2000 word essay. To complete this assignment you need read the two papers specified then apply the concepts we have covered in the course to answer the questions below.Reading the papers referred to in the two articles will help you to understand their arguments and improve your answer to the question.There are a range of theories that seek to explain the capital structure choices of corporations, these theories are summarised in the paper by Myers. Explain how the empirical findings of DeAngelo and Roll prove or disprove the theories of capital structure choice presented in Myers.So this is the question. The files are these two article. Please read these two article very carefully. You must use these two articles to analysis. You can also use other references in this essay. APA style. Assessment Criteria: 1 presentation, communication& style (written) 2 Use of literature/knowledge of theory 3 Analysis 4 Critical reasoning/ critical thinking. High quality please.
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American Economic Association
Capital Structure
Author(s): Stewart C. Myers
Source: The Journal of Economic Perspectives, Vol. 15, No. 2 (Spring, 2001), pp. 81-102
Published by: American Economic Association
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Journal of Economic Perspectives-Volume 15, Number 2-Spring 2001-Pages 81-102
Capital Structure
Stewart C. Myers
he study of capital structure attempts to explain the mix of securities and
financing sources used by corporations to finance real investment. Most of
the research on capital structure has focused on the proportions of debt
vs. equity observed on the right-hand sides of corporations’ balance sheets. This
paper is an introduction to that research.
There is no universal theory of the debt-equity choice, and no reason to expect
one. There are several useful conditional theories, however. For example, the
tradeoff theory says that firms seek debt levels that balance the tax advantages of
additional debt against the costs of possible financial distress. The tradeoff theory
predicts moderate borrowing by tax-paying firms. The pecking order theory says that
the firm will borrow, rather than issuing equity, when internal cash flow is not
sufficient to fund capital expenditures. Thus the amount of debt will reflect the
firm’s cumulative need for external funds. The free cash flow theory says that dangerously high debt levels will increase value, despite the threat of financial distress,
when a firm’s operating cash flow significantly exceeds its profitable investment
opportunities. The free cash flow theory is designed for mature firms that are prone
to overinvest.
There is another possibility: perhaps financing doesn’t matter. Modigliani and
Miller (1958) proved that the choice between debt and equity financing has no
material effects on the value of the firm or on the cost or availability of capital. They
assumed perfect and frictionless capital markets, in which financial innovation
would quickly extinguish any deviation from their predicted equilibrium.
The logic of the Modigliani and Miller (1958) results is now widely accepted.
Nevertheless, financing clearly can matter. The chief reasons why it matters include
* Stewart C. Myers is the Gordon Y Billard Professor of Finance, Sloan School of Manage-
ment, Massachusetts Institute of Technology, Cambridge, Massachusetts.
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82 Journal of Economic Perspectives
taxes, differences in information and agency costs. Theories of optimal capital
structure differ in their relative emphases on, or interpretations of, these factors.
The tradeoff theory emphasizes taxes, the pecking order theory emphasizes differ-
ences in information, and the free cash flow theory emphasizes agency costs. I will
review the theories in that order.
Most research on capital structure has focused on public, nonfinancial corporations with access to U.S. or international capital markets. This is the right place
to start. These companies have the broadest menu of financing choices and can
adjust their capital structures at relatively low cost. Yet even 40 years after the
Modigliani and Miller research, our understanding of these firms’ financing
choices is limited. We know much more about financing tactics-for example the
tax-efficient design or timing of a specific security issue-than about financing
strategy, for example the firm’s choice of a target overall debt level.
Research on financing tactics confirms the importance of taxes, information
differences and agency costs. Whether these factors have first-order effects on the
overall levels of debt vs. equity financing is still an open question. Debt ratios of
established, public U.S. corporations vary within apparently homogenous indus-
tries. There is also variation over time, even when taxation, information differences
and agency problems are apparently constant.
Some Facts about Financing
Most of the aggregate gross investment by U.S. nonfinancial corporations has
been financed from internal cash flow (depreciation and retained earnings).
