AUTHOR INDEX OF REVIEWED CAPITAL STRUCTURE ARTICLES

SORTED BY AUTHOR

(Author name preceded by article index #)

32

Asquith, Paul, Mullins, D

1991

Convertible Debt: Corporate Call Policy and Voluntary Conversion

Journal of Finance

43

Bagwell, Laurie S., Zechner, J

1993

Influence Costs and Capital Structure

Journal of Finance

48

Barclay,Michael J., Smith, C

1995

The Priority Structure of Corporate Liabilities

Journal of Finance

59

Berger, Philip G, Ofek,Eli; & Yermack,David

1997

Managerial Entrenchment and Capital Structure Decisions

Journal of Finance

57

Berkovitch, Elazar; Israel, R.

1996

The Design of Internal Control and Capital Structure

Review of Financial Studies

23

Berkovitch, Elazar; Kim, E

1990

Financial Contracting and Leverage Induced Over- and Under-Investment Incentives

Journal of Finance

38

Chang, Chun

1992

Capital Structure as an Optimal Contract Between Employees and Investors

Journal of Finance

42

Chang, Chun

1993

Payout Policy, Capital Structure, and Compensation Contracts when Managers Value Control

Review of Financial Studies

44

Chemmanur, Thomas J., Fulghieri, P

1994

Reputation, Renegotiation, and the Choice between Bank Loans and Publicly Traded Debt

Review of Financial Studies

4

DeAngelo, Harry; Masulis, R.

1980

Optimal Capital Structure Under Corporate and Personal Taxation

Journal of Financial Economics

21

Denis, David J.

1990

Defensive Changes in Corporate Payout Policy: Share Repurchases and Special Dividends

Journal of Finance

34

Diamond, Douglas W.

1991

Debt Maturity Structure and Liquidity Risk

Quarterly Journal of Economics

31

Dybvig, Philip H., Zender, J

1991

Capital Structure and Dividend Irrelevance with Asymmetric Information

Review of Financial Studies

65

Fluck, Zsuzsanna

1998

Optimal Financial Contracting: Debt versus Outside Equity

Review of Financial Studies

12

Friend, Irwin; Lang, L.

1988

An Empirical Test of the Impact of Managerial Self-Interest on Corporate Capital Structure

Journal of Finance

64

Fries, Steven; Miller, M, Perraudin, W

1997

Debt in Industry Equilibrium

Review of Financial Studies

60

Garvey, Gerald T.

1997

Marketable Incentive Contracts and Capital Structure Relevance

Journal of Finance

61

Gilson, Stuart C.

1997

Transactions Costs and Capital Structure choice: Evidence from Financially Distressed Firms

Journal of Finance

50

Guedes, Jose; Thompson, R.

1995

Tests of a Signaling Hypothesis: The Choice between Fixed- and Adjustable-Rate Debt

Review of Financial Studies

67

Hanka, Gordon

1998

Debt and the terms of employment

Journal of Financial Economics

16

Harris, Milton; Raviv, A

1988

Corporate Control Contests and Capital Structure

Journal of Financial Economics

22

Harris,Milton; Raviv, A

1990

Capital Structure and the Informational Role of Debt

Journal of Finance

47

Hart,O & Moore, J

1995

Debt and Seniority: An Analysis of the Role of Hard Claims in Constraining Management

American Economic Review

56

Helwege, J., Liang, N

1996

Is there a pecking order? Evidence from a panel of IPO firms

Journal of Financial Economics

36

Hirshleifer,David, Thakor, A

1992

Managerial Conservatism, Project Choice, and Debt

Review of Financial Studies

27

Israel, Ronen

1991

Capital Structure and the Market for Corporate Control: The Defensive Role of Debt Financing

Journal of Finance

39

Israel, Ronen

1992

Capital and Ownership Structures, and the Market for Corporate Control

Review of Financial Studies

8

Jensen, Michael C.

1986

Agency Costs of Free Cash Flow, Corporate Finance, and Takeovers

American Economic Review

41

John, Teresa A., John, K

1993

Top-Management Compensation and Capital Structure

Journal of Finance

30

Kale,Jayant R., Noe, T, Ramirez, G

1991

The Effect of Business Risk on Corporate Capital Structure: Theory and Evidence

Journal of Finance

63

Kamath, Ravindra R.

1997

Long-Term Financing Decisions: Views and Practices of Financial Managers of NYSE Firms

The Financial Review

33

Korajczyk, Robert A., Lucas, D., McDonald, R

1991

The Effect of Information Releases on the Pricing and Timing of Equity Issues

Review of Financial Studies

62

Kovenock, Dan; Phillips, G

1997

Capital Structure and Product Market Behavior: an Examination of Plant Exit

and Investment Decisions

Review of Financial Studies

55

Lang, Larry H.P., Ofek, E, Stulz, R

1996

Leverage, investment, and firm growth

Journal of Financial Economics

25

Lang, Larry H.P., Stulz, R, Walkling, R

1991

A Test of the Free Cash Flow Hypothesis: The Case of Bidder Returns

Journal of Financial Economics

46

Leland, Hayne E.

1994

Corporate Debt Value, Bond Covenants, and Optimal Capital Structure

Journal of Finance

3

Leland, Hayne E., Pyle, D

1977

Informational Asymmetries, Financial Structure, and Financial Intermediation

Journal of Finance

58

Leland, Hayne E., Toft, KB

1996

Optimal Capital Structure, Endogenous Bankruptcy, and the Term Structure of Credit Spreads

Journal of Finance

53

Li,David D., Li, Shan

1996

A Theory of Corporate Scope and Financial Structure

Journal of Finance

20

Lucas, Deborah J., Mcdonald, R

1990

Equity Issues and Stock Price Dynamics

Journal of Finance

45

Mauer, David C., Triantis, A

1994

Interactions of Corporate Financing and Investment Decisions: A Dynamic Framework

Journal of Finance

49

McConnell, John J, Servaes, H

1995

Equity ownership and the two faces of debt

Journal of Financial Economics

1

Miller, Merton H.

1977

Debt and Taxes

J of Finance

10

Miller, Merton H.

1988

The Modigliani-Miller Propositions After Thirty Years

Journal of Economic Perspectives

29

Miller,Merton H.

1991

Leverage

Journal of Finance

5

Modigliani, Franco

1982

Debt, Dividend Policy, Taxes, Inflation and Market Valuation

Journal of Finance

2

Myers, Stewart C.

1977

Determinants of Corporate Borrowing

Journal of Financial Economics

6

Myers, StewartC., Majluf, N

1984

Corporate Financing and Investment Decisions when Firms have Information that

Investors do not Have

Journal of Financial Economics

7

Myers, Stuart C.

1984

The Capital Structure Puzzle

Journal of Finance

14

Noe, Thomas H.

1988

Capital Structure and Signaling Game Equilibria

Review of Financial Studies

54

Noe, Thomas H., Rebello, M

1996

Asymmetric Information, Managerial Opportunism, Financing, and Payout Policies

Journal of Finance

40

Ofek, Eli

1993

Capital structure and firm response to poor performance

Journal of Financial Economics

51

Phillips, Gordon M.

1995

Increased debt and industry product Markets: An empirical analysis

Journal of Financial Economics

18

Ravid, S. Abraham

1988

On Interactions of Production and Financial Decisions

Financial Management

66

Repullo, Rafael; Suarez, J

1998

Monitoring,Liquidation, and Security Design

Review of Financial Studies

11

Ross, Stephen A.

1988

Comment on the Modigliani-Miller Propositions

Journal of Economic Perspectives

24

Seward, James K.

1990

Corporate Financial Policy and the Theory of Financial Intermediation

Journal of Finance

37

Shleifer, Andrei, Vishny, R

1992

Liquidation Values and Debt Capacity: a Market Equilibrium Approach

Journal of Finance

35

Smith, CW; Watts, RL

1992

The investment opportunity set and corporate financing, dividend, and compensation policies

Journal of Financial Economics

26

Stein, Jeremy C.

1991

Convertible bonds as backdoor equity financing

Journal of Financial Economics

9

Stiglitz, Joseph E.

1988

Why Financial Structure Matters

Journal of Economic Perspectives

17

Stulz, Rene M.

1988

Managerial Control of Voting Rights: Financing Policies and the Market for Corporate Control

Journal of Financial Economics

19

Stulz, Rene M.

1990

Managerial discretion and optimal financing policies

Journal of Financial Economics

15

Titman, Sheridan; Wessels, R.

1988

The Determinants of Capital Structure Choice

Journal of Finance

13

Williamson, Oliver E.

1988

Corporate Finance and Corporate Governance

Journal of Finance

28

Zender, Jaime F

1991

Optimal Financial Instruments

Journal of Finance

52

Zwiebel, Jeffrey

1996

Dynamic Capital Structure under Managerial Entrenchment

American Economic Review

CITATION INDEX OF REVIEWED CAPITAL STRUCTURE ARTICLES (67 Total)

(IN CHRONOLOGICAL ORDER)

1

Debt and Taxes

Miller, Merton H.

Journal of Finance, vol. 32, May 1977, pp. 261-75.

2

Determinants of Corporate Borrowing

Myers, Stewart C.

Journal of Financial Economics 5 (1977) 147-175.

3

Informational Asymmetries, Financial Structure, and Financial Intermediation

Leland, Hayne E., Pyle, D

Journal of Finance, vol. 32, May 1977, pp. 371-87.

4

Optimal Capital Structure Under Corporate and Personal Taxation

DeAngelo, Harry; Masulis, R.

Journal of Financial Economics, 8 (1980) 3-29.

5

Debt, Dividend Policy, Taxes, Inflation and Market Valuation

Modigliani, Franco

Journal of Finance, vol. 37, May 1982, pp. 255-273.

6

Corporate Financing and Investment Decisions when Firms have Information that Investors do not

Have

Myers, StewartC., Majluf, N

Journal of Financial Economics (13) 1984 187-224.

7

The Capital Structure Puzzle

Myers, Stuart C.

Journal of Finance, vol. 39, July 1984, 575-592.

8

Agency Costs of Free Cash Flow, Corporate Finance, and Takeovers

Jensen, Michael C.

American Economic Review, vol. 76, May 1986, pp. 323-339.

9

Why Financial Structure Matters

Stiglitz, Joseph E.

Journal of Economic Perspectives, vol. 2, Fall 1988, pp. 121-126.

10

The Modigliani-Miller Propositions After Thirty Years

Miller, Merton H.

Journal of Economic Perspectives, vol. 2, Fall 1988, pp. 99-120.

11

Comment on the Modigliani-Miller Propositions

Ross, Stephen A.

Journal of Economic Perspectives, vol. 2, Fall 1988, pp. 127-134.

12

An Empirical Test of the Impact of Managerial Self-Interest on Corporate Capital Structure

Friend, Irwin; Lang, L.

Journal of Finance, vol. 43, 1988, pp. 271-281.

13

Corporate Finance and Corporate Governance

Williamson, Oliver E.

Journal of Finance, vol. 43, July 1988, pp. 567-91.

14

Capital Structure and Signaling Game Equilibria

Noe, Thomas H.

Review of Financial Studies, 1988, vol.1 no. 4, 331-356.

15

The Determinants of Capital Structure Choice

Titman, Sheridan; Wessels, R.

Journal of Finance, vol. 43, March 1988, pp. 1-19.

16

Corporate Control Contests and Capital Structure

Harris, Milton; Raviv, A

Journal of Financial Economics 20 (1988) 55-86.

17

Managerial Control of Voting Rights: Financing Policies and the Market for Corporate Control

Stulz, Rene M.

Journal of Financial Economics 20 (1988) 25-54.

18

On Interactions of Production and Financial Decisions

Ravid, S. Abraham

Financial Management, vol. 8, Autumn 1988, pp. 87-99.

19

Managerial discretion and optimal financing policies

Stulz, Rene M.

Journal of Financial Economics, 26 (1990) 3-27.

