts. The literature of corporate nance relies on the early work of Coase (1937) and Williamson (1981) that explain the reasons for existence of organizations. The corporation has served as a major form for organizing economic activity. The ability of the corporation to survive through the last century must reect benets from the organizational structure that protects the real and nancial resources. The value of the corporation must be derived from costs and imperfections inherent in markets: information asymmetries, transaction costs, economies of scale and scope, and forms of taxation. Financing is a mirror image of the real activities of an organization. Asymmetric information and transaction costs faced by agents in the organization create an opportunity to organize economic activity differently from how a market or a contractor-based activity would be organized. Instead of project nancing the rm takes on corporate debt, thereby reducing transaction costs, and construct budgets and incentive schemes for the sub-divisions of a rm. 2
2 A project manager is allocated capital from the rms investment budget. Alternatively, she could have raised capital in a bank or in the capital market. That would be difcult if the asset base for the project is shared with many other projects and possible collateral is already occupied. The corporate debt reduces transaction costs compared to many separate project debts to different lenders.


F. Risk Shifting (Asset Substitution) Problem

The basic idea, that increases in leverage induce equity holders to pursue riskier strategies, was introduced by Jensen and Meckling (1976). Since decisions concerning dividend payments, issuance of new debt, and investments are made by the owners, these decisions are a potential source of conict between equity investors and debt investors. The nancial structure affects the cash ow through investment decisions. Smith and Warner (1979) argues that there are four major sources of conict. These are dividend payments, claim dilution, asset substitution, and under-investment. Briey, asset substitution is an incentive problem associated with debt. Stockholders are the residual claimants to the rm cash ow. Their claim is analogous to a call option on the rms asset, with a strike price equal to the face value of the debt. It is well known that the value of a call option increases as the risk in the underlying asset increases. Bonds are, however, sold with the prospect of a certain level of risk. If stockholders increase risk beyond this initial level, they can expropriate wealth from bond-investors. Bondholders will, under rational expectations, recognize this incentive, and require a discount when they invest in debtsecurities in a rm. This discount is a cost that reduces the total value of a rm and as such is eventually born in total by the stockholders. This risk shifting incentive can be mitigated by covenants in the debt contract, legislation and by using convertible debt or straight debt with warrants. The asset substitution problem can be described using a model that integrates models used by Green (1984) and Green and Talmor (1986). When the investment decision of the bondholders precede that of the stockholders, it is to the stockholders advantage to choose a distribution of returns with relatively more weight in the upper tail. Rothscild and Stiglitz (1970) have shown that increasing the investment in the risky project is equivalent to increasing the mass in the tails of the distribution of total return. How likely is this theory to have any effect in practice? Does lenders care about the possible asset substitution when contemplating a loan to a rm? In the loan application process the investment objects and future strategy is certainly a talking point. The problem is


that it is almost impossible to construct a contract where the borrower cannot renegade and invest in something more risky. That might not even be in the best interest of the lender either. If rm management sees a better investment project than the one they originally lent money for, should they not invest because the loan contract has restrictions on the possible investments? It is likely that it is better to control management incentives through stock options and stock market monitoring than through costly restrictions in the loan contracts. The risk-shifting incentive problem can be controlled through restrictions in the loan contract and through management incentives. But such monitoring is costly and with uncertain effects. It is therefore likely that lenders seek to insure themselves to an increase in business risk. The simplest method is to demand collateral for the loan and to demand an equity of some size in the rm before lenders grant a loan. This incentive is even addressed by legislature in Norway that demands an equity of minimum 100.000 NOK. Even for a small rm, the amount is very low and the demand for public disclosure of nancial report is therefore more important. In the US, quarterly disclosures of nancial reports are the standard among listed rms, the activities of management is therefore more transparent than in Norway. The conclusion must be that the risk-shifting problem is hypothesized to be severe, but it is empirically very difcult to measure, if not impossible.

G. Under-Investment Problem
The problem is that stockholders will have to share the extra value created by their additional investments with creditors. Myers (1993)

Under-investment is dened as forgoing a project with a positive net present value. The argument in this section was introduced by Myers (1977) and is called the under-investment hypothesis. Highly levered companies are more likely to pass up protable investment opportunities. Firms expecting high future growth should therefore use a greater amount of equity nancing. 18

I0 is the investment in product development made at time t = 0. Due to the investment in product development, the rm holds a growth opportunity. from the product At t =1, the rm must invest an additional I1 , to get the cash ow X I0 r developed. The investment I1 could for instance be machinery needed to produce the developed product.

