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3.4
Bankruptcy laws and the quality of governance . . . . . . . . . . 119
3.5
The effects of asset value volatility on financing costs . . . . . . . 137
Conclusions
153
Appendix A
158
Bibliography
161
6
List of Figures
1.1
Modigliani-Miller versus Traditional view. . . . . . . . . . . . . .
20
1.2
Payoffs to different claimholders. . . . . . . . . . . . . . . . . . .
21
1.3
Debt tax shield and firm value. . . . . . . . . . . . . . . . . . . .
23
1.4
Demand for debt. . . . . . . . . . . . . . . . . . . . . . . . . . . .
26
1.5
Supply of debt. . . . . . . . . . . . . . . . . . . . . . . . . . . . .
27
1.6
Miller equilibrium
. . . . . . . . . . . . . . . . . . . . . . . . . .
28
1.7
Value of a firm with taxes and bankruptcy costs. . . . . . . . . .
31
1.8
Agency costs of outside equity . . . . . . . . . . . . . . . . . . . .
34
1.9
Agency costs and the optimal capital structure . . . . . . . . . .
38
1.10 Issue-investment decision with asymmetric information about as-
set value.
. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
41
2.1
Debt ratios at market values of debt across the Euro Area.
. . .
55
2.2
Debt ratios at book values of debt across the Euro Area. . . . . .
56
2.3
Debt ratios at book vs market values of debt. . . . . . . . . . . .
57
2.4
Marginal Tax Rate: mean values. . . . . . . . . . . . . . . . . . .
60
2.5
Market debt ratios: actual and fitted values. . . . . . . . . . . . .
84
2.6
Market debt ratios: actual and fitted values. (continued) . . . . .
85
2.7
Book debt ratios: actual and fitted values. . . . . . . . . . . . . .
92
2.8
Book debt ratios: actual and fitted values. (continued) . . . . . .
93
3.1
Cross-country standard deviation among euro area countries. . . 102
3.2
Standard deviation of government bond yield spreads across the
Euro area. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 103
3.3
Evolution of beta coefficients for government bonds in the euro
area. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 103
3.4
Variance ratios for corporate bond spreads in the Euro area. . . . 105
3.5
Cross-country standard deviation of interest rates on loans to
non-financial enterprises. (Source: ECB ) . . . . . . . . . . . . . . 106
7
3.6
Cross-country standard deviation of banks' margin on loans to
non-financial enterprises.(Source: ECB ) . . . . . . . . . . . . . . 107
3.7
Cross-border loans as percentage of domestic loans (Source: ECB ).108
3.8
Country vs. sector dispersion of stock returns (in %) . . . . . . . 109
3.9
Stock market average sensitivity to euro area vs. US shocks. . . . 109
3.10 Real GDP annual growth rates in the euro area, 2000-2003
. . . 115
3.11 Research & Development expenditure as percentage of GDP (2000-
2003). . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 116
3.12 Research & Development personnel, 2003. . . . . . . . . . . . . . 117
3.13 Research & Development: patent applications to the EPO per
million inhabitants. . . . . . . . . . . . . . . . . . . . . . . . . . . 117
3.14 Imports and exports of good and services, as percentage of GDP. 118
3.15 State aids as percentage of GDP . . . . . . . . . . . . . . . . . . 133
8
List of Tables
2.1
Sample size by country.
. . . . . . . . . . . . . . . . . . . . . . .
52
2.2
Tax codes: main characteristics. . . . . . . . . . . . . . . . . . . .
59
2.3
Summary statistics.
. . . . . . . . . . . . . . . . . . . . . . . . .
67
2.4
Summary statistics (continued). . . . . . . . . . . . . . . . . . . .
68
2.5
Correlation matrix. . . . . . . . . . . . . . . . . . . . . . . . . . .
71
2.6
Correlation matrix (continued). . . . . . . . . . . . . . . . . . . .
72
2.7
Correlation matrix (continued). . . . . . . . . . . . . . . . . . . .
73
2.8
Correlation matrix (continued). . . . . . . . . . . . . . . . . . . .
74
2.9
Regression results with market debt. . . . . . . . . . . . . . . . .
77
2.10 Regression results with market debt (continued). . . . . . . . . .
78
2.11 Regression results with market debt (continued). . . . . . . . . .
79
2.12 Regression results with market debt (continued). . . . . . . . . .
80
2.13 Regression results with book debt . . . . . . . . . . . . . . . . . .
87
2.14 Regression results with book debt (continued) . . . . . . . . . . .
88
2.15 Regression results with book debt (continued) . . . . . . . . . . .
89
2.16 Regression results with book debt (continued) . . . . . . . . . . .
90
2.17 Distribution of firms across sectors. . . . . . . . . . . . . . . . . .
91
2.18 Average market debt ratios, by country and by sector of activity.
94
2.19 Cross-sector vs. cross-country regression.
. . . . . . . . . . . . .
95
2.20 France and Germany: cross-sectors regression. . . . . . . . . . . .
96
2.21 France and Germany: regression results for biggest sectors.
. . .
97
3.1
Regression coefficients for corporate bond yields. . . . . . . . . . 105
3.2
Stock market capitalisation as percentage of GDP. . . . . . . . . 111
3.3
Debt securities: outstanding amounts as percentage of GDP.
. . 112
3.4
MFI loans to financial and non-financial corporations: outstand-
ing amounts as percentage of GDP. . . . . . . . . . . . . . . . . . 113
3.5
Mean market debt ratio and financial markets size: regression
results. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 114
9
3.6
Main accounting obligations in Euro-area countries.
. . . . . . . 120
3.7
Internal and external controls for identifying potentially distressed
companies.
. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 122
3.8
In-court and out-of-court proceedings: main characteristics
. . . 125
3.9
Possible consequences of bankruptcy for the entrepreneur. . . . . 131
3.10 The attitude toward default risk: a survey (Flash Eurobarometer
134, November 2002 ). . . . . . . . . . . . . . . . . . . . . . . . . 132
3.11 Perceived Quality of Firm Level Corporate Governance. . . . . . 134
3.12 Perceived Quality of Public Institutions. . . . . . . . . . . . . . . 135
3.13 World Bank Governance Indicators (2002).
. . . . . . . . . . . . 136
10
Introduction
Since the publication of the seminal paper by Modigliani and Miller in 1958,
where the two authors discussed their well-known capital structure irrelevance
proposition, hundreds of papers have investigated how firms determine their
financing policy.
