During the 1980s, the proportion of business assets financed by debt exceeded that of any other period since World War II. Although much of this leverage accommodated new investment, during the last half of the decade corporations also replaced more than one-sixth of their outstanding stock with debt securities. Because of this surge in leverage, many analysts and policymakers are wary that businesses may have become too vulnerable, perhaps imperiling prospects for capital formation and employment opportunities. As the financial structure of businesses changed during the past decade, the characteristics of financial securities also changed. Junk bonds, variants of preferred stock, yield enhancements, warrants, and other forms of mezzanine financing became more common in credit markets and in private loan contracts. Furthermore, the potential risks and returns offered by all securities have been altered as otherwise familiar financial instruments increasingly contain novel options (puts, indexed terms, resets, auctions, caps) and as derivative securities and various swap agreements are accepted as standard financial instruments. These innovations have challenged the traditional financial and legal distinctions between debt and equity. Accordingly, public policy may need to adapt along with financial relationships, because income tax laws, regulations governing financial institutions, corporation law, and definitions of the legal rights and responsibilities of an enterprise’s
*Vice President and Economist, and Assistant Vice President and Economist, Federal Reserve Bank of Boston.
Richard W. Kopcke and Eric S. Rosengren
owners or creditors depend on clear boundaries to separate classes of creditors and equityholders. For example, if varieties of debt and equity instruments are more commonly regarded merely as alternative methods of financing businesses, both the bankruptcy law’s distinctions among stakeholders and the income tax law’s traditional distinction between interest payments (an expense) and profits (taxable income) may need to be amended. Similarly, many of the laws, regulations, and conventions that encourage financial intermediaries to hold debt rather than equity may require revision. Whether these distinctions account for the recent increase in leverage or not, if policymakers regard leverage as excessive, reforms of the appropriate laws and regulations could foster equity financing. In the fall of 1989 the Federal Reserve Bank of Boston sponsored this conference to examine the changes in business financing, why these changes have occurred, and the implications of these changes for public policy. In general, the participants observed that no simple theory explains fully the recent trends in business finance. For example, tax laws alone do not determine a corporation’s capital structure. A satisfactory explanation might also depend on agency costs, objectives of stakeholders, the importance of corporate control, financial regulations, the relative cost of funds, and the dynamic strategies of management. Consequently, an attempt to reduce leverage through a simple reform of tax law, financial regulations, or bankruptcy law may not succeed. Even if it were successful, the cost of reforming policy could exceed its benefits, especially if other objectives of these policies were compromised in order to regulate leverage. Many participants also questioned the threat posed by the recent surge in debt financing. Some thought that the trend toward greater leverage has run its course, and equity financing will become more prevalent. The conference comprises three sections. The first section surveys the financial and legal theories concerning an enterprise’s choice of capital structure. The financial survey concludes that a promising financial theory is more likely to describe the optimal form...