The investment option is rm specic and cannot be sold. The rm that made the initial investment has an exclusive right to exercise the option. If the rm chooses not to invest, the option has zero value. This constitutes an imperfection in the market for real options of this category. First I consider a rm that is entirely equity nanced and then a rm that issues debt to nance the initial investment I0 . The intuition behind the model is not complicated. The consequences and practical implications of the model, however, is a subject for discussion. The intuition is that an investor possessing a growth option will not share the gains of the option with nanciers if the growth option has prior debt nancing. After having paid off the debt holders to the option, there will be too little left for the investor of the prot that comes from implementing the growth option. When B0 V is fullled, the incentive not to invest in certain states are present.

Whether the option has any value when it expires depends on the assets future value and also on whether the rm chooses to exercise. The funds needed to make the investment I 0 in this case are raised by selling bonds with face value F. To be able to invest at t = 1, the rm must raise I1 , and does so by outlays from the current stockholders. We abstract from the signalling considerations of a security issue. The timing of events at time t = 1 is important. First, the return is revealed to the stockholders, the initial investment becomes certain at this point. Second, investment I1 is made, and then the debt matures. The rm will invest if the return cash ow is large enough to cover both the rst investment which is debt nanced and the second investment which is equity nanced. However, since the rst investment, made at time zero, is in fact sunk cost at time t = 1, the rm should make the investment if the return cash 19

Figure 1.
The Firms Investment Decision with Prior Debt Financing

Return X in state s d(s)=0 d(s)=1

I1 F

s, State of the world sb sa ow is larger than the equity investment at time t = 1. In some unfavourable states of nature the rm will forgo a positive NPV investment, because of the seniority of the debt. From the stockholders perspective, they would be throwing good money after bad money. This is a cost that in a rational expectations equilibrium in the capital market will be borne entirely by the stockholders. The bond holders will require a premium to nance a product development that may not result in production in anticipation of the shareholders not being willing to supply the rm with additional funds to buy the necessary machinery for the production if the return does not cover the cost of the machinery. This premium reduces the value of the rm and is a cost of debt nancing compared to equity nancing. Firms with growth options would hence be reluctant to nance themselves with debt. I can illustrate this incentive not to invest in certain unfavorable states of nature in a gure. Shaded area in Figure (G) is loss of value in some states. A high F implies a larger loss of value. Myers (1977) is often cited in the literature. This is partly due to the seminal real option aspect, but also to the fact that he describes a unique incentive problem. Myers argument hinges on the fact that that the lender has no additional collateral except the growth option. If


you do not invest, you walk away from the debt on the growth option. If the growth option could be sold to the lender, she could invest herself as long the second investment, I 1 , is positive NPV. But, that is not possible, the growth option is a real-option which cannot be sold in the market as described in the paper by Myers (1977). A contracting possibility would therefore be that the lender and the rm split the prot otherwise lost, in a Nash (50/50) bargain solution, by letting the rm exercise the growth option and nance only a part of the new investment while the lender nanced the rest. As long as V(s) is larger than I1 , both parties could be made better off by sharing the investment and gains than letting the option expire unexercised. Imagine that the debt F is just a tiny bit larger than V(s)- I1 . The creditor could then recoup almost half the debt in a bargaining solution. This is also seen in real life, it is not uncommon for banks to grant further loans to a rm to salvage some of their outstanding debt.

H. Free Cash Flow Problem

Debt creation, without retention of the proceeds of the issue, enables managers to effectively bond their promise to pay out future cash ows. Thus debt can be an effective substitute for dividends, something not generally recognized in the corporate nance literature. Jensen (1986) The argument of the free cash ow and the role of debt to control opportunistic management is due to Jensen (1986). Debt reduces management opportunity to spend excess cash ow in non-protable investments. Management has less control over the rms cash ows since these cash ows have to be used to repay creditors. Jensen and Meckling (1976) have argued that managerial incentives to allocate the rms resources to their private benet are larger when the rm is mainly equity nanced. The free cash ow term is the amount by which a rms operating cash ow exceeds what can be protably reinvested in its basic business and the emphasis is here on the word protably. Conicts of interest between stockholders and managers over payout policies are especially severe when the organization generates substantial free cash ow. So, there is a dark side to the nancial slack. Too much of it may encourage managers to take it easy, expand their perks, or empire-build with cash that should 21

