Capital Structure and Corporate Financing Decisions

Theory, Evidence, and Practice

H. Kent Baker, Gerald S. Martin

• Publisher: Wiley
• Year: 2011
• ISBN:
  9781118022948
• Edition: 1
• Topic: Business
• Subtopic: Finance
• Index: Business

A comprehensive guide to making better capital structure and corporate financing decisions in today's dynamic business environment

Given the dramatic changes that have recently occurred in the economy, the topic of capital structure and corporate financing decisions is critically important. The fact is that firms need to constantly revisit their portfolio of debt, equity, and hybrid securities to finance assets, operations, and future growth.

Capital Structure and Corporate Financing Decisions provides an in-depth examination of critical capital structure topics, including discussions of basic capital structure components, key theories and practices, and practical application in an increasingly complex corporate world. Throughout, the book emphasizes how a sound capital structure simultaneously minimizes the firm's cost of capital and maximizes the value to shareholders.

• Offers a strategic focus that allows you to understand how financing decisions relates to a firm's overall corporate policy
• Consists of contributed chapters from both academics and experienced professionals, offering a variety of perspectives and a rich interplay of ideas
• Contains information from survey research describing actual financial practices of firms

This valuable resource takes a practical approach to capital structure by discussing why various theories make sense and how firms use them to solve problems and create wealth. In the wake of the recent financial crisis, the insights found here are essential to excelling in today's volatile business environment.

PART I

The Elements of Capital Structure

Chapter 1

Capital Structure: An Overview

H. Kent Baker

University Professor of Finance and Kogod Research Professor, American University

Gerald S. Martin

Associate Professor of Finance, American University

INTRODUCTION

According to Baker and Powell (2005, p. 4), financial management is “an integrated decision-making process concerned with acquiring, financing, and managing assets to accomplish some overall goal within a business entity.” Jensen (2001) indicates that among most financial economists the criterion for evaluating performance and deciding between alternative courses of action should be maximization of long-term market value of the firm. He notes that this value maximization proposition has its roots in 200 years of research in economics and finance. For publicly-held firms, the maximization of shareholder wealth is reflected in the market price of the stock. By maximizing shareholder wealth, managers are serving the interests of the firm's owners as residual claimants. Under most circumstances, the premise of maximizing total firm value is also consistent with maximizing shareholder wealth.

This book focuses on one major aspect of financial management—how capital structure and financing decisions can contribute to maximizing the value of the firm. Financing decisions go hand in hand with investment decisions. That is, a firm needs sufficient funds to support its activities resulting from its investment decisions. Capital structure refers to the sources of financing employed by the firm. These sources include debt, equity, and hybrid securities that a firm uses to finance its assets, operations, and future growth. Often thought of in terms of financial leverage, a firm's capital structure is a direct determinant of its overall risk and cost of capital. The sources of capital have important consequences for the firm and can affect its value and hence shareholder wealth. For example, while debt is the least costly form of capital, the effects of increasing leverage through the use of debt simultaneously increase financial risk. Borrowing not only increases the risk of default for a firm but also increases the volatility of a firm's earnings per share and its return on equity. The benefits of a lower cost of debt decrease as leverage rises due to increasing financial risk and the likelihood of financial distress and bankruptcy. As with most financial decisions, financing decisions involve a risk-return trade-off. Given the dramatic changes that have occurred recently in the economy such as the global financial crisis, the topic of capital structure and corporate financing decisions is critically important.

Barclay and Smith (1999, p. 8) make the following observation:

A perennial debate in corporate finance concerns the question of optimal capital 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?

An optimal capital structure is the financing mix that maximizes the value of the firm. Yet, mixed views exist about whether an optimal capital structure actually exists. Some believe that a firm's value does not depend on its financing mix, and hence an optimal capital structure does not exist. The modern theory of capital structure started with Modigliani and Miller (1958), who pioneered the research efforts relating capital structure and the value of the firm. In their seminal work, they show that under stringent conditions of competitive, frictionless, and complete capital markets, the value of a firm is independent of its capital structure. That is, managers cannot alter firm value or the cost of capital by the capital structures that they choose. Further, business risk alone determines the cost of capital. Thus, financing and capital structure decisions are not shareholder value enhancing and are deemed to be irrelevant. In reality, these conditions rarely exist. Empirical evidence suggests that financing does matter.

