Explaining Firm Capital Structure: The Role of Agency Theory vs.

Transaction Cost Economics

Author(s): Rahul Kochhar
Source: Strategic Management Journal, Vol. 17, No. 9 (Nov., 1996), pp. 713-728
Published by: Wiley
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 Strategic Management Journal, Vol. 17, 713-728 (1996)

EXPLAINING FIRM CAPITAL STRUCTURE: THE

ROLE OF AGENCY THEORY VS. TRANSACTION
COST ECONOMICS
RAHUL KOCHHAR
Department of Management, Metropolitan State College of Denver, Denver, Colo-
rado, U.S.A.

The study of capital structure has increasingly gained importance in strategic management
research. Paradigms derived from organizational economics have also gained popularity in
explaining firm actions. Agency theoty and transaction cost economics represent two such
paradigms that rely on the notion of market impeifections. Notwithstanding the similarities
between them, these two offer different explatnations of the role of debt and equity in a firm.
The governance abilities of the financing structures and the nature of assets of the firm provide
two key sources of differences. Viewing capital structure from transaction cost economics gives
rise to predictions that are contradictory to those presented by agency theory. It is argued
that the extant evidence mainly supports the transaction cost viewpoint. Two organizational
phenomena-leveraged buyouts and product diversification-are used to highlight the compari-
sotI.

INTRODUCTION pline of finance. Modigliani and Miller (1958)

were the first to raise the issue of capital structure
Capital is a critical resource for all firms, the relevance. They argued that, under certain con-
supply of which is uncertain. This uncertainty ditions, the choice between debt and equity does
enables the suppliers of finance to exert control not affect firm value, and hence, the decision
over the firm (Stearns, 1986; Stearns and Mizru- is 'irrelevant'. These conditions included, among
chi, 1993). The two major classes of financial others, assumptions about the absence of taxes,
liabilities-debt and equity-are associated with of negligible transaction costs in the capital mar-
different levels of benefits and control. Questions ket, and of no information asymmetry between
related to the choice of financing have increas- various market players. Subsequent work by fi-
ingly gained importance in strategic management nancial theorists is driven towards relaxing these
research. It has been suggested that the capital assumptions to provide several hypotheses for the
structure of a firm results from managerial risk- capital structure decision (see Harris and Raviv,
taking propensity (Barton and Gordon, 1987, 1991; and Myers, 1984, for reviews). Firms do
1988), is affected by corporate governance mech- differ in their capital structures and, as theories
anisms (Chaganti and Damanpour, 1991; Stearns based on perfect markets are unable to provide
and Mizruchi, 1993), and influences the diversi- satisfactory explanations, it is the imperfections
fication strategy of a firm (Chatterjee, 1990; Chat- in the market that become more important
terjee and Wernerfelt, 1991). (Miller, 1989).
The study of capital structure has been tra- This paper examines two explanations of capi-
ditionally carried out by researchers in the disci- tal structure based on market imperfections,
namely those based on agency theory (Jensen and
Meckling, 1976) and transaction cost economics
Key words: capital structure;transaction cost econom- (Williamson, 1975, 1979). Dissatisfaction with
ics; agency theory traditional neoclassical precepts of market clear-

CCC 0143-2095/96/090713-16 Received 23 June 1994

(? 1996 by John Wiley & Sons, Ltd. Final revision received 12 February 1996

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714 R. Kochhar

ing have led to the development of these two similarities along various dimensions. The notion
approaches of incomplete contracting. Complex of opportunism and self-interest is a common
exchanges often differ from the assumptions made dominant assumption (Eisenhardt, 1989; Oviatt,
in neoclassical economics; two such attributes 1988; Williamson, 1988). This behavioral feature,
being information asymmetry and the potential for in the presence of uncertainty, leads to conflicts
opportunism (Barney and Ouchi, 1986). Agency arising from a divergence of goals between con-
theory and transaction cost economics were tracting parties (Jensen, 1983; Jensen and Smith,
developed to address these issues, although their 1985; Yarbrough and Yarbrough, 1988). The
emphasis differs somewhat (McGuire, 1988; focus is on the incentive systems and governance
Reeve, 1990; Robins, 1987; Yarbrough and Yar- mechanisms that work towards economic
brough, 1988). efficiency in the presence of this conflict. The
result is the setup of an efficient contracting
mechanism that serves to minimize (agency or
Strategic management and capital structure
transaction) costs.
research
Notwithstanding these similarities, several con-
Agency theoretic and transaction cost economiz- ceptual differences exist between agency theory
ing issues are likely to provide two routes for the and transaction cost economics. As the two pre-
integration of strategic management and finance sent a coherent and internally consistent approach
(Oviatt, 1984). While some believe that the two to theory development, they represent two differ-
disciplines are based on very different paradigms, ent research paradigms (Kuhn, 1970). It has been
and thus integration is difficult (Bettis, 1983; suggested that pluralism in paradigm
Bromiley, 1990), other scholars hold that these development-presence of multiple theoretical
differences may have been overstated (Barton and lenses-is a necessary condition for the advance-
Gordon, 1987, 1988; Peavy, 1984). Nevertheless, ment of knowledge in organizational sciences in a
a common viewpoint held by all is that financial systematic manner (Cannella and Paetzold, 1994).
decisions are important from a strategic perspec- Such advancement, however, also requires that
tive, and should be included in the domain of researchers achieve some degree of consensus
strategic management research (Bromiley, 1990; as to the acceptability of the various competing
Sandberg, Lewellen, and Stanley, 1987). More- paradigms (Kuhn, 1970; Pfeffer, 1993). If one
over, capital structure decisions are also likely to paradigm is to be selected over others, however,
affect a firm's competitive position (Balakrishnan it should be better than its competitors at solving
and Fox, 1993). Following this premise, this research problems. That is, it should demonstrate
paper builds on research in both disciplines to a higher level of predictability in various phenom-
suggest that financial strategies may be influenced ena (Kuhn, 1970; Weick, 1979).
by a firm's corporate strategies. Strategic management researchers have yet to
The agency theory viewpoint of debt has had a systematically examine the implications of view-
strong influence on strategic management research ing transaction cost economics and agency theory
(Rumelt, Schendel, and Teece, 1991). Some as competing paradigms. Viewing organizational
scholars (e.g., Hitt and Smart, 1994; Rappaport, phenomena from an agency and a transaction cost
1990), however, have questioned the theoretical perspective may lead to different predictions. This
standing of this viewpoint and argued that it may paper first argues that although the two paradigms
lead to possibly harmful implications for firm share several similarities, substantive conceptual
managers, such as the excessive use of debt. differences arise when they are applied to firm
On the other hand, others have suggested that capital structure. Following this, it is shown that
transaction cost theory is a powerful viewpoint contradicting predictions often emerge when the
by which to examine capital structure role of debt, and its relationship with firm strat-
(Balakrishnan and Fox, 1993). From a conceptual egy, is considered. The contradictory predictions
perspective, therefore, it becomes important to are then tested by drawing on empirical evidence
carry out a comparison of the two theories, from existing research to examine the relative
especially regarding their explanation of firm predictive power of the two paradigms. Thus, this
leverage. paper adopts the approach suggested by Kuhn
Transaction cost and agency theories share (1970) to advance knowledge, i.e., to examine