be paid back to stockholders. The problem is to motivate managers to disgorge the cash rather than investing it below the cost of capital or wasting it in organizational inefciencies. Jensen (1986) validates his stories by referring to the empirical literature on debt for common stock exchanges that leads to stock price increases. This evidence is, however, also credited for the potential signalling effect of debt. Debt as a signal of high-quality rms is treated in Section IV. The evidence from the leveraged buy out and going private transactions is that many of the benets in an LBO seem to be due to the control function of debt. The conclusion of this theory is that Jensen claim that by strapping the management to the mast i.e. make them pay out xed amounts of money to the investors each year, the agency cost of free-cash ow can be reduced.

H.1. Protability Protability affects leverage in at least two directions. First, higher protability usually provides more internal nancing. More earnings can be kept in the rm and hence a lower level of debt. Less debt is then needed to nance already planned investments. Secondly, debt introduces an agency cost argument. Management will refrain from the building of empires and excessive consumption of perquisites, when large sums of money must be paid to creditors each year. Debt keeps the rm slim and cost efcient. Unnecessary non-protable investments will be avoided because creditors demand annual payments and claim any free cash ow. High protability should result in higher leverage according to the free cash ow hypothesis, but a high leverage would result in high protability on the basis of the pecking order hypothesis. The problem is that leverage and protability are linked both ways, and that the causal direction is uncertain. This problem could be avoided empirically if I estimate a system of two equations instead of one equation. This approach is used in Stein Frydenberg (2001). Since causality here works both ways, it would be possible to control these two effects by a system of equations.


IV. The Pecking Order Theory

According to the pecking order theory, the rms will prefer internal nancing. The rms prefers internal to external nancing, and debt to equity if the rm issues securities. In the pure pecking order theory, the rms have no well-dened debt-to-value ratio. There is a distinction between internal and external equity. Several authors have been given credit for introducing signaling as an argument in the discussion of debts explanatory factors. Ross (1977), Leland and Pyle (1977) and Myers and Majluf (1984) are often quoted as the seminal articles in this branch of the literature. Myers and Majluf (1984) describes the preference like this: The rms prefer internal nancing, they target dividends given investment opportunities, then chose debt and nally raise external equity. The pecking order was traditionally explained by transaction and issuing costs. Retained earnings involve few transaction costs and issuing debt incurs lower transaction costs than equity issues. Debt nancing also involves a tax - reduction if the rm has a taxable prot. Myers and Majluf (1984) invoked asymmetric information to give a theoretical explanation for the pecking order phenomena. The signaling model described in Section A leads to a pecking order concept of capital structure, where retained earnings are preferred to debt and debt is preferred to new equity. The signaling model showed that only low prot type rms would issue equity in a separating equilibrium. Rational investors foresee this and demand a discount in Initial Public Offerings (IPO). This discount is a cost of raising equity that will be borne by the internal stockholders. Debt signals to the capital market that the issuing rm is a high performance rm.

A. Asymmetric Information (Signalling) Problem

Asymmetric information between old and new investors, and managers and investors incite to signaling games where the amount of debt, and the timing of new issues is viewed as a signal of the performance of the rm. Akerlof (1970) introduced an adverse selection argument


that explains why prices of used cars drops signicantly compared to new cars. The seller of a used car will usually have more information about the true performance of the car than the prospective buyer. The buyers best guess would be the average performance of cars in the market. The buyer, when offered a car, expects the performance of the car to be below average, otherwise the car would not have been offered to the market. Consequently, the price of used cars decline and the only cars offered for sale are the cars not well made and maintained. The buyers require a discount to compensate for the possibility that they might purchase an Akerlof lemon. Earlier there used to be a tendency that cars built on Mondays for some obscure reason had more problems than other cars. The focus on quality control may have put this problem to an end, but still some cars seem to endure longer than others. The heart of the matter is that the seller is aware of the upcoming reparations and problems, but the buyer is not. A recent trend in Norway to overcome this problem is to require a complete check of the car by an authorized workshop before buying. The work - shop produces a status report on the technical condition of the car, which serves as a signal of performance of the car to prospecting buyers. This signal reduces the asymmetric information in this market. Analogously, the only rms for sale, in the market for corporate control, are those with below average excellence. The rms will, according to the adverse selection argument only issue new equity when the stock is overpriced. Issuing debt can be a signal to the capital market that the rm is in fact an excellent rm and that the management is not afraid to borrow money. The bankruptcy possibility is supposedly not large enough to let extensive borrowing bring about the current managements control of the rm. The idea underlying the signaling models, is that stockholders or managers signal private information to the security market in order to correct the markets perception of excellence.


