V O LU ME 3 2

N UMB ER 1
WIN TER 2 0 2 0

Journal of

APPLIED
CORPORATE FINANCE
IN THIS I SSU E:

Honoring 8 Economics and Ethics: The Case of Salomon Brothers

Clifford Smith, University of Rochester

Cliff Smith 14 University of Georgia Roundtable on Enterprise-Wide Risk Management

Panelists: Clifford Smith, University of Rochester; Greg Niehaus, University of South Carolina;
Christie Briscoe, AGL Resources; Walter Coleman, First Data Corp; Keith Lawder, Wachovia Bank;
Sailesh Ramamurtie, Mirant Corporation. Moderated by James Verbrugge, University of Georgia, and
Donald Chew, Stern Stewart & Co.

36 Risk and Regulation in Derivatives

(or Why Derivatives Are a Blessing, Not a Curse)
Ludger Hentschel and Clifford Smith, University of Rochester

48 Corporate Insurance Strategy: The Case of British Petroleum

Neil A. Doherty, University of Pennsylvania, and Clifford Smith, University of Rochester

58 University of Rochester Roundtable on Bankruptcy vs. Bailouts:

The Case of General Motors and the U.S. Auto Industry
Panelists: Thomas Jackson, James Brickley, and Clifford Smith, University of Rochester;
Charlie Hughes, Past President and CEO of Mazda North America; and Joel Tabas,
Tabas, Freedman, Soloff and Miller. Moderated by Mark Zupan.

80 The Capital Structure Puzzle: Another Look at the Evidence

Michael J. Barclay and Clifford Smith, University of Rochester

92 Morgan Stanley Roundtable on Capital Structure and Payout Policy

Panelists: Clifford Smith, University of Rochester; David Ikenberry, University of Illinois;
Arun Nayar, PepsiCo; and Jon Anda and Henry McVey, Morgan Stanley.
Moderated by Bennett Stewart, Stern Stewart & Co.

108 The Economics of Organizational Architecture

James Brickley, Clifford Smith, and Jerold Zimmerman, University of Rochester

120 Transfer Pricing and the Control of Internal Corporate Transactions

James Brickley, Clifford Smith, and Jerold Zimmerman, University of Rochester

128 Using Organizational Architecture to Lead Change

James Brickley, Clifford Smith, and Jerold Zimmerman, University of Rochester,
with Janice Willett, Journal of Financial Economics
The Capital Structure Puzzle:
Another Look at the Evidence
by Michael J. Barclay and Clifford Smith, University of Rochester

perennial debate in corporate finance concerns the question of optimal capital

A structure: Given a level of total capital necessary to support a company’s

activities, is there a way of dividing up that capital into debt and equity that maximizes

current firm value? And, if so, what are the critical factors in setting the leverage ratio for a

given company?

Although corporate finance has been taught in business What makes the capital structure debate especially
schools for almost a century, the academic finance profes- intriguing is that the different theories represent such
sion has found it remarkably difficult to provide definitive different, and in some ways almost diametrically opposed,
answers to these questions—answers that can guide prac- decision-making processes. For example, some finance
ticing corporate executives in making their financing scholars have followed Miller and Modigliani by arguing
decisions. Part of the difficulty stems from how the disci- that both capital structure and dividend policy are largely
pline of finance has evolved. For much of this century, both “irrelevant” in the sense that they have no significant,
the teaching of finance and the supporting research were predictable effects on corporate market values. Another
dominated by the case-study method. In effect, finance school of thought holds that corporate financing choices
education was a glorified apprenticeship system designed reflect an attempt by corporate managers to balance the
to convey to students the accepted wisdom—often codified tax shields of greater debt against the increased probabil-
in the form of rules of thumb—of successful practitioners. ity and costs of financial distress, including those arising
Such rules of thumb may have been quite effective in a given from corporate underinvestment. But if too much debt can
set of circumstances, but as those circumstances change over destroy value by causing financial distress and underinvest-
time, such rules tend to degenerate into dogma. An exam- ment, others have argued that too little debt—at least in
ple was Eastman Kodak’s long-standing decision to shun large, mature companies—can lead to overinvestment and
debt financing—a policy stemming from George Eastman’s low returns on capital.
brush with insolvency at the turn of the century that was Still others argue that corporate managers making
not reversed until the 1980s. financing decisions are concerned primarily with the “signal-
But this “anecdotal” approach to the study of finance ing” effects of such decisions—for example, the tendency
is changing. In the past few decades, financial economists of stock prices to fall significantly in response to common
have worked to transform corporate finance into a more stock offerings (which can make such offerings very expensive
scientific undertaking, with a body of formal theories that for existing shareholders) and to rise in response to lever-
can be tested by empirical studies of market and corporate age-increasing recapitalizations. Building on this signaling
behavior. The ultimate basis for judging the usefulness of a argument, MIT professor Stewart Myers has suggested that
theory is, of course, its consistency with the facts—and thus corporate capital structures are simply the cumulative result
its ability to predict actual behavior. But this brings us to the of individual financing decisions in which managers follow
most important obstacle to developing a definitive theory of a financial pecking order—one in which retained earnings
capital structure: namely, the difficulty of designing empiri- are preferred to outside financing, and debt is preferred
cal tests that are powerful enough to distinguish among the to equity when outside funding is required. According to
competing theories. Myers, corporate managers making financing decisions are

