In the previous article, we explained how debt increases your firm’s value through the effect of tax shields. We continue our exploration into the literature on Capital Structure in this article. By reading this article, we hope that readers will understand:
- Agency costs of debt
- Two theories on how firms choose their capital structure
- Which theory is a better fit to empirical evidence?
Agency costs of debt
Although the effect of tax shields increases the value of the firm, there is a ceiling to debt levels. Beyond this point, the firm enters the debt overhang territory. Debt overhang is an outcome where existing debt levels are too high for the firm to borrow more money without 1) incurring interest costs that are higher than the project’s expected profits, or 2) convincing shareholders to part with their capital at a lower rate of return that is supposed to be enhanced by debt.
The outcome is the same as the under-investment problem: Managers choose to invest in safe projects with expected returns lower than what their shareholders are willing to take. They please debt holders at the expense of shareholders.
On the contrary, we face the over-investment and asset substitution problem: Managers promise debt holders that they will only invest their loans in low-risk projects, but commit to high-risk ones after loan disbursement. They please shareholders at the expense of debt holders in this case.
The economic loss to owners of capital (shareholders or debt holders) due to incentive misalignments, between managers and them, is known as the agency cost of debt (related article: Corporate Governance Part 1).
Theories of capital structure
Firms require financing to expand and grow through investing activities, and the mix of debt, equity, and retained earnings (internal savings) forms the capital structure of the firm. Now, how do firms decide how much debt to equity and retained earnings is optimal? Researchers who first studied this question put forth two competing theories: Pecking order theory and trade-off theory1.
Firms that adopt the pecking order theory prefer to use retained earnings to finance investments first, followed by debt, then equity. The reason is due to potential investors’ belief that managers will issue equity only when the firm’s stock price is overvalued. This belief is rational because managers know more about their firm than outsiders (this condition is known as asymmetric information), and outsiders should read the signals of the managers’ actions to augment their current understanding of the managers’ intent.
Firms that adopt the trade-off theory balance the costs of bankruptcy (debt obligations exceed the firm’s ability to pay) and the tax benefits of debt. The trade-off theory prescribes an optimal equilibrium where the marginal benefit of debt meets the marginal cost of debt, and this debt-equity ratio is the target that managers will engineer towards.
Despite the trade-off theory being the more dominant theory taught in corporate finance courses, empirical evidence fits this theoretical construct poorly. An optimal debt-equity ratio implies that similar firms in the same environment should have a similar debt-equity mix, but we observe hugely varying ratios in real life. Also, due to the low probability of bankruptcy, we should observe debt levels that are way higher than what the trade-off theory predicts. Lastly, we seldom observe management issuing equity and buy back debts when their debt-equity ratio is high. Neither do we observe management issuing debt when their firm’s stock prices rise (they tend to issue equity instead!).
The modified pecking order theory
These puzzling observations are collectively known as the Capital Structure Puzzle. Many researchers have spent a huge amount of efforts to fit alternative theories to the empirical evidence. Although we are still unable to explain how firms choose their capital structures, we agree that the modified pecking order theory is a good starting point for managers to consider their debt-equity position:
- Avoid equity financing to prevent passing up NPV-positive projects.
- Avoid equity financing that requires issuing new stocks that are grossly underpriced.
- Set target dividend payout ratio to ensure that the firm has sufficient internal funds to cover investment opportunities when required.
- Borrow sparingly to avoid bankruptcy costs, and to shore up borrowing capacity when needed in the future.
- If investment opportunities are larger than what internal funds can support, point (4) allows the firm to issue debts at low-interest costs.
 Myers and Majluf (1984), Kraus and Litzenberger (1973)
Dr. Jack Hong is the co-founder of Research Room Pte. Ltd., a management consulting and advanced analytics company that delivers complex prediction and decision-making capabilities for commercial, government, and not-for-profit organizations. Dr. Hong has extensive research and commercial experience in applying advanced empirical science to drive business, financial and policy value chains. He is concurrently an adjunct faculty with the Singapore Management University (SMU).