V. Summary of the Theoretical Literature

Capital structure remains enigmatic Chirinko and Anuja R. Singha (2000).

Although we have come along way towards a better understanding of why and how rms choose their capital structure, there are still unresolved issues. First, there is no current model that put all the pieces of theory together in a model that might be suitable for textbook presentation and, hence, presentable to the general public. Thus, students when they enter the job market have no comprehensive model to relate their capital structure decisions to. Second, the empirical evidence is mixed and does not point out a single empirical model as a good explainer of corporate practice. At the same time, everybody understands that borrowing too much is not good for your rms health and not borrowing at all is a waste of precious equity. The academic communitys 40 year struggle with the issue since Miller and Modigliani (1958b) have in essence found that your capital structure is a trade off between many interests and that some times you would prefer to issue debt and sometimes equity. I think the root to the problem here is exactly many interest. The capital structure being a mirror image of the real side of the balance sheet is a too complex fabric to t into a single model. Academics have not tried to make a single model for how rms should invest or operate; realizing that the environments and circumstances a rm could be operating under is endless. Instead we have several partial models for how rms should operate and invest contingent on the environment and circumstances surrounding the rms. It is time to realize that this goes for the nancing aspect as well. I can only hope to make models that suit one type of rm well; other types of companies need other approaches. One of my contributions is to show that the theoretical models developed seem to explain differently if I divide the data into several generic groups of rms. This idea is explored in Frydenberg (2001). Models invented for homogenous rms should be tested on homogenous


rms. The notion that every rm can be described within the same capital structure model is a bit too much to hope for at the moment.

Value relevance of capital Structure

What factors have to be present for leverage to mat-

ter? First, there has to be market imperfections present like tax consideration, asymmetric information, transaction costs and bankruptcy costs. But second, there has to be an absence of the possibility to make a trade of the rm with the sub-optimal capital structure for the rm with the optimal capital structure. For leverage to matter for the value of a corporation, it has to be the case that no clever arbitrageurs can make money from such a situation. Stulz (1990) In a small rm, the stocks are not traded, if there exist an arbitrage possibility, the stockholders cannot take advantage of the arbitrage possibility. Two rms with equal future cash ow should be worth the same. The capital markets are probably not perfect because in real business life, capital structure is a subject of great concern to many nancial managers. Many investors have tried to earn a higher return than the market return, some have managed just that, but most have not. This fact is often used as an argument for an information efcient capital market. The markets may be efcient, but still less than perfect. Asymmetric information may be present between the rms managers and the capital market, and we may still have efcient markets, although in a semi-strong form. The insiders information about the rms business future will not be discounted in the market prices of the rms stocks in this situation. A denition of a perfect market is that costless trade in other assets can copy any cash ow. The markets are complete, for any future state there exist a primitive security that gives a unit income and the price today for that primitive security reects the probability for that state to happen and the investors inter-temporal marginal substitution rate of consumption. However,


the markets may be correlated and if your rm runs into difculties so will probably most other rms do and the price you get for your assets in a recession could be very low. An old adage in business is that everything is for sale, if only the price is right, but the price in a recession may be ridiculously low compared to replacement values. Today, some of the rms in the technology sector are trading at market values under their cash position. The nancial markets have been prune to manias or nancial excesses. The prices tend to overshoot in either positive or negative direction. You do not want to liquidate your stocks or real assets in a recession time period. Therefore, common sense is to keep enough equity to survive the next recession and rather sell your assets when the markets are favorable once more. Haugen and Senbet (1988) claim that in the case of bankruptcy costs, market impediments are easily eliminated through the inclusion of simple provisions in corporate charters and bond indentures. Liquidation costs cannot explain capital structure they say, because if the rm is to be liquidated on the basis of a rule instead of what maximizes the total value of all the claimants, arbitrage prots arise, and informal reorganization will discipline management to follow the liquidation rule that is optimal for existing security holders. This result is not readily extended to other classes of market failure and agency costs, especially the risk-incentive problem. The risk-incentive problem can be overcome through complex contracting, such as the inclusion of call or conversion provisions in debt. The reasons for why capital structure should matter are all related to the assumptions of the Miller and Modigliani theorem. If a reason for capital structure relevancy were not included in the assumption, the theorem would not hold. That is perhaps the beauty of the theorem, the all-inclusiveness of the assumptions. If you could think of a reason for capital structure relevancy, which is not included in the general assumptions of MM, then that would be a good research idea. Taxes, transaction costs, asymmetric information, real options, bankruptcy costs and entrenchment of managers are imperfections of well functioning capital market. In a world of perfect markets, neither the under investment problem nor the bondholderstockholder conict would exist because in a world without contracting costs, the capital 27