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 Explaining Firm Capital Structure 715

the predictability of competing paradigms by lies in decreasing the amount of free cash flow
cumulating existing research evidence. available to managers by making them disgorge
it to investors (Jensen, 1986). This explanation
of the role of capital structure is presented in
TWO ORGANIZATIONAL ECONOMIC Figure 1.
VIEWS ON CAPITAL STRUCTURE
A transaction cost perspective on capital
The capital structure of a firm is the result of
structure
the transactions with various suppliers of finance.
These are complex exchanges associated with Transaction cost economics is concerned with the
the same difficulties that may lead to market governance of contractual relations in transactions
imperfections (Yao, 1988). This section discusses between two parties (Coase, 1937; Williamson,
the agency and transaction cost perspectives on 1975, 1985). Governance structures can be
capital structure. Brief explanations of the two matched to transactions in a manner that leads to
perspectives are followed by a comparison lowered costs of exchange (Williamson, 1979).
between them. Each structure is associated with a different level
of transaction costs (Goldberg, 1985; Hennart,
1993)-costs not dependent on the competitive
An agency theory perspective on capital
market price of the goods or services exchanged
structure
(Robins, 1987). These costs arise from the setup
Agency theory is chiefly interested in the design and running costs of the governance structures,
of alternative governance structures to mitigate as well as other costs, such as those due to
the agency conflict arising from the possible renegotiation, that arise from a shift in the align-
divergence of interests between shareholders ment. Under competitive conditions firms seek
(principals) and managers (agents) (Berle and governance structuresto economize on transaction
Means, 1932; Jensen and Meckling, 1976). Man- costs. The cost of market exchange is high when
agers have incentives to pursue strategies that the specificity of assets under exchange is high.
reduce their employment risk (Amihud and Lev, Under these circumstances, other forms of
1981), or increase firm size resulting in greater governance, such as 'hierarchy', may prove
compensation (Baker, Jensen, and Murphy, 1988; efficient.
Donaldson, 1984). Consequently, they may adopt Transactions with potential suppliers of finance
nonprofitable investments, even though the out- are associated with contracts that delineate the
come is likely to be losses for shareholders. This benefits and recourse available to them
agency cost is likely to be exacerbated in the (Williamson, 1988). The benefits represent the
presence of free cash flow in the firm (Jeinsen, property rights present in their rights over return
1986). streams generated from the assets. The recourse
The agency theory viewpoint presents debt as a available is in the form of various control rights
governance device useful in reducing the conflict over managerial actions. The debt instrument pos-
(Jensen, 1986). The creation of debt reduces the sesses fixed benefits with the principal and inter-
agency costs of free cash flow by reducing the est repayment schedules stipulated in the contract.
amount available to managers. Managers are con- It is only when a firm defaults on this schedule
tractually bound to repay the interest payments. and does not meet its contractual obligations can
If they spend the free cash on wasteful expendi- debtholders step in, exercise their preemptive
tures, the probability that the repayment schedule claim, and push the firm into bankruptcy if neces-
will be met decreases. In case of default, debt- sary. Thus, debtholders have little control over
holders may take the firm to bankruptcy court managerial actions in ensuring that resources are
and get a claim over its assets. Managers would utilized efficiently. They are unable to interfere
lose their decision rights and possibly their with firm operations so long as the contractual
employment in the firm. This threat prevents stipulations are satisfied.
managers from undertaking wasteful actions and The benefits for equity owners are not certain
they aim to utilize assets efficiently, increasing as they have a residual claimant status over the
firm value. Therefore, the control role of debt cash flow from asset earnings and liquidation.