20

Equity Issues and Stock Price Dynamics

Lucas, Deborah J., Mcdonald, R

Journal of Finance, vol 45, September 1990, pp. 1019-1043.

21

Defensive Changes in Corporate Payout Policy: Share Repurchases and Special Dividends

Denis, David J.

Journal of Finance, vol. 45, December 1990, 1433-56.

22

Capital Structure and the Informational Role of Debt

Harris,Milton; Raviv, A

Journal of Finance, vol. 45, June 1990, pp. 321-49.

23

Financial Contracting and Leverage Induced Over- and Under-Investment Incentives

Berkovitch, Elazar; Kim, E

Journal of Finance, vol. 45, July 1990, pp. 765-94.

24

Corporate Financial Policy and the Theory of Financial Intermediation

Seward, James K.

Journal of Finance, vol. 45, June 1990, pp. 351-77.

25

A Test of the Free Cash Flow Hypothesis: The Case of Bidder Returns

Lang, Larry H.P., Stulz, R, Walkling, R

Journal of Financial Economics, 1991 (29) 315-335.

26

Convertible bonds as backdoor equity financing

Stein, Jeremy C.

Journal of Financial Economics, 1991 (32) 3-21.

27

Capital Structure and the Market for Corporate Control: The Defensive Role of Debt Financing

Israel, Ronen

Journal of Finance, vol 46, September 1991, pp. 1391-1409.

28

Optimal Financial Instruments

Zender, Jaime F

Journal of Finance, vol 46, December 1991, pp. 1665-91.

29

Leverage

Miller,Merton H.

Journal of Finance, vol 46, June 1991, pp. 479-88.

30

The Effect of Business Risk on Corporate Capital Structure: Theory and Evidence

Kale,Jayant R., Noe, T, Ramirez, G

Journal of Finance, vol. 46, December 1991, pp. 1693-715.

31

Capital Structure and Dividend Irrelevance with Asymmetric Information

Dybvig, Philip H., Zender, J

Review of Financial Studies, 1991 vol. 4 no. 1, pp. 201-219.

32

Convertible Debt: Corporate Call Policy and Voluntary Conversion

Asquith, Paul, Mullins, D

Journal of Finance, vol 46, September 1991, pp. 1273-89.

33

The Effect of Information Releases on the Pricing and Timing of Equity Issues

Korajczyk, Robert A., Lucas, D., McDonald, R

Review of Financial Studies, vol. 4 no. 4 1991, pp. 685-708.

34

Debt Maturity Structure and Liquidity Risk

Diamond, Douglas W.

Quarterly Journal of Economics, vol. 106, August 1991, pp. 709-737.

35

The investment opportunity set and corporate financing, dividend, and compensation policies

Smith, CW; Watts, RL

Journal of Financial Economics 32 (1992) 263-292.

36

Managerial Conservatism, Project Choice, and Debt

Hirshleifer,David, Thakor, A

Review of Financial Studies, 1992 v.5 no. 3, pp. 437-470.

37

Liquidation Values and Debt Capacity: a Market Equilibrium Approach

Shleifer, Andrei, Vishny, R

Journal of Finance, vol. 47, September 1992, pp. 1343-66.

38

Capital Structure as an Optimal Contract Between Employees and Investors

Chang, Chun

Journal of Finance, vol. 47, July 1992, pp. 1141-58.

39

Capital and Ownership Structures, and the Market for Corporate Control

Israel, Ronen

Review of Financial Studies, 1992 vol. 5 no. 2, pp. 181-198.

40

Capital structure and firm response to poor performance

Ofek, Eli

Journal of Financial Economics 34 (1993) 3-30.

41

Top-Management Compensation and Capital Structure

John, Teresa A., John, K

Journal of Finance, vol. 48, July 1993, pp. 949-74.

42

Payout Policy, Capital Structure, and Compensation Contracts when Managers Value Control

Chang, Chun

Review of Financial Studies, Winter 1993 vol. 6 no. 4, pp. 911-933.

43

Influence Costs and Capital Structure

Bagwell, Laurie S., Zechner, J

Journal of Finance, vol. 48, July 1993, pp. 975-1008.

44

Reputation, Renegotiation, and the Choice between Bank Loans and Publicly Traded Debt

Chemmanur, Thomas J., Fulghieri, P

Review of Financial Studies, Fall 1994, vol. 7, no. 3, pp. 475-506.

45

Interactions of Corporate Financing and Investment Decisions: A Dynamic Framework

Mauer, David C., Triantis, A

Journal of Finance, vol. 49, September 1994, pp. 1253-77.

46

Corporate Debt Value, Bond Covenants, and Optimal Capital Structure

Leland, Hayne E.

Journal of Finance, vol. 49, September 1994, pp. 1213-52.

47

Debt and Seniority: An Analysis of the Role of Hard Claims in Constraining Management

Hart,O & Moore, J

American Economic Review, vol. 85, no. 3, June 1995, pp. 567-85.

48

The Priority Structure of Corporate Liabilities

Barclay,Michael J., Smith, C

Journal of Finance, vol 50, no. 3, July 1995, pp.899-917.

49

Equity ownership and the two faces of debt

McConnell, John J, Servaes, H

Journal of Financial Economics, 1995 (39) 131-157.

50

Tests of a Signaling Hypothesis: The Choice between Fixed- and Adjustable-Rate Debt

Guedes, Jose; Thompson, R.

Review of Financial Studies, Fall 1995 vol. 8, no. 3, pp. 605-636.

51

Increased debt and industry product Markets: An empirical analysis

Phillips, Gordon M.

Journal of Financial Economics 37 (1995) 189-238.

52

Dynamic Capital Structure under Managerial Entrenchment

Zwiebel, Jeffrey

American Economic Review, vol. 86, December 1996, pp. 1197-1215.

53

A Theory of Corporate Scope and Financial Structure

Li,David D., Li, Shan

Journal of Finance, vol 51, no. 2, June 1996, pp. 691-709.

54

Asymmetric Information, Managerial Opportunism, Financing, and Payout Policies

Noe, Thomas H., Rebello, M

Journal of Finance, vol. 51, June 1996, pp. 637-60.

55

Leverage, investment, and firm growth

Lang, Larry H.P., Ofek, E, Stulz, R

Journal of Financial Economics 40 (1996) 3-29.

56

Is there a pecking order? Evidence from a panel of IPO firms

Helwege, J., Liang, N

Journal of Financial Economics, 40 (1996) 429-458.

57

The Design of Internal Control and Capital Structure

Berkovitch, Elazar; Israel, R.

Review of Financial Studies, Spring 1996, vol. 9, no. 1, pp. 209-240.

58

Optimal Capital Structure, Endogenous Bankruptcy, and the Term Structure of Credit Spreads

Leland, Hayne E., Toft, KB

Journal of Finance, vol. 51, July 1996, pp. 987-1019.

59

Managerial Entrenchment and Capital Structure Decisions

Berger, Philip G, Ofek,Eli; & Yermack,David

Journal of Finance, vol 52, September 1997, pp. 1411-38.

60

Marketable Incentive Contracts and Capital Structure Relevance

Garvey, Gerald T.

Journal of Finance, vol 52, March 1997, pp. 341-52.

61

Transactions Costs and Capital Structure choice: Evidence from Financially Distressed Firms

Gilson, Stuart C.

Journal of Finance, vol. 52, March 1997, pp. 111-33.

62

Capital Structure and Product Market Behavior: an Examination of Plant Exit and Investment

Decisions

Kovenock, Dan; Phillips, G

Review of Financial Studies, Fall 1997 vol. 10, no. 3, pp 767-803.

63

Long-Term Financing Decisions: Views and Practices of Financial Managers of NYSE Firms

Kamath, Ravindra R.

The Financial Review, vol. 32, May 1997, pp. 331-56.

64

Debt in Industry Equilibrium

Fries, Steven; Miller, M, Perraudin, W

Review of Financial Studies, Spring 1997, vol. 10, no. 1, pp. 39-67.

65

Optimal Financial Contracting: Debt versus Outside Equity

Fluck, Zsuzsanna

Review of Financial Studies, 1998 vol. 11 no. 2, pp. 383-418.

66

Monitoring,Liquidation, and Security Design

Repullo, Rafael; Suarez, J

Review of Financial Studies, Spring 1998 vol. 11 no. 1, pp. 163-187.

67

Debt and the terms of employment

Hanka, Gordon

Journal of Financial Economics 48 (1998) 245-282.

ARTICLES

Title

Author(s)

Journal, date

Sections

Sections Reviewed

Area

Theoretical/Empirical

1

Debt and Taxes

Miller, MH

Journal of Finance, May 77

Intro, 1-5

Intro, 1-5

Cap. Structure

Theoretical

Level 1

Personal taxation possibly offsets the corporate tax benefits of higher leverage

Level 2

Bankruptcy and corporate tax explanations of how US firms choose leverage levels do not hold.

Possible that there exists an equilibrium where leverage doesn't matter and personal taxes offset

the tax advantages of higher leverage.

Level 3

Firms supposedly optimize tax benefits from debt versus bankruptcy costs. But bankruptcy costs

are too small to explain why firms don't use higher leverage (e.g. Kodak and IBM were low levered

but had virtually no bankruptcy risk). Also, economy-wide leverage hasn't responded to the

quintupling of tax rates since the 1920s. Thus the offset provided by personal taxes may explain

the insensitivity of leverage to changing corporate tax rates.

"…the tax advantages of debt financing must be substantially less than the conventional wisdom

suggests."

Miller proposes an equilibrium based on the existence of differentially taxed classes of investors.

There would be "…an equilibrium debt-equity ratio for the corporate sector as a whole. But there

would be no optimum debt ratio for any individual firm. Thus low-leverage firms would find clientele

among high tax brackets and high-leverage firms would attract tax-exempt investors.

2

Determinants of Corporate Borrowing

Myers, SC

Journal of Financial Economics,5 (1977)

1-5

1,2,3-,5

Cap. Structure

Theoretical

Level 1

The firm's growth opportunities can be viewed as call options whose value depends on discretionary

future investment by the firm

Level 2

The firm's future growth opportunities, viewed as call options, depend on future investment by the

firm. A firm "with risky debt outstanding, and which acts in its stockholders' interest, will follow a

different decision rule than one which can issue risk-free debt…" and thus sometimes pass up

positive NPV projects. Optimal leverage obtains as "…a tradeoff between the tax advantages of

debt and the costs of the suboptimal future investment strategy."

Level 3

Paper predicts that borrowing is inversely related to percentage of market value of a firm's real

options. Also explains the matching of the maturities of assets and debt liabilities and why firm's

use target ratios denominated in book values (book values are acceptable indicators of the value of

assets in place-- as opposed to future growth opportunities).

(From Harris & Raviv (91)): "equity holders bear the entire cost of the investment, but the returns

from the investment may be captured mainly by the debt holders."

The intuition is that "outstanding debt will change the firm's investment decisions in some states."

Since risky debt payments are due after a firm's investment is made, the s/h's can refrain from

investing in a positive NPV project; whereas had the debt payment been due before the investment

decision, then s/h's would accept all positive NPV projects.

3

Informational Asymmetries, Financial Structure, and Financial Intermediation

Leland, HE; Pyle, DH

Journal of Finance, May 1977

Intro, 1-4

Intro, 1-,4

Cap. Structure

Theoretical

Level 1

Willingness of insiders to invest serves as signal of true quality of the project or firm

Level 2

An entrepreneur's willingness to invest in his own project signals higher quality. In an asymmetric

information environment, "The value of the firm increases with the share of the firm held by the

entrepreneur." Authors "suggest that financial intermediation…can be viewed as a natural

response to asymmetric information."

Level 3

The market views the entrepreneur's investment level as a noiseless signal of the project's

expected return.

(The following is drawn from Harris & Raviv, 1991):** The entrepreneur chooses the fraction of

equity retained, alpha, and the debt level in order to maximize his expected utility of end of period

wealth, subject to the constraint of raising the necessary capital.