structure of the rm can always costless be changed, to make sure that a rm take advantage of all protable investment opportunities and does not invest inefciently as a result of leverage.Stulz (1990) A key result of Merton Millers research is that for leverage to matter no clever arbitrageurs can take advantage of a situation where leverage matters. The perfect market assumptions are sufcient (second-order) conditions for leverage to be irrelevant, but not necessary conditions (rst-order. Although the assumptions may be broken, we may still have the irrelevance. Chiang (1984) say that the rst order (tangency) of a maximizing function is necessary for a maximum point, the second order (convexity) is sufcient. So, we could have all the conditions of perfect capital market broken but still leverage would not matter if clever arbitrageurs could take advantage of the situation. Miller shows that in equilibrium the coupon on taxable bonds must be the coupon on tax-exempt bonds grossed-up for taxes at the corporate rate. Think of the value of the rm as a convex function of the debt ratio. If the function is convex, but increasing in the entire domain from zero to all debt nanced rm, we have no internal optimum. An arbitrage exists if an investor could costless trade in the securities of the rms and make money. Assume that one or more of the perfect market assumptions are broken and that we have two rms A and B that are equal in intrinsic value, i.e. the cash ow these two rms generate are equally distributed in time and magnitude. But rm B has a sub-optimal high debt capital structure which makes the value of B lower than A. Is this an equilibrium situation? No, smart speculators would sell stocks in rm A and buy more of stocks in rm B, since both rms would eventually earn the same cash ow. Even though expected bankruptcy costs in rm B may be higher than in rm A, that does not matter because we have assumed that the rms are equal. If the high debt in rm B creates costs because management does not dare to pursue the best projects, then that will change the cash ows of rm B. Then the cash ows are not equal anymore. The message is that leverage cannot matter if rms are equal and arbitrage trading is allowed. But leverage could matter if rm cash ows are not equal because some market imperfection plays a part in the equation and if arbitrage trading is not allowed.


It is therefore likely that leverage only matters for rms that do not have access to the less than perfect Norwegian capital market. Firms that are closely held by families and not traded are especially susceptible to such a situation. A young entrepreneur in the construction segment with many good business ideas could launch positive NPV projects if he had the money to back them. Being a small enterprise he is shut out of the equity market and can only get bank nancing. The debt-ratio in this rm is therefore much higher than the ideal, because the interest payments on the debt reduce the entrepreneurs willingness to raise capital and the courage to enter high-risk and high-return projects. Even though the entrepreneur has many good business ideas, he cannot easily get more equity to his ideas. The second step is that the rm uses the pecking order theory to arrive, that is, they very seldom arrive at this target debt structure. However, they use the pecking order to adjust as far as they can, under the given transaction costs toward their target dent structure. The target debt structure was determined in the rst step of the process, trading off various costs of debt versus equity. Evidence for the pecking order; rms having low protability generally borrow more. Not because they belong to industries with a high target debt ratio, but because they are on the top of the pecking order and can nance most of their capital expenditures by retained earnings.