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716 R. Kochhar

E.=~~~~~~~I- -

Figure 1. Agency perspective on capital structure

The equity contract is not for a fixed period and firm into bankruptcy. As is their right, they would
runs for the life of the firm. The board of direc- aim to recover their investment by liquidating
tors is present to ensure that the investment of assets and selling them to another firm which can
equityholders is protected. The board has the utilize them for the original or a different purpose.
authority to monitor internal performance, However, firm specificity would indicate that the
approve significant decisions, decide on mana- assets are not likely to be as valuable when put
gerial compensation, and replace managers if it to another use or in the hands of another user
deems so necessary (Fama and Jensen, 1983). (Klein, Crawford, and Alchian, 1978; Williamson,
Therefore, as it can monitor and evaluate mana- 1979); maximum productive value was present
gerial actions continuously, the instrument of in the original use of the now bankrupt firm
equity possesses stronger governance abilities (Williamson, 1991). Thus, the value obtained
when compared to the debt instrument. from asset liquidation would be extremely low,
It appears that the two broad ways of organiz- and lenders will recover only a small fraction of
ing the financial structure of a firm, debt and their initial investment. The loss in investment
equity, represent alternative governance struc- will be greater the higher is the level of firm
tures.' Debt is akin to the 'price system' of specificity. Therefore, debtholders will be unwill-
organizing usually associated with the 'market' ing to invest in projects with high firm-specific
(Williamson, 1988), where agents are rewarded assets, and prefer low-specificity investments
on the basis of output (Hennart, 1993). Equity (Williamson, 1988).
emphasizes behavior control present in the 'hier- For assets that are not redeployable outside
archy system' of organizing activities (Hennart, the firm, financing that has stronger governance
1993). For a particular investment, the choice of abilities, namely equity, will be utilized. When
financing structure is likely to depend on the control is to be exerted, equityholders, as residual
trade-off between the benefits and governance claimants, have the right to revise the employ-
ability. The specificity of assets in the transaction ment terms of managers (Alchian and Demsetz,
is likely to be a determining factor in the choice 1972). For instance, managers who shirk in the
between the two (Williamson, 1975). utilization of assets may be replaced by the board.
Consider first the scenario when the project to Thus, equity is the form of financing more suit-
be financed consists primarily of firm-specific able for high-specificity projects (Williamson,
assets. These assets may be beneficial to the firm 1988). As Klein et al. (1978) suggest, the owners
because of locational, technological, human, or of specialized assets should be the residual claim-
specialized investment advantages (Reeve, 1990). ants of the rents obtained from the assets. The
If firm managers default on some or all of their transaction cost perspective on capital structure
contractual obligations, debtholders may push the is presented in Figure 2.
R&D intensity has often been used as a meas-
ure of intangible and firm-specific know-how
' The discussion regarding the governance properties of debt- (Helfat, 1994). That is, it is an indicator of firm
holders and equityholders is based on the U.S. economic specificity of the assets. Research evidence has
system. Systems that have different institutional frameworks, shown that R&D intensity of a firm is negatively
such as Germany and Japan, would ascribe different rights to
suppliers of capital (Aoki, 1989; Berglof, 1990; Gerlach, related to its leverage (Balakrishnan and Fox,
1987; Hill, 1995). 1993; Baysinger and Hoskisson, 1989). Also,

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 Explaining Firm Capital Structure 717

Need for 2c
FinaicingAssets|

Figure 2. Transaction cost perspective on capital structure

firm-specific effects were much more important agency conflict, its presence is reflected in
than industry effects in explaining capital struc- improved stock price.
ture across firms (Balakrishnan and Fox, 1993).
Finally, Titman and Wessels (1988) found that a
Determination of relevant costs
firm's leverage was negatively related to product
uniqueness, a measure of firm specificity. These In agency theory, the focus is on the relevant
findings lend support to the link between speci- contracting action before the incentive scheme
ficity and capital structure. is introduced (Williamson, 1990). The resultant
agency costs arise from an interaction of the risk-
taking propensity of agents, uncertainty about
Differences in the agency and transaction
their efforts, and the incentive intensity
cost perspectives
(Eisenhardt, 1989). Therefore, they are determin-
At the elementary level, there is a difference in able primarily before the incentive systems are
the level of analysis between the agency theory established into the contract. The usage of incen-
and transaction cost viewpoints of capital struc- tive schemes with varying intensity is likely to
ture. Whereas transaction cost economics is based lead to different agency costs. For instance, such
on the importance of the specific transaction costs would differ for a firm depending on the
between the parties entering into the contract, amount of leverage in its capital structure.
agency theory highlights the role of individual In transaction cost theory, ex ante costs arise
agents (Eisenhardt, 1989). The former focuses on from the setup and running costs of alternative
the characteristics of the transaction and the latter governance systems (Hill, 1994; Williamson,
deals more with the characteristics of the agents. 1990). However, the impossibility of drafting
However, deeper theoretical differences are evi- complete contracts (under bounded rationality)
dent when attention is paid to the mechanisms implies that the likelihood of uninsurable oppor-
of conflict reduction. tunism still exists. The ex post contracting action
then becomes more relevant to the interested
parties. Costs can arise from renegotiation neces-
Market characteristics
sary at a later date in case of a shift between
For complex exchanges, transaction cost theory the governance structureand transaction (Hennart,
assumes that optimal contracts cannot be written 1993). Hence, although transaction costs have ex
due to bounded rationality. Hence, it rests on the ante and ex post components, the emphasis is
notion of market failure (Rumelt et al., 1991). primarily after the transaction is entered into
The transaction costs of governance through debt with a specific governance structure (Barney and
will be extremely high when firm specificity of Ouchi, 1986). As governance structures, debt and
assets is high; the resulting market failure leads equity are associated with different levels of ex
to exchange through equity. Agency theory, on ante costs (benefits) and ex post costs (control
the other hand, adopts the assumption of market rights). Even if the benefits can be satisfactorily
efficiency (Barney and Ouchi, 1986) and seeks negotiated, the optimal selection strategy requires
to find the optimal contract for the exchange. As the matching of control rights to the specificity
debt is an alignment device that reduces the of the assets.