80 Journal of Applied Corporate Finance • Volume 32 Number 1 Winter 2020

not really thinking about an optimal capital structure—that tax credits) should have less debt in their capital structures;
is, a long-run, targeted debt-to-equity ratio they eventually but the theory does not tell us how much less.
want to achieve. Instead, they simply take the “path of least Second, most of the competing theories of optimal capital
resistance” and choose what then appears to be the low-cost structure are not mutually exclusive. Evidence consistent with
financing vehicle— generally debt—with little thought about one theory—say, the tax-based explanation—generally does
the future consequences of these choices. not allow us to conclude that another factor—the value of
In his 1984 speech to the American Finance Association debt in reducing overinvestment by mature companies—is
in which he first presented the pecking order theory, Professor unimportant. In fact, it seems clear that taxes, bankruptcy
Myers referred to this conflict among the different theories costs (including incentives for underinvestment), and infor-
as the “capital structure puzzle.” As we already suggested, mation costs all play some role in determining a firm’s optimal
the greatest barrier to progress in solving the puzzle has been capital structure. With our current tests, it is generally not
the difficulty of devising conclusive tests of the competing possible to reject one theory in favor of another.
theories. Over 30 years ago, researchers in the capital markets Third, many of the variables that we think affect optimal
branch of finance, with its focus on portfolio theory and capital structure are difficult to measure. For example, signal-
asset pricing, began to develop models in the form of precise ing theory suggests that the managers’ “private” information
mathematical formulas that predict the values of traded about the company’s prospects plays an important role in
financial assets as a function of a handful of (mainly) observ- their financing choices. But since there is no obvious way to
able variables. The predictions generated by such models, after identify when managers have such proprietary information,
continuous testing and refinement, have turned out to be it is hard to test this proposition.
remarkably accurate and useful to practitioners. For example, For all of these reasons and others, the state of the art in
the Black-Scholes option pricing model—variations of which corporate finance is less developed than in asset pricing. Thus
have long been widely used on options exchanges—has it is important for the academic community to continue to
enabled traders to calculate the value of traded options of all develop the theory to yield more precise predictions, and to
kinds as a function of just six variables (all but one of which devise more powerful empirical tests as well as better proxies
can be directly observed). for the key firm characteristics that are likely to drive corpo-
The key to financial economists’ success in capital markets rate financing decisions.
is this: Armed with specific hypotheses, they have been able In this paper, we offer our assessment of the current state
to develop sophisticated and powerful empirical tests. The of the academic finance profession’s understanding of these
evidence from such tests has in turn allowed theorists to issues and suggest some new directions for further explora-
increase the “realism” of their models to the point where they tion. We also offer in closing what we feel is a promising
have been used, and in some cases further refined, by practi- approach to reconciling the different theories of capital struc-
tioners. And while no one would argue that all major asset ture.
pricing issues have been resolved, the continuing interaction
between theory and testing has yielded a richer understand- The Theories1
ing of risk-return tradeoffs than anyone might have imagined Current explanations of corporate financial policy can be
decades ago. grouped into three broad categories: (1) taxes, (2) contract-
Empirical methods in corporate finance have lagged ing costs, and (3) information costs. Before discussing these
behind those in capital markets for several reasons. First, our theories, it is important to keep in mind that they are not
models of capital structure decisions are less precise than asset mutually exclusive and that each is likely to help us under-
pricing models. The major theories focus on the ways that stand at least particular facets of corporate financing. Our aim
capital structure choices are likely to affect firm value. But is to determine the relative importance of the different theo-
rather than being reducible, like the option pricing model, ries and to identify those aspects of financial policy that each
to a precise mathematical formula, the existing theories of theory is most helpful in explaining.
capital structure provide at best qualitative or directional
predictions. They generally identify major factors like taxes
or bankruptcy costs that would lead to an association between
particular firm characteristics and higher or lower leverage. 1 This section draws on the discussion of capital structure theory in Michael J.
Barclay, Clifford W. Smith, Jr., and Ross L. Watts “The Determinants of Corporate Lever-
For example, the tax-based theory of capital structure suggests age and Dividend Policies,” Journal of Applied Corporate Finance, Vol. 7 No. 4 (Winter
that firms with more non-interest tax shields (like investment 1995).

Journal of Applied Corporate Finance • Volume 32 Number 1 Winter 2020 81

Taxes expected costs, of financial distress. In this view, the optimal
The basic corporate profits tax allows the deduction of inter- capital structure is the one in which the next dollar of debt is
est payments but not dividends in the calculation of taxable expected to provide an additional tax subsidy that just offsets
income. For this reason, adding debt to a company’s capital the resulting increase in expected costs of financial distress.
structure lowers its expected tax liability and increases its after- Costs of Financial Distress (or the Underinvestment
tax cash flow. If there were only a corporate profits tax and no Problem). Although the direct expenses associated with the
individual taxes on corporate securities, the value of a levered administration of the bankruptcy process appear to be quite
firm would equal that of an identical all-equity firm plus the small relative to the market values of companies,3 the indirect
present value of its interest tax shields. That present value, costs can be substantial. In thinking about optimal capital
which represents the contribution of debt financing to the structure, the most important indirect costs are likely to be
market value of the firm, could be estimated simply by multi- the reductions in firm value that result from cutbacks in
plying the company’s marginal tax rate (34% plus state and promising investment that tend to be made when companies
local rates) times the principal amount of outstanding debt get into financial difficulty.
(assuming the firm expects to maintain its current debt level). When a company files for bankruptcy, the bankruptcy
The problem with this analysis, however, is that it judge effectively assumes control of corporate investment
overstates the tax advantage of debt by considering only the policy—and it’s not hard to imagine circumstances in which
corporate profits tax. Many investors who receive interest judges do not maximize firm value. But even in conditions
income must pay taxes on that income. But those same inves- less extreme than bankruptcy, highly leveraged companies
tors who receive equity income in the form of capital gains are are more likely than their low-debt counterparts to pass up
taxed at a lower rate and can defer any tax by choosing not to valuable investment opportunities, especially when faced with
realize those gains. Thus, although higher leverage lowers the the prospect of default. In such cases, corporate managers
firm’s corporate taxes, it increases the taxes paid by investors. are likely not only to postpone major capital projects, but to
And, because investors care about their after-tax returns, they make cutbacks in R&D, maintenance, advertising, or training
require compensation for these increased taxes in the form of that end up reducing future profits.
higher yields on corporate debt—higher than the yields on, This tendency of companies to underinvest when facing
say, comparably risky tax-exempt municipal bonds. financial difficulty is accentuated by conflicts that can arise
The higher yields on corporate debt that reflect investors’ among the firm’s different claimholders. To illustrate this
taxes effectively reduce the tax advantage of debt over equity. conflict, consider what might happen to a high-growth
In this sense, the company’s shareholders ultimately bear all of company that had trouble servicing its debt. Since the value
the tax consequences of its operations, whether the company of such a firm will depend heavily on its ability to carry out
pays those taxes directly in the form of corporate income tax its long-term investment plan, what the company needs is an
or indirectly in the form of higher required rates of return on infusion of equity. But there is a problem. As Stewart Myers
the securities its sells. For this reason alone,2 the tax advantage pointed out in his classic 1977 paper titled “Determinants of
of corporate debt is almost certainly not 34 cents for every Corporate Borrowing,”4 the investors who would be asked to
dollar of debt. Nor is it likely to be zero, however, and so a provide the new equity in such cases recognize that much of
consistently profitable company that volunteers to pay more the value created (or preserved) by their investment would
taxes by having substantial unused debt capacity is likely to go to restoring the creditors’ position. In this situation, the
be leaving considerable value on the table.
3 Perhaps the best evidence to date on the size of direct bankruptcy costs comes
Contracting Costs from Jerry Warner’s study of eleven railroads that declared bankruptcy over the period
1930-1955. (Jerold B. Warner, “Bankruptcy Costs: Some Evidence,” Journal of Fi-
Conventional capital structure analysis holds that financial nance, Vol. 32 (1977), pp. 337-347.) The study reported that out-of-pocket expenses
managers set leverage targets by balancing the tax benefits of associated with the administration of the bankruptcy process were quite small relative to
higher leverage against the greater probability, and thus higher the market value of the firm—less than 1% for the larger railroads in the sample. For
smaller companies, it’s true, direct bankruptcy costs are a considerably larger fraction of
firm value (about five times larger in Warner’s sample). Thus, there are “scale econo-
mies” with respect to direct bankruptcy costs that imply that larger companies should
2 The extent to which a company benefits from interest tax shields also depends on have higher leverage ratios, all else equal, than smaller firms. But even these higher es-
whether it has other tax shields. For example, holding all else equal, companies with timates of direct bankruptcy costs, when weighted by the probability of getting into
more investment tax credits or tax loss carryforwards should have lower leverage ratios bankruptcy in the first place, produce expected costs that appear far too low to make
to reflect the lower value of their debt tax shields. See Harry DeAngelo and Ronald Ma- them an important factor in corporate financing decisions.
sulis, “Optimal Capital Structure Under Corporate and Personal Taxation,” Journal of 4 Stewart C. Myers, “Determinants of Corporate Borrowing,” Journal of Financial
Financial Economics, Vol. 8 No. 1 (1980), pp. 3-29. Economics, Vol. 5 (1977), pp. 147-175.