The market's valuation of the firm is increasing in alpha, thus there's a tradeoff for the

entrepreneur's optimal choice of alpha. Higer alpha leads to greater risk but is counterbalanced by

the higher per-share price that the entrepreneur receives for his equity offering. First order

conditions show that ownership increases with firm quality. It can also be shown that debt is (for

given parameter bounds) an increasing function of alpha; thus firms with more debt have higher

inside ownership and are of higher quality.

**

Transaction costs don't seem high enough to explain existence of financial intermediaries. But,

given the asymmetric environment, there exists an incentive for costly acquisition of information.

Potential failures in the market for such information may lead to intermediaries collecting such

information and then buying and holding assets based on their findings.

4

Optimal Capital Structure Under Corporate and Personal Taxation

DeAngelo, H; Masulis, RW

Journal of Financial Economics, 8 (1980)

1-8

1,2-,4--,8

Cap. Structure

Theoretical

Level 1

Non-debt corporate tax shields sufficient to overturn Miller's (77) leverage irrelevancy

Level 2

"…realistic tax code features imply a unique interior optimum leverage decision for each firm in

market equilibrium after all supply side adjustments are taken into account."

Level 3

Key assumptions: i) equity-biased personal tax code ii) there exist corporate tax shield substitutes

for debt, and/or there exist positive default costs iii) heterogeneous personal tax rates

"…our model predicts that firms will select a level of debt which is negatively related to …tax shield

substitutes for debt such as depreciation deductions or investment tax credits."

Here's why:

"…relative market prices [of debt and equity] will adjust until in market equilibrium,

each firm has a unique interior optimum leverage decision. This unique interior optimum exists

because there is a constant expected marginal personal tax disadvantage to debt while positive

tax shield substitutes imply that the expected marginal corporate tax benefit declines as leverage

is added to the capital structure. At the unique optimum, the expected marginal corporate tax

benefit just equals the expected marginal personal tax disadvantage of debt."

5

Debt, Dividend Policy, Taxes, Inflation and Market Valuation

Modigliani, F

Journal of Finance, May 1982

1-3

1

Cap. Structure

Theoretical

Level 1

Considers leverage and firm value in a mean-variance framework

Level 2

In an environment of (stable) inflation and differentially taxed investors, the model solves for the

value of leverage from a demand-side analysis using a mean-variance portfolio approach.

Implications are: leverage has modest value, inflation increases both leverage and polarization of

a firm's debt clientele.

Level 3

The MM "Correction" paper, 1963 implied a 100% debt corner solution for leverage. Four

"supply-side" reasons this doesn't happen: i) bankruptcy costs ii) agency costs iii) moral hazard

(a la Myers [1977]) iv) possibility that tax shields go unused. Modigliani goes on to criticize

Miller's[1977] demand-side analysis: "I discovered serious difficulties with Miller's framework,

because of its tendency to lead to unstable corner solutions."

Modigliani reconsiders the demand-side problem in a mean-variance framework. He solves for the

value of leverage (and of the firm) and an individual's demand for debt and equity, in a constant

inflation environment.

Implications are: i) if tax savings flow is regarded as risky, than leverage will be modestly valuable

ii) inflation should increases the value of leverage iii) dividends should modestly reduce market

value, but this effect attenuated by uncertainty of tax consequences iv) differential tax rates and

heterogeneous firm returns will result in clientele effects

6

Corporate Financing and Investment Decisions when Firms have Information that Investors do not

Have

Myers, SC; Majluf, NS

Journal of Financial Economics, 1984 no. 2, June

1-6

1,2,6

Cap. Structure

Theoretical

Level 1

Under asymmetric information, firms mayn't issue stock when needed (and thus underinvest)

Level 2

If the firm is (via asymmetric information) undervalued by the market, and a positive NPV project

requires the issuance of new equity, then the project may be foregone if the new equity is so

undervalued that the value of existing stock will be overdiluted. This creates an incentive to

maintain financial slack (borrowing power) and to avoid external finance.

Level 3

Firms rely first on internal funds, then on riskless debt, and finally by issuing new equity.

Key assumptions: managers act in interest of existing s/h's, existing s/h's remain passive

throughout any new equity issues.

The firm can build financial slack by issuing stock in periods when manager's information

advantage is small.

"…firm should not pay a dividend if it has to recoup the cash by selling stock or some other risky

security."

"A merger of a slack-rich and slack-poor firm increases the firm's[sic] combined value."

Negotiating such a merger requires conveyance of the asymmetric information.

7

The Capital Structure Puzzle

Myers, SC

Journal of Finance, July 1984

Intro, 1-5

Intro, 1-5

Cap. Structure

Theoretical

Level 1

Reviews arguments for two theories on capital structure: target leverage ratio vs. pecking order

Level 2

"If this story[the pecking order] is right, average debt ratios will vary from industry to industry,

because asset risk, asset type, and requirements for external funds also vary by industry. But a

long-run industry average will not be a meaningful target for individual firms in that industry."

Level 3

Myers restricts attention in this analysis only to value-maximizing managers.

In the static framework, the firm is "portrayed as balancing the value of interest tax shields against

various costs of bankruptcy or financial embarrassment." If leverage adjustment costs are small,

so that firms are staying close to their optimal leverage, "I find it hard to understand the observed

diversity of capital structures across firms that seem similar in a static tradeoff framework."

The static framework predicts a positive relation between leverage and a firm's effective tax rate.

For 1973-82, for non-financial firms, "internally generated cash covered, on average, 62 percent of

capital expenditures, …" This fact supports the pecking order theory. Transaction costs

of equity issues may explain this fact from the static framework, except that transaction costs are

low for share repurchases.

The pecking order asserts: i) firms avoid issuing risky securities (as per Myers/Majluf '84) ii) firms

set dividends so that normal investment can be internally funded iii) firms try to maintain reserve

(i.e. low-risk) borrowing power, and iv) since dividend payout ratios are sticky, and investment is

lumpy, the firm must occasionally rely on external finance.

"The crucial difference between this and the static tradeoff story is that, in the modified pecking

order story, observed debt ratios will reflect the cumulative requirement for external financing--a

requirement cumulated over an extended period."

8

Agency Costs of Free Cash Flow, Corporate Finance, and Takeovers

Jensen, MC

American Economic Review, May 86

Intro, 1-6

Intro, 1-6

Cap. Structure

Theoretical

Level 1

Debt for equity exchanges induce organizational changes that reduce agency costs

Level 2

Managers maximize their power and "have incentives to cause their firms to grow beyond the

optimal size." Payoffs to shareholders suffer from this agency relationship. Increased debt levels

(from LBOs, restructurings, takeovers) serve as means to disgorge free cash flow and prevent

wasteful investment.

Level 3

"Debt creation, without retention of the proceeds of the issue, enables managers to effectively bond

their promise to pay out future cash flows."

Optimal debt level trades off the use of debt as a motivating force vs. the negative effect of debt on

bankruptcy costs.

Simple debt sales, without payout of cash to s/h's, will not increase value, but just give mngment

more free cash.

The free cash flow theory helps explain takeovers in the oil & broadcasting industries.

9

Why Financial Structure Matters

Stiglitz, JE

J of Economic Perspectives, Fall 1988

1

1

Cap. Structure

Theoretical

Level 1

The MM theorem forced skeptics to identify which of the MM assumptions should be modified or

rejected.

Level 2

Four assumptions: i) risk class assumption ii) homemade leverage iii) full returns information

available iv) tax policy treats debt & equity similarly. When does altering these assumptions

matter?

Level 3

Risk class assumption not needed if there's no chance of bankruptcy (Stiglitz's 1969 general

equilibrium approach), or if other special conditions hold.

Validity of the homemade leverage assumption (individuals can borrow at the same rate as

corporations) was largely ignored, except by Tobin.

Full information assumption: existence of asymmetric information leads to situation where

financial structure matters.

Tax differential assumption: "there exists, in effect, a tax on financial restructuring", thus

some firms loathe to change existing structure.

Puzzles: i) Why do firms rely so heavily on dividends, as opposed to say share repurchases? ii)

Since firms have different financial structure, why is their not more heterogeneity in their clientele?

10

The Modigliani-Miller Propositions After Thirty Years

Miller, MH

J of Economic Perspectives, Fall 1988

3

3

Cap. Structure

Theoretical

Level 1

Reflections on Propositions I and II and Dividend irrelevance

Level 2

Reviews three lines of objection to the original MM propositions, relating to dividends, debt default

and taxes

Level 3

Dividends

MM Proposition I based on idea that investor, by buying a share, obtains cash flow of the firm. But,

legally, all he gets is rights to (a possibly very different) dividend stream. MM proved dividend

irrelevance in order to bolster their original propositions.

Dividend irrelevance took for granted that dividend policy was independent of investment policy.

Limited Liability

Can view the put-call parity theorem [S = C(K) + Kexp(-rt) - P(K) ] as an MM Proposition. S is the

market value of the firm; C(K) is the mkt. value of the equity (viewed as a call option with a strike

price equal to K, the face value of the firm's debt); and [Kexp(-rt) - P(K)] is the riskless valuation of

the firms debt less the value of the shareholder's put option on the debt.

Taxes

MM Prop I holds when viewing the IRS as just another claim holder on the firm (not a favorable

approach). Looking for reasons why US corporations didn't use greater leverage.

A sequence of bad years could wipe out a firm's interest tax shields. It's possible that some

personal tax effects offset the benefits of leveraging. Miller finds, on the whole, it puzzling that

more leverage and greater use of share repurchases (as opp

11

Comment on the Modigliani-Miller Propositions

Ross, SA

J of Economic Perspectives, Fall 1988

1

1

Cap. Structure

Theoretical

Level 1

The arbitrage outlook simplifies some of the MM assumptions

Level 2

Arbitrage Analysis and Risk Classes

Original MM theorem required the perfectly correlated companion firm (risk class assumption).

"Now we merely invoke the result that the absence of arbitrage implies the existence of a linear

pricing rule". (Linear pricing implies that the value of a firm's cash flows, regardless of whether

they're dedicated to debt or equity, is a constant.) The no-arbitrage/linear pricing rule also does

away with the homemade-leverage assumption, providing that "changing the firm's capitalization

does not alter the pricing of risky cash flows in the economy as a whole".

Level 3

"…richness of substitutes for the cash flows offered by any one firm now takes the place of the

identical firms in the original MM risk classes."

12

An Empirical Test of the Impact of Managerial Self-Interest on Corporate Capital Structure

Friend, I; Lang, LHP

Journal of Finance, vol. 43, 1988, pp. 271-281.

Intro, 1-4

Intro,1-,2-,4-

Cap. Structure

Empirical

Level 1

Leverage is correlated with degree of management's shareholding

Level 2

Leverage decreases as management's shareholding increases. (There's greater nondiversifiable

risk of debt to management than to average shareowner.) Firms having a nonmanagerial

shareowner have significantly higher debt ratio than those without, suggesting that nonmanagerial

shareholders may effectively perform a monitoring function.

Level 3

Empirical results from regressing debt ratio (DRT=debt/assets on book basis) on FR (fraction of

equity held by dominant insider) and LMV (log of mkt. value of own firm equity held by dominant

insider) and other indep. variables:

LMV

FR

Closely held

w/out nonmngrial princ. s/holder

-0.037

corporations

-0.18

w/ nonmngrial princ. s/holder

-0.05

-0.149

Widely held

w/out nonmngrial princ. s/holder

0.003*

corporations

0.477

w/ nonmngrial princ. s/holder

-0.025

-0.577

*Only coefficient w/ insignificant t-ratio

Note that "In our specification, we are implicitly assuming that causality runs from the

insider-holding measures to the debt ratio….The possibility of reverse causality remains an open

question…"

13

Corporate Finance and Corporate Governance

Williamson, OE

Journal of Finance, July 1988

1-4

1-4

Cap. Structure

Theoretical

Level 1

Debt and Equity viewed as alternative governance structures

Level 2

Simple governance structures (debt) are appropriate for simple projects. Equity is a "more

complex and costly governance structure" which adds value, in certain situations, by being more

flexible. Transaction-Cost Economics argues for a project-financing approach to corporate finance

with debt or equity chosen based on the redeployability of assets.