Others contend that managers can theoretically determine a firm's optimal capital structure. During the last five decades, financial economists have relaxed the restrictive assumptions underlying the theory of capital structure irrelevance and have introduced capital market frictions into their models. By introducing capital market frictions, such as taxes, bankruptcy costs, and asymmetric information, they are able to explain at least some factors driving capital structure decisions. Consequently, financial economists have set forth various capital structure theories such as trade-off theory (Kraus and Litzenberger 1973), pecking order theory (Myers 1984; Myers and Majluf 1984), signaling (Ross 1977), and market timing theory (Baker and Wurgler 2002) to explain the relevance of capital structure. These theories relate directly to taxes, asymmetric information, agency problems, and bankruptcy costs. Taken separately, these theories cannot explain certain important facts about capital structure. Despite extensive research into the area of capital structure, determining the precise financing mix that maximizes the market value of the firm remains elusive.

PURPOSE OF THE BOOK

The purpose of this book is to provide an in-depth examination of important topics about capital structure and corporate financing decisions. The coverage extends from discussing basic components and existing theories to their application to increasingly complex and real-world situations. Throughout, the book emphasizes how a sound capital structure can simultaneously reduce a firm's cost of capital while increasing value to shareholders. Given the sheer volume of theoretical and empirical studies involving capital structure and financing decisions, the prospect of surveying the extant literature is a formidable task. Although coverage is not exhaustive, the book includes a review of several hundred articles. Leading academics and researchers from around the globe provide a synthesis of the current state of capital structure and give their views about its future direction.

FEATURES OF THE BOOK

Many finance books deal with capital structure. Yet, few, if any, offer the scope of coverage and breadth of viewpoints contained in this volume. The book differs from others in several major ways. Perhaps the book's most distinctive feature is that it provides a comprehensive discussion of financial theory, empirical work, and practice involving corporate financial policies, strategies, and choices. This is an up-to-date book in terms of theoretical developments, empirical results, and practical applications.

Although the book cannot cover every topic on capital structure, given the voluminous amount of writing on the subject, it does seek to highlight some of the most important topics. The book takes a practical approach to capital structure by discussing why various theories make sense, the empirical support for them, and how firms use these theories to solve problems and to create wealth. This volume uses theoretical and mathematical derivations only when necessary to explain the topic. Although the book also reports the results of many empirical studies that link theory and practice, the objective is to distill them to their essential content so that they are understandable to the reader.

The book has six other distinguishing features.

1. The book contains contributions from numerous authors. This breadth of contributors provides a wide range of viewpoints and a rich interplay of ideas.

2. The book offers a strategic focus to help provide an understanding of how financing decisions relate to a firm's overall corporate policy. Because financial decisions are interconnected, managers must incorporate them into the overall corporate strategy of the firm.

3. The book has a global focus and examines worldwide patterns in capital structure. It reviews research not only centered on U.S. firms but also from companies around the world.

4. This volume takes both a prescriptive and descriptive perspective. Using a prescriptive approach, it examines how corporate managers should make financial decisions to improve firm value. The book's descriptive perspective discusses theories that shed light on which financial decisions managers make and analyzes the impact of these decisions on financial markets. The book also provides results from survey research describing actual financial practices of firms.

5. The book identifies areas needing future research in capital structure and financing decisions.

6. Each chapter except this introductory chapter contains a set of discussion questions to reinforce key aspects of the chapter's content. A separate section near the end of the book provides a guideline answer to each question.