External financing in most years covers less than 20 percent of real investment, and
most of that financing is debt. Net stock issues are frequently negative: that is, more
shares are extinguished in acquisitions and share repurchase programs than are
created by new stock issues. For example, in 1999 internal cash flow financed about
85 percent of aggregate investment by U.S. nonfarm, nonfinancial corporations
($805 billion out of $944 billion). External financing was $139 billion. Corporations raised this sum by net additional borrowing of $283 billion; net share issues
were negative at $144 billion (Federal Reserve System, 1999, Flow of Funds Accounts,
Table F.102).
Of course, these are aggregate figures. Some companies rely heavily on stock
issues. They tend to be the smaller, riskier and more rapidly growing firms.
Debt ratios vary across industries. For example, the large, integrated oil companies have relied mostly on debt for external financing. Many of these companies
have simultaneously retired equity through share repurchases. Exxon spent
$29 billion on share repurchases from the mid-1980s to its merger with Mobil in
1999. Other relatively heavy debt users include the utility, chemical, transportation,
telecommunications, forest products and real estate development industries.
At the other extreme, the major pharmaceutical companies typically operate at
negative debt ratios: their holdings of cash and marketable securities exceed their
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Stewart C. Myers 83
Table 1
Median Debt-to-Capital Ratios, 1991
Debt to Total Capital
Book Book, Adjusted Market Market, Adjusted
Canada
39%
France
Germany
Italy
53
States
41
18
39
29
28
37
32%
28
23
46
37
Kingdom
United
35%
34
38
47
Japan
United
37%
48
16
33
15
36
17
19
28
11
23
Source: Rajan and Zingales (1995).
outstanding debt, so they are net lenders. Other net lenders include Ford Motor
Co., which had roughly $25 billion of cash and marketable securities in 2000 vs.
$10 billion of outstanding debt. Debt ratios are also low or negative for many
prominent growth companies. At mid-year 2000, Microsoft had no long-term debt
but held $24 billion in cash and marketable securities.
In general, industry debt ratios are low or negative when profitability and
business risk are high. Intangible assets are also associated with low debt ratios. For
example, marketing- and advertising-intensive companies such as Procter & Gamble have traditionally operated at low debt ratios. Their profits flow mainly from
intangible assets. Firms with valuable growth opportunities also tend to have low
debt ratios (Long and Malitz, 1985; Smith and Watts, 1992; Barclay, Smith and
Watts, 1995; Barclay and Smith, 1999).
Reported debt ratios for U.S. corporations are generally lower than in other
industrialized countries. This seems to be due to differences in accounting. Table 1
is drawn from Rajan and Zingales (1995), who calculated debt ratios for a large
sample of publicly traded firms in several countries.’ They compared the ratios fo
both reported and adjusted balance sheets. The adjustments removed the effects of
the most important differences in accounting. For example, German firms report
pension liabilities as a debt-equivalent liability, with no offset for pension assets.
U.S. companies report a net liability only if the pension plan is underfunded. Also,
German firms segregate “reserves” from equity. Under U.S. accounting, the reserves would be included in equity. The median adjusted debt ratio of the U.S.
1 These are debt-to-capital ratios, that is, ratios of debt to the sum of debt and equity financing.
Sometimes debt-to-equity ratios are reported instead. Debt and equity levels are usually taken from
corporations’ annual reports or filings with the Securities and Exchange Commission. In other words,
they are based on accounting or “book” values. For some purposes, for example calculating weighted
average costs of capital, debt ratios should be based on the market values of the firm’s debt and equity
securities. Where these distinctions are important, I point them out in the text. Otherwise, I just say
“debt ratio.”
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84 Journal of Economic Perspectives
sample is in the middle of the pack of the adjusted ratios for the other six countries.
At the end of the day, Rajan and Zingales found no systematic differences between
debt ratios in the United States and the other major industrialized countries.
Financial Innovation and the Modigliani’-Miller Propositions
Surveys of the theory of optimal capital structure always start with the
Modigliani and Miller (1958) proof that financing doesn’t matter in perfect
capital markets.2 Consider the simple, market-value balance sheet in Figure 1.