Level 3

Author notes that from the MM theorems onwards, analyses of leverage focus on "Capital being of

an undifferentiated (composite) kind…" The theory views debt as useful "only for special purposes.

It signals better opportunities (Ross); it avoids dilution (Stiglitz, Jensen and Meckling); it compels

managers to behave in a fashion more consonant with the stockholders interests (Grossman and

Hart, Jensen)…there is no suggestion that debt is better suited for some projects and equity for

others."

The costs of debt financing increases with asset specificity and with uncertainty. Contrarily, equity

adds value by not forcing too-early liquidation and by financially enabling firms to undertake highly

specific investments. Transaction-Cost Economics "postulates that debt (the market form) is the

natural financial instrument. Equity (the administrative form) appears as the financial instrument of

last resort."

Transaction-Cost Economics views LBOs as a case where the leverage ratio was too low

compared to how unspecific target firm assets were. The pecking order of financing is anathema,

especially the desire to use retained earnings first to finance new projects. The pecking order

theory makes no reference to asset specificity.

14

Capital Structure and Signaling Game Equilibria

Noe, TH

Review of Financial Studies, 1988, v.1 no. 4

Intro, 1-5

Intro, 1--,2--,3--,5

Cap. Structure

Theoretical

Level 1

Signaling and pecking-order theories very sensitive to informational assumptions

Level 2

Signaling equilibria can generate dominance of debt over equity when insiders have perfect

information. If insiders have imperfect information, there may exist equilibria when firms prefer

equity to debt. Noe also proves that the announcement effect of equity financing will be negative.

Level 3

When insiders have perfect information, debt is preferred because low-quality firms know for sure

that they can't repay, thus they opt out of debt financing--implying that debt is now risk-free.

When insiders have imperfect information, the pecking order theory can break down as i) low

quality firms issue debt (they are no longer certain to fail) ii) high quality firms avoid equity

issuance in order to avoid dilution losses from pooling with other types.

If debt and equity exist in equilibrium, then on average the quality of the firms issuing debt will be

greater than the quality of firms issuing equity. (The argument follows Brennan and Kraus 1987

and is based on a zero-profit condition in financial markets, see section 4, par. 2). Thus the

announcement of an equity issue will always be viewed negatively.

15

The Determinants of Capital Structure Choice

Titman, S; Wessels, R

Journal of Finance, March 1988

Intro, 1-7

Intro,1,2,4,5,7

Cap. Structure

Empirical

Level 1

Measures capital structure choice with a linear factor model

Level 2

Uses linear structural modeling to simultaneously estimate regressions of types of debt on the

indicator variables suggested by numerous theories. Finds that firms with unique products have

low leverage; small firms rely more on short-term debt; and no evidence found for relating leverage

to expected growth, non-debt tax shields, volatility, or collateral asset value.

Level 3

Article takes the view that the typical approach of testing a theory by measuring proxy variables of

theoretical attributes is weak. Instead, the article poses a linear relationship between observable

variables and the unobservable attributes from a number of theories. Then six measures of

different types of debt are simultaneously regressed on estimates of the unobservable attributes.

Attributes were taken from theories positing relationship of leverage to: asset collateral value,

non-debt tax shields, growth, uniqueness (unique firms cause stakeholders to incur high liquidation

costs, and thus avoid bankruptcy by reducing leverage), firm size, volatility, and profitability.

"…small firms tend to use significantly more short-term financing than large firms…reflects the high

transaction costs that small firms face…"

The importance of transaction costs "in this study suggests that the various leverage-related costs

and benefits may not be particularly significant."

"The coefficient estimate of -0.263 …indicates that firms that differ in "uniqueness" by one variance

are expected to have long-term debt ratios that differ by 0.263 variances." Thus firms requiring

specialized investments by employees and suppliers, for example, will reduce leverage to avoid

imposing bankruptcy costs on these and other stakeholders.

16

Capital Control Contests and Capital Structure

Harris, M; Raviv, A Journal of Financial Economics

1-6

1,2-,6

Cap. Structure

Theoretical

Level 1

Explores effects of leverage on corporate takeover methods (proxy fights vs. tender offers),

outcomes, and prices

Level 2

Managers increase their voting power by raising debt. Resisting takeovers helps managers retain

private control benefits but reduces their share of capital gains from better management, and

reduces their control benefits. This tradeoff determines (short-run) optimal capital structure choice

by managers and whether control contests will be by proxy or tender offer.

Level 3

Low debt levels (mngrs have less concentrated voting power) lead to tender offers. Intermediate

leverage leads to proxy fights. At higher debt levels, incumbents can control the contest.

Managers tradeoff benefits of debt (greater likelihood of incumbency) vs. costs of debt (greater risk

of bankruptcy, lower private benefits of control) in choosing capital structure and thus

endogenously determine takeover method, outcome, and price effects.

Seven implications:

"u"==unsuccessful

"a"==announcement

"incr"==increases

"s"==successful

(higher debt==>)

if proxy contest

(low debt==>)

if tender offer

1

avg. stk price

s: incr

u: no change

2

avg. stk price

s: incr more

u: incr

3

avg. stk price

a: incr

a: incr more

3.1

avg. stk price

s: incr

s: incr more

4

leverage

incr

incr

5

leverage

s: incr

u: incr more

5.1

leverage

s or u: incr more

s: incr

6

leverage

s or u: incr

u: incr more

(if small investors vote

for the better mngment team)

7

leverage

Incumbents keep control: incr

Rivals get control: incr more

17

Managerial Control of Voting Rights: Financing Policies and the Market for Corporate Control

Stulz, RM

Journal of Financial Economics, 20 (1988)

1-6

1,2-,6

Cap. Structure

Theoretical

Level 1

Value of potential takeover targets depend on fraction of votes held by management

Level 2

Changes in leverage imply changes in managerial control over voting rights. If management 's

percentage of the vote is too small, then the probability of a takeover is greater but the premium

paid by a bidder is smaller, and vice-versa if management's percentage of votes is very high.

Level 3

Key assumption: "..a successful tender offer affects the welfare of outside shareholders and

managers differently." Also, the expected fraction of shares tendered to a bidder increases

with the premium offered by the bidder but the number of shares tendered is uncertain.

"Alpha" is the percentage of voting rights controlled by management. "We show that the value of

the firm is positively related to [alpha] for low values of [alpha] and negatively related to [alpha] as

[alpha] becomes large." For low alpha, prospective bidders lower their bids. For high alpha, the

probability of a takeover decreases as alpha increases (for high alpha a bidder has to induce a

larger percentage of nonmanagerial s/h's to tender their shares).

Empirically, Morck, Shleifer and Vishny (1988) show that, after controlling for industry effects, that

Tobin's Q falls as alpha becomes large.

The model leaves open, for future research, issues related to informational asymmetries, incentive

effects on management of greater alpha, and distribution-of-votes effects.

18

On Interactions of Production and Financial Decisions

Ravid, SA

Financial Management, Autumn 1988

Intro, 1-7

Intro, 1,2,3,5,7

Cap. Structure

Review

Level 1

"One must conclude that the interaction story is basically about bankruptcy and taxes."

Level 2

"If the firm is profitable and will never go bankrupt, then there is no conflict between shareholders

and bondholders." With the threat of bankruptcy, the firm can influence strategic relationships with

its customers, competitors, employees, etc. The firm's tax status, particularly the existence of

redundant tax shelters, must be accounted when making debt and investment decisions.

Level 3

If interactions between production and financing decisions are significant, "…then proper financial

management may be vastly more difficult than typically portrayed in modern textbooks."

Section 5 (interaction in the product markets) of the article focuses on works by Titman, and

Brander & Lewis, that are mentioned elsewhere in these reviews. Also mentions papers

by Sarig and Allen (not covered herein) that seem not to have been widely cited since 1988.

Bankruptcy provides a "…strategic advantage to debt without the need to assume tax benefits."

Leverage can thus benefit s/h's at the expense of rival firms, bondholders, suppliers, and other

stakeholders.

19

Managerial discretion and optimal financing policies

Stulz, RM

Journal of Financial Economics, 26 (1990)

1-9

1-3, 6-,9

Cap. Structure

Theoretical

Level 1

Under asymmetric information, financing policies can restrict the costs of managerial discretion

Level 2

Under asymmetric information, financing policies trade off benefits of debt in reducing

overinvestment vs. costs of debt in those cases when it inhibits advantageous investment.

Level 3

Managers can't credibly communicate w/ s/h's because managers always want to invest, thus

always claim that cash flow is too low, thus s/h's never believe mngrs.' claims. Underinvestment

can result when cash flow is low and managers have trouble funding positive NPV projects.

"The distribution of cash flows matters period by period, because shareholders want to

optimize…each period to maximize their wealth." S/h's optimize by selecting a target for

investment resources available to managers. Thus cash flow volatility inhibits s/h efforts to

attenuate costs of managerial discretion . Thus a rationale is provided for diversification across

projects.

Likewise, leverage depends on stochastic nature of investment opportunities.

20

Equity Issues and Stock Price Dynamics

Lucas, DJ; Mcdonald, RL

Journal of Finance, September 1990

Intro, 1-8

Cap. Structure

Theoretical

Level 1

Asymmetric information model explains stock price reactions to new equity issues

Level 2

Managers have one period's worth of inside information and know if their firm is under or over

valued. If overvalued, equity is issued immediately and pre-issue returns are just average. If

undervalued, managers wait. market undervaluation is removed only after firm has abnormal positive

returns, after which equity is immediately issued. Thus, overall, equity issues are preceded by

above-average returns.

Level 3

Empirical observations & explanations:

i) Stock prices on average experience abnormal positive return prior to an equity issue.

ii) Substantial variation over time in the volume of equity issues. Issues increase as the market

goes up.(Reason: the undervaluation problem attenuated as mkt. rises.)

iii) Announcements of equity issues associated with stock price drops. (Same adverse selection

problem as in Myers & Majluf, undervalued firms wait to issue equity while overvalued firms don't.)

This model differs from others in "…assumptions of infinitely lived firms and short-term information

asymmetries between managers and outside investors."

Extension: model can explain open market share repurchases. Again, undervalued firms

repurchase shares immediately, while overvalued firms wait.

(FR comment: In an asymmetric information model, if managers have knowledge that their stock

is undervalued then maybe they should buy it. The fact that they don't buy it, is perhaps evidence

that the stock is priced fairly. Then again, managers of undervalued firms may believe that their

undervalued stock will become more undervalued in the future, and thus they shouldn't buy now. Or

maybe the undervalued firm faces other constraints preventing it from buying its own stock. In any

case, a firm's ability to repurchase its stock appears to be a constraint on the extent of market

undervaluation in asymmetric information models.)

Authors perform a simulation and "With reasonable parameter values…model reproduces most of

the stylized facts.."

21

Defensive Changes in Corporate Payout Policy: Share Repurchases and Special Dividends

Denis, DJ

Journal of Finance, December 1990

Intro,1-5

Intro, 2-, 5

Cap. Structure

Empirical

Level 1

Announcements of different defensive changes in payout policy have different wealth effects

Level 2

Defensive share repurchase announcements have negative average impact on target firms while

"…special dividend payments generally increase the wealth of target firm shareholders."

Level 3

Corporate control contests, in general, lead to wealth increases for s/h's. Shareholders experience

absolute wealth increases, but relative losses compared to bidders' offers, after managers take

defensive share repurchases. Defensive purchases are successful at maintaining independence.

"Managers implement major strategic changes in the target firm as a result of the control contest."

"…structural changes are generally more dramatic for those firms announcing special dividends,

suggesting a possible explanation as to why these firms exhibit substantially higher cumulative

stock returns over the entire control contest." Implies that special dividends hold some signal

value.