82 Journal of Applied Corporate Finance • Volume 32 Number 1 Winter 2020

cost of the new equity could be so high that managers acting Information Costs
on their shareholders’ behalf might rationally forgo both the Corporate executives often have better information about the
capital and the investment opportunities. value of their companies than outside investors. Recognition
Myers referred to this as “the underinvestment problem.” of this information disparity between managers and inves-
And, as he went on to argue, companies whose value consists tors has led to two distinct, but related theories of financing
primarily of intangible investment opportunities—or “growth decisions—one known as “signaling,” the other as the “peck-
options,” as he called them—will choose low-debt capital ing order.”
structures because such firms are likely to suffer the greatest Signaling. With better information about the value
loss in value from this underinvestment problem. By contrast, of their companies than outside investors, managers of
mature companies with few profitable investment opportu- undervalued firms would like to raise their share prices by
nities where most of their value reflects the cash flows from communicating this information to the market. Unfortu-
tangible “assets in place” incur lower expected costs associ- nately, this task is not as easy as it sounds; simply announcing
ated with financial distress. Such mature companies, all else that the companies are undervalued generally isn’t enough.
equal, should have significantly higher leverage ratios than The challenge for managers is to find a credible signaling
high-growth firms. mechanism.
The Benefits of Debt in Controlling Overinvestment
If too much debt financing can create an underinvestment
problem for growth companies, too little debt can lead to an “
overinvestment problem in the case of mature companies.
As Michael Jensen has argued,5 large, mature public compa- If too much debt financing can create an underinvest-
nies generate substantial “free cash flow”—that is, operating ment problem for growth companies, too little debt
cash flow that cannot be profitably reinvested inside the
can lead to an overinvestment problem in the case of
firm. The natural inclination of corporate managers is to
use such free cash flow to sustain growth at the expense of mature companies.
profitability, either by overinvesting in their core businesses
or, perhaps worse, by diversifying through acquisition into ”
unfamiliar ones. Economic theory suggests that information disclosed by
Because both of these strategies tend to reduce value, an obviously biased source (like management, in this case) will
companies that aim to maximize firm value must distrib- be credible only if the costs of communicating falsely are large
ute their free cash flow to investors. Raising the dividend enough to constrain managers to reveal the truth. Increasing
is one way of promising to distribute excess capital. But leverage has been suggested as one potentially effective signal-
major substitutions of debt for equity (for example, in the ing device. Debt contracts oblige the firm to make a fixed set
form of leveraged stock repurchases) offer a more reliable of cash payments over the life of the loan; if these payments are
solution because contractually obligated payments of inter- missed, there are potentially serious consequences, including
est and principal are more effective than discretionary bankruptcy. Equity is more forgiving. Although stockholders
dividend payments in squeezing out excess capital. Thus, also typically expect cash payouts, managers have more discre-
in industries generating substantial cash flow but facing few tion over these payments and can cut or omit them in times
growth opportunities, debt financing can add value simply of financial distress.
by forcing managers to be more critical in evaluating capital For this reason, adding more debt to the firm’s capital
spending plans.6 structure can serve as a credible signal of higher future
cash flows.7 By committing the firm to make future inter-
5 See Michael C. Jensen, “Agency Costs of Free Cash Flow, Corporate Finance, and
Takeovers,” American Economic Review 76 (1986), pp. 323-329. greatly increases the ability of small investor groups (including management) to control
6 More generally, the use of debt rather than equity reduces what economists call large asset holdings.
the agency costs of equity—loosely speaking, the reduction in firm value that arises from The concentration of ownership made possible by leverage appears to have been a
the separation of ownership from control in large, public companies with widely dis- major part of the value gains achieved by the LBO movement of the 1980s, and which
persed shareholders. In high-growth firms, the risk-sharing benefits of the corporate form has been resurrected in the 1990s. And, to the extent there are gains from having more
are likely to outweigh these agency costs. But in mature industries with limited capital concentrated ownership (and, again, these are likely to be greatest for mature industries
requirements, heavy debt financing has the added benefit of facilitating the concentration with assets in place), companies should have higher leverage ratios.
of equity ownership. To illustrate this potential role of debt, assume that the new owner 7 Stephen Ross, “The Determination of Financial Structure: The Incentive Signaling
of an all-equity company with $100 million of assets discovers that the assets can sup- Approach,” Bell Journal of Economics, Vol. 8 (1977), pp. 23-40.
port $90 million of debt. Reducing the firm’s equity from $100 million to $10 million