Theoretical research has focused on three main aspects which may cause the
irrelevance proposition to be violated: the potential tax benefit of debt, the
costs of financial distress, informational asymmetries. This research has led to
two main theories of capital structure: the trade-off theory and the pecking
order theory. Under the trade-off theory, firms balance costs connected with
alternative sources of funds and choose the mix which minimises the aggregate
cost. Under the pecking order theory, informational asymmetries lead to mis-
pricing of securities issued by firms: the optimal financial policy then consists in
first using the least-information-sensitive financing source, and then moving on
to more sensitive securities. This policy leads to a ranking of sources of funds:
first internally generated funds, then debt and, only as a last resort, equity.
Whereas theoretical research has deeply investigated which factors may af-
fect financing choices and make capital structure relevant, empirical work has
lagged behind: while it has been able to find some variables which systemati-
cally affect capital structure decisions, it has failed to discriminate between the
potential explanations, often due to the fact that it is hard to connect statisti-
cally significant results with theoretical explanations because the same variable
may be consistent with several approaches.
Moreover, most studies try to explain debt policies within countries, but they
rarely test (Rajan and Zingales, 1995, is one of the few relevant exceptions) if
and how their results are robust when the same model is applied to international
samples.
This work aims at testing a set of variables as potential determinants of
observed capital structures for non-financial listed firms located in any of the
twelve countries of the Euro area, for the financial year 2003. The choice of
13
using listed firms is motivated by the fact that this allows to use market, rather
than book, values of equity, which better reflect the true amount of resources
invested in the firms. I exclude financial firms from the sample because their
capital structure is strongly affected by public regulation aimed at protecting
the soundness of the financial system. I choose the Euro area as a geographical
sample for two reasons: on the one hand, the freedom of capital movements
across countries and the monetary union raise the possibility of an integration
of financial markets, and eliminate the exchange rate risk which might otherwise
prevent firms from raising funds abroad; on the other hand, laws and institutions
are still different between countries and this may help to better understand
which factors affect capital structure decisions.
Theoretical literature on capital structure is based on market-value measures
of debt, and hence leverage, while, with few exceptions, the empirical tests use
book-value measures; if the difference between the two measures of leverage is
relevant, then empirical results obtained with book values may be inconsistent
and unreliable for testing alternative hypothesis. The use of book values as
proxies for market values is due to the fact that, while nearly all firms have
debt outstanding, most of it is not publicly traded. This obviously creates a
problem, for not enough observations could be used if researchers only relied on
firms having publicly traded debt for their studies; the easiest solution is then
to use the book value as approximation, an approach which most find justifiable
by observing that the average market value of debt is close to the book value.
However, as Sweeney et al. (1997) report, many corporate bonds trade at values
which differ significantly from their book value, and the consequences of these
differences can be remarkable.
Here I use both market and book values of debt, and I find that, despite
the corresponding leverage ratios being strongly correlated, the two approaches
yield partially different results and goodness-of-fit measures are higher when
market, rather than book, values of leverage are used as dependent variable.
Since most European firms do not have publicly traded debt, I estimate
the market value from the book value and observable data from stock markets,
using the Black-Scholes-Merton model, derived from option pricing theory. By
means of that same model I also estimate the volatility of the enterprise value,
which I then use as a proxy measure of the operational risk of the firm. Results
indicate that this variable is the best predictor of observed leverage ratios; I
find that a trade-off theory of financing costs fits the data better than the
pecking order theory. Regression results are sensible to the national sample
considered: national environment thus has some influence on financing choices.
14
I also examine whether the sector of activity is an important determinant of
debt-equity choices; I find that, for some specific firm variables, coefficients
significantly change of magnitude, and in a few cases also of sign, from one
sector to another. Thus, both national environment and sector of activity may
affect financing decisions.
The importance of the national environment can be explained by two differ-
ent factors: the imperfect integration of European financial markets and insti-
tutional and legal differences across countries.
Despite the introduction of the common currency, financial markets in the
area are still not completely integrated: the money market and the inter-bank
segments have reached a near-perfect integration soon after the birth of the
Euro; the bond market and the equity market are converging towards integra-
tion, but the segment for bank retail loans is still strongly fragmented.
Legal frameworks are quite different across countries: tax laws, bankruptcy
procedures and national and corporate governance are far from being har-
monised between the countries of the area; these differences are well reflected
by rankings on the perceived quality of national and corporate governance, the
attitude towards bankruptcy and the statistics about the economic background.
I finally investigate how operating risk may affect debt-equity choices: an
higher risk clearly increases expected bankruptcy costs, and at the same time,
assuming that it reflects return volatility, it reduces the expected tax shield
produced by debt. An increase in risk may also increase agency costs connected
with debt, both in presence of moral hazard and adverse selection, hence making
this financing instrument less attractive for riskier firms. A trade-off theory of
costs connected with debt and equity financing is the one that better allows to
explain the observed leverage ratios. The use of market, rather than book values
of debt, is important not only because it permits to estimate empirical models
in accordance with the theoretical literature, which also yield higher values for
goodness-of-fit measures, but also because it gives the opportunity to estimate
the volatility of the asset value, which I find to be the best predictor of firms'
capital structures.
15
Chapter 1
Review of the literature
1.1
The theoretical literature
1.1.1
The irrelevance proposition
In their seminal paper of 1958, Modigliani and Miller derived the well-known
irrelevance proposition: under perfect capital markets, the market value of any
firm is independent of its capital structure and is given by capitalizing its ex-
pected return at the rate appropriate to its class
1
; in other words, the average
cost of capital to any firm is totally independent of its capital structure, and it
is equal to the rate of return required for an all-equity financed stream of cash
flows of the same risk class.
This result is derived under a set of hypothesis which can often be considered
unrealistic: frictionless capital markets, possibility of borrowing and lending at
the same risk-free rate, costless bankruptcy, tax neutrality, absence of infor-
mational asymmetries. All these assumptions assure that the operating cash
flows are independent of the firms' capital structure: as a consequence, financ-
ing choices only affect the way cash flows are partitioned, but not their total
value.
As later works have shown, relaxing some of these assumptions can be crit-
ical: the irrelevance proposition would not hold anymore, and capital structure
choices can affect the value of the firm. Moreover, investment and financing de-
cisions might become interconnected so that the two aspects cannot be analyzed
separately since they are jointly determined.
The derivation of the irrelevance proposition is based on an arbitrage argu-
ment, for if it did not hold, then investors could buy and sell stocks and bonds
1
Modigliani and Miller (1958, 268). Indicated as MM Proposition I in the following text.