Announcement effects, after controlling for information imparted by the announcement, differ for

share repurchases vs. special dividends. The two-day returns are, resp., -1.62% and 2.66%.

22

Capital Structure and the Informational Role of Debt

Harris,M; Raviv, A

Journal of Finance, June 1990

Intro, 1-4

Cap. Structure

Theoretical

Level 1

Investors use debt to generate information about the firm in order to oversee managers

Level 2

In default, investors gain information from a costly investigation of the firm and make an efficient

liquidation decision (managers never want to liquidate or provide relevant liquidation information).

"…optimal amount of debt is determined by trading off the value of information and opportunities for

disciplining management against the probability of incurring investigation costs."

Level 3

For firms with higher liquidation value (and/or low investigation costs), liquidation is more likely to

be the best strategy. Since information is more useful for such firms they will therefore have more

debt.

Some distinct implications of their model:

I) the probability of being reorganized decreases with liquidation value and is independent

of investigation costs.

ii) leverage increases brought on by increases in liq'n value and/or decreases in default costs,

increase firm value.

iii) highly leveraged firm offer larger promised yields, have lower debt coverage ratios, and have

lower probability of reorganization after default.

The article works out a static model, a dynamic model, and numerous comparative statics results.

23

Financial Contracting and Leverage Induced Over- and Under-Investment Incentives

Berkovitch, E; Kim, EH

Journal of Finance, July 1990

Intro, 1-4

Cap. Structure

Theoretical

Level 1

Bond indentures allowing issuance of future collateralized debt can increase firm value

Level 2

Model examines "how ex-ante seniority rules designed to mitigate under-investment problems are

likely to affect the total agency costs of debt." "…derive optimal ex-ante contracting rules

concerning the relative seniority between new and existing debt."

Level 3

By granting new debtholders senior claims on positive NPV projects (e.g. project finance) the

firm avoids asset-substitution and obtains lower interest rates. But lower interest rates may enable

managers to engage in overinvestment.

Model shows that, under symmetric information, project financing optimizes tradeoff between over-

and under-investment.

Informational asymmetries between stock and debtholders lead to different conclusion:

subordination will depend on the perceived risk of the project with risky projects leading to financing

by strictly subordinated debt.

General idea is to separate the new project from existing assets as much as possible, given the

asymmetry of information constraints.

24

Corporate Financial Policy and the Theory of Financial Intermediation

Seward, JK

Journal of Finance

Intro, 1-5

Intro, 4-,5

Cap. Structure

Theoretical

& Sec. Design

Level 1

Moral hazard (& monitoring problems) generates a role for multiple classes of financial claimants

Level 2

"Existence of an intermediated financial contract market improves economic efficiency due to the

reduced aggregate costs of monitoring." The firm's optimal financial structure (priority structure)

depends on an investment project's risk and observability characteristics.

Level 3

Moral hazard exists in an environment of private action (unobservable investment allocations) and

private information (partially unobservable project cash flows).

The economic inefficiencies are distorted investment incentives that are "mitigated by the

appropriate construction of a complex financial structure."

Paper shows how an intermediated financial contract market "emerge(s) in conjunction with a

direct financial contract market, rather than in place of it."

Implication for debt/equity: as a firm's unobservable returns (as opposed to its observable returns)

increase, so does its reliance on debt (vs. reliance on outside equity ownership). This follows from

the monitoring role played by debt holders.

25

A Test of the Free Cash Flow Hypothesis: The Case of Bidder Returns

Lang, LHP; Stulz, RM; Walkling, RA

Journal of Financial Economics, 1991 (29)

1-8

1,8

Cap. Structure

Empirical

Level 1

Low Tobin's q firms do poorly in takeovers

Level 2

In a sample of corporate takeovers, versus high Tobin's q firms, the gain for low q firms falls as their

(free) cash flow increases--supporting the free cash flow hypothesis

Level 3

Jensen's free cash flow (fcf) hypothesis predicts that growth seeking mngrs. will invest fcf in

negative NPV projects rather than disburse cash to s/h's. Firms w/ high Tobin's q (I.e. w/ good

growth opportunities) engage in takeovers because the takeovers have positive NPV. Low q firms

engage in takeovers only because they have fcf to invest.

Result: returns are significantly negatively related to cash flow for low q bidders, but not for high q

bidders.

Abnormal Returns

low q firms

high q firms

low cash flow firms

0.011

0.005

high cash flow firms

-0.059

0.054

26

Convertible bonds as backdoor equity financing

Stein, JC

Journal of Financial Economics, 1991 (32)

1-5

1,2-,3-,4,5

Cap. Structure

Theoretical

Level 1

Corporations use convertible bonds, in presence of asymmetric information, as an indirect way to

issue equity.

Level 2

Companies may find convertible bonds an attractive middle ground between the informational

asymmetry problems of direct equity issuance and the costly financial distress potentially

associated with issuing debt.

Level 3

The model shows how convertible debt allows the existence of a separating equilibrium (for firms of

3 quality types: low, medium, high) when no such equilibrium is possible when only debt and

equity instruments are available.

Past surveys show financial mngrs use convertibles as means to raise common equity on a

delayed basis while believing that their stock price will rise in the meantime.

Theory also supported by the following facts:

I) convertible bond issues usually lead to less negative announcement effects than

comparable equity issues

ii) convertibles tend to be called right after their call protection ends

iii) convertibles tend to be used by firms with high leverage, volatility, R&D, and intangible assets

27

Capital Structure and the Market for Corporate Control: The Defensive Role of Debt Financing

Israel, R

Intro, 1-5

Intro, 1,2, 5

Cap. Structure

Theoretical

Level 1

In market for corporate control, higher target firm debt reduces its probability of acquisition but

helps it obtain a greater slice of the synergy pie.

Level 2

Better management, post takeover, raises the value of risky debt. Target firm shareholders capture

the expectation of this debtholder benefit ex ante. Greater leverage thus allocates a larger slice of

synergy benefits to the target shareholders from the acquirer. But a smaller share for the acquirer

reduces the probability of a takeover.

Level 3

This is a two-stage model with an initiation phase and an acquisition phase.

Some implications (some of which are not generalizable beyond this model):

I) as leverage increases, the probability of a takeover decreases (reduced benefit for the acquirer

implies that only the best acquirers will be interested)

ii) When acquisition is initiated, target's stock price & debt value, and acquirer's firm value, will

increase

iii) During acquisition, target firm's stock price changes further, w/ mean zero and variance

decreasing w/ target debt level

28

Optimal Financial Instruments

Zender, JF

Journal of Finance, December 1991

Intro, 1-4

Intro, 1-,4

Cap. Structure

Theoretical

Level 1

Debt and equity are developed as optimal financial instruments

Level 2

Debt and equity are derived as optimal financial instruments in an environment of risk neutrality,

asymmetric information and limited liability. The division of a firm's cash flow and control rights into

debt and equity enable optimal investment decisions.

Level 3

Model focuses on the control features of debt and equity and making sure that whoever has control

makes the proper investment decision. The optimal result occurs (Kuhn-Tucker optimization) when

the "investor in possession of the control rights is also the residual claimant." Bankruptcy allows

control to pass from the original equity holder to the bondholder. Thus "state contingent transfer of

control can mitigate opportunistic behavior by the controlling investor."

"When one claimant is denied control over decision making, the payments to this claimant are

fixed to ensure optimal decision making by the owner of the control rights."

29

Leverage

Miller,MH

Journal of Finance, June 1991

1-3

1-3

Cap. Structure

Nobel speech

Level 1

The LBOs of the 80s were the US's "perestroika"

Level 2

Confusion and hysteria surrounded the wave of LBOs in the 80s. The US wasn't necessarily

overleveraged; LBOs--or other financing tools--cant create risk; and the ill-advised political reaction

only makes/made things worse.

Level 3

LBOs are just another financial instrument (and junk bonds are similar to preferred stock). A given

level of risk is inherent in a firm's earning stream; thus partitioning this stream into different pieces

can't change the total risk of the stream.

LBO premiums routinely ran greater than 40% and could not be justified by tax effects alone--rather

by real efficiency gains.

The bond market, like other markets, has self-correcting tendencies. Government intrusion (e.g.

criminal indictments of investment bankers, forcing S&Ls to dump junk bonds, tighter regulations of

commercial banks) has destroyed the junk bond market and w

30

The Effect of Business Risk on Corporate Capital Structure: Theory and Evidence

Kale,JR; Noe, TH; Ramirez, GG

Journal of Finance, December 1991

Intro, 1-4

Intro,1-,3-,4

Cap. Structure

Theor./Empirical

Level 1

Derives the optimal debt-level/business-risk relationship within framework of corporate and personal

taxation

Level 2

Derives a U-shaped relation between optimal debt level and business risk. Result follows from

minimizing the government's combined share of corporate and personal tax. Empirical tests

"generally support the predicted U-shape."

Level 3

As leverage increases, for a given level and variance of a firm's cash flow, the probability of

bankruptcy increases. Conventional wisdom thus suggests that firms with higher business risk

ought to have less debt. The U-shaped relation counters this wisdom.

The analysis chooses the capital structure that minimizes the expected value of the total tax

liability generated by the firm. The total tax liability consists of the corporate tax (which can be

viewed as the government owning a European call option on the firm's cash flows with an exercise

price equal to the sum of debt and non debt tax shields) and the personal income tax (personal tax

payments by debt holders can be viewed as an option written by the government with an exercise

price equal to the firms debt level). The value-maximizing firm minimizes the value of the

government's option portfolio.

Empirical results for the quadratic regression gave the correct sign for both the linear and quadratic

terms. t-tests were significant for the quadratic term in both years (1984/5) but only significant in

1985 for the linear term.

31

Capital Structure and Dividend Irrelevance with Asymmetric Information

Dybvig, PH; Zender, JF

Review of Financial Studies, 1991 vol. 4 n1

Intro, 1-3

Cap. Structure

Theoretical

Level 1

Extends the MM propositions to a large class of asymmetric info models

Level 2

Takes the Myers & Majluf (1984) model, endogenizes the manager's objective, and shows that the

MM irrelevancy propositions obtain in a wide range of asymmetric information models. As opposed

to Myers & Majluf, the endogenized incentive contract allows for optimal firm investment.

Level 3

Regarding the issuance of new financial instruments, the model creates an incentive contract for

the mngr that makes "the manager indifferent about the price at which the new issue is made, and

to care only about the fundamental value of the firm." The optimal contract achieves the 1st-best

solution when managerial effort is not costly, and the 2nd-best when it is costly.

The authors note that the "..existing empirical evidence does not discriminate between a

Myers-Majluf world and a world with efficient investment" in which the MM irrelevancy propositions

hold.

32

Convertible Debt: Corporate Call Policy and Voluntary Conversion

Asquith, P; Mullins, DW

Journal of Finance, September 1991

Intro, 1-4

Intro,1,4

Cap. Structure

Empirical

Level 1

Tax-based reasoning explaining why too many convertible bonds remain uncalled

Level 2

Firms have tax-based cash flow incentives explaining why they don't call convertible bonds as

readily as financial theory predicts (e.g. some firms pay less after-tax interest than they would in

dividends were they to call the bond).

Level 3

Three rationales provided for explaining why a sample of 208 convertible bonds, with conversion

value greater than call price, were not called. (Financial theory [Ingersoll, 1977] states that a firm

should call a convertible bond as soon as its conversion value exceeds its call price.)

i) The bond is call-protected (30 of 208 bonds were call protected)

ii) The conversion value is < 120% of the call price. Given that convertibles typically have a 30-day

call notice period, mngrs may avoid possibility of a failed forced conversion (i.e. stock price drops

during the 30 days and then bondholders receive the maximum of the now-fallen conversion value

or the call price). Rationale II covered 66 of the 208 bonds. The 120% threshold is a

rule of thumb among managers.

iii) After-tax interest on the bond is less than the dividends to be paid upon conversion.

120 of 208 bonds.

