1. Capital Structure Concepts12
Capital Structure Concepts

2. Introduction
This chapter examines some of the basic concepts used in determining a firm’s optimal capital structure. It deals only with the total permanent sources of a firm’s financing.

3. Capital Structure vs. Financial Structure
Capital Structure Permanent S-T debt
L-T debt
P/S
C/S
Financial Structure Total current liabilities
L-T debt
P/S
C/S

4. Capital Structure vs. Financial Structure
Capital structure is defined as the amount of permanent short-term debt, long-term debt, preferred stock, and common equity used to finance a firm.
Financial structure refers to the amount of total current liabilities, long-term debt, preferred stock, and common equity used to finance a firm.

5. Capital Structure vs. Financial Structure
Capital structure is part of the financial structure, representing the permanent sources of the firm’s financing.

6. Capital Structure Terminology
Optimal capital structure
Minimizes a firm’s weighted average cost of capital
Maximizes the value of the firm
Target capital structure
Capital structure at which the firm plans to operate
Debt capacity
Amount of debt contained in a firm’s optimal capital structure

7. Capital Structure Terminology
The optimal capital structure and, accordingly, the debt capacity of a firm are determined by the following factors:
Business risk of the firm
Tax structure
Extent of potential financial distress (e.g., bankruptcy)
Agency costs
Role played by capital structure policy in providing signals to the capital markets regarding the firm’s performance

8. Capital Structure Assumptions
It is assumed that a firm’s investment policy is held constant when we examine the effects of capital structure changes on firm value and particularly on the value of common stock, which means that the level and variability of EBIT is not expected to change as changes in capital structure are contemplated.

9. Capital Structure Assumptions
Capital structure changes affect only distribution of the operating income between the claims of debt holders, preferred stockholders, and common stockholders.
It is also assumed that the investments undertaken by the firm do not materially change the debt capacity of the firm.

10. Business Risk
Business risk refers to the variability or uncertainty of a firm’s operating income (EBIT).

11. Factors Influencing a Firm’s Business Risk
Variability of sales volume
Variability of selling price
Variability of cost
Amount of market power
Extent of product diversification
Firm’s growth rate
Degree of operating leverage (DOL)
Both systematic and unsystematic risk
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12. Business Risk: Systematic or Unsystematic Risk?
Business risk possesses elements of both systematic risk and unsystematic risk. Some of the variability in operating income that results from business cannot be diversified away by investors who hold a broad-based portfolio of securities.
For example, variability attributable to business cycle behavior is clearly systematic. In contrast, the variability attributable to specific managerial decisions, such as product line diversity, is primarily unsystematic.

13. Financial Risk
Financial risk refers to the additional variability of earnings per share and the increased probability of insolvency that arises when a firm uses fixed-cost sources of funds, such as debt and preferred stock, in its capital structure.
Insolvency occurs when a firm is unable to meet contractual financial obligations—such as interest and principal payments on debt, payments on accounts payable, and income taxes—as they come due.

14. Fixed Financial Costs
Fixed financial costs represent contractual obligations a company must meet regardless of the EBIT.
The use of increasing amounts of debt and preferred stock raises the firm’s fixed financial costs; this, in turn, increases the level of EBIT that the firm must earn in order to meet its financial obligations and remain in business.

15. Fixed Financial Costs
The reason a firm accepts the risk of fixed-cost financing is to increase the possible returns to stockholders.

16. Financial Leverage
The use of fixed-cost financing sources is referred to as the use of financial leverage.
Financial leverage causes a firm’s earnings per share (EPS) to change at a rate greater than the change in operating income (EBIT).

17. Financial Leverage
If a firm is 100 percent equity financed and EBIT increases (decreases) by 10 percent, EPS will also increase (decrease) by 10 percent. When financial leverage, such as long-term debt, is used, a 10 percent change in EBIT will result in a greater than 10 percent change in EPS.

18. Financial Leverage
Figure 12.1 illustrates the concept of financial leverage.
Line A represents the financial leverage used by a firm financed entirely with common stock. A given percentage change in EBIT results in the same percentage change in EPS.
Line B represents a firm that use debt (or other sources of fixed-cost funds) in its capital structure. As a result, the slope of the EPS-EBIT line is increased, thus increasing the responsiveness of EPS to changes in EBIT.