17
in order to transfer one income stream for another stream, totally identical
other than the price. This exchange would clearly give favorable opportunities
of trade to investors independently of their risk attitude. Obviously, such op-
portunities cannot exist in equilibrium, since investors would take advantage of
them in order to make risk-less profits. Thus, overvalued securities would fall
and underpriced securities would rise until the equilibrium is achieved, that is,
until the law of one price is restored: being the streams of income identical, in
equilibrium they must sell at the same price.
To prove this, consider a two-period model with two firms that have the
same expected (positive) cash flow (X) from operations to be obtained in the
next period, but with different capital structures in the current period. Firm U
is an all-equity firm, while firm L has both equity and debt; the interest rate on
debt is r. Now assume first that the value of the unlevered firm U, V
U
, is greater
than the value of the levered firm L, V
L
: an holder of a share of equity of
firm A could either keep his shares, and receive V
U
at the end of the following
period, or sell them today, buy a fraction V
U
/V
L
of firm L's debt and equity
as:
V
U
=
V
U
V
L
V
L
=
V
U
V
L
D
L
+
V
U
V
L
E
L
.
At the end of the following period, the investor would receive:
V
U
V
L
rD
L
+
V
U
V
L
(X - rD
L
) =
V
U
V
L
X > X, X > 0.
So, he would make an arbitrage profit: arbitrageurs can `undo firm L's
leverage' by buying its debt and equity in such proportions that interests paid
and received cancel out, and earn a riskless profit. Clearly this cannot be an
equilibrium solution, so the inequality V
U
> V
L
cannot hold. Conversely, it can
be shown that the inverse relation V
L
> V
U
cannot hold as well. Suppose it is
true: then, by holding a fraction of firm L's shares, at the end of the following
period an investor would get (X - rD). If, instead, he sells the shares for
E
L
, borrows D
L
and invests the total amount in a fraction V
L
/V
U
of shares
of firm U, such that
E
L
+ D
L
= V
L
=
V
L
V
U
V
U
.
At the end of the following period, the investor, as a shareholder of firm
U, would receive (V
L
/V
U
) X and would have to pay interests on debt for an
amount of rD
L
, so that he would have a payoff of:
V
L
V
U
X - rD
L
=
V
L
V
U
X - rD
L
> (X - rD
L
) , X > 0.
18
Again, he would make an arbitrage profit by `levering up' firm U by borrow-
ing, hence this cannot be an equilibrium solution as well.
As a result, it must be that in equilibrium V
U
= V
L
.
The underlying idea is that, in the absence of distortionary taxation and
costs of bankruptcy, and given the possibility of borrowing and lending at the
same rate, when market values differ investors can `unlever' the levered company
by selling stocks in the unlevered firm in order to buy stocks and bonds of the
levered one, or `lever' the unlevered firm by selling the stocks of the levered one,
borrowing the required money and buying stocks of the unlevered, thus creating
an homemade leverage, in order to recreate the different types of earning streams
and take advantage of any difference in value.
A consequence of this result is the second proposition derived in the paper,
concerning the rate of return on equity of levered firms inside the same risk class:
the expected yield of a share of stock is equal to the appropriate capitalization
rate for a pure equity stream in the class, plus a premium related to financial
risk equal to the debt-to-equity ratio times the spread between and (the interest
rate on debt) r.
2
The final result of the paper is that, if a firm is acting in the best interest of
stockholders, it will undertake an investment project if and only if the expected
rate of return of the investment is greater than (or at least as large as) the
required rate of return. In other words, the level of investments is not affected
by the type of securities issued to finance them.
Compared to the conventional view of the period, which believed that, for
moderate amounts of debt, the required rate of return could be assumed to
remain constant, so that, until debt remained below a `reasonable' amount,
the firm could increase its value by increasing leverage, the result obtained by
Modigliani and Miller is clearly `revolutionary': for any level of debt, the return
on equity is always an increasing linear function of leverage, while the traditional
view stated that, until a certain threshold, it could be assumed to be constant,
while once above it the required rate of return would rise sharply. The (at
that time) accepted idea that, if not pushed too far, debt could be a cheaper
source of financing is then clearly rejected: what the traditional view failed to
recognize was the fact that, as debt increases, the required rate of return on
stocks increases as well, independently of the level of leverage, so that, despite
being the required return on debt lower than the one for stocks, the average cost
of capital remains constant at the value it has for an all-equity financed firm.
With their work, Modigliani and Miller introduced the arbitrage argument
2
Modigliani and Miller (1958, 271).
19
Figure 1.1: Modigliani-Miller versus Traditional view.
as a proof for financial theorems; moreover, they showed what is not relevant for
capital structure choices: once we know this, we can investigate what is, instead,
actually relevant, and that is what has been debated in numerous papers in the
following years.
Moreover, financial innovation has introduced instruments offering investors
low cost, limited-liability substitutes for corporate leverage: put and call op-
tions. As shown in figure 1.2, payoffs to debtholders and stockholders can be
reinterpreted in terms of options: the stockholders in a levered, limited-liability
corporation are basically the owners of a call option on the asset value of the
firm, where the exercise price is the payment they promised to the debtholders.
Debt will thus be repaid whenever the firm value is higher than the promised
payment: in that case, shareholders repay the debt and get the residual value;
on the other hand, if the firm value is lower than the promised payment, stock-
holders will not exercise their option, default on the payment and transfer the
control of the firm to the debtholders. As a consequence, risky debt in a lev-
ered firm can be seen as a portfolio of two securities: risk-free debt and a short
position in a put option.
The description of a firm as a portfolio of securities and options can be
illustrated more clearly by means of the relation between prices of different
options on the same stock. The familiar Put-Call Parity Theorem
3
can actually
be seen as an alternative formula for the description of the MM Proposition
3
First illustrated formally by Stoll, 1969
20
R R
45°
45°
X
D
X
Unlevered Equity
Levered equity
R R
D
45°
45°
D
X
D
X
Riskless debt + Short position in Put option
Risky Debt
Figure 1.2: Payoffs to different claimholders.
I; the put-call parity requires that, under frictionless market conditions, the
following relation must hold as an equality for any value of the strike price of
the option:
S = C (K) + Ke
-rt
- P (K)
where S is the current price of the stock on which the put and call options are
written, K is the common exercise price of the options, t is the time to maturity
of the options, r is the risk-free interest rate, and C(K) and P(K) the current
prices of the call and put options respectively. As Black and Scholes (1973)
and Merton (1974) have shown, each of these elements can be reinterpreted in
terms of capital structure: S becomes the market enterprise value (the present
value of firm's expected cash flows), K the face value of debt, and C(K) the
market value of the shares in a levered firm. The term Ke
-rt
is the market
value that the debt would have if it were riskless; however, if the value of S at
maturity falls below K, the shareholders would invoke limited liability, default
on the payment and put the firm back to the debtholders. The market value
of risky debt is then given by the value it would have if it were riskless, Ke
-rt
,
minus the value of the option to default that shareholders have, given by the
value of the put option P(K).