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718 R. Kochhar

Role of lenders resources of the firm. The differences between

the two perspectives can, thus, be considered to
In agency theory debt is a mechanism to decrease be based on the governance of free cash flow vs.
conflict; the willingness of potential debtholders the governance of resources.
to supply finance is, however, not considered. The above suggests that agency theory expla-
Even though a higher level of debt may be nations are applicable narrowly whereas trans-
suitable to decrease agency costs, debtholders action cost explanations have a much wider
may not be willing to lend funds in certain cases, scope. As long as there are profitable investment
especially when they believe that their investment opportunities, agency costs from free cash flow
is not safeguarded. In these cases they would do not arise, and hence, the role of debt is not
lend at such high interest rates that the costs of relevant. Transaction cost explanations, however,
utilizing debt would increase substantially. Debt are relevant for all firms. The choice of the mix
would become an unprofitable device wiping of debt and equity is a function of the nature of
away any (probable) gains from a reduction in resources of the firm and is relevant even when
agency costs. The role that lenders play in affect- the firm is investing in profitable projects. As
ing capital structure, however, is incorporated in resources valuable to a firm are idiosyncratic to
the transaction cost viewpoint. it (Barney, 1991; Wemerfelt, 1984), they have
higher specificity (Amit and Schoemaker, 1993;
Peteraf, 1993; Mahoney and Pandian, 1992).
Assumptions about governance properties
Governance of these specific resources is essential
In agency theory, the incentive alignment ability to extract value from their potential benefits. Thus
of debt arises from the power available to debt- the nature of resources under a firm's control
holders in case of default. Managers are forced appears to be a driving feature determining its
to be efficient to meet payment schedules to capital structure (Balakrishnan and Fox, 1993).
avoid scrutiny and interference by debtholders.
The transaction cost logic also assigns the same
Summary
governance properties to debt, with debtholders
possessing identical rights. However, equity is The preceding discussion notes that there are
considered a more powerful governance device several theoretical differences between the two
than debt, mainly because debt is less interfering organizational economic perspectives of trans-
than equity. As long as the firm is meeting its action cost economics and agency theory when
contractual obligations, debtholders are not able applied to an examination of firm capital struc-
to influence managerial actions. On the other ture. A summary table of these differences is
hand, equityholders are able to continuously presented in Table 1. Information asymmetry
monitor and evaluate managerial decisions between the contracting parties is an important
through the board of directors. Thus, both equi- element in both viewpoints. In agency theory,
tyholders and debtholders are able to influence however, information can be purchased through
managerial actions, albeit to differing degrees. expenditure on monitoring devices (Eisenhardt,
While the transaction cost logic of capital struc- 1989). Information asymmetry cannot be reduced
ture recognizes the difference, the agency per- in the transaction cost logic, and the result is
spective is silent on this regard. failure of the market form of exchange (debt).
The notion of market failure is more in agreement
with the current line of thinking that demonstrates
Assets under governance
dissatisfaction with the neoclassical viewpoint of
A final difference, and perhaps the most critical, the firm (Arrow, 1985; Rumelt et al., 1991).
between the two perspectives is based on the Conceptually, it appears that the transaction
question: What is being governed? According to cost logic may be preferable over the agency
agency theory, the free cash flow present in a perspective as a theoretical explanation of capital
firm gives rise to difficulties that are resolved structure. Transaction cost economizing recog-
through the choice of financing. On the other nizes that suppliers of funds also play a role in
hand, in transaction cost economizing, suitable affecting capital structure. Moreover, the rights
financing resolves difficulties arising from the of both types of suppliers are considered. The

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 Explaining Firm Capital Structure 719

Table 1. Conceptual differences between the agency theory and transaction cost perspectives on capital structure