19. Financial Leverage
As can be seen in Figure 12.1, a given change in EBIT yields a larger change in EPS if the firm is using debt financing (ΔEPSB) than if the firm is financed entirely with common stock (ΔEPSA).

20. Financial Leverage
It is also clear from Figure 12.1 that the use of financial leverage magnifies the returns—both positive and negative—to the shareholder. When EBIT is at a relatively high level, such as EBIT2, Firm B’s use of financial leverage increases EPS above the level attained by Firm A, which is not using financing leverage.

21. Financial Leverage
On the other hand, when EBIT is relatively low—for example, at EBIT0—the use of financial leverage decreases EPS below the level that would be obtained otherwise; that is, EPS’0 < EPS0. At EBIT0, the use of financial leverage results in negative EPS for Firm B.

22. Financial Risk: Systematic or Unsystematic Risk?
Financial risk, like business risk, contributes to both the systematic and unsystematic risk of a firm’s securities. To the extent that the use of financial leverage magnifies variations in operating income that come about because of unsystematic risk factors, financial leverage contributes to the unsystematic risk of a firm’s securities.

23. Financial Risk: Systematic or Unsystematic Risk?
Financial researchers have also studied the contribution that financial leverage makes to the systematic risk of a firm’s securities. It is well established that systematic risk is a function both of financial risk and operating risk. Hence, security analysts and investors find the measurement of a company’s financial risk to be an important element of good financial analysis.

24. Factors Indicating a Firm’s Financial Risk
Factors indicating financial risk
Debt-to-asset ratio
Debt-to-equity ratio
Fixed charge coverage ratio
DFL
Probability distribution of profits
Times interest earned ratio
EBIT-EPS analysis

25. Effect of Financial Leverage on Stockholder Returns and Risk
Firms employ financial leverage to increase the returns to common stockholders at the expense of increased risk.
The objective of capital structure management is to find the capital mix that leads to shareholder wealth maximization.

26. Effect of Financial Leverage on Stockholder Returns and Risk

27. Effect of Financial Leverage on Stockholder Returns and Risk
To illustrate the effects of financial leverage on stockholder returns and risk, consider the following example of KMI Technology, Inc. As can be seen in Table 12.1, KMI has total assets of $1 million. Suppose KMI expects an operating income (EBIT) of $200,000. If KMI uses debt in its capital structure, the cost of this debt will be 10 percent per annum.

28. Effect of Financial Leverage on Stockholder Returns and Risk
Table 12.1 shows the effect of an increase in the debt to total assets ratio (debt ratio) from 0 percent to 40 percent and to 80 percent on the return stockholders’ equity.
With an all-equity capital structure, the return on equity is 12 percent.
At a debt ratio of 40 percent, the return on equity increases to 16 percent.
At a debt ratio of 80 percent, the return on equity is 36 percent.

29. Effect of Financial Leverage on Stockholder Returns and Risk
KMI is earning 20 percent (pretax) on its assets. The cost of debt is 10 percent pretax. Thus, when KMI uses debt in its capital structure, the difference between the return on its assets and the cost of debt accrues to the benefit of equity holders.

30. Effect of Financial Leverage on Stockholder Returns and Risk

31. Effect of Financial Leverage on Stockholder Returns and Risk

32. Effect of Financial Leverage on Stockholder Returns and Risk
However, this increased equity return is achieved only at the cost of higher risk.
For example, if EBIT declines by 25 percent to $150,000, the return on equity for the all-equity capital structure also declines by 25 percent to 9.0 percent.
In contrast, at a 40 percent debt ratio, the return on equity declines by percent to 11 percent.
At an 80 percent debt ratio, the return on equity declines by percent to 21 percent.

33. Effect of Financial Leverage on Stockholder Returns and Risk
The effects of a 60 percent reduction in EBIT to $80,000 are even more dramatic. In this case, the pretax return on assets is less than the pretax cost of debt.
To pay the prior claims of the debt holders, the equity returns are reduced to a level below those that prevail under the all-equity capital structure.

34. Effect of Financial Leverage on Stockholder Returns and Risk
In the case of a 40 percent debt ratio, the return on equity is only 4.0 percent, and in the case of an 80 percent debt ratio, the return on equity is 0 percent.

35. Effect of Financial Leverage on Stockholder Returns and Risk
Thus it can be seen that the use of financial leverage both increases the potential returns to common stockholders and the risk, or variability, of those returns.