Journal of Applied Corporate Finance • Volume 32 Number 1 Winter 2020 83

est payments to bondholders, managers communicate their important thing to recognize is that most companies issuing
confidence that the firm will have sufficient cash flows to meet new equity—those that are undervalued as well as those that
these obligations. are overvalued—can expect a drop in stock prices when they
Debt and equity also differ with respect to their sensitiv- announce the offering. For those firms that are fairly valued
ity to changes in firm value. Since the promised payments to or undervalued prior to the announcement of the offering,
bondholders are fixed, and stockholders are entitled to the this expected drop in value represents an economic dilution
residual (or what’s left over after the fixed payments), stock of the existing shareholders’ interest. Throughout the rest of
prices are much more sensitive than bond prices to any propri- this paper, we refer to this dilution as part of the “information
etary information about future prospects. If management is in costs” of raising outside capital.
possession of good news that has yet to be reflected in market The Pecking Order. Signaling theory, then, says that
prices, the release of such news will cause a larger increase financing decisions are based, at least in part, on manage-
in stock prices than in bond prices; and hence current stock ment’s perception of the “fairness” of the market’s current
prices (prior to release of the new information) will appear valuation of the stock. Stated as simply as possible, the theory
more undervalued to managers than current bond prices. For suggests that, in order to minimize the information costs of
this reason, signaling theory suggests that managers of compa- issuing securities, a company is more likely to issue debt than
nies that believe their assets are undervalued will generally equity if the firm appears undervalued, and to issue stock
choose to issue debt—and to use equity only as a last resort. rather than debt if the firm seems overvalued.
To illustrate this with a simple example, let’s suppose that The pecking order theory takes this argument one step
the market price of a stock is $25.00. Investors understand further, suggesting that the information costs associated with
that its “real” value—that is, the value they would assign if issuing securities are so large that they dominate all other
they had access to the same information as the firm’s manag- considerations. According to this theory, companies maximize
ers—might be as high as $27.00 or as low as $23.00; but value by systematically choosing to finance new investments
given investors’ information, $25.00 is a fair price. Now let’s with the “cheapest available” source of funds. Specifically, they
suppose that the managers want to raise external funds and prefer internally generated funds (retained earnings) to exter-
they could either sell equity or debt. If the managers think the nal funding and, if outside funds are necessary, they prefer
stock is really worth only $23.00, selling shares for $25.00 debt to equity because of the lower information costs associ-
would be attractive—especially if their compensation is tied ated with debt issues. Companies issue equity only as a last
to stock appreciation. But if the managers think the stock is resort, when their debt capacity has been exhausted.9
really worth $27.00, equity would be expensive at $25.00 and The pecking order theory would thus suggest that compa-
debt would be more attractive. nies with few investment opportunities and substantial free
Investors understand this—and so if the company cash flow will have low debt ratios—and that high-growth
announces an equity offer, investors reassess the current price firms with lower operating cash flows will have high debt
in light of this new information. Since it is more likely that ratios. In this sense, the theory not only suggests that inter-
the stock is worth $23.00 than $27.00, the market price est tax shields and the costs of financial distress are at most a
declines. Such a rapid adjustment in valuation associated second-order concern; the logic of the pecking order actually
with the announcement thus eliminates much of any poten- leads to a set of predictions that are precisely the opposite of
tial gain from attempting to exploit the manager’s superior those offered by the tax and contracting cost arguments
information. presented above.
Consistent with this example, economists have
documented that the market responds in systematically The Evidence
negative fashion to announcements of equity offerings, Having discussed the different theories for observed capital
marking down the share prices of issuing firms by about 3% structure, we now review the available empirical evidence to
on average. By contrast, the average market reaction to new assess the relative “explanatory power” of each.
debt offerings is not significantly different from zero.8 The

8 More generally, the evidence suggests that leverage-increasing transactions are to common-for-debt exchanges and by 7.7% in preferred-for-debt exchanges. For a re-
associated with positive stock price reactions while leverage-reducing transactions are view of this evidence, see Clifford Smith, “Investment Banking and the Capital Acquisi-
associated with negative reactions. In reaction to large debt-for-stock exchanges, for ex- tion Process,” Journal of Financial Economics, Vol. 15 (1986), pp. 3-29.
ample, stock prices go up by 14% on average. The market also reacts in a predictably 9 See Stewart Myers, “The Capital Structure Puzzle,” Journal of Finance, 39
negative way to leverage-reducing transactions, with prices falling by 9.9% in response (1984), pp. 575-592.

84 Journal of Applied Corporate Finance • Volume 32 Number 1 Winter 2020

Evidence on Contracting Costs cial distress for growth companies, which tend to have more
Leverage Ratios. Much of the previous evidence on capi- volatile earnings as well as higher spending on R&D.12
tal structure supports the conclusion that there is an optimal Several studies have also reported finding that the debt
capital structure and that firms make financing decisions and ratios of individual companies seem to revert toward optimal
adjust their capital structures to move closer to this optimum. targets. For example, a 1982 study by Paul Marsh estimated
For example, a 1967 study by Eli Schwartz and Richard Aron- a company’s target ratio as the average ratio observed over
son showed clear differences in the average debt to (book) the prior ten years. He then found that the probability that a
asset ratios of companies in different industries, as well as a firm issues equity is significantly higher if the firm is above its
tendency for companies in the same industry to cluster around target debt ratio, and significantly lower if below the target.13
these averages.10 Moreover, such industry debt ratios seem As described in a 1995 article in this journal, we (together
to align with R&D spending and other proxies for corpo- with colleague Ross Watts) attempted to add to this body of
rate growth opportunities that the theory suggests are likely empirical work on capital structure by examining a much
to be important in determining an optimal capital struc- larger sample of companies that we tracked for over three
ture. In a 1985 study, Michael Long and Ileen Malitz showed decades.14 For some 6,700 companies covered by Compustat,
that the five most highly leveraged industries—cement, blast we calculated “market” leverage ratios (measured as the book
furnaces and steel, paper and allied products, textiles, and value of total debt divided by the book value of debt and
petroleum refining—were all mature and asset-intensive. At preferred stock plus the market value of equity) over the period
the other extreme, the five industries with the lowest debt 1963-1993. Not surprisingly, we found considerable differ-
ratios—cosmetics, drugs, photographic equipment, aircraft, ences in leverage ratios, both across companies in any given
and radio and TV receiving—were all growth industries with year and, in some cases, for the same firm over time. Although
high advertising and R&D.11 the average leverage ratio for the 6,700 companies over the
30-year period was 25%, one fourth of the cases had market
leverage ratios that were higher than 37.5% and another one
“ fourth had leverage ratios less than 10.3%.
To test the contracting cost theory described earlier in
A 1985 study showed that the five most highly lever- this paper, we attempted to determine the extent to which
aged industries—cement, blast furnaces and steel, corporate leverage choices can be explained by differences in
companies’ investment opportunities. As suggested earlier,
paper and allied products, textiles, and petroleum
the contracting cost hypothesis predicts that the greater these
refining—wer eall mature and asset-intensive. At the investment opportunities (relative to the size of the company),
other extreme, the five industries with the lowest debt the greater the potential underinvestment problem associated
with debt financing and, hence, the lower the company’s target
ratios were all growth industries with high advertising leverage ratio. Conversely, the more limited a company’s
and R&D. growth opportunities, the greater the potential overinvest-
ment problem and, hence, the higher should be the company’s
” leverage.
To test this prediction, we needed a measure of investment
Other studies have used “cross-sectional” regression opportunities. Because stock prices reflect intangible assets
techniques to test whether the theoretical determinants of an such as growth opportunities but corporate balance sheets do
optimal capital structure actually affect financing decisions. not, we reasoned that the larger a company’s “growth options”
For example, in their 1984 study, Michael Bradley, Greg relative to its “assets in place,” the higher on average will be its
Jarrell, and Han Kim found that the debt to (book) asset market value in relation to its book value. We accordingly used
ratio was negatively related to both the volatility of annual a company’s market-to-book ratio as our proxy for its invest-
operating earnings and to advertising and R&D expenses. ment opportunity set. The results of our regressions provide
Both of these findings are consistent with high costs of finan-
12 Michael Bradley, Greg Jarrell, and E. Han Kim, “The Existence of an Optimal
10 Eli Schwartz and J. Richard Aronson, “Some Surrogate Evidence in Support of Capital Structure: Theory and Evidence,” Journal of Finance, Vol. 39 No. 3 (1984).
Optimal Financial Structure,” Journal of Finance Vol. 22 No. 1 (1967). 13 Paul Marsh, “The Choice Between Equity and Debt,” Journal of Finance, 37,
11 Michael Long and Ileen Malitz, “The Investment-Financing Nexus: Some Empirical (1982), pp. 121-144.
Evidence,” Midland Corporate Finance Journal, Vol. 3 No. 3 (1985). 14 Barclay, Smith, and Watts (1995), cited above.