Only 22 of 208 bonds didn't meet any of the given rationales (note that 30+66+120>208-22, so

some bonds fell into multiple rationale categories)

33

The Effect of Information Releases on the Pricing and Timing of Equity Issues

Korajczyk, RA; Lucas, DJ; McDonald, RL

Review of Financial Studies, v. 4 no. 4 1991

Intro, 1-6

Intro, 6

Cap. Structure

Empirical

Level 1

Firms prefer to issue equity when the market is most informed about the firm

Level 2

Under asymmetric information, firms will prefer to issue equity when the market is most informed,

i.e. after credible information releases. Data shows that the price drop at announcement of an

equity issue increases in the time since last information release.

Level 3

Facts: announcements of a new share issue typically followed by a 3% drop in share price; further

0.65% drop at actual issue.

Expect to see new share issues clustered after release of annual reports and quarterly earnings

reports. The price drop should be smaller after these events than at other times.

Data show strong evidence for issues clustering close to information release and that firms rarely

issue equity just prior to an information release.

Data show that "...delaying announcement of an issue by one month leads to an adverse

announcement day price reaction of 0.44 percent. In addition, the magnitude of the price drop at

issue is increasing in the time since the issue announcement." (The 0.44% figure is marginally

statistically significant.)

34

Debt Maturity Structure and Liquidity Risk

Diamond, DW

QJE, 8/91

1-11

1,11

Cap. Structure

Theoretical

Level 1

High credit-rating borrowers prefer shorter term debt

Level 2

"Optimal maturity structure trades off a preference for short maturity due to expecting their credit

rating to improve, against liquidity risk."

Level 3

Assumes that firms have private information about their future credit rating and have "…projects

[that have] provided them with rents that they cannot assign to lenders." So lenders are overly

willing to liquidate the firm and thus short-term debt generates a risk that lenders won't be

willing to refinance in the face of bad news.

Highest credit rated class of borrowers prefer "…short-term debt as a type of 'bridge financing' that

allows them to choose to refinance when good news arrives"; while the next highest class prefers

long-term debt and the lowest class of borrowers have no choice but short-term debt.

Empirical studies of the model should attempt to distinguish between high- and low-rated firms that

use short-term debt. Short-term bank debt may be a proxy for low-rated firms while commercial

paper may proxy for high-rated firms.

35

The investment opportunity set and corporate financing, dividend, and compensation policies

Smith, CW; Watts, RL

Journal of Financial Economics

Intr, 2-4, Con.

Intro, 1,2-

Level 1

Cross-sectional empirical study supports explanatory power of contracting theories as opposed to

tax-based or signaling theories

Level 2

Regressions of policies for financing (equity /value), dividends (D /price), compensation, and

incentive plans against three exogenous variables (investment opportunity set, regulation, size)

given some support to contracting theories. Empirical results for tax theories inhibited by a lack of

data. Evidence provided against signaling (Ross (77), Battacharya (79)) models.

Level 3

Dependent Variable

Indep. Variable

Assets/value (a measure of investment opportunities)

Equity/Value

-0.62

t-stat=-12.47

By contracting theory (Myers[77]), more growth options imply more equity, thus relation

should be negative (more growth options =>lower Assets/value ratio).

In contrast, signaling theory suggests a positive relationship, with higher debt levels

signaling greater growth options

D/price

0.05

t-stat=9.19

By contracting theory (Jensen[86]), greater growth options imply lower dividends

implying corr(Assets/value, dividends)>0.

In contrast, signaling theory (Battacharya[79]) implies reverse (higher dividends go with

greater growth options)

36

Managerial Conservatism, Project Choice, and Debt

Hirshleifer,D; Thakor, AV

Review of Financial Studies, 1992 v.5 no. 3

Intro, 1-4

Intro, 4

Cap. Structure

Theoretical

Level 1

Mngrs' incentive to build their reputations make them overly conservative

Level 2

Managerial reputation building leads to managerial conservatism, thus reducing threat to

bondholders of expropriation by overly risky investments. Thus agency costs are reduced (asset

substitution) leading to higher leverage as firms take advantage of tax benefits of debt.

Level 3

Other implications:

i) In an unlevered firm, managerial reputation building can lead to excessive conservatism in

investment policy

ii) Increased takeover activity can (by making manager's more career sensitive) increase the firm's

optimal leverage by reducing the asset substitution costs

iii) Anti-takeover measures have the opposite effect, implying lower leverage

iv) As the CEO reduces retirement (becomes less conservative), firms will reduce debt levels

37

Liquidation Values and Debt Capacity: a Market Equilibrium Approach

Shleifer, A; Vishny, RW

Journal of Finance, September 1992

Intro, 1-7

Intro, 1, 3-,4-,7

Cap. Structure

Theoretical

Level 1

Asset illiquidity is a significant private cost of leverage

Level 2

In a general equilibrium setting, firm-specific assets can be liquidated only at "fire-sale" prices

because next best users are likely to be firms in the same industry also experiencing financial

distress. Underpricing of illiquid assets in recessions is an important cost of leverage and is a

significant explanatory variable in cross-sectional and time series financing patterns.

Level 3

Industry-wide or economy-wide adverse shocks can drive asset liquidation values "below value in

best use because some or all industry buyers have trouble raising funds…A firm-idiosyncratic

adverse shock to the cash flow would not have the same effect."

Example: in the mid-80s some airlines experienced idiosyncratic shocks (Peoples' Express w/

overexpansion, Eastern Airlines w/ unions) and their gates, planes, and routes were easily sold.

Later, in December. 91 when the industry was having trouble, Pan Am's Latin American routes sold for

$135M, vs. the $342M American paid to Eastern at an earlier time for similar routes.

The airline case also shows that potential buyers (e.g. foreign airlines) may be legally prevented

(antitrust) from buying the assets and putting them to next best use.

Theory predicts that small companies are better financed by debt while growth companies and

cyclical assets are not (variable cash flow). Thus conglomerates and multi-division firms have

higher optimal leverage.

38

Capital Structure as an Optimal Contract Between Employees and Investors

Chang, C

Journal of Finance, July 1992

Intro, 1-7

Intro,

Cap. Structure

Theoretical

Level 1

Views capital structure as part of a contract between investors and employees

Level 2

"…optimal debt level is generally below the level that maximizes the financial value of the firm

because the restructuring-related loss to the employees…" should be reckoned. The model goes

on further to endogenously derive optimal capital structure as part of an optimal contract between

investors and employees.

Level 3

Assumes that there exists significant nonmonetary restructuring-related cost to risk-averse

employees, e.g. learning a new job, working harder in the new job. Also assumes that the value of

the firm increases with leverage.

Derives result that employees' claims on the firm are senior to investors' claims.

39

Capital and Ownership Structures, and the Market for Corporate Control

Israel, R

Review of Financial Studies, 1992 v.5 no. 2

Intro, 1-5

Intro, 4-,5

Cap. Structure

Theoretical

Level 1

Leverage is a device that enables a firm to extract maximum value from a rival in a control contest

Level 2

"Capital and ownership structures are used by the entrepreneur to determine the winner of the

future control contest" and to extract the largest possible premium from the rival if there is a

control change.

Level 3

"…anticipated competition for control influences a firm's capital and ownership structures."

Reasoning:

i) Managers value control

ii) When considering takeover bids, managers optimize value of keeping control against potential

appreciation in their personal shareholdings

iii) thus, to maximize the takeover bid, managers should be given a smaller equity stake (fewer

manager-held shares imply that a successful bid must sport a higher price to entice managers to

relinquish control)

iv) can't reduce managers' equity holdings by too much, they still need to retain power enough to

determine the contest

v) therefore, issue risky debt to reduce managers' equity stake while retaining their decision power

over the contest

Implications:

i) "…managers with higher ability …expected to use less leverage." (Empirically, negative

correlation between profitability and leverage.) Reason is that leverage is a tool to extract value

from the rival. But there's less value to extract from the rival when the manager is more able.

ii) leverage increases with the ability of the rival and with the rival's private benefits of control (same

reason--more to extract)

40

Capital structure and firm response to poor performance

Ofek, E

Journal of Financial Economics 34 (1993)

1-7

Cap. Structure

Empirical

Level 1

Higher predistress leverage quickens a firms reaction to poor performance

Level 2

Empirical results consistent with Jensen's (1989) hypothesis that higher predistress leverage

increases the speed with which a firm reacts to poor performance.

Level 3

Study measures the short-term response from a sample of 358 firms having one year of normal

performance followed by a year of very poor performance.

Logit regressions of (asset restructuring, layoffs, mngment turnover, debt restructuring, dividend

cuts) on base-year leverage (and other independent variables) give all positive and significant

coefficients except for management turnover, which is insignificantly negative.

The larger the share of firm equity held by mngment, the lower is the probability that an operational

action will be taken, thus management holdings can actually discourage value-maximizing

behavior.

41

Top-Management Compensation and Capital Structure

John, TA; John, K

Journal of Finance, July 1993

Intro, 1-5

Cap. Structure

Theoretical

Level 1

Derives a negative relationship between pay-performance sensitivity and

leverage.

Level 2

Claimants of the firm know, when managerial incentives are not aligned with their interests, that

they suffer as a result. The firm determines optimal management compensation by aligning

managerial incentives with various claimants, thus reducing the firm's total agency costs.

Level 3

Management compensation must trade off reducing the agency costs of equity (mngrs vs. s/h's) vs.

agency costs of debt (mgrs. too closely allied to s/h's engage in risk shifting). Likewise,

"Contracts with external claimholders, suppliers, employees, and consumers may have a bearing

on the structure of optimal managerial contracts."

Key implication is that pay-performance sensitivity drops w/ leverage. A high sensitivity level aligns

managerial and s/h interests, but may lead mangrs. into risk-shifting activities. Risk shifting leads

to asset substitution costs. A similar implication, for bond pricing, is that firms w/ high

pay-performance sensitivity will pay higher rates.

42

Payout Policy, Capital Structure, and Compensation Contracts when Managers Value Control

Chang, C

Review of Financial Studies, v. 6 no. 4, 1993

Intro, 1-5

Cap. Structure

Theoretical

& Security Design/Div. Policy

Level 1

A principal-agent model with asymmetric information

Level 2

If risk-averse managers in an asymmetric information model (only they know the optimal payout to

shareholders) value both compensation and control, managers will overretain earnings. But they

can be induced to make payouts via compensation incentives. In this environment, the model

endogenously derives public equity and debt as an optimal contract.

Level 3

Given that managers have a minimum utility constraint, "…too much can be retained in the firm or

the managers can be paid more than their reservation utility levels in order to motivate them to pay

out the funds." These are the model's agency costs.

Investors solve an optimization problem subject to manager participation and truth-telling (about the

payout) constraints knowing that the manager optimizes himself between on the job consumption

of corporate resources vs. his incentive contract.

43

Influence Costs and Capital Structure

Bagwell, LS; Zechner, J

Journal of Finance, July 1993

Intro, 1-4

Intro, 4

Cap. Structure

Theoretical

Level 1

Optimize influence costs versus costs of making poor divestiture decisions

Level 2

Optimal capital structure trades off the costs of influence activities (e.g. costs from division

managers influencing top management's decision to divest the division) versus the costs of making

poor divestiture decisions.

Level 3

Capital structure affects the firm's future divestiture decisions. Top management relies on divisional

management for information on whether to divest a division. But workers and managers, if

divested, may loose quasi rents intrinsic to their current positions.

A first specification of influence activities is managers lowering the arrival of a high-synergy bidder

for their division. A second specification is managers front-loading divisional cash flows to make

the division appear more attractive in the short-run. Note: to the extent that cash flows are

imperfect signals of divisional worth, such influence activities can possibly improve top

management's decision ability.

There are a number of stylized, context-sensitive results. "…the term structure of debt can alter

the effects of influence activities by affecting the firm's divestiture decisions: risky short-term debt

by committing the firm to liquidate divisions in the event of low cash flow realization, and

collateralized long-term debt by making it more expensive for the firm to liquidate divisional assets.

