On Financial Architecture Leverage

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Journal of Applied Corporate Finance
W I N T E R 1 9 9 6 V O L U M E 8. 4

On Financial Architecture: Leverage, Maturity, and Priority
by Michael J. Barclay and Clifford W. Smith, Jr., University of Rochester


by Michael J. Barclay and Clifford W. Smith, Jr., University of Rochester

n an article published in this journal a year ago, we reported the findings of our study of corporate financing and payout policies covering some 6,700 industrial companies over the past 30 years.1 Our analysis suggests that the most important systematic determinant of a company’s leverage ratio and dividend yield is the nature of its investment opportunities. Companies whose value consists largely of intangible growth options (as indicated by high market-to-book ratios and heavy R&D spending) have significantly lower leverage ratios and dividend yields, on average, than companies whose value is represented primarily by tangible assets (with low market-to-book ratios and high depreciation expense). We explained this pattern of financing and dividend choices as follows: For high-growth firms, the “underinvestment problem” associated with heavy debt financing and the flotation costs of high dividends make both policies potentially quite costly. But, for mature firms with limited growth opportunities, high leverage and dividends can have substantial benefits from controlling the “free cash flow” problem—the temptation of managers to overinvest in mature businesses or make diversifying acquisitions. (Taxes, too, may play a role in this pattern since low-growth companies are likely to be generating more taxable income and thus have greater use for interest tax shields. But, because there are important managerial incentive benefits as well as costs to having higher debt and dividends, companies would have optimal leverage and dividend ratios even in a world without income taxes.)


Throughout our previous paper, we effectively assumed that all debt financing is the same. In practice, of course, debt can differ in several important respects, including maturity, covenant restrictions, convertibility, call provisions, security, and whether the debt is privately placed or held by widely-dispersed public investors. Each of these features is potentially important in determining the extent to which debt financing can help control (or exacerbate) problems. For example, as we argue below, companies with lots of investment opportunities can be expected to issue debt with shorter maturities, not only to protect lenders against the greater uncertainty associated with growth firms, but also to preserve their own financing flexibility and future ability to invest. Growth companies are also likely to choose private over public sources of debt because renegotiating a troubled loan with a banker (or a handful of private lenders) will generally be much easier than getting hundreds of widely dispersed bondholders to restructure the terms of a public bond issue. In this paper, we expand the scope of our earlier study, examining broader facets of corporate financial architecture. Here we focus specifically on the maturity and priority structure of the firm’s debt by looking at 6000 firms during the period 1981-1993. As in our earlier study, we test three basic explanations of these corporate financing choices. In addition to the incentive-contracting argument described above, we also test “signaling” and “tax” explanations. Consistent with our earlier findings, this study provides strong evidence for the incentive-contracting explanation, but only weak support for the signaling and tax arguments. as two other recently published studies by Barclay and Smith: “The Maturity Structure of Corporate Debt,” Journal of Finance, Vol. 50, No. 2 (1995); and “The Priority Structure of Corporate Liabilities,” Journal of Finance, Vol. 50, No. 3 (1995).

1. Michael J. Barclay, Clifford W. Smith, Jr. and...
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