Journal of Applied Corporate Finance • Volume 32 Number 1 Winter 2020 85

strong support for the contracting cost hypothesis. Companies (which reduce the required coupon payments), less restrictive
with high market-to-book ratios had significantly lower lever- covenants, and a smaller group of private investors rather than
age ratios than companies with low market-to-book ratios. public bondholders (which makes it easier to reorganize in
(The t-statistic on the market-to-book ratio in the leverage the event of trouble). By recognizing this array of financing
regression was about 130.) To make these findings a little choices, we can broaden the scope of our examination and
more concrete, our results suggest that as one moves from raise the potential power of our tests, while at the same time
companies at the bottom 10th percentile of market-to-book increasing the relevance of the analysis for managers who must
ratios (0.77) to the 90th percentile (2.59), the predicted lever- choose the design of their debt securities.
age market ratio falls by 14.3 percentage points—which is a
large fraction of the average ratio of 25%.
(For further discussion of these results, see the box on “
the next page.)
Moreover, such a negative relation between corporate As one moves from companies at the bottom 10th
leverage and market-to-book ratios appears to hold outside percentile of market-to-book ratios (0.77) to the 90th
the U.S. as well. In a 1995 study, Raghuram Rajan and Luigi
percentile (2.59), the predicted leverage market ratio
Zingales examined capital structure using data from Japan,
Germany, France, Italy, the U.K., and Canada, as well as falls by 14.3 percentage points—which is a large frac-
the U.S. They found that in each of these seven countries, tion of the average ratio of 25%.
leverage is lower for firms with higher market-to-book ratios
and higher for firms with higher ratios of fixed assets to total
assets.15 The above evidence on leverage ratios, it should be
”
pointed out, is also generally consistent with the tax hypoth- As described in our 1996 article in this journal,16 we
esis in the following sense: The same low-growth companies designed an empirical test of the suggestion—offered by
that face low financial distress costs and high free-cash-flow Stewart Myers in his 1977 article—that one way for companies
benefits from heavy debt financing are also likely to have with lots of growth options to control the underinvestment
greater use for interest tax shields than high-growth compa- problem is to issue debt with shorter maturities. The argument
nies. At the same time, the above evidence is inconsistent with is basically this: A firm whose value consists mainly of growth
the predictions of the pecking order theory—which, again, opportunities could severely reduce its future financing and
suggests that low-growth firms with high free cash flow will strategic flexibility—and in the process destroy much of its
have relatively low debt ratios. value—by issuing long-term debt. Not only would the interest
Debt Maturity and Priority. Like this article up to this rate have to be high to compensate lenders for their greater
point, most academic discussions of capital structure focus risk, but the burden of servicing the debt could cause the
just on the leverage ratio. In so doing, they effectively assume company to defer strategic investments if their operating cash
that all debt financing is the same. In practice, of course, flow turns down. By contrast, shorter-term debt, besides carry-
debt differs in several important respects, including maturity, ing lower interest rates in such cases, would also be less of
covenant restrictions, security, convertibility, and call provi- a threat to future strategic investment because, as the firm’s
sions, and whether the debt is privately placed or held by current investments begin to pay off, it will be able over time
widely dispersed public investors. Each of these features is to raise capital on more favorable terms.17
potentially important in determining the extent to which debt When we tested this prediction (again using market-to-
financing can cause, or exacerbate, a potential under-invest- book as a measure of growth options), we found that growth
ment problem. For example, debt-financed companies with companies tended to have significantly less debt with a
more investment opportunities would prefer to have debt with maturity greater than three years than companies with limited
shorter maturities (or at least with call provisions, to ensure investment opportunities. More specifically, our regressions
greater financing flexibility), more convertibility provisions
16 Michael J. Barclay and Clifford W. Smith, Jr., “On Financial Architecture: Lever-
15 See Raghuram Rajan and Luigi Zingales, “What Do We Know About Capital Struc- age, Maturity, and Priority,” Journal of Applied Corporate Finance, Vol. 8 No. 4 (1996).
ture? Some Evidence from International Data,” Journal of Finance, Vol. 50 No. 5 17 If the firm’s debt matures before a company’s growth options must be exercised,
(1995). These relations are statistically significant for each country for the coefficient on the investment distortions created by the debt is eliminated. Since these investment
growth options and for every country but France and Canada for the coefficient on assets distortions are most severe, and most costly, for firms with significant growth options,
in place. high-growth firms should use more short-term debt.

86 Journal of Applied Corporate Finance • Volume 32 Number 1 Winter 2020

 ROBUSTNESS OF THE EVIDENCE ON CONTRACTING COSTS

number of empirical tests of the contracting (2) the interest coverage ratio (EBIT over interest).

A cost hypothesis have taken the form of a

regression with market leverage (measured as
the ratio of the book value of debt to the total
On purely theoretical grounds, these regressions are
expected to produce less significant results. Recall that
the contracting cost hypothesis predicts that tangible
market value of the firm) as the dependent variable and “assets in place” provide good collateral for loans while
the corporate market-to-book ratio together with a few intangible investment opportunities do not. If leverage
“control” variables as the independent variables. Because is measured as the ratio of total debt to the book value
the market value of the firm appears on both the left and of assets, we are really measuring the extent to which
right-hand sides of this regression (in the denominator of the firm has leveraged just its tangible (book) assets
the leverage ratio and in the numerator of the market- while essentially ignoring the intangible assets. For this
to-book ratio), some researchers have questioned whether reason, the theory predicts less variation in leverage when
the strong negative relation between these variables really measured in relation to book assets than when measured
supports the theory or is simply the “artificial” result of in relation to total market value.
large variations in stock prices. Nevertheless, when we reestimated the leverage regres-
To examine the robustness of these results, our 1995 sion substituting book leverage as the dependent variable,
study with Ross Watts used other proxies for the firms’ the results again supported the contracting cost hypoth-
investment opportunities (the independent variable) esis. The regression coefficient on the market-to-book
that do not rely on market values. For example, when ratio in the book-leverage regression was smaller (with a
we substituted a company’s R&D and advertising as a somewhat lower t-statistic), as predicted. But the coeffi-
percentage of sales for its market-to-book ratio, our results cient was still reliably negative, with a t-statistic greater
were consistent with the contracting cost hypothesis. The than 45.
coefficients on both of our alternative proxies for the firm’s A similar problem arises with the coverage ratio.
investment opportunities had the correct sign, and the In this case, the benefits of intangible growth opportuni-
t-statistics, although lower than 130, were still impres- ties (in the form of higher expected future cash flow) are
sive—about 65 in the R&D regression and 18 in the not reflected in current earnings when we use the coverage
advertising regression. ratio as our proxy for leverage. Yet, even so, the correla-
In a more recent series of tests, we used two different tion coefficient was positive; that is to say, companies
proxies for leverage (the dependent variable): with higher market-to-book values tended to have signifi-
(1) the ratio of total debt to the book value of assets; cantly higher interest coverage ratios (the t-statistic
and exceeded 70).