36. Effect of Financial Leverage on Stockholder Returns and Risk
Generally, the greater a firm’s business risk, the less the amount of financial leverage that will be used in the optimal capital structure, holding constant all other relevant factors.

37. Capital Structure Theory
Studies the relationship between
Capital structure
Debt/Total assets
Cost of capital
Value of the firm

38. Capital Structure without a Corporate Income Tax
In 1958, two prominent financial researchers, Franco Modigliani and Merton Miller (MM), showed that, under certain assumptions, a firm’s overall cost of capital, and therefore its value, is independent of capital structure.

39. Capital Structure without a Corporate Income Tax
In particular, assume that the following perfect capital market conditions exist:
There are no transaction costs for buying and selling securities.
A sufficient number of buyers and sellers exists in the market, so no single investor can have a significant influence on security prices.
Relevant information is readily available to all investors and is costless to obtain.
All investors can borrow or lend at the same rate.

40. Capital Structure without a Corporate Income Tax
All investors are rational and have homogeneous expectations of a firm’s earnings.
Firms operating under similar conditions are assumed to face the same degree of business risk. This assumption is called the homogeneous risk class assumption.
There are no income tax.

41. Capital Structure without a Corporate Income Tax
In the no-tax MM case, the cost of debt and the overall cost of capital are constant regardless of a firm’s financial leverage position, measured as the firm’s debt-to-equity ratio, B/E.

42. Capital Structure without a Corporate Income Tax
As a firm increases its relative debt level, the cost of equity capital, ke, increases, reflecting the higher return requirement of stockholders due to the increased risk imposed by the additional debt.

43. Capital Structure without a Corporate Income Tax
The increased cost of equity capital exactly offsets the benefit of the lower cost of debt, kd, so that the overall cost of capital does not change with changes in capital structure. This is illustrated in Figure 12.2.

44. Capital Structure without a Corporate Income Tax
Because the firm’s market value is calculated by discounting its expected future operating income by the weighted (marginal) cost of capital, ka, the market value of the firm is independent of capital structure.

45. Capital Structure without a Corporate Income Tax
MM support their theory by arguing that a process of arbitrage will prevent otherwise equivalent firms from having different market values simply because of capital structure differences.

46. Capital Structure without a Corporate Income Tax
Arbitrage is the process of simultaneously buying and selling the same or equivalent securities in different markets to take advantage of price differences and make a profit.
Arbitrage transactions are risk-free.

47. Capital Structure without a Corporate Income Tax
For example, suppose two firms in the same industry differed only in that one was levered (that is, it had some debt in its capital structure) and the other was unlevered (that is, it had no debt in its capital structure). If the MM theory did not hold, the unlevered firm could increase its market value by simple adding debt to its capital structure.

48. Capital Structure without a Corporate Income Tax
However, in a perfect capital market without transactions costs, MM argue that investors would not reward the firm for increasing its debt. Stockholders could change their own financial debt-equity structure without cost to receive an equal return.

49. Capital Structure without a Corporate Income Tax
Therefore, stockholders would not increase their opinion of the market value of an unlevered firm just because it took on some debt.

50. Capital Structure without a Corporate Income Tax
The MM argument is based on the arbitrage process. If one of two unlevered firms with identical business risk took on some debt and the MM theory did not hold, its value should increase and, therefore, so would the value of its stock. MM suggest that under these circumstances, investors will sell the overpriced stock of the levered firm.

51. Capital Structure without a Corporate Income Tax
They can use an arbitrage process of borrowing, then buying the unlevered firm’s stock, and investing the excess funds elsewhere. Through these costless transactions, investors can increase their return without increasing their risk. Hence, they have substituted their own personal financial leverage for corporate leverage.

52. Capital Structure without a Corporate Income Tax
MM argue that this arbitrage process will continue until the selling of the levered firm’s stock drives down its prices to the point where it is equal to the unlevered firm’s stock price, which has been driven up due to increased buying.

53. Capital Structure without a Corporate Income Tax
The arbitrage process occurs so rapidly that the market values of the levered and unlevered firms are equal. Therefore, MM conclude that the market value of a firm is independent of its capital structure in perfect capital markets with no income taxes.

