capital structure puzzle
I s there a way of dividing a company’s capital base between debt and equity that can be expected to maximize fi rm value? And, if so, what are the critical factors in determining the target leverage ratio for a given company?
Although corporate fi nance has been taught in business schools for more than a century, the academic fi nance profession has found it diffi cult to come up with defi nitive answers to these questions. Part of the diffi culty stems from how the discipline has evolved. For much of the last century, fi nance education was a glorifi ed apprenticeship system designed to pass on to students the accepted wisdom—often codifi ed in the form of rules of thumb—of successful practitioners.
However effective in certain circumstances, such rules tend to harden into dogma and lose their relevance when circumstances change. A good example is Eastman Kodak’s complete avoidance of debt fi nancing until the 1980s, a policy that can be traced back to George Eastman’s brush with insolvency at the turn of the 20th century.
Over the past several decades, fi nancial economists have worked to transform corporate fi nance into a more scientifi c undertaking, with a body of formal theories that can be tested by empirical studies of corporate and stock market behavior. But this brings us to the most important obstacle to developing a defi nitive theory of capital structure: designing empirical tests that are powerful enough to provide a basis for choosing among the various theories.
What makes the capital structure debate especially intriguing is that the theories lead to such different, and in some ways diametrically opposed, decisions and outcomes.
For example, some fi nance scholars have followed Miller and Modigliani in arguing that both capital structure and dividend policy are largely “irrelevant” in the sense that they have no predictable material effects on corporate market values. Another school of thought holds that corporate
Although corporate fi nance has been taught in business schools for more than a century, the academic fi nance profession has found it diffi cult to come up with defi nitive answers to these questions. Part of the diffi culty stems from how the discipline has evolved. For much of the last century, fi nance education was a glorifi ed apprenticeship system designed to pass on to students the accepted wisdom—often codifi ed in the form of rules of thumb—of successful practitioners.
However effective in certain circumstances, such rules tend to harden into dogma and lose their relevance when circumstances change. A good example is Eastman Kodak’s complete avoidance of debt fi nancing until the 1980s, a policy that can be traced back to George Eastman’s brush with insolvency at the turn of the 20th century.
Over the past several decades, fi nancial economists have worked to transform corporate fi nance into a more scientifi c undertaking, with a body of formal theories that can be tested by empirical studies of corporate and stock market behavior. But this brings us to the most important obstacle to developing a defi nitive theory of capital structure: designing empirical tests that are powerful enough to provide a basis for choosing among the various theories.
What makes the capital structure debate especially intriguing is that the theories lead to such different, and in some ways diametrically opposed, decisions and outcomes.
For example, some fi nance scholars have followed Miller and Modigliani in arguing that both capital structure and dividend policy are largely “irrelevant” in the sense that they have no predictable material effects on corporate market values. Another school of thought holds that corporate