Source of difference Agency theory perspective Transaction cost perspective

1. Market characteristics Capital markets are efficient Capital markets can fail
2. Determination of relevant costs Before contract is established After contract is established
3. Role of lenders of funds Excluded Included
4. Assumptions about governance Debt has governance abilities Debt and equity both possess
properties governance abilities, with equity
being more powerful
5. Assets under governance Free cash flow Firm resources

type of financing selected for an asset depends on LBO. The firm is converted to private ownership
its characteristics. The transaction cost perspective with management usually holding a substantial
emphasizes that capital structure results from the portion of the equity. Subsequent to the conver-
choices based on the governance of resources, sion, the large-block investors play an active
and that firm specificity is a determining factor. monitoring role and often have representatives on
Thus, the transaction cost logic is more appealing the board of directors. Additionally, the trans-
than the agency framework because of the action is financed with large debt issues. Thus,
inclusion of several factors; i.e., it may provide high leverage, increased management sharehold-
a more 'complete' picture. ing, active corporate governance from blockhold-
If one paradigm is to be chosen over the other, ers, and loss of access to the public equity mar-
however, the differences should be visible in kets are the key distinguishing features between
empirical tests of specific organizational actions. an LBO and a public corporation (Palepu, 1990).
Jensen (1986, 1989a) applied the agency theory LBOs have come to represent a large part of the
perspective of capital structure in the context of restructuring and takeover activity of the U.S.
leveraged buyouts (LBOs) and diversification into economic system in value and frequency of
new businesses. He suggests that the two occurrence (Lehn and Poulsen, 1988, 1989).
phenomena provide supporting evidence for the Jensen (1986, 1989a) has argued that LBOs
control role of debt (Jensen, 1989b). Organiza- provide support for the agency perspective of
tional scholars have also devoted much attention debt. High leverage increases the repayment bur-
to these phenomena (Fox and Marcus, 1992; den and reduces the free cash flow, limiting the
Ramanujam and Varadarajan,1989; Seth and Eas- amount available for wasteful expenditures (Fox
terwood, 1993). Therefore, this paper utilizes the and Marcus, 1992). Firms with stable business
two as a basis for contrasting the agency and histories operating in industries with low growth
transaction cost viewpoints. This process leads to prospects (and consequently, high free cash flow),
the development of testable predictions that such as those in oil, tobacco, forest products,
enable a comparison of the two theories. As will food, and broadcasting, are prime targets for
be seen below, agency theory and transaction cost LBOs (Easterwood, Seth, and Singer, 1989; Seth
economics often lead to opposing predictions. It and Easterwood, 1993).
is suggested that the existing empirical evidence LBOs have been found to improve performance
mainly supports the transaction cost explanation in operating income (Kaplan, 1989), operating
of capital structure. cash flows (Smith, 1991), plant productivity
(Lichtenberg and Siegel, 1991), and inventory
management and accounts receivables (Singh,
LEVERAGED BUYOUTS 1990). Given these findings, and the observation
that there is no difference in sales growth between
The transaction in which a corporation (or the firms undergoing LBOs and their industry rivals
division of a corporation) is purchased by a small (Singh, 1990), the primary value creation of
group of investors and is subsequently delisted LBOs appears to stem from changes in oper-
from the stock exchange is referred to as an ational efficiencies, as predicted by agency theory.

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720 R. Kochhar

In other words, the benefits seem to arise from the cation, and unrelated diversification. Contrary to
cost side, rather than from changes in revenues. the agency theory prediction of pAT 1, over 40
The application of agency principles, however, percent of firms had an initial strategy of single
suggests that undergoing an LBO is not likely to business or related diversification. Liebeskind et
be beneficial for a firm when its managers are al. (1992) compared a sample of LBOs to a
not opportunistic and are investing cash flow control group of public firms matched by indus-
wisely. Governance of free cash flow is not a try, size, and level of diversification. They exam-
problem for these firms. From an efficiency per- ined differences in corporate refocusing, measured
spective, therefore, LBOs are more likely to occur by the change in number of businesses and the
in firms where a free cash flow problem exists entropy index, across the two groups. Contrary
and managers are not pursuing value enhancement to the agency viewpoint, they failed to find any
strategies. Evidence has shown that entry into a significant differences in changes in total and
product market that does not share commonalities related diversification. Seth and Easterwood
with existing businesses does not generally benefit (1993) also found that the restructuring activity
the firm in the long run (Ravenscraft and Scherer, of LBOs was not exclusively targeted towards
1987; Shleifer and Vishny, 1991). Performance businesses unrelated to their core businesses; a
is likely to improve when the businesses share pattern of both related and unrelated divestment
some commonalities and are related to each other was observed. Finally, in his qualitative study of
(Porter, 1987). Thus, diversification into unrelated the managers of eight U.K. LBOs, Green (1992)
businesses is potentially a value-reducing strategy, did not find any inclination towards either an
and a symptom of a free cash flow problem. unrelated or a related diversification strategy.
Based on agency theory, Jensen (1986, 1989a) Therefore, it appears that the existing evidence
proposed the following pre-buyout relationship is also inconsistent with pAT 2.
between firm strategy and the likelihood of LBOs; While no direct tests exist, the evidence in the
literature is consistent with the transaction cost
PAT]: LBOs are more likely to occur in firms perspective. The predictions made by Jensen
pursuing a pre-buyout strategy of unrelated (1986, 1989a) regarding LBOs relied on the
diversification. delineation of industries that had large cash flows.
A careful analysis, however, indicates that these
industries were in the mature life cycle phase,
Researchers have also examined the post-buyout
and that their resources were no longer unique
strategies of firms that have undergone LBOs. As
(Hall, 1980), being characterized by decreased
the restructuring after an LBO intensifies the
specificity. As discussed previously, the trans-
incentives available to managers, they should
action cost explanation suggests that high debt is
cease to indulge in wasteful actions. That is, high
useful as a governance device for firms when
leverage in LBO firms ensures that managers
their resources have low firm specificity. Thus,
invest in related businesses, and move away from
the shift from equity to large amounts of debt,
value-reducing investments such as unrelated
as done in LBOs, may be a shift towards a better
diversification. Based on these arguments derived
fit between type of assets and the governance of
from agency theory, several researchers have put
such assets. It is not merely a form of cash flow
forth the following prediction regarding the
governance, as specified in agency theory. For
relationship between LBOs and diversification
these firms, continuous monitoring by the board
strategy (Fox and Marcus, 1992; Green, 1992;
of directors is not critical, and monitoring is
Liebeskind, Wiersema, and Hansen, 1992):
carried out by the debtholders. Moreover, as per
the transaction cost logic, there is no a priori
pAT 2: Post-buyout, firms are likely to refo- reason to expect systematic differences in the
cus their businesses leading to a related diver- pre-buyout diversification strategies of firms
sification strategy. undergoing LBOs, or in the post-LBO strategic
shifts; consistent with the evidence. Based on the
In a sample of LBO firms, Seth and Easterwood transaction cost relationship between the nature
(1993) found that all types of strategies existed of resources and governance through debt, the
prior to buyout: single business, related diversifi- following proposition can be developed:

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 Explaining Firm Capital Structure 721
pTC I LBOs are more likely to occur in firms the firm managers, impeding their competitive
that have low firm specificity. ability in the product market (Rappaport, 1990).
Moreover, these firms may have to forego some
As mentioned earlier, R&D intensity has often profitable investment opportunities as they do not
been used as an indicator of firm specificity of have access to equity markets. These criticisms
resources (Helfat, 1994). Thus, as per pTC 1, there may be misfounded when it is considered that
is likely to be a negative association between LBOs occur in firms with nonunique assets. These
LBOs and R&D spending. Although several stud- firms may not face any significant investment
ies have examined the relationship between LBO opportunities, and are less likely to require flexi-
occurrence and R&D expenditure, they have bility. Any loss in innovative capability does not
primarily viewed the latter as a measure of firm effect either short-term or long-term performance
innovation, rather than firm specificity. Despite (Bruton and Scrifes, 1992; Long and Ravenscraft,
conflicting results regarding post-buyout R&D 1993). On the other hand, these firms can actually
(see Bruton and Scrifes, 1992; and Zahra and gain a competitive advantage over their rivals by
Fescina, 1991, for reviews), research evidence reducing governance costs. Contrary to criticisms,
does support the notion that it is firms with lower the high interest burden does not really pose
levels of firm specificity that undergo an LBO. difficulties, as most firms after an LBO are able
LBOs do not occur in R&D-intensive industries to meet repayment schedules without any great
or firms, and are more likely in firms where R& difficulties (Seth and Easterwood, 1993). More-
D is not an important factor for success (Hall, over, in case of financial distress, or if the need
1990; Jensen, 1989b; Kaplan, 1989; Smith, 1991). for additional funds arises, firms can negotiate
In fact, most firms that undergo an LBO do not with their investors who have substantial owner-
deem R&D important enough to report it in their ship stakes and often a representative on the
financial statements (Kaplan, 1989; Smith, 1991). board of directors.
Long and Ravenscraft (1993) also found that
LBOs are usually targeted towards firms in low- PRODUCT DIVERSIFICATION
tech industries-those with below normal R&D
intensity. Firms that have high R&D expenditures Firms diversify in response to the presence of
are less likely to go through an LBO (Opler and unutilized resources (Penrose, 1959; Teece,
Titman, 1993). These results suggest that it is in 1980). The distinction between related and unre-
firms composed primarily of nonunique assets lated diversification is closely tied to the charac-
that debt is the efficient form of governance, via teristics of these resources. It has been argued
an LBO. Thus, the evidence on the relationship that specialized assets are more likely to lead to
between firm specificity and LBO occurrence sup- related diversification (Teece, 1982). Firms with
ports pTC 1. A summary table depicting the com- high levels of intangible assets, which tend to be
parison between the two perspectives is presented specialized and inflexible, transfer them across
in Table 2. similar businesses (Lemelin, 1982), leading to
The preceding discussion supports that notion more related diversification (Chatterjee and Wer-
that LBOs can be better explained from a trans- nerfelt, 1991). A less-focused strategy, i.e., unre-
action cost perspective rather than from agency lated diversification, indicates that the resources
theory. Predictions from the former perspective are not highly specific to the firm (Montgomery
are supported, while those from the latter are not. and Wernerfelt, 1988; Wernerfelt and Montgom-
It is the presence of non-specific assets requiring ery, 1988). Thus, with respect to the resource
governance through high leverage that leads to requirements, a distinguishing feature between the
firms going private. The performance improve- two types of diversification strategies is the level
ment that is observed is because of the changes of asset specificity (Mahoney and Pandian, 1992).
in its cost structure and not a correction of over- The value gained from entry into a related busi-
diversification (Seth and Easterwood, 1993). ness depends primarily on the synergies with
Viewing LBOs from a different-the trans- existing businesses. Entry into an unrelated busi-
action cost-lens has implications for the going- ness, however, depends mainly on corporate-level
private strategy. Critics of LBOs have argued that strengths, such as the ability to obtain financial
the high interest burden imposes inflexibility on synergies (Hitt and Ireland, 1986). Therefore,

