Graham-Harvey (2001): Theory-Practice of Corporate Finance Survey of 392 CFOs. Survey of 392 CFOs. Fig 1 Fig 1 Panel A: Range of firm sizes. Panel A: Range

Graham-Harvey (2001): Theory-Practice of Corporate FinanceGraham-Harvey (2001): Theory-Practice of Corporate Finance

Survey of 392 CFOs.Survey of 392 CFOs. Fig 1Fig 1

Panel A: Range of firm sizes.Panel A: Range of firm sizes. Panel C: Range of industries.Panel C: Range of industries. Panel E: Range of debt ratios.Panel E: Range of debt ratios. Panel K: About 38% of CEOs have an Panel K: About 38% of CEOs have an

MBA.MBA. Panel N: Sample includes private and Panel N: Sample includes private and

public companies.public companies.


Fig 2: Popularity of different capital Fig 2: Popularity of different capital budgeting techniques (in order):budgeting techniques (in order): IRRIRR NPVNPV Hurdle rateHurdle rate PaybackPayback

Large firms, highly levered firms, and Large firms, highly levered firms, and firms with MBA-CEOs more likely to use firms with MBA-CEOs more likely to use NPV method.NPV method.

NPV and IRRNPV and IRR

Expected Return

Beta

Security Market Line (CAPM)

Rf

Accept

Reject


Expected Return

Beta

Accept

Reject

IRR Cost of Capital


Expected Return

Beta

Security Market Line (CAPM)

Rf

A

D

Cost of CapitalB

C

A: CAPM (Accept), CoC (Accept)

B: CAPM (Reject), CoC (Accept)

C: CAPM (Accept), CoC (Reject)

D: CAPM (Reject), CoC (Reject)


Fig 3: Popularity of different methods for calculating Fig 3: Popularity of different methods for calculating cost of equity capital (in order):cost of equity capital (in order): CAPMCAPM Average historical returnAverage historical return Multibeta CAPMMultibeta CAPM

Large firms, low levered firms, and firms with MBA-Large firms, low levered firms, and firms with MBA-CEOs more likely to use CAPM.CEOs more likely to use CAPM.


Fig 5: Factors that CFOs thought determined the Fig 5: Factors that CFOs thought determined the appropriate amount of debt (in order):appropriate amount of debt (in order): Financial flexibility (p. 218: minimizing interest obligations such that Financial flexibility (p. 218: minimizing interest obligations such that

they do not need to shrink their business in case of an economic they do not need to shrink their business in case of an economic downturn).downturn).

Credit rating.Credit rating. Earnings and cash flow volatility.Earnings and cash flow volatility. Insufficient internal funds.Insufficient internal funds. Level of interest rates.Level of interest rates. Interest tax savings.Interest tax savings. Transaction cost and fees.Transaction cost and fees. Equity misvaluation.Equity misvaluation. Comparable firm debt levels.Comparable firm debt levels. Bankruptcy/distress costs.Bankruptcy/distress costs.


Fig 7: Factors that CFOs thought relevant in deciding Fig 7: Factors that CFOs thought relevant in deciding whether or not to issue stock (in order):whether or not to issue stock (in order): Earnings per share dilution.Earnings per share dilution. Stock misvaluation.Stock misvaluation. Recent rise in stock price.Recent rise in stock price. Providing shares for employee/bonus stock option plans.Providing shares for employee/bonus stock option plans. Maintaining target debt-to-equity ratio.Maintaining target debt-to-equity ratio. Diluting holding of certain shareholders.Diluting holding of certain shareholders. Stock is least risky source of funds.Stock is least risky source of funds.


5.1. 5.1. Tradeoff theory of capital structure choiceTradeoff theory of capital structure choice: Firms have : Firms have optimal debt-equity ratios which they determine by trading off optimal debt-equity ratios which they determine by trading off the benefits of debt (tax advantage of interest deductibility), with the benefits of debt (tax advantage of interest deductibility), with the costs of debt (financial distress costs, and tax expense the costs of debt (financial distress costs, and tax expense incurred by bondholders).incurred by bondholders). Fig 5: Corporate tax advantage of debt only moderately important.Fig 5: Corporate tax advantage of debt only moderately important. Fig 5: Financial distress moderately important. But credit rating may Fig 5: Financial distress moderately important. But credit rating may

be a proxy for financial distress costs.be a proxy for financial distress costs. Fig 5: Personal tax considerations appears to be not important.Fig 5: Personal tax considerations appears to be not important.