The market values of the firm’s debt and equity, D and E, add up to total firm
value V. Modigliani and Miller’s (1958) Proposition 1 says that Vis a constant,
regardless of the proportions of D and E, provided that the assets and growth
opportunities on the left-hand side of the balance sheet are held constant.
“Financial leverage”-that is, the proportion of debt financing-is irrelevant.
This leverage-irrelevance result generalizes to any mix of securities issued by the
firm. For example, it doesn’t matter whether the debt is short- or long-term,
callable or call-protected, straight or convertible, in dollars or euros, or some
mixture of all of these or other types.
Proposition 1 also says that each firm’s cost of capital is a constant,
regardless of the debt ratio. The cost of capital is a standard tool of practical
finance, so it’s worth writing out the formula. Let rD and rE be the cost of debt
and the cost of equity-that is, the expected rates of return demanded by
investors in the firm’s debt and equity securities. The overall (weighted-average)
cost of capital depends on these costs and the market-value ratios of debt and
equity to overall firm value.
Weighted Average Cost of Capital = rA= rDD/V + rEE/ V
The weighted average cost of capital rA is the expected return on a portfolio of all
the firm’s outstanding securities. It is also the discount or “hurdle rate” for capital
investment.3
The weighted average cost of capital rA is, according to Modigliani and Miller,
a constant. Also, debt has a prior claim on the firm’s assets and earnings, so the cost
2 It took some time to sort out what “perfect” means in the Modigliani-Miller context. (Ezra Solomon
once quipped: “A perfect capital market should be defined as one in which the MM theory holds.”)
Strictly speaking, the capital market must be not only competitive and frictionless, but also “complete,”
so that the risk characteristics of every security issued by the firm can be matched by purchase of another
existing security or portfolio, or by a dynamic trading strategy. In complete markets, a change in capital
structure does not change range of risk characteristics attainable in investors’ portfolios. Fama (1978)
summarizes the conditions required for Modigliani and Miller’s (1958) Proposition 1.
3 I am ignoring taxes. Corporations actually use the after-tax weighted average cost of capital (WACC):
WACC = rD(l – Tc)D/V + rEE/V
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Capital Structure 85
Figure 1
A Market-value Balance Sheet
Assets-in-place Debt (D)
and growth
opportunities Equity (E)
Firm value (V)
of debt is always less than the cost of equity. Suppose we solve the equation for the
cost of equity.
rE= rA+ (rA- rD)D/E
In other words, the cost of equity-the expected rate of return demanded by equity
investors-increases with the market-value debt-equity ratio D/E. The rate of increase depends on the spread between the overall cost of capital rA and the cost of
debt rD. This equation is Modigliani and Miller’s Proposition 2. It shows why “there
is no magic in financial leverage.” Any attempt to substitute “cheap” debt for
“expensive” equity fails to reduce the overall cost of capital because it makes the
remaining equity still more expensive-just enough more expensive to keep the
overall cost of capital constant.
Modigliani and Miller’s (1958) propositions are no longer controversial as a
matter of theory. The economic intuition is simple, equivalent to asserting that in
a perfect-market supermarket, the value of a pizza does not depend on how it is
sliced.
The Modigliani-Miller theory may be intuitive, but is it credible? Are capital
markets really sufficiently perfect? After all, the values of pizzas do depend on how
they are sliced. Consumers are willing to pay more for the several slices than for the
equivalent whole. Perhaps the value of the firm does depend on how its assets, cash
flows and growth opportunities are sliced up and offered to investors as debt and
equity claims.4 We see constant innovation in the design of securities and in new
financing schemes. Innovation proves that financing can matter. If new securities
This incorporates the after-tax cost of debt, calculated at the marginal corporate rate Tc. WACC is the
correct discount rate for after-tax cash flows from capital investments that do not change the firm’s
business risk. See Brealey and Myers (2000, Chapter 19).
4 There are surely investors who would be willing to pay extra for particular types or mixes of corporate
securities. For example, investors cannot easily borrow with limited liability, but corporations provide
limited liability and can borrow on their stockholders’ behalf.