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722 R. Kochhar
Table 2. Summary of predictions developed and compared in two organizational phenomena

Agency theory perspective Transaction cost perspective

Prediction Referencesa Prediction Referencesa

Leveraged buyouts Leveraged buyouts

PATI: LBOs are more likely to occur Jensen (1986, PTCl: LBOs are more likely to occur Hall (1990),
in firms pursuing a pre-buyout 1989a) in firms that have low firm Kaplan (1989),
strategy of unrelated diversification specificity Long and
Ravenscraft
(1993 )b
PAT2: Post-buyout, firms are likely to Fox and
refocus their businesses leading to a Marcus
related diversification strategy (1992), Green
(1992),
Liebeskind et
al. (1992)

Product diversification Product diversification

pAT3: The debt-equity ratio of a PTc2: The debt-equity ratio of a
firm is positively related to the firm is negatively related to the
degree of relatedness among its degree of relatedness among its
businesses businesses
pAT4: The debt-equity ratio of a Gibbs (1993)
firm is negatively related to the
amount of refocusing
pAT5: An increase in the debt-equity PTc3: An increase in the debt-equity
ratio of a firm is associated with an ratio of a firm is associated with a
increase in the degree of related decrease in its degree of related
diversification diversification

a
Prior research that has examined the relationship is listed here. Absence of any references indicates that the prediction is
original.
bThese papers use R&D as an indicator of innovation, rather than firm specificity.

related diversification is associated with the pres- financed. From a transaction cost perspective,
ence of more firm-specific assets, when compared therefore, the following prediction can be made:
to unrelated diversification.
These differences in the degree of firm speci- PTC2: The debt-equity ratio of a firm is
ficity between the two diversification strategies negatively related to the degree of relatedness
suggest that the suitable modes of financing the among its businesses.
two may differ. As discussed earlier, the trans-
action cost perspective argues that the efficient Application of the agency theory viewpoint, how-
form of governance for specific assets is via ever, suggests opposing predictions regarding the
equity financing; debt financing is likely to be relationship between leverage and diversification
preferred when specificity is low (Williamson, strategy. Due to higher total interest charges,
1988). Related diversifiers, in general, tend to be firms with higher leverage will distribute a greater
composed primarily of firm-specific assets, fraction of their earnings as payments to their
whereas firms adopting unrelated diversification debtholders. These firms will be associated with
have lower specificity assets. Thus, specificity is lower free cash flow resulting in lowered agency
positively related to the degree of relatedness. costs. The increased payment to debtholders will
The relationship between specificity and financing decrease the amount available to managers for
suggests that firms following related diversifi- potentially wasteful investments. Agency costs
cation strategies are likely to be mainly equity will also decrease due to the monitoring by debt-
financed and- unrelated diversifiers to be debt holders. The increased scrutiny by debtholders

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 Explaining Firm Capital Structure 723

implies that managers would need to provide capital structure, therefore, firms with high lever-
stronger justification for their actions. Conse- age exhibit superior monitoring and fewer free
quently, they will be less likely to follow value- cash flow problems, and hence, have less need
decreasing strategies such as unrelated diversifi- to restructure their portfolio of businesses. Gibbs
cation (Jensen, 1986, 1989a). Thus, according to (1993) has argued that if debt acts primarily as
the agency viewpoint, the following prediction an incentive alignment device, then high initial
can be made: debt levels would imply less subsequent corporate
restructuringsuch as the refocusing of businesses.
pAT 3. The debt-equity ratio of a firm is Thus, the agency theory prediction is as follows:
positively related to the degree of
relatedness among its businesses. pAT4: The debt-equity ratio of a firm is
negatively related to the amount of refocusing.
The two predictions, pTC 2 and pAT 3, suggest
opposing directions regarding the relationship Gibbs (1993) examined several measures of free
between the diversification strategy of a firm and cash flow, corporate governance, and takeover
its capital structure, hence, are contradictory. threat as predictors of corporate restructuring.
There is little previous research that has system- Contrary to the free cash flow hypothesis, he
atically examined the relationship betwen diversi- found that the initial financial leverage of a firm
fication strategy and capital structure. Barton was positively associated with the amount of
(1988) and Barton and Gordon (1988) compared subsequent refocusing. In his study of restructur-
leverage ratios across diversification strategy ing firms, Markides (1992) found that the initial
groups and found that the debt-equity ratio of debt-equity ratio of a firm was not an important
unrelated diversifiers was significantly greater variable in predicting refocusing. The evidence
than that of related diversifiers; consistent with from both studies suggests that high leverage is
pTC 2. In other words, lower firm specificity is not necessarily reflective of lower agency costs
associated with higher levels of debt. Thus, it in a firm, and therefore does not support pAT 4.
appears that existing research, though scant, pro- Agency theory also suggests that the increased
vides evidence in support of the transaction cost presence of incentive systems in a firm pursuing
prediction, and favors rejection of the agency a strategy that is value reducing would lead to a
theory prediction. strategy shift that is value enhancing (Bethel
Recent years have witnessed an increase in and Liebeskind, 1993). If leverage is indeed an
the level of restructuring activity among firms incentive system, the increased monitoring by
(Bowman and Singh, 1990). While many firms debtholders and the need to meet regular interest
are downsizing, several of them have changed the payments would pressure managers to limit
number and mix of businesses in their portfolio actions that may be wasteful, and instead, focus
(Williams, Paez and Sanders, 1988), thereby on actions that are beneficial to the firm. In
changing the diversification strategy adopted. This unrelated diversified firms, therefore, this would
portfolio restructuring has often been accompa- lead to strategic shifts toward greater related
nied by a financial restructuring (Bowman and diversification that tends to increase firm value.2
Singh, 1993). Predictions PTC 2 and pAT 3 pre- Hence, the following prediction can be developed:
sented cross-sectional relationships between lever-
age and firm strategy. Longitudinal studies, that pAT 5.- An increase in the debt-equity ratio of
relate the change in a firm's capital structure to a firm is associated with an increase in the
the change in its diversification strategy, would degree of related diversification.
provide more robust support to the theories. As
per agency theory, restructuring is a corrective The transaction cost rationale, however, suggests
response (i.e., value increasing) to the overexpan- that a shift towards a focused strategy, i.e., a
sion that occurred in the previous decades. Firms more related strategy, will be associated with a
with better initial monitoring would have a lesser decrease in the debt-equity ratio. Due to the
need for restructuring as they would not have
overdiversified in the first place (Bethel and Lie- 2These arguments match the benefits of debt discussed in
beskind, 1993). According to this perspective of pAT 2, albeit for a different organizational phenomenon.