Obviously, the values of the firm's debt and equity are a function of the
firm's leverage; however, what the put-call parity tells us is that the sum of
21
their values is independent of the level of leverage: the sum of the values of
the single securities is always equal to the underlying present value of unlevered
cash flows, just like as stated in the MM Proposition I.
Several potential candidates arise as forces which might well lead the market
to depart systematically from the predictions resulting from the MM Proposi-
tion I: corporate taxation, bankruptcy costs and agency relationships. These
elements will be discussed in the sections that follow.
1.1.2
The role of corporate and personal taxes
In their later work of 1963, Modigliani and Miller corrected their analysis and
derived the result that, everything else being equal, the tax deductibility of
interest payments at corporate level generates a tax advantage of debt: firms
can increase their value (or, equivalently, reduce the cost of capital) by increasing
their leverage: an higher leverage generates a lower tax payment, which in turn
increases the firms' cash flows, and, consequently, their market value. Corporate
income tax is the element upon which everyone agreed that the financing mix
really does matter.
No arbitrage is possible in order to make the value of two firms in the same
risk class, but with different leverage, equal when a corporate income tax exists,
which allows the deduction of interest payments but not the compensation of
equity; in fact, arbitrage will make values in each class proportional not only to
the expected return, but also to the tax rate and the level of leverage. Under
these assumptions, the optimal capital structure for a firm would be to raise
funds only by issuing debt, in order to maximize the tax benefits of this type of
security. Propositions I and II, then, clearly fail
4
.
The value of the levered firm, V
L
, is now equal to the value of an unleverd
firm, V
U
, plus the present value of the tax shield provided by debt (
C
D),
that is, the gain from leverage deriving from the fact that, in some sense, the
government `subsidizes' interest payments to debtholders by allowing firms to
4
Strictly speaking, one could, in a somewhat original fashion, state that, even in presence
of corporate taxation, propositions I and II continue to hold: this would happen if we assume
that the government, when collecting taxes, is just another holder of an equity-type security.
After all, securities are just a way to divide firm's income among different claimholders, one of
which could be said to be the government. In this case, the sum of all claims would again be
independent of how the partitions are made; thus, the two propositions would hold. However,
for the (non-government) equityholders, the share of earnings paid out to the government is
a net subtraction from their own portion. Moreover, governments do not contribute to the
initial insertion of funds, in contrast with the other claimholders.
22
deduct interest payments from their taxable earnings:
V
L
= V
U
+
c
D.
Several critics, however, have been addressed to the result of the optimality
of an all-debt financing strategy, both because, empirically, no such high degrees
of leverage are observed, and because the assumption of a constantly increasing
tax advantage of debt is not compatible with the way tax systems operate.
First of all, debt can give a tax advantage as long as the before-interest, pre-
tax firm income is higher than the interest payments, otherwise the firm would
incur gross losses so that no taxes would have to be paid and the fiscal benefit of
debt would disappear. This, in turn, would imply that, beyond a certain level,
an higher leverage would not increase firm value anymore, so that the corner
solution of an all-debt capital structure would not be optimal anymore. In such
cases, the way fiscal losses are treated affects significantly the tax advantage
of debt, which might decline significantly leading to an optimal leverage lower
than an 100% debt financing.
Debt
Firm value
Value of
Unlevered
firm
Value of Levered firm
(unlimited tax shield)
Value of Levered firm
(limited tax shield)
Figure 1.3: Debt tax shield and firm value.
Firms could then rationally choose to target a specific debt ratio, which
would correspond to their debt capacity, that is, the level above which an in-
crease in debt would not generate an higher tax shield.
In addition, as Miller showed with his paper in 1977, the introduction of per-
sonal taxes leads to possibly different results, depending on the various tax rates
23
and the mechanism of the fiscal system. In particular, given the different tax
treatment of interest income and equity income (capital gains and dividends), it
is possible that the combined effect of personal and corporate taxation reduces,
cancels, or even inverts the tax advantage of debt.
Following Miller (1977), let's assume that investors face a tax rate of
D
on
interest income and a tax rate of
E
on equity income; firms pay an interest
rate equal to r on their debt and face a corporate tax rate of
C
. The after-tax
return to the investor from owning debt can then be written as:
After-tax return from owning debt = r(1
-
D
)
while the after-tax return to the investor from owning equity, which, since
cash flows to equityholders (K
E
) have to be paid out of after-corporate-tax cash
flows, is taxed twice (once at the corporate level and once at the equityholder
level), is obtained as follows:
After-tax return from owning equity = K
E
(1
-
C
)(1
-
E
)
Under these (reasonable) assumptions, the tax advantage of corporate debt
in presence of both corporate and personal taxation (G
L
) can be expressed with
the following formula:
G
L
= 1
-
(1
-
C
) (1
-
E
)
(1
-
D
)
D
Now, depending on the values taken by the three different tax rates, various
scenarios are possible:
1. If all of the three tax rates are equal to zero, we fall into Proposition I of
Modigliani and Miller: capital structure is irrelevant;
2. If the corporate tax rate is positive, and the personal rates on equity
income and debt income are equal, then the optimal capital structure
would include only debt
5
;
3. If the tax rate on debt is higher than the tax rate on equity, but the in-
equality (1
-
D
) (1-
C
)(1
-
E
) holds, then an all-debt capital structure
is still optimal, but the debt tax shield is lower than in absence of personal
taxation;
5
A particular case, in which both the tax rate on equity income and the one on debt income
are zero, is the one considered by Modigliani and Miller (1963)
24
4. If the equality (1
-
D
) = (1
-
C
)(1
-
E
) holds, the tax advantage of debt
at corporate level is completely offset by the higher tax rate at personal
level: as a consequence, we are back to the capital structure irrelevance
proposition;
5. finally, if the inequality (1
-
D
) (1-
C
)(1
-
E
) holds, then, despite the
tax advantage of debt at corporate level, the penalizing treatment of debt
income at personal level makes equity preferable to investors: in this sit-
uation, an all-equity choice would be optimal.
Empirical observations indicate that taxation at individual level has different
rates depending on the nature of the investor: some are tax-exempt, some pay
reduced rates, some pay the top statutory rate of the class of investors they
belong to. Tax rates on interest income generally differ from tax rates on equity
income.