5.2. 5.2. Asymmetric information explanations of capital structure Asymmetric information explanations of capital structure choicechoice: :

5.2.1 5.2.1 Pecking-order theoryPecking-order theory: Firms do not target a specific debt : Firms do not target a specific debt ratio, but instead use external financing only when internal funds ratio, but instead use external financing only when internal funds are insufficient: External funds are less desirable because are insufficient: External funds are less desirable because informational asymmetries between management and investors informational asymmetries between management and investors imply that external funds are undervalued. Hence, if firms use imply that external funds are undervalued. Hence, if firms use external funds, they prefer to use debt, convertible securities, external funds, they prefer to use debt, convertible securities, and, as a last resort, equity.and, as a last resort, equity. Table 9: Consistent with the pecking-order theory : Having Table 9: Consistent with the pecking-order theory : Having

insufficient internal funds is a moderately important influence on the insufficient internal funds is a moderately important influence on the decision to issue debt, especially for smaller firms (that are likely to decision to issue debt, especially for smaller firms (that are likely to suffer from greater asymmetric-information-related equity suffer from greater asymmetric-information-related equity undervaluation). undervaluation).


5.2. 5.2. Asymmetric information explanations of capital structure Asymmetric information explanations of capital structure choicechoice: :

5.2.2 5.2.2 Recent increase in stock priceRecent increase in stock price: A surge in share price : A surge in share price increase can correct an undervaluation or lead to an increase can correct an undervaluation or lead to an overvaluation.overvaluation. Table 8: Recent stock price increase third most important factor in Table 8: Recent stock price increase third most important factor in

equity-issuance decision.equity-issuance decision. 5.2.4 5.2.4 Convertible debt issuanceConvertible debt issuance: Conversion feature makes : Conversion feature makes

convertible debt relatively insensitive to asymmetric information convertible debt relatively insensitive to asymmetric information (between management and investors) about the risk of the firm.(between management and investors) about the risk of the firm. Table 10: Firms use convertible debt to attract investors unsure Table 10: Firms use convertible debt to attract investors unsure

about the riskiness of the firm (more relevant for smaller firms).about the riskiness of the firm (more relevant for smaller firms).


5.3. 5.3. Underinvestment problemUnderinvestment problem Table 6: Consistent with theory underinvestment more of a concern Table 6: Consistent with theory underinvestment more of a concern

for growth firms compared to non-growth firms.for growth firms compared to non-growth firms. Table 6: Overall, underinvestment does not appear to be a major Table 6: Overall, underinvestment does not appear to be a major

concern.concern.

What Do We Know About Capital What Do We Know About Capital StructureStructure

Rajan-Zingales (1995)Rajan-Zingales (1995)

Factors Correlated with LeverageFactors Correlated with Leverage

1.1. Tangibility of AssetsTangibility of Assets

Tangible assets can serve as collateral, diminishing the Tangible assets can serve as collateral, diminishing the risk of the lender.risk of the lender.

Assets would retain more value in case of liquidation.Assets would retain more value in case of liquidation.


2.2. Investment OpportunitiesInvestment Opportunities

The Underinvestment Problem : With risky debt The Underinvestment Problem : With risky debt outstanding, shareholders may sometimes not undertake outstanding, shareholders may sometimes not undertake positive NPV projects.positive NPV projects.

Company Value = Value of Tangible Assets in Place + Value Company Value = Value of Tangible Assets in Place + Value of of Future Growth Future Growth OpportunitiesOpportunities

V = TA + GV = TA + G

V/TA = 1 + G/TAV/TA = 1 + G/TA

Market/Book : Correlated with Growth Opportunities.Market/Book : Correlated with Growth Opportunities.

Hence, high Market/Book companies (because they have Hence, high Market/Book companies (because they have more future growth opportunities) will issue less debt (be more future growth opportunities) will issue less debt (be less levered). less levered).


2.2. Investment OpportunitiesInvestment Opportunities

High Market/Book companies (because they have more High Market/Book companies (because they have more future growth opportunities) will issue less debt (be less future growth opportunities) will issue less debt (be less levered).levered).

