On Financial Architecture Leverage
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
ON FINANCIAL ARCHITECTURE: LEVERAGE, MATURITY, AND PRIORITY
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.)
I
Throughout our previous paper, we
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
ON FINANCIAL ARCHITECTURE: LEVERAGE, MATURITY, AND PRIORITY
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.)
I
Throughout our previous paper, we