This differential treatment creates tax clienteles: the existence of differences
in taxation of personal income implies that, given the returns, some investors
prefer debt over equity, while others prefer equity over debt. If a firm acts in
order to maximise its value, then any given firm would prefer debt over equity
if and only if:
(1
-
C
) (1
-
E
) (1 -
D
)
In absence of tax clienteles, all firms would use either only debt or only
equity, depending on the sign of the tax shield of debt when personal taxation
is considered, as described before; in the particular case where personal taxation
exactly offsets the tax advantage of debt at corporate level, then the financing
mix would be irrelevant and we would end up in the same situation as in the
MM Proposition I.
If, instead, we assume that tax rates differ across agents, then tax clienteles
arise, and an optimum debt ratio exists at an aggregate level.
To show this, assume (for simplicity) that
E
is the same for all investors,
while
D
can differ;
i
D
is the marginal tax rate of agent i : an agent i, then, has
an after-personal tax return of:
· 1 -
i
D
r
D
, if he invests in debt;
· (1 -
E
) r
E
, if he invests in equity.
An investor i will prefer debt if
1
-
i
D
r
D
(1 -
E
) r
E
, he will pre-
fer equity if 1
-
i
D
r
D
(1 -
E
) r
E
, and will be indifferent if 1
-
i
D
r
D
=
(1
-
E
) r
E
.
25
Due to the fact that
i
D
differs across agents, for any r
D
and r
E
some of
them will prefer debt, some will prefer equity and others will be indifferent. If
we denote by
D
the marginal tax rate on interest income that makes an investor
indifferent between debt and equity for a given level of r
D
and r
E
, then, for given
r
D
and r
E
, all investors with a tax rate on interest income
i
D
D
will prefer
debt, while those with
i
D
D
will prefer equity.
This implies that, everything else remaining the same, the demand for cor-
porate bonds is given by the equation:
r
D
=
(1
-
E
) r
E
1
-
i
D
At low levels of r
D
only tax-exempt investors (
i
D
= 0)are attracted; in
order to attract tax-paying investors, firms must be willing to increase the rate
of return they pay on debt, r
D
, to compensate them for the taxes paid. Demand
of debt has thus the shape illustrated in figure 1.4.
r
D
Demand for debt
r
min
0 Amount
held
by
D
tax-exempt investors
Figure 1.4: Demand for debt.
On the other hand, firms will maximise their value by minimising their cost
of capital, taking the rates of return as given. Consequently, firms will issue
only debt if r
D
(1
-
C
) r
E
, they will issue only equity if r
D
(1
-
C
) r
E
,
and will be indifferent if r
D
(1
-
C
) = r
E
. Hence firms are willing to issue debt
as long as r
D
(1
-
C
)
r
E
; supply of debt is then given by the equation:
26
r
D
=
r
E
1
-
C
.
Figure 1.5 shows the corresponding graph.
r
D
r
D
=
r
E
1
C
Supply
of
debt
D
Figure 1.5: Supply of debt.
For the market to be in equilibrium, demand has to equal supply: the
marginal investor will be indifferent between buying debt and equity, while
marginal companies will be indifferent between issuing debt or equity. This
happens when the following equality holds:
r
E
1
-
C
=
(1
-
E
) r
E
(1
-
D
)
which can be rearranged as:
(1
-
C
) (1
-
E
) = (1
-
D
)
Figure 1.6 shows graphically this solution, known as the Miller equilibrium;
the equlibrium level of debt is D
. The shaded area in the graph indicates the
`surplus' obtained in equilibrium by those debtholders whose tax rate on interest
income is lower than the one of the marginal investor
D
: market interest rates
have to be grossed up in equilibrium in order to pay taxes of the marginal
27
debtholder, until the marginal tax rate on interest income equals the joint effects
of the tax rate on corporate income and the tax rate individuals pay on equity
income (that is, until the personal tax disadvantage of debt exactly offsets the
tax advantage at firm level): thus, tax-exempt investors, as well as those in the
lower tax brackets, benefit of the rise in market rates whenever they receive
income from debt. However, this can have an equivalent, negative effect for
such investors: when they want to borrow funds, they end up paying an higher
interest rate.
r
D
Demand for debt
Debtholders' surplus.
r
D
=
r
E
1
C
r
min
0
Amount held by
D* D
tax-exempt investors
Supply
of debt
Figure 1.6: Miller equilibrium
The main implication of the Miller equilibrium is that the amount of debt
issued in the economy as a whole, D
, is uniquely determined: there is an equi-
librium level of aggregate corporate debt, and, as a consequence, an equilibrium
debt-equity ratio for the corporate sector as a whole, whose level depends on
tax rates (both on corporate and on individual incomes) and funds available for
investment to agents in each tax bracket.
However, there is no optimum leverage ratio at firm level: capital structure
is, again, irrelevant. The leverage policy of a firm would affect the class of
investors who are interested in holding its securities, but one clientele is as
good as another; in this sense, it would still be true that the value of a firm is
independent of its capital structure, despite the tax advantage of debt at firm
level.
28
1.1.3
Bankruptcy costs and the trade-off theory
One important critique moved to the irrelevance proposition concerns the as-
sumption of costless bankruptcy: in the real world, when firms fall into bankruptcy,
several costs occur
6
, both explicitly (for example, costs of the procedure) and im-
plicitly (forgone investment opportunities, among others). Given that an higher
level of leverage makes bankruptcy more likely to occur, expected bankruptcy
costs are an increasing function of debt.
Under certain conditions, a bankruptcy without costs would not change the
value of the firm. Once we introduce (costless) bankruptcy, however, debt be-
comes risky and a higher nominal interest rate should be paid on debt, to
compensate for the risk of default.
The two MM propositions continue to hold even if we assume that debt is
risky, as long as there are no costs associated with bankruptcy (so that operating
cash flows remain unaffected) and arbitrageurs are free to `undo' the leverage
by acquiring a mix of stocks and bonds. Both economic theory and empirical
observation, in fact, agree that the interest rate paid on debt tends to increase
as the leverage of the borrower increases; however, while the average cost of
borrowed funds increases with leverage, the average cost of all the raised capital
remains constant, independently of leverage. This is due to the fact that, as
leverage rises, the increase in the cost of borrowed funds is offset by a reduction
in the speed of growth in the yield required by the holders of stocks compared
to the case of risk-free debt: stockholders transfer to debtholders a portion of
the operating risk, so that the return they require increases more slowly than
in the case when they bear the entire risk while debt is riskless.