suggest that moving from companies at the 10th to the 90th into financial difficulty, complicated capital structures with
percentile of market-to-book ratios (that is from 0.77 to 2.59) claims of different priorities can generate serious conflicts
reduces the ratio of long-term debt to total debt by 18 percent- among creditors, thus exacerbating the underinvestment
age points (a significant reduction, given our sample average problem described earlier. And because such conflicts and
ratio of 46%). the resulting underinvestment have the greatest potential to
Moreover, we also found in the same study that the debt destroy value in growth firms, those growth firms that do
issued by growth firms is significantly more concentrated issue fixed claims are likely to choose mainly high-priority
among high-priority classes. Consistent with our results fixed claims.
indicating that firms with more growth options tend to have
lower leverage ratios, we find that changing the market-to- The Evidence on Information Costs
book ratio from the 10th to the 90th percentile is associated Leverage. Signaling theory says that companies are more
with reductions in leasing of 89%, in secured debt of 71%, likely to issue debt than equity when they are undervalued
in ordinary debt of 78%, and in subordinated debt of almost because of the large information costs (in the form of dilu-
250%. Our explanation for this is as follows: When firms get tion) associated with an equity offering. The pecking order

Journal of Applied Corporate Finance • Volume 32 Number 1 Winter 2020 87

model goes even farther, suggesting that the information costs Such findings have generally been interpreted as confir-
associated with riskier securities are so large that most compa- mation that managers do not set target leverage ratios—or at
nies will not issue equity until they have completely exhausted least do not work very hard to achieve them. But this is not
their debt capacity. Neither the signaling nor the pecking the only interpretation that fits these data. Even if companies
order theory offers any clear prediction about what optimal have target leverage ratios, there will be an optimal deviation
capital structure would be for a given firm. The signaling from those targets—one that will depend on the transactions
theory seems to suggest that a firm’s actual capital structure costs associated with adjusting back to the target relative
will be influenced by whether the company is perceived by to the costs of deviating from the target. To the extent
management to be undervalued or overvalued. The pecking there are fixed costs and scale economies in issuing securi-
order model is more extreme; it implies that a company will ties, companies with capital structure targets—particularly
smaller firms—will make infrequent adjustments and often
will deliberately overshoot their targets. (And, as we argue in
“ the closing section of this paper, a complete theory of capital
structure must take account of these adjustment costs and
Even if companies have target leverage ratios, there how they affect expected deviations from the target.)
will be an optimal deviation from those targets—one In our 1995 paper with Ross Watts, we attempted to
devise our own test of how information costs affect corporate
that will depend on the transactions costs associated
financing behavior. According to the signaling explana-
with adjusting back to the target relative to the costs tion, undervalued companies will have higher leverage than
of deviating from the target. overvalued firms. One major challenge in testing this signaling
argument is coming up with a reliable proxy for undervalua-
” tion that can be readily observed. In devising such a measure,
we began with the assumption that corporate earnings follow
not have a target capital structure, and that its leverage ratio a random walk, and that the best predictor of a company’s
will be determined by the gap between its operating cash flow next year’s earnings is thus its current year’s earnings. We then
and its investment requirements over time. Thus, the pecking classified firms as undervalued in any given year in which their
order predicts that companies with consistently high prof- earnings (excluding extraordinary items and discontinued
its or modest financing requirements are likely to have low operation and adjusted for any changes in shares outstanding)
debt ratios—mainly because they don’t need outside capital. increased in the following year. We designated as overvalued
Less profitable companies, and those with large financing all firms whose ordinary earnings decreased in the next year.
requirements, will end up with high leverage ratios because Our regressions showed a very small (but statistically
of managers’ reluctance to issue equity. significant) positive relation between a company’s lever-
A number of studies have provided support for the age ratio and its unexpected earnings, thus suggesting that
pecking order theory in the form of evidence of a strong this undervaluation variable has a trivial effect on corporate
negative relation between past profitability and leverage. capital structure. For example, moving from the 10th percen-
That is, the lower a company’s profits and operating cash tile of abnormal earnings in our sample (those firms whose
flows in a given year, the higher its leverage ratio (measured earnings decreased by 12%) to the 90th percentile (those
either in terms of book or market values).18 Moreover, in whose earnings increased by 13%) raised the predicted lever-
an article published in 1998, Stewart Myers and Lakshmi age ratio by only 0.5 percentage points. Moreover, in our
Shyam-Sunder added to this series of studies by showing that 1996 study (which also uses COMPUSTAT data, although
this relation explains more of the time-series variance of debt for a somewhat different time period), we again found a small
ratios than a simple target-adjustment model of capital struc- relation between leverage and unexpected earnings. In this
ture that is consistent with the contracting cost hypothesis.19 regression, however, the relation was negative.
Maturity and Priority. Signaling theory implies that
18 See, for example, Carl Kester, “Capital and Ownership Structure: A Comparison of undervalued firms will have more short-term debt and more
Unites States and Japanese Manufacturing Corporations,” Financial Management, Vol.
15 (1986); Rajan and Zingales (1995); and Sheridan Titman and Roberto Wessels, senior debt than overvalued firms because such instruments
“The Determinants of Capital Structure Choice,” Journal of Finance, 43 (1988), pp. are less sensitive to the market’s assessment of firm value and
1-19.
19 Lakshmi Shyam-Sunder and Stewart Myers, “Testing Static Tradeoff Against Peck-
thus will be less undervalued when issued. The findings of
ing Order Models of Capital Structure,” Journal of Financial Economics, Vol. 51 No. 2. our 1996 study are inconsistent with the predictions of the