54. Capital Structure without a Corporate Income Tax
The MM no-tax theory is illustrated in the example shown in Table The table contains financial data on two firms, U and L, that have equal levels of net operating income (EBIT = $1,000) and operating risk and differ only in their capital structure. Firm U is unlevered, and firm L is levered, with a perpetual debt of $2,000 having a coupon rate (i) of 5 percent in its capital structure.

55. Capital Structure without a Corporate Income Tax
For simplicity, we assume that the income of both firms available for stockholders is paid out as dividends. As a result, the expected growth rate of both firms is zero, because no income is available for the firms to reinvest.

56. Capital Structure without a Corporate Income Tax

57. Capital Structure without a Corporate Income Tax
The present value of both firms is calculated using the following perpetuity valuation equation:
Market value of firm
= Market value of equity (E) + Market value of debt (B)
= (D ÷ ke) + (I ÷ Kd)
where E and B are the respective market values of equity and debt in the firm’s capital structure; D is the annual of dividends paid to the firm’s stockholders; I is the interest paid on the firm’s debt; ke is the return required on common equity; and kd is the return on required on debt.

58. Capital Structure without a Corporate Income Tax
The required rate of return on the common equity for the unlevered firm (U) is 10 percent. Because of the increased financial risk associated with the $2,000 in debt financing, the required rate of return on the common equity of the levered firm (L) is percent. The required return on debt, kd, is assumed to equal the coupon rate on the debt, i.

59. Capital Structure without a Corporate Income Tax
For firm U, the present value of the expected future cash flows is $10,000 calculated as follows:
Market value of firm U
= $1,000/0.10 = $10,000
For firm L, the present value is also $10,000, calculated as follows:
Market value of firm L
= ($900/0.1125) + ($100/0.05) = $10,000

60. Capital Structure without a Corporate Income Tax
Thus, the market value of firms U and L are equal. This example shows that the market value of the firm is independent of capital structure, assuming that the MM theory holds and no corporate income tax exists.

61. Capital Structure with a Corporate Income Tax
Table 12.3 shows financial data for an unlevered firm, U, and a levered firm, L, assuming a corporate income tax rate, T, of 40 percent.

62. Capital Structure with a Corporate Income Tax

63. Capital Structure with a Corporate Income Tax
The total income available to the security holders of firm U is $600, and assuming a cost of equity capital equal to 10 percent, the value of firm U is calculated as follows:
Market value of firm U
= $600/0.10 = $6,000

64. Capital Structure with a Corporate Income Tax
Because interest paid to debt holders is a tax-deductible expense, the total income available to the debt and equity security holders of firm L, shown in Table 12.3, is $640. This amount is greater than the $600 available to the firm U equity security holders by $40. The $40 amount is the tax shield caused by the tax deductibility of the interest payments.

65. Capital Structure with a Corporate Income Tax
The annual tax shield amount is calculated using the following equation:
Tax shield amount
= i*B*T = (0.05)*($2,000)*(0.40) = $40

66. Capital Structure with a Corporate Income Tax
The total market value of firm L is obtained as follows:
Market value of firm L
= (D ÷ ke) + (I ÷ Kd)
= ($540/0.1125) + ($100/0.05) = $6,800

67. Capital Structure with a Corporate Income Tax
In this example, the value of firm L is greater than firm U’s value by an amount equal to $800. This difference in value is caused by the tax shield. In fact, the difference in value between the levered and unlevered firm is equal to the present value of the tax shield from the perpetual debt:
Present value of tax shield
= (i*B*T) ÷ i = B*T

68. Capital Structure with a Corporate Income Tax
In this equation, the annual tax shield amount, i*B*T, is discounted at a rate, i(i = kd). In this case of firm L, the present value of the tax shield is $800, calculated as follows:
Present value of tax shield
= B*T
= $2,000*0.40 = $800

69. Capital Structure with a Corporate Income Tax
We can now state that the market value of the levered firm is equal to the market value of the unlevered firm plus the present value of the tax shield:
Market value of levered firm
= Market value of unlevered firm +
Present value of tax shield

70. Capital Structure with a Corporate Income Tax
From the equation in the previous slide, we can conclude that the value of the firm increases linearly as the amount of debt in the capital structure increases, as shown in Panel (a) of Figure This result implies that a firm should increase its level of debt to the point at which the capital structure consists entirely of debt.