Stiglitz (1969) has shown that the value of a security is the same, regardless
of whether a bankruptcy can or cannot occur, if an individual investor can
borrow using securities issued by the firm as collateral: if this is possible, then
the value of the firm is invariant to the capital structure of the firm itself.
Once again, the proof relies on an arbitrage argument: if the individual can
borrow using as collateral the securities he purchases with the borrowed money,
then he can replicate the stream of cash flows offered by the firm, and capital
structure becomes irrelevant. If however, individuals are not able to obtain such
a `limited liability' agreement, then firms can generate streams of returns which
individuals cannot replicate, and the value of the firm may consequently depend
on its debt-equity ratio.
However, this assumption of limited liability applied also to individual in-
6
As later will be shown, though, an exact measure of their amount is quite difficult to
obtain.
29
vestors can be considered quite restrictive: after all, one of the main advantages
of the corporate form instead of the personal entrepreneurships or partnerships
in running business is the possibility of excluding unsatisfied creditors from
personal wealth through limited liability, which generally does not apply to in-
dividuals but only to corporations. This assumption may fit better by assuming
that corporations, and not only individuals, act as arbitrageurs in the market:
investors could channel their financial operations through corporate investment
accounts, rather than personal, thus benefiting of the limited liability given to
corporations.
When bankruptcy becomes costly, then firms substitute debt for equity, or
equity for debt, until the value of the firm is maximised. The gain of debt fi-
nancing is represented by the tax-shield effect, which arises when paid interests
on debt are deductible on the profit and loss account, while remuneration of eq-
uity (like dividends and share repurchases) are not; the costs of debt are mainly
constituted by direct and indirect expected bankruptcy costs. Bankruptcy costs
are expected to increase for all levels of leverage; these costs are not only the
direct costs of transferring the assets to the new owners, lawyers' fees and court
fees, but also indirect costs, like the loss of key qualified employees, which might
pursue alternative opportunities elsewhere, loss of customers and suppliers that,
relying on continuous business relationships with the distressed firm, may lose
confidence and focus their attention on other companies, and so on.
Firms' managers will then act in order to balance these two contrasting
effects of debt financing, in order to obtain the financing mix which maximise
the value of the firm, as a trade-off between gains and costs of issuing debt or
equity.
With costly bankruptcy, an increase in debt level has two effects:
1. as debt increases, the present value of the tax shield (and, hence, the firm
value) increases, as long as the debt capacity of the firm is not exhausted
(that is, until interest payments are lower than firm income);
2. an higher debt increases the probability of financial distress, thus increas-
ing the expected bankruptcy costs.
As a result, the value of a levered firm (V
L
) can be written as the sum of
three elements:
V
L
= V
U
+ V
T S
- V
BC
where V
U
is the value of an equivalent, unlevered firm, V
T S
is the present
value of debt tax shield, and V
BC
is the present value of expected bankruptcy
30
costs. The optimum level of debt is such that the marginal increase in the
present value of the tax shield is exactly equal to the marginal increase in
expected bankruptcy costs; figure 1.7 shows the graphical solution.
V
V
L
(without BC)
V
BC
V
L
V
TS
V
U
0
D*
D
Figure 1.7: Value of a firm with taxes and bankruptcy costs.
1.1.4
Agency costs and firms financing
The next step in the analysis of the determinants of capital structure has been
the introduction of agency costs in the theory of the ownership of firms. Agency
costs typically arise as a consequence of the separation between ownership and
control over a firm; this problem, and the connected costs, was already known
long before it started to be deeply discussed by researchers in corporate finance:
The directors of such companies, however, being the managers
rather of other people's money than of their own, it cannot well
be expected that they should watch over it with the same anxious
vigilance with which the partners in a private copartnery frequently
watch over their own. Like the stewards of a rich man, they are
apt to consider attention to small matters as not for their master's
honour, and very easily give themselves a dispensation from having
it. Negligence and profusion, therefore, must always prevail, more
or less, in the management of the affairs of such a company.
7
7
Adam Smith, An Inquiry into the Nature and Causes of the Wealth of Nations, 1776.
31
It took, however, around two-hundred years after Adam Smith's work before
a deep investigation of agency issues in corporate finance could actually take
place.
Jensen and Meckling (1976) pioneered the work in this area: tying together
elements from the theory of agency, the theory of property rights and the theory
of finance, they investigated the `separation and control' issue. They argue that,
as a result of agency relationships, the probability distribution of cash flows
provided by the firm is not independent of its ownership structure and this fact
might explain the existence of an optimal leverage.
An agency relationship is defined as a contract under which one -or more-
persons (which we call `principal(s)') engage another person (which we call
`agent') to perform on their behalf some tasks which leave some decision power
to the agent; assuming that both parties in the contract act as utility maximis-
ers, it is reasonable to assume that under some circumstances the agent will not
act in such a manner that would best pursue principal's interests. The prin-
cipal can avoid this conflict of interests by creating correct incentives for the
agent and by monitoring the activities of the agents so that they will behave
in the principal's best interest. Obviously, both incentives and monitoring ac-
tivities cannot generally be obtained at no costs; it is also almost impossible to
completely eliminate the divergence of interests between agents and principals,
so that the decisions actually taken will not always be the ones which would
maximise the welfare of the principal. Agency cost are then the sum of the
monitoring expenses to be paid by the principal, the costs borne by the agent in
order to bind his behaviour towards the interests of the principal, and the resid-
ual loss of the final outcome compared to the optimal result in an hypothetically
perfect world without agency issues.
The first thing Jensen and Meckling investigated was the agency cost of
outside equity. If a wholly owned firm is managed by its owner, then the owner-
manager will take decisions which maximise his utility. The decisions he takes
will involve pecuniary as well as non-pecuniary aspects; the optimum mix will
be such that his utility is maximised with respect to both those aspects.
If the owner-manager sells equity claims on his firm, agency costs will be
generated, since he will take full advantages of non-pecuniary benefits while
paying only a fraction of the corresponding costs in terms of lower pecuniary
returns. These costs can be limited if the manager can credibly bind himself to a
more efficient behaviour, and if the outside equityholder can monitor his activity.
However, this can be done only at some cost, and as Jensen and Meckling have
shown this cost entirely falls on the owner-manager. As the fraction of the
32
equity owned by the manager falls, his fractional claim on the outcomes falls
as well and this will clearly tend to encourage him to obtain larger amounts
of corporate resources in form of private (non-pecuniary) benefits. This would
in turn increase the amount that outside shareholders are willing to spend in
order to monitor his behaviour. As a result, the costs to the owner-manager of
obtaining new funds from the equity market increase as his fraction of ownership
falls.
