Capital Structure

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Global Markets

Liability Strategies Group

January 2006

Corporate Capital Structure

Authors
Henri Servaes
Professor of Finance London Business School

The Theory and Practice of Corporate Capital Structure

Peter Tufano
Sylvan C. Coleman Professor of Financial Management Harvard Business School

Editors
James Ballingall
Capital Structure and Risk Management Advisory Deutsche Bank +44 20 7547 6738 james.ballingall@db.com

Adrian Crockett
Head of Capital Structure and Risk Management Advisory, Europe & Asia Deutsche Bank +44 20 7547 2779 adrian.crockett@db.com

Roger Heine
Global Head of Liability Strategies Group Deutsche Bank +1 212 250 7074 roger.heine@db.com

The Theory and Practice of Corporate Capital Structure

January 2006

Executive Summary
This paper discusses the theory and practice of corporate capital structure, drawing on results from a recent survey. Theoretical Considerations A firm could use three methods to determine its capital structure: Trade off Theory: There are various costs and benefits associated with debt financing. We would expect firms to trade off these costs and benefits to come up with the level of debt that maximizes the value of the firm or the value accruing to those in control of the firm. The most significant factors are listed below, together with the impact on the optimal level of debt. indicates that the factor is a benefit of debt and leads to a higher optimal debt level, while indicates a cost of debt that reduces the optimal level. For some factors the impact is not clear and these are indicated as / Variable Taxes Corporate tax rate Personal tax rate on equity income Personal tax rate on debt income Financial Distress Costs Direct Indirect Debt Mispricing Interest rates on my debt are too low Interest rates on my debt are too high Positive market sentiment towards debt financing Negative market sentiment toward debt financing Information Signalling firm quality Signalling aggressive competition Flexibility Access to capital markets at fair price Costs of excess investment Costs of underinvestment Other Transaction costs Creditor rights Control Competitiveness of the industry Improved bargaining ability Effect on level of debt

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Pecking Order Theory: The pecking order theory of capital structure says that firms do not have a target amount of debt in mind, but that the amount of debt financing employed depends on the profitability of the firm. Firms will use funds from the following sources in order until that source is exhausted or the cost of that source becomes too high: Retained Profits Debt Financing

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Liability Strategies Group

January 2006

The Theory and Practice of Corporate Capital Structure

Equity Financing The theoretical justification behind this argument is that access to capital markets— especially for equity—is so expensive that it totally dominates all other factors. This is only true if there are very significant information asymmetries Inertia: The final view of capital structure is that the debt/equity choice is mainly driven by inertia. If firms only raise outside financing when needed, the observed behaviour may be very similar to that which would emerge if firms follow the pecking order theory. However, the decision is not driven by the worry about flexibility or cost of access, but by the fact that this is the easiest outcome—i.e., this argument suggests that firms follow that course of action which takes the least effort Practical Considerations The firm’s credit rating is an important communication tool and previous research has shown that many companies consider it important in capital structure decisions In practice, firms may be concerned about their ability to access markets and their ability to achieve fair pricing, these concerns often feed into their capital structure decisions Earnings per Share (EPS), while irrelevant from a strictly theoretical perspective, are often actively managed by...
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