Option theory as a summarizing concept

I will in this section describe how theories re-

ferred to earlier in this paper can be built into a coherent model. Not necessarily rigorously, but intuitively giving ideas for future research and giving the reader a comprehensible model to refer to. This idea was presented by Miller (1988), but I have elaborated the idea to incorporate also the assumptions of the MM propositions. The model I have in mind is the put-call parity model for European options stated in eq. (17). A much-invoked analogy is that the stock of a rm can be compared to a call option on the rms assets. This is not entirely true, the stock is more like a down-and-out call on the rms assets. This call is not a standard call, but related to the barrier option class of the down-and-out call type. If the value of the rm breaks down through the barrier created by par value of debt, the rm is bankrupt and the equity of the rm has no


value if the creditors take over the rm. A down and out call barrier option, where the option is worthless once the underlying asset touches a oor is in general worth less than a regular call. It is in general worth less than the regular call because the regular call is a sum of the downand-out and the down-and-in call. The down and in has a value if there is a possibility that the asset price will reach the barrier in the options lifetime. ..barrier options regularly trade in over-the-counter market. They are attractive to some market participants because they are less expensive than the corresponding regular options. Hull (2003) The barrier 3 In this case would be the par value of the debt. Let us for the sake of the argument; however, describe the situation in the rm by European call and puts in a well-known parity. The put-call parity model is given by:

S where S = Asset value, C = Equity of rm, a call on the assets of the rm with a strike price X

C erT X P


P = The put option of the creditors with a strike of X. This model will not generally hold unless the options are European. The bonds market value is thus X minus the put option, P, while equity is worth C. A dening concept of options is that they cannot have negative values. If S is larger than X, then the equity of the rm has some value at the expiring date of the option. Interestingly the options has a time value so out of the money call options has a value even if c S. Assuming the usual technical conditions

for option valuation in a perfect capital market, the call option is a function underlying of asset S, strike price X, volatility of S parameterized by , interest rate r and the time T to date of expire. C0

f S X r T


barrier option has an important result, the barrier call should be sold cheaper when there is downside skew than when there is a at skew. See Nassim Taleb (1997).



f S X r T


The theories of corporate capital structure can be incorporated in this model. 4

Risk substitution

First, there is the risk substitution hypothesis presented by Jensen and

Meckling (1976) that is said to increase volatility of the underlying asset S. Both the call and the put option will increase when the volatility of the underlying is increasing. If the volatility increases and the put increases more than the call, then the rm value is decreased. So, when volatility increases the risk may not be justly distributed on bond and stockholders. The stockholders may gain at the bondholders expense as described by Jensen and Meckling (1976). The vegas of put and call options are equal in the theoretical Black and Scholes pricing formula. An interesting venue for future research could be to investigate the vegas of formulas like the barrier options that can model the option value where the underlying is the value of the rm. Barrier options often have quite different properties from regular options. For example, sometimes vega is negative. Consider an up-and-out call option when the asset price is close to the barrier level. As volatility increases the probability that the barrier will be hit increases. As a result, a volatility increase causes a price decrease. Hull (2003) page 441 Since the call must be considered a down-and-out call, while the put must be considered an up-and-in put, there may be different signs of the vegas for these two options when the barrier is close to the rm value.


Second, there is the under-investment problem described by Myers (1977)

that reduces the rm values because a debt nanced growth opportunity or real option might not be exercised because debt investors normally receives their interest and principal loan berelation between the variables in the option functions and the option values. Call options increase with the stock price and the exercise price X. Put options decreases with the stock price and the exercise price X. Both put and call options increase with the time T to maturity because the owner of a long lived option always has all the exercise opportunities open to the owner of the short life option. Increasing the time T transfers value from debt owners who has X-P0 to equity owners who have C 0 at their disposal. Choosing the debt ratio in this model would amount to choosing another strike price for the debt.
4 The


fore the equity investors receive their dividend and residual capital left in the rm after having paid off all the creditors. That should reduce C0 and increase P0 . Both debt owner and equity owners lose. Remember that the value of the bonds in this model is not P0 , but X-P0 . The equity owners have a right to sell the assets to the bondholders for the face value of debt X. If the assets could be worth less than X, this guaranty for sale has a value P0 , which the bondholders must cover.

Tax incentive

Third, the tax theory by Myers (1984) predict that X-P0 is tax subsidized and

cheaper than C. By weighting the capital structure towards debt, the after tax value of the rm can be increased. The after tax value of the rm S = C0 + X - P0 can be increased by shifting over to debt nancing. This corporate level one-sided effect of tax-benets of debt nancing is in many countries offset by the personal investor taxes on interest income. Depending on the relative size of the corporate and personal tax-rates, a tax-incentive for debt might be present for rms with taxable prots.