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724 R. Kochhar

greater degree of interrelationships among the ally neglected by strategy researchers. Several
businesses, an increasing level of related diversi- scholars have noted that the issues involved are
fication leads to higher firm specificity of concerned with fundamental choices 'which
resources. Transaction cost economizing suggests should support and be consistent with the long-
that these resources require financing structures term strategy of the firm' (Barton and Gordon,
that have stronger governance abilities, namely 1987: 67), and that strategic management research
equity. Conversely, a shift into more unrelated should be inclusive of financial decisions
businesses implies a decrease in the degree of (Bromiley, 1990). The arguments presented in
firm specificity of resources. For these firms, this paper suggest that there are likely to be
financing structures with weaker governance strong theoretical linkages between the financial
ability, i.e., financing via debt, would be more and strategic management of a firm.
suitable: Thus, according to transaction cost eco- From an organizational economic perspective,
nomics, the following prediction can be two explanations for capital structure emerge.
developed: The explanations based on agency theory and
transaction cost economics are dissimilar and lead
pTC 3: An increase in the debt-equity ratio to different predictions about firm behavior. On
of a firm is associated with a decrease in its a conceptual basis, the transaction cost perspec-
degree of related diversification. tive is more appealing than the agency theory
viewpoint. By including the role of suppliers of
It can be noted that, akin to the cross-sectional funds the former is able to consider all parties
relationships, opposing predictions are obtained that are involved in the economic exchanges that
even in the case of firm actions over time. While lead to the capital structure decision in a firm.
extant research has not tested the above relation- Moreover, it realizes that both classes of
ships, some indirect evidence is available. In suppliers-debtholders and equityholders-have
Gibbs (1993), the amount of refocusing was governance abilities. The level of governance
negatively correlated with the change in firm ability varies between the two and the optimal
leverage, supporting pTC 3 and rejecting pAT 5. selection of the type of financing depends on the
That is, firms that increased the degree of nature of resources of the firm. The transaction
relatedness among the businesses in their portfolio cost framework considers that the nature of firm
also decreased their debt-equity ratio. This evi- resources may lead to market failure. The extant
dence provides support for the transaction cost empirical evidence also seems to favor the trans-
explanation and favors rejection of the free cash action cost perspective, at least in the case of
flow hypothesis of agency theory. LBOs and diversification.
The discussion above indicates that an appli- The choice of a governance mechanism not
cation of agency theory and transaction costs based on transaction characteristics may lead to
principles to capital structure and diversification poor performance (Hennart, 1994). By selecting
strategy leads to the development of opposing suitable financing, a 'firm's ability to manage its
predictions. The evidence in the literature pri- relationship with lenders thus becomes a key
marily supports the transaction cost perspective. source of competitive advantage' (Balakrishnan
Debt vs. equity financing becomes important for and Fox, 1993: 3). Hence, financing choices have
governance of firm resources, and not for govern- the potential to affect performance by changing
ance of free cash flow. However, more research the level of governance costs. While this issue
is required to test the competing viewpoints has not yet been adequately researched, some
before these relationships can be conclusively supporting evidence is available. Seth (1990)
established. found that the value created from unrelated acqui-
sitions is positively related to increased debt uti-
lization, suggesting that low-specificity assets
CONCLUSIONS should be financed through debt. Also, share-
holders react more favorably to equity issues
Financing and capital structurechoices are among (which decrease leverage) in firms that adopt a
the several key decisions made by firm managers. related acquisition strategy, when compared to
Yet the study of these questions has been gener- similar issues by other firms (Mann and Sicher-

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All use subject to JSTOR Terms and Conditions
 Explaining Firm Capital Structure 725

man, 1991). In other words, high specificity Barney, J. B. and W. G. Ouchi (1986). Organizational
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of ownership structure on corporate restructuring',
Mike Hitt. Thanks are due to Parthiban David,
Strategic Management Journal, Summer Special
Javier Gimeno, Hicheon Kim, and Ed Levitas for Issue, 14, pp. 15-31.
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