INTENDED AUDIENCE

The intended audience for this book includes academics, researchers, corporate managers, students, and others interested in capital structure and corporate financing decisions. Considering its extensive coverage and focus on the theoretical and empirical literature, this book should be appealing to academics and researchers as a critical resource. Given the book's intuitive and largely nontechnical approach, it is geared toward helping corporate managers formulate policies and financial strategies that maximize firm value and policymakers in understanding capital structure choices. This volume can also stand alone or in tandem with another text or casebook for graduate and advanced undergraduate students, especially those in business or finance. This book should be especially useful in helping students develop the critical analytical skills required to understand the implications of capital structure. Finally, libraries should find this work to be suitable for reference purposes.

STRUCTURE OF THE BOOK

The remaining 23 chapters of this book are organized into four parts. A brief synopsis of each chapter follows.

Part I The Elements of Capital Structure

Chapters 2–7 provide an overview of the elements of capital structure. These chapters lay the foundation and discuss important principles and concepts involving capital structure. Chapters in this section examine the factors influencing capital structure decisions as well as the interactions among capital structure, strategy, risk, returns, and compensation. Additionally, this section identifies differences in capital structure across countries with different legal and institutional settings.

Chapter 2 Factors Affecting Capital Structure Decisions (Wolfgang Bessler, Wolfgang Drobetz, and Robin Kazemieh)

In perfect capital markets, capital structure decisions should not have any impact on the market value of a firm. However, once capital market frictions such as taxes, bankruptcy costs, and asymmetric information are introduced into the model, there are factors related to these frictions that affect capital structure decisions. This chapter provides a review of the main capital structure factors that have been identified in the literature. Survey evidence indicates that the most dominant factor that affects the decision to issue debt is maintaining financial flexibility. The major factors that determine the issuance of stock are earnings per share dilution and equity undervaluation or overvaluation. Results from regression studies using comprehensive firm-level data sets indicate that the most reliable factors for explaining corporate leverage are: market-to-book ratio (–), tangibility (+), profitability (–), firm size (+), expected inflation (+), and median industry leverage (+ effect on leverage).

Chapter 3 Capital Structure and Corporate Strategy (Maurizio La Rocca)

This chapter responds to the general call for integration between finance and strategy research by examining the relationship between capital structure decisions and corporate strategy. The literature on finance and strategy analyzes how the strategic actions of key players such as managers, shareholders, debt holders, competitors, workers, and suppliers affect firm value and its allocation between claimholders. Specifically, financing decisions can affect the value creation process by influencing efficient investment strategies due to conflicts of interest among managers, firm's financial stakeholders, and firm's nonfinancial stakeholders. In turn, the potential interactions between financial and nonfinancial stakeholders may give rise to inefficient managerial decisions or may shape the industry's competitive dynamics to achieve a competitive advantage. A good integration between finance and strategy can be tantamount to a competitive weapon.

Chapter 4 Capital Structure and Firm Risk (Valentin Dimitrov)

With market frictions, the real and financial sides of the firm are interrelated. As a result, variables such as financial leverage can have important consequences for firm risk. Prior analytical work has identified several mechanisms through which financial leverage can affect risk but has not reached a consensus on the relative importance of these mechanisms. The empirical evidence is more conclusive. When subjected to adverse economic shocks, highly leveraged firms have lower growth in sales, make fewer investments, and are less likely to survive than firms with low leverage. These findings suggest that financial leverage amplifies negative shocks; it makes firms riskier. However, shareholders of highly leveraged firms do not appear to be compensated for this higher risk. Highly leveraged firms earn lower stock returns in the cross-section. Furthermore, increases in leverage are associated with low subsequent stock returns. These return patterns present a challenge to traditional capital asset pricing models.

Chapter 5 Capital Structure and Returns (Yaz Gulnur Muradoglu and Sheeja Sivaprasad)

This chapter examines the link between stock returns and leverage. Proposition II of the Modigliani-Miller theorem on capital structure postulates that stock returns increase with leverage due to the increase in financial risk attached to debt. A limited number of studies test this ass...

Table of contents

• Cover
• Series
• Title Page
• Copyright
• Acknowledgments
• Part I: The Elements of Capital Structure
• Part II: Capital Structure Choice
• Part III: Raising Capital
• Part IV: Special Topics
• Answers to Chapter Discussion Questions
• Index