Bankruptcy costs Fourth, bankruptcy Warner (1977) theory predicts that an increase in X beyond sustainable levels of debt would incur expected direct and indirect bankruptcy costs that would reduce the value of S, thus decreasing C0 , increasing P0 . The market value of both equity and debt would fall when the debt and equity investors start to believe that the rm might run into serious nancial distress soon. This effect of expected bankruptcy costs are predicted to off-set any incentive from taxes. One feature of the down-and-out call is that the delta (1st. derivative of option with respect to underlying asset) is considerably higher near the barrier than the regular option delta. When the asset price hit the barrier, the barrier delta goes to zero. This phenomenon illustrate the agency cost problem of stockholders. A lower delta means that stockholders do not get hit by the decline in asset price until the bankruptcy barrier is reached. Then they lose all their claims. This atter delta function near bankruptcy compared to a regular call option illustrate the tendency of stockholders to make desperate actions near bankruptcy. With limited downside risk, they are inclined to bet with creditors


money on high risk projects. Nassim Taleb (1997) page 315 describe this discontinuity at the barrier.

Asymmetric information Fifth, the pecking order theory predicts that increases in internal cash ow, discounted to market value of cash ows S, is cheaper than obtaining external equity by increasing X. Increasing X is on the other hand cheaper than increasing C. The exercise price X denes the level of debt, while C0 and X-P0 denes the market value of respectively equity and debt. S CX P (20)

The un-leveraged rm is represented by S0 initially, if the costs of changing the capital structure is larger than the benets, then C1 + X - P1 should be less than S0 . The new value of the rm S1 would be equal to the market value of equity, C0 , plus the market value of debt, X1 -P1 ex post change of capital structure. Finally, we have the interesting aspect of the feedback effect. Both C and P in eq. (17) are endogenous functions of the underlying S that are part of the eq. (17). There is a feedback effect, a change of the equity value, C, would by eq. (17) lead to change in S and then next a second change in the equity value, C. What is the mechanism that gives a change in S because C changed in the rst place. Well, one could argue that a loss of equity would restrict the investment possibilities of the rm, leading to a lower S. The value of the rm, S, is the sum of two components, rst the equity value, C, and the debt value, X-P. If an exogenous change of X, increasing the debt ratio, decreases the value of equity, C, more than the increase of the market value of debt, X-P, then there is a net decrease of the value of the rm S. If both P and C has the same sensitivity to changes in the underlying asset S, then the change stops. This is probably not the case and this will therefore give a feedback loop towards S once more. The case is that for a change in the debt ratio, X, to have any effect on the value of the rm, the market value of equity and debt has to react differently to this change. If the size of the debt was irrelevant; an increase of X of 2 units would result in a decrease of C 33

with 1 units and increase of P with 1 units. In the put call parity they would neutralize the change in X so that S would be left unchanged. It is likely that a rm close to bankruptcy, will see that the market value of equity drops more than the market value of debt. The put-call parity is based on no-arbitrage, if the equality of eq. (21) where replaced with a larger than sign, then arbitrageurs could short-sell the assets, and buy stocks and bonds. That sounds like the recipe of a leveraged buy-out. To get control over an undervalued rm where the market value of stocks and bonds does not match the market value of assets, investors buy the stocks with borrowed money, gets control in the board of directors and then sell out valuable assets and daughter-companies. Finally they use the proceeds to reduce the debt to a comfortable level. Buy-candidates that are cash-rich and debt-free are therefore especially vulnerable to leveraged buy-outs. Management in these companies thus often entrench themselves in a fortress of debt, effectively deterring any attempt of leveraged buy-out because the rm has a high debt-ratio to begin with. Debt have been used as a defence mechanism by entrenched managers often as reported by Garvey and Gordon Hanka (1997). A highly levered rm is not so easy to acquire because the assets cannot be used as collateral for further debt.