71. Capital Structure with a Corporate Income Tax
In other words, the market value of the firm is maximized and its optimal capital structure is achieved when capital structure is all debt.

72. Capital Structure with a Corporate Income Tax
As shown in Panel (b) of Figure 12.3, the weighted cost of capital ka declines with increases in financial leverage.
In practice, we do not normally observe companies with extremely high levels of debt in their capital structures. Even in the face of leveraged buyouts, however, we still do not observe many companies that approach a 100 percent debt-financed capital structure.

73. VL = VU + Value of Tax Shield
Mkt Value
of Firm PV of
Tax Shield VU
Debt $

74. Model 2 The cost of capital decreases with the amount of debt.ke ka
ki = kd (1 – T)
Debt
Total Assets
The cost of capital decreases with the amount of debt.
The firm maximizes its value by choosing
a capital structure that is all debt.

75. Capital Structure with a Corporate Income Tax
Hence, other factors must be influencing the determination of an optimal capital structure. Two of the most important factors are financial distress costs and agency costs.

76. What Happens With Taxes, Bankruptcy, and Agency Costs?
Bankruptcy and agency costs increase with the amount of leverage, eventually offsetting the marginal benefits from the value of the tax shield.

77. What Happens With Taxes, Bankruptcy, and Agency Costs?
Market value of leveraged firm
= Market value of unleveraged firm
+ PV of tax shield
– PV of bankruptcy costs
– PV of agency costs
See Figure 12.4.

78. Bankruptcy Costs Lenders may demand higher interest rates.
Lenders may decline to lend at all.
Customers may shift their business to other firms.
Distress incurs extra accounting & legal costs.
If forced to liquidate, assets may have to be sold for less than market value.

79. Agency Costs Stockholder-Bondholder Relationship
Investing in projects with high risk and high returns can shift wealth from bondholders to stockholders.
Stockholders may forgo some profitable investments in the presence of debt.

80. Agency Costs Stockholder-Bondholder Relationship
Stockholders might issue high quantities of new debt and diminish the protection afforded to earlier bondholders.
Bondholders will shift monitoring and bonding costs back to the stockholders by charging higher interest rates.

81. The Cost of Capital and the Optimal Capital Structure
In this section, we examine the relationship between the cost of capital and the firm’s capital structure when corporate taxes, financial distress costs, and agency costs are considered.
In the following analysis, we assume that capital structure contains only permanent debt and common equity; that is, we assume, for simplicity, that no preferred stock financing is used.

82. The Cost of Capital and the Optimal Capital Structure
The first step in the analysis considers the relationship between the cost of debt and capital structure.
All other things being equal, investors in debt consider the debt less risky if the firm has a low, rather than high, proportion of debt in its capital structure.

83. The Cost of Capital and the Optimal Capital Structure
As the proportion of debt in the capital structure increases, investors require a higher return on the more risky debt. And because the firm’s cost of capital is the investor’s required return, the cost of debt increases as the proportion of debt increases.

84. The Cost of Capital and the Optimal Capital Structure
The precise relationship between the cost of debt and the debt ratio is difficult to determine, because it is impossible to observe the cost of debt at two different capital structures (at the same time) for a single firm. Nevertheless, evidence suggests that the cost of debt increases rather slowly for moderate amounts of debt.

85. The Cost of Capital and the Optimal Capital Structure
There is a point at which the capital markets begin to consider any new debt “excessive” and therefore much more risky. The cost of debt curve, ki, in Figure 12.5 illustrates such a relationship.
The actual region where the cost of debt begins to increase more rapidly varies by firm and industry, depending on the firm’s level of business risk.

86. The Cost of Capital and the Optimal Capital Structure
The next step focuses on the relationship between the cost of equity capital and capital structure.
When a firm has low financial leverage, that is, a low debt-to-equity ratio, any equity employed is less risky than equity used when the firm is financed with a relatively high proportion of debt.

87. The Cost of Capital and the Optimal Capital Structure
Earlier in this chapter was shown that the greater the fraction of debt used, the greater is the variability in earnings per common share.
In addition, the greater the fraction of debt used, the greater is the risk of financial distress.

88. The Cost of Capital and the Optimal Capital Structure
Because the returns expected by stockholders in the form of present and future dividends depend partly on current earnings, it can be concluded that variability in earnings per common share can result in variability of the returns to investors, that is, greater risk.