If the effort level of the manager
8
is verifiable, then a first-best solution is
obtained. When the effort cannot be observed, so that it cannot be contractible,
then agency costs arise.
Specifically, let's consider a firm in which X indicates a vector of activities
from which the manager derives nonpecuniary benefits; C(X) is the present
value of the costs generated by X, while the present value of productive benefits
of X is P(X). Therefore, the net gain to the firm of X is V(X)=P(X)-C(X).
The optimal level of X, for a firm entirely owned by the manager, is then the
value X* such that:
V (X
)
X
=
P (X
)
X
-
C (X
)
X
= 0
Thus for any X
X
9
, the net gain to the firm must be lower than at the
optimal value of X*, that is, V (X) V (X
). Now, define by F = V (X
)
-V (X)
the cost to the firm of providing the increment X-X*, and assume that the
manager chooses the value of X that maximises his utility, ^
X; thus, a cost
F = V (X
)
- V ( ^
X) is generated, whenever X
= ^
X.
Figure 1.8 sketches the solution of the problem. The line V F indicates the
set of possible combinations of V and F available to the firm and its owners.
It is an analogous of a budget constraint. V is the value of the firm when the
amount of nonpecuniary income consumed is zero; therefore, it is the maximum
present value of the cash flows generated by the firm, for a given wage for the
manager, when all the activities of the vector X are at the optimal level X*.
Since one monetary unit of present value of nonpecuniary benefits withdrawn
from the firm by the manager reduces the market value of the firm by one, the
slope of the line V F is -1. Consider a manager whose utility function U(V,F)
8
With the word "effort" we indicate how the manager allocates his time and resources
between activities yielding returns shared by all investors in the firm, and those generating
private benefits accruing exclusively to him. An inefficient low effort indicates that the man-
ager devotes too much time and resources to obtain private benefits rather than returns to be
shared with other investors.
9
That is, for any X where at least one of the elements of X is greater than the corresponding
element of X*
33
is defined as in fig. 1.8 by the indifference curves U
1
, U
2
, U
3
.
V
V*
A
B U
3
V
1
F
1
U
2
V`
U
1
C
V
2
F
2
F*
F`
F
Value of nonpecuniary benefits
Valu
e
of
f
irm
Figure 1.8: Agency costs of outside equity
A manager who entirely owns the firm would choose the combination of V
and F that maximises his utility: this happens when the indifference curve is
tangent to the line V F , as in point A in the figure. The corresponding value of
the firm is V* and the value of nonpecuniary benefits is F*. If the owner decides
to sell the entire equity, but maintains his position as manager, the buyer would
pay a price V*, only if he could, at no cost, force the previous owner to take, as
manager, the private benefits he got when he was also the owner of the firm.
This, however, is not generally true: in most cases, such an enforcement
cannot be made at zero costs.
Suppose the original owner-manager sells a
fraction (1
- ) of the firm, hence retaining a fraction for himself, for an
amount of (1
- ) V
. Now, although the decision to consume an additional
unit in nonpecuniary benefits reduces firm value by one unit (as before), the
cost to the manager is only since the remaining portion (1 - ) is borne by
outside investors: a typical situation of moral hazard.
The new constraint for the manager is thus a line that passes thorugh point
A but with a slope of
-, the line V
1
F
1
in the figure. The optimal solution for
the manager is then to choose the combination indicated by point B, where the
firm value decreases to V' and private benefits increase to F'. Rational outside
34
investors are aware of this distortionary incentive, so they will not be willing
to pay the amount (1
- ) V
: investors will accept to pay an amount equal to
(1
- ) times the value they expect the firm to have, taking into account the
change in behaviour of the manager once he sells a fraction of the firm.
This happens in a point like C, where the indifference curve of the manager
is tangent to the new constraint V
2
F
2
. After selling a fraction of the firm, the
wealth of the manager is given by the sum of the received payment P and the
value of the firm V (F, ); the line V
2
F
2
, with a slope of , represents the new
tradeoff between V and F after the sale.
In the new optimum point C, the value of the firm is V' and the value of
nonpecuniary benefits is F'. The price the outside investors pay, S, must satisfy
the condition S = (1 - )V ; therefore, the wealth of the manager after the sale
is exactly equal to the new firm value, V' :
S + V = (1
- ) V + V = V .
This implies that, after the sale, the loss in total value of the firm, (V*-V'), is
completely imposed on the manager, who therefore suffers a welfare loss. In this
case the manager incurs a welfare loss because the increase in utility associated
with higher private benefits is more than offset by the reduction in firm value.
It is thus rational for the manager to sell the fraction of the firm only if, by
using the cash received with the sale, he can achieve an increment in welfare
which is worth to him more than the amount itself. The reduction in market
value represents the agency costs of selling equity to outside financiers.
This issue can cause profitable investment opportunities to be forgone: if
the investment is financed by issuing equity to outsiders, then it is undertaken
only if the increase in firm value deriving from the project is larger than the
decrease caused by agency costs; whenever these costs are positive, profitable
opportunities can be forgone. Agency costs can thus affect also the dimension
of the firms.
This can be avoided if the manager issues debt rather than equity: a debt-like
contract, which has a concave payoff, maximises the fraction of the incremental
expected return from exerting effort that accrues to the entrepreneur; therefore,
it maximises his incentive to exert effort. In the extreme case where risk-free
debt can be issued, then the moral hazard problem disappear. If debt is risky,
the moral hazard problem is minimised but not completely eliminated.
On the other hand, Jensen and Meckling highlighted how the issuance of new
debt can generate agency costs as well. This explains why we do not observe
many large firms financed almost entirely with debt and just a tiny fraction
35
supplied as equity by an owner-manager. With such a financial structure, the
manager would have a strong incentive to engage in activities which promise
very high payoffs when successful even if they have a low probability of success:
in the event of success, he would get most of the gains while if they turn out
badly, debtholders would bear most of the costs. As shown before, levered equity
can be seen as a long position in a call option, a convex claim, while risky debt
is a portfolio of risk-free debt and a short position in a put option, a concave
claim: therefore, since an increase in risk increases the value of both the call
and the put option, equityholders increase their expected wealth by increasing
risk at the expense of debtholders, whose implicit short position in a put option
becomes more penalising.
If a firm has alternative investment opportunities, which differ only for the
underlying risk, but not for their expected return, if the manager decides which
investment program to undertake, and only after that decision he can sell part
or all of his claims on the outcomes, in order to raise funds to finance the
project, in the form of either debt or equity, then he will be indifferent among
the various opportunities.