Implying negative correlation between market/book and Implying negative correlation between market/book and leverage.leverage.

Rajan-Zingales (1995) Page 1456: Rajan-Zingales (1995) Page 1456: “ “The negative correlation of market-to book with leverage The negative correlation of market-to book with leverage seems to be driven mainly by large equity issuers.”seems to be driven mainly by large equity issuers.” Above evidence for companies in the US, Japan, UK, and Above evidence for companies in the US, Japan, UK, and Canada.Canada. “ “From a theoretical standpoint, the evidence is puzzling. If From a theoretical standpoint, the evidence is puzzling. If the market-to-book ratio proxies for the underinvestment the market-to-book ratio proxies for the underinvestment costs associated with high leverage, then firms with high costs associated with high leverage, then firms with high market-to-book ratios should have low debt, market-to-book ratios should have low debt, independent of independent of whether they raise equity internally via retained earnings, or whether they raise equity internally via retained earnings, or externallyexternally..

““Firms attempt to time the market by Firms attempt to time the market by issuing equity when their price (and hence, issuing equity when their price (and hence, their market-to-book ratio) is perceived to be their market-to-book ratio) is perceived to be high.”high.”


3. Size3. SizeLarger firms tend to be more diversified and fail less often, Larger firms tend to be more diversified and fail less often, so size may be an inverse proxy for the probability of so size may be an inverse proxy for the probability of bankruptcy. Hence, larger firms may issue more debt.bankruptcy. Hence, larger firms may issue more debt.

4. Profitability4. ProfitabilityMore profitable companies use less debt.More profitable companies use less debt.

Firm’s cash flow identity:Firm’s cash flow identity:

New debt + New equity + Net income =

Interest payment + Dividend + New investment

Firms’ Histories and Their Capital StructuresFirms’ Histories and Their Capital Structures

Kayhan-Titman (2004)Kayhan-Titman (2004)

Optimal Capital Structure: Tradeoffs between the Optimal Capital Structure: Tradeoffs between the costs and benefits of debt.costs and benefits of debt.

At the optimum: Relation between capital structure At the optimum: Relation between capital structure and firm value may be weak, such that cost of and firm value may be weak, such that cost of deviating from the optimum is small. deviating from the optimum is small. “ “When this is the case, capital structures are likely When this is the case, capital structures are likely to be strongly influenced by transaction costs and to be strongly influenced by transaction costs and market considerations that may temporarily affect market considerations that may temporarily affect the relative costs of debt versus equity financing, the relative costs of debt versus equity financing, making the idea of a target debt ratio much less making the idea of a target debt ratio much less important.”important.”

Debt-Value Function:Debt-Value Function:

Value of Company

Debt/Total Capital

V0

D0

V1

D1 D2

V2

Debt-Value Function:Debt-Value Function: Small deviations from optimal capital

structure, D0, may not have a big impact on firm value.

Value of Company

Debt/Total Capital

V0

D0

Table A2: Predicting LeverageTable A2: Predicting Leverage

Leverage is Leverage is positivelypositively related to related to Property, plant, and equipmentProperty, plant, and equipment Size.Size.

Leverage is Leverage is negativelynegatively related to related to Market-to-bookMarket-to-book ProfitabilityProfitability Selling expenseSelling expense R&D.R&D.

Leverage Deficit = Actual Leverage – Predicted LeverageLeverage Deficit = Actual Leverage – Predicted Leverage

Table 3: LeverageTable 3: Leverage Prior stock returns have a very significant impact on Prior stock returns have a very significant impact on

capital structure.capital structure.

Prior stock returns might also lead to a change in Prior stock returns might also lead to a change in target capital structure.target capital structure. High stock returns might signal more growth opportunities High stock returns might signal more growth opportunities

suggesting lower debt ratios.suggesting lower debt ratios. As firm performs better, managers may get entrenched. As firm performs better, managers may get entrenched.

Managers prefer less debt (than optimal) because they Managers prefer less debt (than optimal) because they personally incur bankruptcy costs and have less discretion personally incur bankruptcy costs and have less discretion in more levered firms.in more levered firms.

Documents

Graham-Harvey (2001): Theory-Practice of Corporate Finance Survey of 392 CFOs. Survey of 392 CFOs. Fig 1 Fig 1 Panel A: Range of firm sizes. Panel A: Range