89. The Cost of Capital and the Optimal Capital Structure
Therefore, it can be stated that investors’ required returns and the cost of equity capital increase as the relative amount of debt used to finance the firm increases.

90. The Cost of Capital and the Optimal Capital Structure
Once again, the exact nature of the relationship between the cost of equity and financial leverage is difficult to determine in practice.
However, there is agreement that the cost of equity capital increases at a relatively slow rate as the debt proportion increases up to moderate amounts.

91. The Cost of Capital and the Optimal Capital Structure
Then, in the range where additional debt begins to be viewed as excessive and more risky, the cost of equity increases more rapidly. This is shown in Figure 12.5.
As is true in the debt illustration, the region where the cost of equity capital, ke, begins to increase more rapidly varies by firm and industry.

92. The Cost of Capital and the Optimal Capital Structure
The relationship between the weighted cost of capital, ka, and financial leverage can now be considered.
Because the relationships between financial leverage and ke and ki have been developed, the relationship between ka and financial leverage follows accordingly.

93. The Cost of Capital and the Optimal Capital Structure
The following equation can be used to calculated ka for any level of financial leverage, provided that the values of ke and ki at the level of financial leverage are known (B is the market value of debt, and E is the market value of equity in the firm’s capital structure.):

94. The Cost of Capital and the Optimal Capital Structure
The ka curve, shown in Figure 12.5, begins at ka = ke because, by definition, the weighted cost of capital for an all-equity firm equals the cost of equity.
As even small increments of debt are used, ka “bottoms out” and then begins to increase.

95. The Cost of Capital and the Optimal Capital Structure
The resulting saucer-shaped curve contains a point at which the firm’s overall cost of capital is minimized and its value maximized. This point is the firm’s optimal capital structure.
If the firm is thought of as a cash-flow generator, then the lower the discount rate (the weighted cost of capital), the higher the firm’s value.

96. The Cost of Capital and the Optimal Capital Structure
Figure 12.6 ties together the relationship between the optimal capital structure (with taxes, financial distress costs, and agency costs) and the market value of a firm and its weighted cost of capital.
Note that at the optimal capital structure, B*/E*, the market value of the firm is maximized and its weighted cost of capital is minimized.

97. Mkt value of leveraged firm
Optimal Debt Ratio
Market Value of the Firm PV of
Tax
Shield PV
B&A
Costs
Optimal Debt Ratio VL
Mkt value of leveraged firm VU
Debt
Ratio

98. Model 3 Least Cost Capital Structure is Optimal
Cost of
Capital ke ka ki
Optimal Capital
Structure B
B + E

99. Other Impacts on the Optimal Capital Structure
Personal tax effects
Could reverse some tax benefits
Industry effects
Profitability and bankruptcy patterns
Signaling effects
Asymmetric information
Managerial preferences
Pecking order theory

100. Personal Tax Effects
The MM tax case led to the conclusion that, in the absence of financial distress costs and agency costs, the firm should attempt to minimize its taxes by employing the maximum amount of debt. The MM tax case did not consider the effect of personal income taxes, however.

101. Personal Tax Effects
Miller has extended the tax case analysis to include both corporate and personal income taxes.
Miller argued that although a firm can save taxes by increasing its debt ratio, individual investors would pay greater taxes on their returns from the firm if these returns were predominantly interest, rather than dividends and capital appreciation on common stock.

102. Personal Tax Effects
Historically, the tax code has favored capital gains income from stock over interest income because capital gains generally have been taxed at a lower rate than ordinary income (including interest income) and because taxes on capital gains are deferred until the capital gain is realized.

103. Personal Tax Effects
Miller concluded that when both personal and corporate income taxes are considered, there is no optimal debt ratio for an individual firm, although there is an optimal amount of total debt in the marketplace, reflecting the difference in corporate and personal tax rates.

104. Industry Effects
A number of studies have found significant capital structure difference among industries. The more profitable firms are, the less debt they tend to use.
Other studies have found that leverage ratios are negatively related to the frequency of bankruptcy in the industry.

105. Industry Effects
Some evidence indicates that firms generating stable cash flows over the business cycle tend to have higher debt ratios.
In general, the studies of industry effects in capital structure tend to conclude that there is an optimal capital structure for individual firms. The market rewards firms that achieve this capital structure.