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86 Journal of Economic Perspectives
or financing tactics never added value, then there would be no incentive to
innovate.
The practical relevance and credibility of the Modigliani-Miller propositions
therefore cannot rest on a lack of demand for financial leverage or for specialized
securities. The support for the propositions must, in the end, come from the supply
side. The key fact supporting the Modigliani-Miller propositions is that the cost of
supply is very small relative to the market value of the firm. Suppose there is a
clientele of investors who would be willing to pay extra for the debt and equity
securities of a firm with a particular, “optimal” debt ratio. They will not have to pay
extra, because public corporations’ cost of manufacturing debt and equity securities, rather than equity only, is a small fraction of the securities’ market values.
(Underwriting and other issue costs are actually lower for debt than for equity.)
Thus, the supply of debt adjusts until the value added for the marginal investor is
essentially zero.
Modigliani and Miller’s (1958) theory is exceptionally difficult to test directly,
but financial innovation provides convincing circumstantial evidence. The costs of
designing and creating new securities and financing schemes are low, and the costs
of imitation are trivial. (Fortunately, securities and financing tactics cannot be
patented.) Thus temporary departures from Modigliani and Miller’s predicted
equilibrium create opportunities for financial innovation, but successful innovations quickly become “commodities,” that is, standard, low-margin financial products. The rapid response of supply to an innovative financial product restores the
Modigliani and Miller equilibrium. Firms may find it convenient to use these new
products, but only the first users will increase value, or lower the cost of capital, by
doing so.
For regulators and policymakers, the Modigliani and Miller propositions are
the ideal end result. If that result could be achieved in practice, then investors’
diverse demands for specialized securities would be satisfied at negligible cost. All
firms would have equal access to capital, and the cost of capital would not depend
on financing, but only on business risk. Capital would flow directly to its most
efficient use. Therefore public policy should accommodate financial innovation
because it makes financing decisions unimportant.
But for students or practitioners of corporate finance, the Modigliani and
Miller propositions are benchmarks, not end results. The propositions say that
financing does not affect value except for specifically identified costs or imperfec-
tions. As Merton Miller (1989, p. 7) noted, … . showing what doesn’t matter can
also show, by implication, what does.”
Debt and Taxes
The United States taxes corporate income, but interest is a tax-deductible
expense. A taxpaying firm that pays an extra dollar of interest receives a partially
offsetting “interest tax shield” in the form of lower taxes paid. Financing with debt
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Stewart C. Myers 87
instead of equity increases the total after-tax dollar return to debt and equity
investors, and should increase firm value.
This present value of interest tax shields could be a very big number. Suppose
debt is fixed and permanent, as Modigliani and Miller (1963) assumed, and that
corporate income is taxed at the current 35 percent statutory rate.5 The firm
borrows $1 million and repurchases and retires $1 million of equity. It commits to
maintain this debt level and to make annual interest payments for the indefinite
future. Absent taxes, this new debt does not increase or decrease firm value: the
firm is borrowing on fair terms, so the money raised is exactly offset by the present
value of the future interest payments. But for a taxpaying firm the net liability
created by the $1 million debt issue is only $650,000, because the Internal Revenue
Service effectively pays 35 percent of the interest payments. The after-tax net
present value of this transaction would be NPV = + 1 – .65 = + $.35 million. The
gains from borrowing $10 million or $500 million scale up proportionally.
Such calculations are now understood as remote upper bounds. First, the firm
may not always be profitable, so the average effective future tax rate is less than the
statutory rate. Second, debt is not permanent and fixed. Investors today cannot
know the size and duration of future interest tax shields. “Debt capacity” depends
on the future profitability and value of the firm; it may be able to increase
borrowing if it does well, or be forced to pay down debt if it does poorly. The future
interest tax shields flowing to investors are therefore risky.
Third, the corporate-level tax advantages of debt could be partly offset by the
tax advantage of equity to individual investors, namely, the ability to defer capital
gains and then to pay taxes at a lower capital gai …
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