44

Reputation, Renegotiation, and the Choice between Bank Loans and Publicly Traded Debt

Chemmanur, TJ; Fulghieri, P

Review of Financial Studies, Fall 1994, v. 7, no. 3

Intro, 1-4

Intro, 3, 4

Cap. Structure

Theoretical

Level 1

Firms choose financing between banks (more flexible) and publicly traded debt (inflexible)

Level 2

As opposed to bondholders, banks have a reputation incentive to make superior

liquidate/renegotiate decisions. Firms pay for this ability by paying higher rates on bank loans, or,

if default is unlikely, a firm avoids this cost and offers public debt.

Level 3

Banks have a long-term interest in acquiring a reputation of making better liquidation/renegotiation

decisions for borrowers in distress versus holders of public debt (who care only for the immediate

case). This type of "good-decision insurance" (term by FR) is costly to borrowers. Thus there

exists a pooling equilibrium: firms with low default probability opt for lower-cost public debt while

other firms borrow from banks at a somewhat higher rate.

The model does not assume that banks have access to private information or that bondholders face

higher monitoring cost. Rather, the result that banks are better liquidation decision makers is

endogenously derived.

Major implications: i) bank borrowers will (vs. public debtors) have greater probability of distress ii)

higher yield on bank loans, particularly from banks with reputation for flexibility iii) bank loans will

be renegotiated more often iv) renewal of bank loans greeted more favorably in stock market vs.

renewal of public debt.

45

Interactions of Corporate Financing and Investment Decisions: A Dynamic Framework

Mauer, DC; Triantis, AJ

Journal of Finance, September. 1994

Intro, 1-4

Cap. Structure

Theoretical

Level 1

"…optimal dynamic financing policy is characterized by a tradeoff between the tax advantage of

debt financing and recapitalization and financial distress costs."

Level 2

Model numerically solves for dynamic interactions among the firm's investment, operating, and

financing decisions. Finds that higher production flexibility increases net tax shield value of debt

and that "…the impact of debt financing on the firm's investment and operating decisions is

economically insignificant."

Level 3

Production flexibility has a positive effect on the value of interest tax shields because its easier to

shut-down losing operations, thus implying lower firm value variance, implying higher debt capacity

and thus greater interest tax shields. Financial flexibility (low recapitalization costs) is a (imperfect)

substitute for production flexibility since the savings from production flexibility are smaller for a

more financially flexible firm.

"…debt financing has a negligible impact on the firm's investment and operating policies." A

levered firm, in the typical static model, earns interest tax shields over the life of the investment.

But, in this dynamic model, the firm can delay investment (and thus gains an option on the

resolution of product market uncertainty) but only loses interest tax shields during the periods that

it is waiting. The net result is not much different from the actions of an unlevered firm.

46

Corporate Debt Value, Bond Covenants, and Optimal Capital Structure

Leland, HE

Journal of Finance, September. 1994

Intro, 1-9

Cap. Structure

Theoretical

Level 1

Derives closed-form results for the value of debt and optimal capital structure

Level 2

Paper "derives closed-form results relating the value of long-term corporate debt and optimal capital

structure to firm risk, taxes, bankruptcy costs, bond covenants, and other parameters when firm

asset value follows a diffusion process with constant volatility."

Level 3

Value of corporate debt and optimal capital structure depend on each other. A firm's leverage

affects valuation of its debt while debt valuation helps determine its optimal leverage.

Major assumptions: i) debt securities are "time independent" (e.g. very long maturity) ii) "face

value of debt, once issued, remains static through time." iii) investment decisions unaffected by

financial structure iv) "capital structure decisions, once made, are not subsequently changed."

Debt issuance tradeoff is considered by the firm "...in two ways. First, it reduces firm value

because of possible bankruptcy costs. Second, it increases firm value due to the tax

deductibility of the interest payments…"

Two observations on optimal leverage: i) "a rise in the risk-free interest rate (increasing the cost of

debt financing) leads to a greater optimal debt level." (A tax consequence.) ii) firms w/ high

bankruptcy costs may carry a lower interest rate as they choose lower operating leverage and

avoid bankruptcy

There are numerous (context sensitive) comparative statics results on p. 1224.

47

Debt and Seniority: An Analysis of the Role of Hard Claims in Constraining Management

Hart,O & Moore, J

American Economic Review, June 1995

Intro, 1-4

Intro, 1, 2-,4

Cap. Structure

Theoretical

Level 1

Types of debt matters

Level 2

Senior long-term debt prevents self-interested management from financing

unprofitable investments.

Level 3

If managers aren't self-interested, then all debt should be "soft", i.e. subordinated debt.

But firms issue senior, nonpostponable debt. Authors discuss role of hard debt in

constraining managers and explaining the types of debt claims observed in practice.

There is an optimal debt-equity ratio and mix of senior vs. junior debt. There exists

optimization between too little debt (resulting in self-indulgent overinvestment by

managers) and too much debt (leading to underinvestment a la Myers[77] ). Authors show

optimality of firm issuing classes of debt of different seniorities, with covenants allowing

dilution of each class.

48

The Priority Structure of Corporate Liabilities

Barclay,MJ & Smith, CW

Journal of Finance,July 1995

Intro,1-5

Intro,1,2,5

Cap. Structure

Empirical

Level 1

Provides data on different types of corporate liabilities

Level 2

Empirical examination of firms' liabilities. Tests hypotheses that predict variation in

priority structure (from capital leases, to types of debt and types of equity).

Level 3

Debt differs in many ways, one of which is by priority. B&S provide data on the variation in

industrial use of capital leases, secured debt, ordinary debt, subordinated debt, preferred

and common stock. The authors examine several hypotheses that predict variation in said

priority structure. Evidence supports incentive contracting hypotheses, gives mixed support

for tax hypotheses, and little support for signaling hypotheses.

49

Equity ownership and the two faces of debt

McConnell, JJ; Servaes, H

Journal of Financial Economics, 1995 (39)

1-6

1-3,4-,5--,6

Cap. Structure

Empirical

Level 1

Debt plays fundamentally different role in firms w/ many, vs. firms w/ few, growth opportunities

Level 2

Supports hypothesis (Myers[77]) that debt has a negative underinvestment influence on firm with

high growth opportunities, as opposed to low-growth firms. Also supports hypothesis that debt has

favorable influence, on low growth opportunity firms, in curtailing free cash flow.

Level 3

Main results, from regressing Tobin's Q on leverage (mkt. value of debt/replacement value),

allocation of equity ownership, and control variables (in 3 different samples):

coeffct. on leverage

Low-growth firms (1976,1986,1988):

(0.25, 0.56, 0.58)

High-growth firms(1976,1986,1988):

(-1.13,-1.11,-0.70)

50

Tests of a Signaling Hypothesis: The Choice between Fixed- and Adjustable-Rate Debt

Guedes, J; Thompson, R

Review of Financial Studies, Fall 1995 v. 8, no. 3

Intro, 1-4

Intro, 4

Cap. Structure

Theor./Empir.

Level 1

Choice between adjustable- and fixed-rate debt can signal firm quality

Level 2

Firms can signal their high quality status, in the presence of bankruptcy costs, by choosing the

riskier of fixed- or adjustable- rate debt. Whether adjustable- or fixed-rate debt is more risky

depends on the relative volatility of expected inflation versus expected real interest rates.

Level 3

Bankruptcy costs motivate managers to stabilize net income. High quality firms aren't so worried

about bankruptcy and can signal their status by taking on more variable debt. Low-quality firms

have greater desire to reduce variance in their cash flows.

Signaling by choice between fixed- and adjustable-rate debt is unusual because "…either contract

can be the more risky and, therefore, the more favorable signal depending upon the relative levels of

expected real rate and inflation volatility." When, for example, expected real volatility exceeds

expected inflation volatility, then adjustable-rate debt destabilizes net income and is thus the risky

signal.

When expected inflation volatility is high, stock price reactions favor fixed-rate debt by 2.05%.

When expected real return volatility is high, stock price reactions favor adjustable-rate debt by

0.98%.

51

Increased debt and industry product Markets: An empirical analysis

Phillips, GM

Journal of Financial Economics, 37 (1995)

1-7

1,5-,7

Cap. Structure

Empirical

Level 1

Output is negatively associated with average industry debt ratio

Level 2

Firms in industries with high entry barriers can use a leverage increasing recapitalization as a

credible commitment to compete less aggressively (which includes investing less free cash flow).

Data show, for 3 such industries, that recapitalizations were correlated with higher prices, lower

quantities, and lower output.

Level 3

In 3 of 4 industries studied at the firm level, leverage increasing recapitalizations implied: i) less

market share ii) higher price iii) higher operating margins and iv) lower output. The 3 industries

were characterized by high entrance barriers, thus the firm's increase in leverage could be viewed

"…as a credible commitment not to exercise investment opportunities and to behave less

aggressively'." (c.f. Kovenock & Phillips (1997), reviewed above.) Also, industry price was

negatively related to industry debt ratio.

In the 4th industry, all the relations were reversed. The 4th industry had low barriers to entry. The

empirical results were "…consistent with firms adopting riskier production strategies and

expanding output…" as per different I/O models (Brander and Lewis (1986) and Maksimovic (1988),

neither of which are reviewed herein).

Simultaneous collection of executive compensation data showed that executives, before

recapitalization, faced sales incentives and then faced incentives better reflecting s/h value after

recapitalization.

52

Dynamic Capital Structure under Managerial Entrenchment

Zwiebel, J

American Economic Review, December 1996

Intro, 1-4

Intro, 1--,3-,4

Cap. Structure

Theoretical

Level 1

Managers voluntarily commit to debt as a dynamic self-disciplining device

Level 2

Bankruptcy-fearing managers reluctantly increase debt to signal abstinence from

empire-building bad investments, thus forestalling raiders.

Level 3

Managers fear loss-of-control from bankruptcy, thus wish to avoid debt. Bankruptcy fears,

not free-cash-flow restrictions, counter empire building. (Ex-ante debt commitments don't

prevent overinvestment: over time managers can retire debt and then overinvest.)

Debt serves as a dynamic disciplinary force, voluntarily chosen by managers, to deter an

ever-present raider. This discipline is counteracted by managerial entrenchment.

Likewise, if bankruptcy appears unavoidable, managers of distressed firms no longer fear

incremental debt, in which case debt loses its effectiveness.

53

A Theory of Corporate Scope and Financial Structure

Li,DD and Li, S

Journal of Finance, June 1996

Intro, 1-3

Intro,1,2--,3

Cap. Structure

Theoretical

Level 1

Firm scope helps determine leverage--which reduces agency costs

Level 2

Higher leverage limits managers' empire-building. An appropriate level of corporate

diversification reduces cash flow volatility, increases optimal leverage, and thus reduces

overinvestment.

Level 3

Self-interested managers may be curbed less expensively by leverage rather than incentive

plans. Optimal debt determined by trading-off benefit of limiting overinvestment (via

higher debt levels) with cost of underinvestment (from too much debt).

Statistical correlations of cash flows determine optical firm scope. Five implications are:

(i) only merge businesses with negatively correlated cash flows; (ii) separate very risky

businesses from very safe ones; (iii) diversify firms w/ poor growth prospects or firms

with high future cash-flow volatility; (iv) conglomerates should have more leverage than

non-conglomerates; (v) conglomerates' investments should be less liquidity sensitive.

Results shed some insight into failure and success of the two post-war US merger waves and

the success of Japanese keiretsu.

54

Asymmetric Information, Managerial Opportunism, Financing, and Payout Policies

Noe, TH; Rebello, MJ

Journal of Finance, June 1996

Intro, 1-7

Intro, 1-, 7

Cap. Structure

Theoretical

Level 1

Signaling leads to radically different financial policies in shareholder-controlled firms versus

management controlled firms.

Level 2

When shareholders determine policies, debt financing is always optimal in presence of adverse

selection or managerial opportunism. But when both problems occur simultaneously, then equity

issuance can become an optimal signaling mechanism.