However, if the manager has the opportunity to
first issue debt, and after that to decide which project to undertake, then once
debt has been issued managers can increase shareholders' value by undertaking
riskier investments: the result is the transfer of wealth from the debtholders to
the shareholders. A typical example is represented by firms close to financial
distress: in such cases, limited liability plays a very important role and the
value of equity can increase considerably by taking higher risk (`gambling for
survival' ).
Suppose that the manager can issue debt at a price D
1
, making the debthold-
ers believe that this is a claim on the project with lower risk; then, after debt has
been issued, the manager can increase the value of equity by changing invest-
ment to take the higher variance of the riskier alternative, thereby increasing
the value of the call option which represents his equity. This would happen
at the expense of the debtholders, whose decrease in value would be equal to
the increase in the value of the put option after the increase in risk. This, of
course, happens if debtholders cannot prevent the manager from changing the
investment profile of the firm. Hence debtholders will seek to obtain various
types of protective covenants and monitoring devices in order to protect them-
selves from raids against their wealth made by the shareholders. The cost of
writing and enforcing such covenants, however, may be nontrivial: debtholders
may require higher yields to compensate them for possible wealth expropriation
by the shareholders and for costs paid for writing and enforcing the contract. If
36
debtholders cannot do so, they will be willing to pay a lower amount D
2
D
1
to the manager, realising that his maximising behaviour will lead him to choose
riskier investments. In this case, no wealth redistribution takes place and no
welfare loss originates. Welfare losses do however occur whenever the riskier
project yields a lower expected value than the safer one, but the combined ef-
fect of differences in risk and expected return induces the risk-shifting behaviour
in the maximisation of the manager's utility function.
Equity financing, on the other hand, would not create any distortion in
the investment decision, because the manager and outside investors would hold
the same type of claim and so there would be no conflict of interests about
investment decisions. An all-equity financed firm, due to the linearity of its
payoff, would entirely eliminate the risk-shifting problem.
Jensen and Meckling suggest that, given that agency costs of debt increase
with the issuance of an higher proportion of debt, and agency costs of equity
increase with an higher issue of equity, there is an optimum combination of
outside equity and debt which minimises total agency costs. Following their
argument, it is then possible to identify an optimal capital structure, given by
the debt-to-equity ratio that minimises agency costs, even in a world without
taxes and bankruptcy costs, as shown in fig. 1.9.
In another seminal paper, Myers (1977) investigates the two issues known
as risk-shifting and debt overhang.
When levered firms have profitable investment opportunities, they might
not undertake them, because the new investment, by affecting the risk of future
cash flows, might generate an increase in the market value of debt higher than
the present value of the project itself, hence reducing the market value of eq-
uity: wealth is transferred from the equityholders to the shareholders (the debt
overhang issue).
The total value of a firm can be decomposed in two main components: the
value of the assets in place and the value of growth opportunities, or, in a
better formulation, between assets whose value does not depend on further dis-
cretionary investments (which we might call `assets in place' with the previous
terminology) and assets that can be seen as call options (the `growth opportuni-
ties') whose value depend, at least partially, on further discretionary investment.
This second component of firm value might generate agency costs: the exis-
tence of debt changes managers' actions in some circumstances. If the additional
investment increases the value of the assets of the firm by an amount which is
smaller than the increase in the market value of debt, then managers acting in
the interest of shareholders might ex post better serve them by making sub-
37
Agency
costs
Total agency costs
A*
Agency
costs
of
debt
Agency costs
of equity
0
D*
1
D/(D+E)
Figure 1.9: Agency costs and the optimal capital structure
optimal (from the perspective of firm value) investment decisions; this, in turn,
reduces ex ante the value of the firm (other things being equal).
If the additional investments can affect the risk profile of the firm, then also
a problem of risk-shifting can arise: managers can better serve shareholders'
interests by undertaking those investments who increase the risk of the firm,
hence transferring wealth from the debtholders to the equityholders, in a similar
fashion to what Jensen and Meckling had proposed in their 1986 paper.
Various possibilities are discussed in order to mitigate the problem.
First of all, the debt contract might include clauses which require the firm
to undertake all investment project with positive net present value. Rewriting a
contract with such specific provisions might however be very costly and hardly
enforceable.
An alternative solution would be to state that, when profitable investment
opportunities arise, creditors and shareholders would renegotiate the debt con-
tract: renegotiation may lead to an agreement where debtholders accept a re-
duction in the face value of debt in exchange for the owners' commitment to
undertake the new investment.
38
One apparently simple solution would be to shorten the maturity of debt, so
that if debt matures before the investment option is to be exercised a situation
of inefficiently low investment does not happen. However, automatically rolling
over short term debt is not the solution, otherwise we would end up again with
the same problem as with longer maturity debt. Short-term debt does not re-
duce monitoring costs; what it does is that it offers more frequent opportunities
to renegotiate conditions of debt contracts, as well as the opportunity of shift-
ing back to equity, rather than debt, financing. Obviously, such a continuous,
flexible and close relationship with debtholders can be obtained at some costs.
Myers (1984) and Myers and Majluf (1984) developed the well-known `peck-
ing order' theory of firm financing.
One of the basic assumptions of their model is that managers have informa-
tion that investor do not have; hence informational asymmetries arise, which
may give relevance to the firm capital structure.
Under the pecking order theory, firms prefer internally generated funds as
source of financing, and when external finance is required, they issue the safest
security first. That is, they start with debt, then hybrid securities like convert-
ible bonds, and equity only as a last resort. This idea starts from the observation
that stock prices often fall when a firm announces a new equity issue: the type
of securities that firms issue might have informational contents, that is, secu-
rities might be used as signalling devices. Under the pecking order theory, in
contrast with models described before, there is no target debt ratio resulting
from a tradeoff of costs and benefits of issuing different securities: an optimum
capital structure does not exist.
Consider a model where there are three dates (t =-1, 0, 1); in the first period
the market has the same information of the managers, in the second period
managers receive additional information about the value of the firm, while the
market receives this information in the following period.
The value of the firm can be decomposed in two components:
1. the value of assets in place at t =-1, whose expected future value is A =
E A ; the distribution of A represents the possible updated values at
t =0 of the assets. The realization of A, a, is the update in managers'
information at t =0
2. the value of growth opportunities, whose net present value in the first
period is
B = E B ; B and b are the distribution of possible updates
and the realization at t =0.
39
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- , 2014, Firm Financing in the Euro Area: How asset risk affects capital structure decisions within the monetary union, Hamburg, Bedey Media GmbH, https://www.anchor-publishing.com/document/312770
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