The rst theory I described was the risk shifting hypothesis. By increasing the volatility of the option, the call option value increases and so does the put option value. The rate of change of the option with respect to the volatility of the underlying asset is always positive. This is true for both the call and the put option. Since both the call and the put option increases monotonic with the volatility of the assets, the debt market value decreases by the increase of p, the put option. The under-investment hypothesis results in an increase (or decrease) in the asset value. The free cash ow hypothesis result in an increase(or decrease) in the asset value S. The put-call parity is based on a nonarbitrage situation. We should be able to exchange a part of the underlying S for a part of the 34

equity C and a part of the debt X-P. If this is not possible, then maybe debt can be relevant. An example is Myers (1977) real options, the rm in question is the only rm that can exercise the growth option. It is therefore not possible to sell the growth option to another rm. If the growth option was marketable in bits and pieces, the rm could sell out a share of the option corresponding with the value of the debt on the option and be left with a pure-equity growth option. This residual option would have to be exercised by the rm since it is a positive NPV project. So, the stockholders in reality own a call option on the rms assets. The position of the bondholders are that of someone having sold a put option to stockholders, giving them the right to sell the rm to the bondholders for the face value. The stockholders can either choose to buy the rms assets for the face value of debt or choose to sell the rms assets to the bondholders for the face value of debt. The stockholders can chose to walk away from the corporate debt and leave the bondholders with the assets. The stockholders are then immune to future claims against them unless they have done something unlawful as a member of the board in the bankruptcy process. The stockholders have the option to bankrupt the rm which is a put option and the option to buy the assets for the exercise price the face value of debt. The bondholders main upside is the option fee which is interest they can receive for the loans they make to the rm. The world of exotic options may help explain the phenomenon known as gamblers ruin. The problem of not being able to take part in the next gamble, because you do not have the necessary stakes for the next dealing of cards. A down-and-out also called a knock-out (KO) option is an option that has a barrier. The value of the option turn zero once the underlying assets fall below a barrier. There are thus several non-linear effects in the Greeks5
Greeks are the rst derivatives of the option price with respect to stock price, time, interest rate, volatility and contract price. C Delta is rate of change of option price with respect to the underlying asset, S . Theta is rate of change of C option price with respect to the time to maturity, T . Vega, is rate of change of option price with respect to C C volatility s . Rho is rate of change of option price with respect to interest rate r . Finally, the second derivate of the option price with respect to the stock price is Gamma,
2 C . 2 S 5 The


Owning levered equity in a rm can be considered like owning a knock-out call. If the assets value sink below par value of debt, creditors might step on the collateral and claim the assets. The equity owner then receives nothing. In the real world several complications as bankruptcy proceedings and friendly bankers exist, but the main mechanism is that creditors can claim the assets when the equity option is out-of-the-money or below the exercise value. The difference between a vanilla call and a KO call is that the KO call expires abruptly at the lower barrier while an out-of-the-money vanilla call still is worth something although the intrinsic value is zero. The vanilla option owner has discretion to wait and see. A knock-in call is the opposite to a knock-out call. The knock-in is worth nothing until the value of the underlying increase above a barrier. It is shown in Nassim Taleb (1997) how to value these calls and under which assumptions the parity Knock-out call + Knock-in call = Vanilla call holds. The conclusion of this discussion is that an exogenous change in one of the factors determining the option values might give a change in the value of the rm if either the put and call options react differently or if they together does not neutralize the change in the debt ratio. Why should an increase of the debt have any effect on the value of the rm? The free cash ows generated from the operations of the rm is still the same. The point is that increasing the debt is likely to change the investments the rm make. With a lot of debt on board, the responsible manager might chose safer projects while the gambling manager might chose riskier projects. Expecting these unpredictable effects, the stockholders change their beliefs about value of the free cash ow of the rm. A change of beliefs often leads to a change of the market value of debt and equity. It is often said that deviation from the normal is not good if you want to succeed in business life. Good looking people with normal habits and behaviour are successful. Persons with an peculiar lifestyle and common looks are more often ousted from business life. As Keynes famous beauty contest analogy depicts, in the stock market you have to choose not the best looking stock available but the stock that a maximum number of investors fancy. You could be right in your choice of the best future performing rm, but if few investors agree with you, it is unlikely that the stock will appreciate in the near future.


The stock markets perception of what constitutes a normal capital structure may punish those rms that have a capital structure that deviates from the norm. Even though your rm would have beneted from a higher debt ratio, bankers and investors perception of a normal capital structure could force the debt ratio down. But why should the bankers perception of a normal capital structure be any different from the cash ow maximizing capital structure. Well, there could be asymmetric information about risk and return, that the banker seeks to control by operating within certain limits. Bankers, being bureaucrats, survive by sticking to the principle that it is better, do never anything really foolish than sometimes doing something smart. Investing is after all a game of survival, not a game of being best in the class, because unlike Survivor, the winner does not take it all.

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