88 Journal of Applied Corporate Finance • Volume 32 Number 1 Winter 2020

signaling hypothesis with respect to debt maturity. Companies But before we conclude that taxes are unimportant in
whose earnings were about to increase the following year in the capital structure decision, it is critical to recognize that
fact issued less short-term debt and more long-term debt than the findings of these studies are hard to interpret because
firms whose earnings were about to decrease. And, whereas the the tax variables are crude proxies for a company’s effective
theory predicts more senior debt for firms about to experience marginal tax rate. In fact, these proxies are often correlated
earnings increases, the ratio of senior debt to total debt is lower with other variables that influence the capital structure
for overvalued than for undervalued firms. choice. For example, companies with investment tax credits,
In sum, the results of our tests of managers’ use of high levels of depreciation, and other non-debt tax shields
financing choices to signal their superior information to the also tend to have mainly tangible fixed assets. And, since
market are not robust, and the economic effect of any such fixed assets provide good collateral, the non-debt tax shields
signaling on corporate decision-making seems minimal. may in fact be a proxy not for limited tax benefits, but rather
According to the pecking order theory, the firm should for low contracting costs associated with debt financing. The
issue as much of the security with the lowest information evidence from the studies just cited is generally consistent
costs as it can. Only after this capacity is exhausted should with this interpretation.
it move on to issue a security with higher information costs. Similarly, firms with net operating loss carryforwards
Thus, for example, firms should issue as much secured debt are often in financial distress; and, since equity values
or capitalized leases as possible before issuing any unsecured typically decline in such circumstances, financial distress
debt, and they should exhaust their capacity for issuing itself causes leverage ratios to increase. Thus, again, it is not
short-term debt before issuing any long-term debt. But these clear whether net operating losses proxy for low tax benefits
predictions are clearly rejected by the data. For example, of debt or for financial distress.
when we examined the capital structures of over 7,000 More recently, several authors have succeeded in
companies between 1980 and 1997 (representing almost detecting tax effects in financing decisions by focusing
57,000 firm-year observations), we found that 23% of these on incremental financing choices (that is, changes in the
observations had no secured debt, 54% had no capital leases, amount of debt or equity) rather than on the levels of debt
and 50% had no debt that was originally issued with less and equity. For example, a 1990 study by Jeffrey Mackie-
than one year to maturity. Mason examined registered security offerings by public U.S.
To explain these more detailed aspects of capital struc- corporations and found that firms were more likely to issue
ture, proponents of the pecking order theory must go debt if they had a high marginal tax rate and to issue equity
outside their theory and argue that other costs and benefits if they had a low tax rate.21 In another attempt to avoid
determine these choices. But once you allow for these other the difficulties with crude proxy variables, a 1996 study by
costs and benefits to have a material impact on corporate John Graham used a sophisticated simulation method to
financing choices, you are back in the more traditional provide a more accurate measure of companies’ marginal tax
domain of optimal capital structure theories. rates.22 Using such tax rates, Graham also found a positive
association between changes in debt ratios and the firm’s
The Evidence on Taxes marginal tax rate.
Theoretical models of optimal capital structure predict that On balance, then, the evidence appears to suggest that
firms with more taxable income and fewer non-debt tax taxes play a least a modest role in corporate financing and
shields should have higher leverage ratios. But the evidence capital structure decisions. Moreover, as mentioned earlier,
on the relation between leverage ratios and tax-related vari- the results of our tests of contracting costs reported above
ables is mixed at best. For example, studies that examine the can also be interpreted as evidence in support of the tax
effect of non-debt tax shields on companies’ leverage ratios explanation.
find that this effect is either insignificant, or that it enters
with the wrong sign. That is, in contrast to the prediction of
the tax hypothesis, these studies suggest that firms with more
non-debt tax shields such as depreciation, net operating loss
carryforwards and investment tax credits have, if anything, and Barclay, Smith, and Watts (1995), all of which are cited above.
more not less debt in their capital structures.20 21 Jeffrey Mackie-Mason, “Do Taxes Affect Corporate Financing Decisions?,” Journal
of Finance, 45 (1990), pp. 1471-1494.
22 John Graham, “Debt and the Marginal Tax Rate, Journal of Financial Economics,
20 See, for example, Bradley, Jarrell, and Kim (1984); Titman and Wessels (1988); 41 (1996), pp. 41-73.

Journal of Applied Corporate Finance • Volume 32 Number 1 Winter 2020 89

Toward a Unified Theory of that companies will not simultaneously pay dividends and
Corporate Financial Policy access external capital markets. But this prediction can,
In addition to explaining the basic leverage (or debt vs. of course, be rejected simply by glancing at the business
equity) decision, a useful theory of capital structure should section of most daily newspapers. With the exception of
also help explain other capital structure choices, such as a few extraordinarily successful high-tech companies like
debt maturity, priority, the use of callability and convert- Microsoft and Amgen, most large, publicly traded compa-
ibility provisions, and the choice between public and private nies pay dividends while at the same time regularly rolling
financing. As discussed above, the contracting-cost theory over existing debt with new public issues. And, as already
provides a unified framework for analyzing the entire range
of capital structure choices while most other theories, such
as the signaling and pecking order theories, are at best silent “
about—and more often inconsistent with—the empirical
evidence on these issues. The key to reconciling the different theories—and
We now take this argument one step further by suggest- thus to solving the capital structure puzzle—lies
ing that a productive capital structure theory should also
in achieving a better understanding of the relation
help explain an even broader array of corporate financial
policy choices, including dividend, compensation, hedging, between corporate financing stocks and flows.
and leasing policies. The empirical evidence suggests that
companies choose coherent packages of these financial ”
policies. For example, small high-growth firms tend to have discussed, although the pecking order predicts that mature
not only low leverage ratios and simple capital structures firms that generate lots of free cash flow should eventually
(with predominantly short-maturity, senior bank debt), but become all equity financed, they are among the most highly
also low dividend payouts as well as considerable stock-based levered firms in our sample. Conversely, the pecking order
incentive compensation for senior executives. By contrast, theory implies that high-tech startup firms will have high
large mature companies tend to have high leverage, more leverage ratios because they often have negative free cash
long-term debt, more complicated capital structures with a flow and incur the largest information costs when issuing
broader range of debt priorities, higher dividends, and less equity. But, in fact, such firms are financed almost entirely
incentive compensation (with greater reliance on earnings- with equity.
based bonuses rather than stock-based compensation Thus, as we saw in the case of debt maturity and priority,
plans).23 Thus, corporate financing, dividend, and compen- proponents of the pecking order must go outside of their
sation policies, besides being highly correlated with each theory to explain corporate behavior at both ends of the
other, all appear to be driven by the same fundamental firm corporate growth spectrum. In so doing, they implicitly
characteristics: investment opportunities and (to a lesser limit the size and importance of information costs; they
extent) firm size. And this consistent pattern of corporate concede that, at least for the most mature and the highest-
decision-making suggests that we now have the rudiments of growth sectors, information costs are less important than
a unified framework for explaining most, if not all, financial other considerations in corporate financing decisions.
policy choices.
As mentioned earlier, proponents of the pecking order Integration of Stocks and Flows
theory argue that the information costs associated with Although the pecking order theory is incapable of explain-
issuing new securities dominate all other costs in deter- ing the full array of financial policy choices, this does not
mining capital structure. But, as we also noted, the logic mean that information costs are unimportant in corporate
and predictions of the pecking order theory are at odds decision-making. On the contrary, such costs will influence
with, and thus incapable of explaining, most other financial corporate financing choices and, along with other costs and
policy choices. For example, in suggesting that firms will benefits, must be part of a unified theory of corporate finan-
always use the cheapest source of funds, the model implies cial policy.
In our view, the key to reconciling the different
theories—and thus to solving the capital structure puzzle—
23 See Clifford W. Smith and Ross L. Watts, “The Investment Opportunity Set and
Corporate Financing, Dividend and Compensation Policies,” Journal of Financial Eco-
lies in achieving a better understanding of the relation
nomics, 32 (1992), pp. 263-292. between corporate financing stocks and flows. The theories