Level 3

Mngrs extract rent from existing s/h's by virtue of their incumbency. Thus s/h's prefer high

dividends and leverage (threatening mngrs with financial distress) as means of bargaining with

mngrs. Likewise, with adverse selection in capital markets, s/h's prefer to issue debt and thus

avoid underpricing of equity. But when both managerial opportunism and asymmetric capital

markets are present, s/h's may wish to issue equity in a signaling equilibrium to signal existence

of favorable investment opportunities.

The model also points to a hierarchy in financial signals. Shareholders preferred signaling

mechanism is restricting dividends, then equity financing, then underpricing securities.

55

Leverage, investment, and firm growth

Lang, L; Ofek, E; Stulz, RM

Journal of Financial Economics, 40 (1996)

1-7

1,2,3-,5,7

Cap. Structure

Empirical

Level 1

Negative correlation of leverage and future growth for firms w/ low Tobin's q

Level 2

Leverage does not reduce growth of firms with known good investment opportunities. But it is

negatively related to growth for firms with unrecognized growth opportunities or prospects

insufficiently valuable to overcome effects of debt overhang.

Level 3

Debt service payments have a greater negative effect on investment than equal decreases in

operating cash flow (FR: I bet managers view cash flow drops as temporary).

Negative "relation between leverage and growth holds strongly only for firms with low Tobin's q

ratios" This supports the debt as disciplinary device view--debt prevents investment in the poor

opportunities held by low Tobin's q firms.

Regression coefficient of book leverage % vs. 1-yr. capital expenditures growth is -0.48.

56

Is there a pecking order? Evidence from a panel of IPO firms

Helwege, J; Liang, N

Journal of Financial Economics, 40 (1996) 429-458

1-6

1,3,5-,6

Cap. Structure

Empirical

Level 1

Empirical study provides little support for the pecking order theory

Level 2

Data do not show that firms tap capital markets because of shortfall in internal funds. (But they do

show that firms with surplus funds avoid capital markets.) Among firms that raise funds externally,

"…asymmetric information variables have no power to predict the relative use of public bonds over

equity."

Level 3

Data are more consistent with managers using a target leverage approach.

Logit regression of seeking external financing on measures of cash deficit gave insignificant

t-statistics, thus "…the probability of obtaining capital externally does not increase directly with a

firm's expected need for funds."

"The coefficients on the cash surplus variable are significantly negative, as predicted by the pecking

order theory." So firms with cash don't go to the capital market.

The second (multinomial logit) regression estimated the effects of risk and asymmetric information

on the type of financing obtained. "The pecking order model predicts that low-risk firms will issue

public debt first, moderately risky firms will issue private debt, and the riskiest firms will choose

equity." However, "Coefficients on risk variables…when significant, have the same effects on the

probability of issuing equity as on the probability of issuing public bonds."

57

The Design of Internal Control and Capital Structure

Berkovitch, E; Israel, R

Review of Financial Studies, Spring 1996, vol. 9, no. 1.

Intro, 1-9

Cap. Structure

Theoretical

Sec. Design

Level 1

Allocation of internal control designed to influence future strategic decisions of the firm

Level 2

Derives the optimal rule for replacing management (via internal means). Ex ante choice of internal

control and capital structure commits shareholders and bondholders to enforce the optimal rule.

Level 3

Manager's value their position but need performance incentives. Firm's for which the marginal

product of managerial effort is high will aggressively replace managers unless a (noisy) signal of

managerial ability is above average.

However, such a replacement strategy, while ex ante optimum, is not an ex post equilibrium: after

the fact, s/h's optimum is to retain average level managers and only fire below average managers.

Capital structure and internal control, chosen by the entrepreneur, are commitment devices forcing

the optimum ex-post aggressive replacement of managers.

Effect of capital structure is similar to the asset-substitution problem: increasing leverage makes

equity holder's more risk tolerant (and firing a manager is a risk increasing event). "Consequently,

when the entrepreneur would like to commit the firm to replace some above average managers, he

issues fixed claim securities and gives absolute control to residual claimholders."

When the marginal product of managerial effort is not as high, and the entrepreneur wishes "…to

commit the firm to retain some below average managers, he issues fixed claim securities and

allocates fixed claimholders enough control to enable them to affect [veto] managerial

replacement."

Major implication: debt level and firm value are negatively (positively) correlated when debtholders

have veto power (s/h's have absolute control). (Lower leverage complements debtholder veto power

while higher leverage complements absolute control by s/h's.)

58

Optimal Capital Structure, Endogenous Bankruptcy, and the Term Structure of Credit Spreads

Leland, HE; Toft, KB

Journal of Finance, July 1996

Intro, 1-6

Intro, 6

Cap. Structure

Theoretical

Level 1

Article extends Leland (JOF,94) by incorporating choice of debt maturity. "(E)xamines the optimal

capital structure of a firm that can choose both the amount and maturity of its debt."

Level 2

Model determines optimal capital structure, optimal maturity, bankruptcy (endogenously), and

predicts credit spreads, default rates, and writedowns. Optimal maturity tradesoff tax and

bankruptcy advantages of long-term debt versus short-term debt's attenuation of agency costs.

Level 3

"Bankruptcy is determined endogenously and will depend on the maturity of debt as well as its

amount." Short term debt reduces optimal leverage, but also reduces agency costs (asset

substitution): "…equity holders of firms issuing short term debt generally will not have an incentive

to raise firm risk."

Firms with higher bankruptcy costs should prefer longer term debt. Firms with high growth

opportunities (or cash flow small relative to asset value) don't garner as many of the benefits of long

term debt, and may desire more short term debt, as per Barclay & Smith's (1995, JOF) empirical

results on maturity.

59

Managerial Entrenchment and Capital Structure Decisions

Berger,PB; Ofek,E; & Yermack,DL

Journal of Finance, September 1997

Intro, 1-4

Intro, 4

Cap. Structure

Empirical

Level 1

Entrenched CEOs avoid debt

Level 2

Data show negative correlation between entrenchment and leverage. "Entrenchment

shocks" (i.e. entrenchment reducing events) are followed by greater leverage.

Level 3

Entrenched managers control leverage decisions and (Jensen,86) need discipline to increase

leverage, thus reducing free-cash flow. Entrenchment reduces discipline. Results show that

leverage is lower when: CEO has long tenure; CEO has weak incentive compensation; CEO

doesn't face strong board or shareholder monitoring. Greater leverage follows entrenchment

shocks like unsuccessful takeovers or forced CEO replacements.

Author's data could support idea of entrenched managers using leverage as means to deter

raiders. But data more strongly support hypothesis of leverage increases as response to

changes in entrenchment.

Authors find that firms tend to be underlevered.

Research question: how does leverage respond to "negative" entrenchment shocks (e.g. more

insiders named to the board)?

60

Marketable Incentive Contracts and Capital Structure Relevance

Garvey, GT

Journal of Finance, March 1997

Intro, 1-3

Intro,3

Cap. Structure

Theoretical

Level 1

Debt is better than mngmt incentives in reducing overinvestment

Level 2

Debt may better mitigate the free cash flow problem than management incentive contracts because

managers can undo such contracts in liquid secondary markets.

Level 3

Management incentive contracts, tied to firm performance, can mitigate the free cash flow problem.

But risk-averse managers can undo such contracts if there exist liquid secondary markets for the

firm's equity. If observability of managers' trades prevent such 'undoings', then managers may also

use "equity swaps" to achieve the same end. In the limit, firm owners can take the firm private to

prevent the frustration of managerial incentives. Debt may be a better alternative for addressing the

overinvestment problem.

61

Transactions Costs and Capital Structure choice: Evidence from Financially Distressed Firms

Gilson, SC

Journal of Finance, March 1997

Intro, 1-4

Intro, 4

Cap. Structure

Empirical

Level 1

Transaction costs discourage out-of-court debt restructurings.

Level 2

Relative to chapter 11, voluntary debt restructurings are adversely affected by transaction costs.

Such transaction costs emanate from tax, regulatory and other factors deterring a firm's creditors

from writing down/renegotiating its debt. The lower transaction costs in Chapter 11 enable firms to

better achieve optimal post-distress leverage.

Level 3

Comparing Chapter 11 to out-of-court restructuring:

I) ex post leverage rations remain high for both

ii) median of [book value of long-term debt/(numerator + market value of equity)] = 0.64 for

out-of-court vs. 0.47 for Chapter 11.

iii) reasons for lower transaction costs in Chapter 11:

a) creditors have less power

b) Chapter 11 gives creditors lower tax penalty for write-offs of loan amounts

c) Institutional lenders have less timing discretion in Chapter 11

d) Chapter 11 facilitates asset sales

iv) Out-of-court restructurings imply a 25% recidivism rate

62

Capital Structure and Product Market Behavior: an Examination of Plant Exit and Investment

Decisions

Kovenock, D; Phillips, GM

Review of Financial Studies, Fall 1997

Intro, 1-4

Intro, 4

Cap. Structure

Empirical

Level 1

Effect of sharp leverage increases on investment depends on product market structure

Level 2

After an LBO or recapitalization, firms in high concentration industries are more likely to disinvest

while their rivals are more likely to invest.

Level 3

The effect of high leverage on plant closure and investment is not--by itself--significant. But it is

significant when the industry is heavily concentrated.

In the IO literature (Brander & Lewis[1986]) increased debt causes a firm to behave more

aggressively. This paper finds the reverse: more passive investment behavior follows the

recapitalization. This signifies a strategic commitment to behave less aggressively. It's possible

that more agency problems occur in concentrated industries, thus recapitalizations may be

instrumental in reducing free cash flow.

The study is done at the plant-level, in a multi-period model (a new approach).

63

Long-Term Financing Decisions: Views and Practices of Financial Managers of NYSE Firms

Kamath, RR

The Financial Review, May 1997

Intro, 1-3

Intro, 1,3

Cap. Structure

Empirical

Level 1

Managers are generally flexible on capital structure, inflexible on dividends & investment policy

Level 2

Sample of 690 NYSE firms (excluding FORTUNE 500 & fin. intermediaries) finds (142 responses):

i) firms are twice as likely to follow a financing hierarchy than adhere to a target capital structure

ii) risks and returns characteristics of projects are most important determinants of long-term

financing decisions of managers

iii) signalling not a factor

iv) only 20 % of firms admit takeover considerations affect financing decisions

v) managers flexible with capital structure, unwilling to let financing factors affect dividend or

investment policy

Level 3

Survey went to CFOs and had only 12 questions on it.

Respondents reporting a hierarchy preference in raising funds gave the following preference

ordering: i) retained earnings ii) straight debt iii) convertible debt iv) common equity v) straight

preferred stock vi) convertible preferred stock

64

Debt in Industry Equilibrium

Fries, S; Miller, M; Perraudin, W

Review of Financial Studies, Spring 1997, vol. 10, no. 1

Intro, 1-4

Intro, 4

Cap. Structure

Theoretical

Level 1

Obtains dynamic theory of optimal leverage in setting of an industry equilibrium with entry and exit

of firms

Level 2

Model values debt in industry equilibrium.** Also shows that when a firm dynamically adjusts

leverage, its ability to add debt over time is equivalent to owning a continuum of options to increase

debt. Underleverage may be viewed as management not yet willing to exercise these options.

Level 3

Key assumptions: i) competitive industry w/ free entry and exit ii) increasing leverage is costless

but unlevering can only be accomplished via liquidation (free-riding bondholders obstruct any debt

renegotiation attempts iii) debt has infinite maturity.

Under these assumptions, a firm may wish to increase its leverage as its profitability improves over

time. The "...value of the firm may be written as the value of its cash flow assuming a fixed level of

leverage, plus that of a continuum of options to increase borrowing."

Since leverage, in this model, is a one-way event, it may explain why firms are underleveraged

over time--they're waiting to "cash in" their leverage options.

**(FR: The major thrust of this article was to offer a method to value debt, and this was not

reviewed. Capital structure was an important but secondary aspect of the paper.)