106. Signal Effects
The officers and managers of a company, as insiders, have access to information about the expected future earnings and cash flows of the firm that is not available to outside investors. This situation is referred to as asymmetric information.

107. Signal Effects
Given that managers know more about the firm than do outside investors, changes in a company’s investment, financing, or dividend decisions can represent a signal to investor concerning management’s assessment of the expected future returns, and hence market value, of the company.

108. Signal Effects
Thus, when a firm issues new securities, this event can be viewed as providing a signal to the financial marketplace regarding the future prospects of the firm or the future actions planned by the firm’s managers.

109. Signal Effects
Ross argues that signals provided by capital structure changes are credible because of the potential bankruptcy cost penalty incurred if the implied future cash flows do not occur.

110. Signal Effects
In general, studies of capital structure changes have found that new common equity offerings tend to yield negative stock price responses and new debt offering tend to yield no significant stock price responses.

111. Signal Effects
Repurchases of common stock have led to large positive announcement returns on the company’s common stock.

112. Signal Effects
Actions that increase leverage have generally been associated with positive stock returns, and actions that decrease leverage are associated with negative stock returns.

113. Signal Effects
The results of many studies of capital structure changes are consistent both with direct effects of the change, such as the benefits of greater tax shields, and with indirect information effects.

114. Signal Effects
Therefore, when a firm makes capital structure changes it must be mindful of the potential signal that the proposed transaction will transmit to the marketplace regarding the firm’s current and future earnings prospects and the intentions of its managers.

115. Managerial Preference Effects: The Pecking Order Theory
According to the pecking order theory, as developed by Myers, a firm may not have a particular target or optimal capital structure. Instead, a company’s capital structure changes when an imbalance between internal cash flows, net of cash dividend payments, and acceptable (i.e., NPV > 0) investment opportunities occurs.

116. Managerial Preference Effects: The Pecking Order Theory
Firms whose investment opportunities exceed internally generated funds tend to issue more debt securities and hence have higher debt ratios.

117. Managerial Preference Effects: The Pecking Order Theory
Conversely, highly profitable firms with limited needs for investment funds will tend to have lower debt ratios. In this situation, the firm builds up financial slack in the form of highly liquid assets (i.e., cash and marketable securities) and unused debt capacity. Financial slack allows a firm to take advantage of any attractive investment opportunities that may occur in the future.

118. Managerial Preference Effects: The Pecking Order Theory
The pecking order theory indicates that firms prefer internal financing (retained earnings) to external financing (new security issues).

119. Managerial Preference Effects: The Pecking Order Theory
This preference for internal financing is based on two considerations.
First, because of flotation costs of new security issues, internal financing is less costly than external financing.
Second, internal financing avoids the discipline and monitoring that occurs when new securities are sold publicly.

120. Managerial Preference Effects: The Pecking Order Theory
Also, according to the pecking order theory, dividends are “sticky,” that is, many firms are reluctant to make major changes in dividend payments and only gradually adjust dividend payout ratios to reflect their investment opportunities and thereby avoid the issuance of new securities.

121. Managerial Preference Effects: The Pecking Order Theory
If external financing is required, the “safest” securities, namely debt, are issued first. As discussed in Chapter 7, the flotation costs of debt securities are generally lower than the costs of equity securities.

122. Managerial Preference Effects: The Pecking Order Theory
Also, as noted in the discussion of asymmetric information above, the stock market tends to react negatively to announcements of new common stock offerings, whereas debt security announcements tend to have little impact on stock prices.

123. Managerial Preference Effects: The Pecking Order Theory
As additional external financing is needed, the firm will work down the pecking order—from safe to more risky debt, then possibly to convertible debt, and finally to common equity as a last resort.

124. Managerial Implications of Capital Structure Theory
First, it is clear that the capital structure decision is one of the centrally important decisions facing financial managers. There is little doubt that changes in capital structure result in changes in the market value of the firm.

125. Managerial Implications of Capital Structure Theory
Second, the benefits of the tax shield from debt lead to increased firm value, at least up to the point that increased financial distress and agency costs begin to offset the debt advantage.
Third, the optimal capital structure is heavily influenced by the business risk facing the firm.

126. Managerial Implications of Capital Structure Theory
Fourth, when managers make explicit changes in a firm’s capital structure, these actions transmit important information to investors about expected future returns and the market value of a company.