90 Journal of Applied Corporate Finance • Volume 32 Number 1 Winter 2020

of capital structure discussed in this paper generally focus on the size and variation of such costs suggests that there
either on the stocks (that is, on the levels of debt and equity is a material fixed component—one that again includes
in relation to the target) or on the flows (the decision of information costs as well as out-of-pocket costs.24 And since
which security to issue at a particular time). For example, average adjustment costs fall with increases in transaction
the primary focus of the contracting-cost theories has been size, there are scale economies in issuing new securities
leverage ratios, which are measures of the stocks of debt and that suggest that small firms, all else equal, are likely to
equity. By contrast, information-based theories like the deviate farther from their capital structure targets than
pecking order model generally focus on flows—for example, larger companies.
on the information costs associated with a new issue of debt Although the different kinds of external financing all
or equity. But, since both stocks and flows are likely to play exhibit scale economies, the structure of the costs varies
important roles in such decisions, neither of these theoretical among different types of securities. Equity issues have both
approaches taken alone is likely to offer a reliable guide to the largest out-of-pocket transactions costs and the largest
optimal capital structure. information costs. Long-term public debt issues, particu-
In developing a sensible approach to capital structure larly for below-investment-grade companies, are less costly.25
strategy, the CFO should start by thinking about the firm’s Short-term private debt or bank loans are the least costly.
target capital structure in terms of stock measures—that is, And because CFOs are likely to weigh these adjustment
a ratio of debt to total capital that can be expected to minimize costs against the expected benefits from moving closer
taxes and contracting costs (although information costs may to their leverage target, it is not surprising that seasoned
also be given some consideration here). That target ratio equity offerings are rare events, that long-term debt issues
should take into consideration factors such as the company’s are more common, and that private debt offerings or bank
projected investment requirements; the level and stability loans occur with almost predictable regularity. Moreover,
of its operating cash flows; its tax status; the expected loss because of such adjustment costs, most companies—partic-
in value from being forced to defer investment because of ularly smaller firms—are also likely to spend considerable
financial distress; and the firm’s ability to raise capital on time away from their target capital structures. Other things
short notice (without excessive dilution). equal, larger adjustment costs will lead to larger deviations
If the company is not currently at or near its optimal from the target before the firm readjusts.
capital structure, the CFO should come up with a plan to In sum, to make a sensible decision about capital struc-
achieve the target debt ratio. For example, if the firm has ture, CFOs must understand both the costs associated with
“too much” equity (or too much capital in general), it can deviating from the target capital structure and the costs
increase leverage by borrowing (or using excess cash) to buy of adjusting back toward the target. The next major step
back shares—a possibility that the pecking order generally forward in solving the capital structure puzzle is almost
ignores. (And the fact that U.S. corporate stock repurchases certain to involve a more formal weighing of these two
have been growing at almost 30% per year for most of this sets of costs.
decade is by itself perhaps the single most compelling piece
of evidence that corporate managers are thinking in terms MICHAEL BARCLAY is Alumni Distinguished Professor of Business
of optimal capital structure.) But if the company needs more Administration at the University of Rochester’s William E. Simon School
capital, then managers choosing between equity and various of Business Administration.
forms of debt must consider not only the benefits of moving
toward the target, but also the associated adjustment costs. clifford smith is the Louise and Henry Epstein Professor of Business
For example, a company with “too much” debt may choose Administration at the University of Rochester’s William E. Simon School
to delay an equity offering—or issue convertibles or PERCS of Business Administration.
instead—in order to reduce the cost of issuing securities that
it perceives to be undervalued.
As a more general principle, the CFO should adjust
the firm’s capital structure whenever the costs of adjust- 24 See, for example, David Blackwell and David Kidwell, “An Investigation of Cost
Differences Between Private Placements and Public Sales of Debt,” Journal of Financial
ment—including information costs as well as out-of-pocket Economics, 22 (1988), pp. 253-278; and Clifford Smith, “Alternative Methods for Rais-
transactions costs—are less than the costs of deviating from ing Capital: Rights vs. Underwritten Offerings,” Journal of Financial Economics, 5
(1977), pp. 273-307.
the target. Based on the existing research, what can we 25 See, in this issue, Sudip Datta, Mai Iskandar-Datta, and Ajay Patel, “The Pricing
say about such adjustment costs? The available evidence of Debt IPOs,” Journal of Applied Corporate Finance, Vol. 12 No. 1 (Spring 1999).

Journal of Applied Corporate Finance • Volume 32 Number 1 Winter 2020 91

ADVISORY BOARD EDITORIAL
Yakov Amihud Carl Ferenbach Donald Lessard Clifford Smith, Jr. Editor-in-Chief
New York University High Meadows Foundation Massachusetts Institute of University of Rochester Donald H. Chew, Jr.
Technology
Mary Barth Kenneth French Charles Smithson Associate Editor
Stanford University Dartmouth College John McConnell Rutter Associates John L. McCormack
Purdue University
Amar Bhidé Martin Fridson Laura Starks Design and Production
Tufts University Lehmann, Livian, Fridson Robert Merton University of Texas at Austin Mary McBride
Advisors LLC Massachusetts Institute of
Michael Bradley Technology Erik Stern Assistant Editor
Duke University Stuart L. Gillan Stern Value Management Michael E. Chew
University of Georgia Gregory V. Milano
Richard Brealey Fortuna Advisors LLC G. Bennett Stewart
London Business School Richard Greco Institutional Shareholder
Filangieri Capital Partners Stewart Myers Services
Michael Brennan Massachusetts Institute of
University of California, Trevor Harris Technology René Stulz
Los Angeles Columbia University The Ohio State University
Robert Parrino
Robert Bruner Glenn Hubbard University of Texas at Austin Sheridan Titman
University of Virginia Columbia University University of Texas at Austin
Richard Ruback
Charles Calomiris Michael Jensen Harvard Business School Alex Triantis
Columbia University Harvard University University of Maryland
G. William Schwert
Christopher Culp Steven Kaplan University of Rochester Laura D’Andrea Tyson
Johns Hopkins Institute for University of Chicago University of California,
Applied Economics Alan Shapiro Berkeley
David Larcker University of Southern
Howard Davies Stanford University California Ross Watts
Institut d’Études Politiques Massachusetts Institute
de Paris Martin Leibowitz Betty Simkins of Technology
Morgan Stanley Oklahoma State University
Robert Eccles Jerold Zimmerman
Harvard Business School University of Rochester

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