Capital structure decisions: what have we learned?

Business Horizons, Sept-Oct, 1997 by Glen T. Ryen, Geraldo M. Vasconcellos, Richard J.' Kish

Were Modigliani and Miller right forty years ago?

The determination of an optimal capital structure has been one of the most contentious topics in the finance literature since Modigliani and Miller (MM) introduced their capital structure irrelevancy propositions in the American Economic Review in 1958. Their Proposition I stated that, in equilibrium and given perfect capital markets without taxes, the value of a firm was independent of its choice of capital structure. Their elegant arbitrage argument revolved around two companies identical in every aspect except for financing mix and market value. Equity holders of the higher-valued, leveraged firm would want to sell their shares; then, using the proceeds plus homemade leverage equivalent to the debt mix of the leveraged firm, they could buy shares of the lower-valued, all-equity firm. Investors would continue in a similar fashion until the companies had exactly the same market value.

These transaction sets of buying and selling would generate riskless profits until equilibrium was established. Thus, MM concluded that capital structure has no impact on the Value of the firm. This represented a radical departure from the conventional wisdom on optimal financing decisions as espoused by Schwartz (1959), among others. The ensuing controversy motivated many researchers to compare and contrast these different views; a comprehensive attempt can be found in Robicheck and Myers (1965).

What MM did not discuss in that article were the practical applications of this theory for individual firms or how well the theory explained observed facts, such as corporate leverage ratios and market reactions to security issues. As Miller (1988) states:

Skepticism about the practical force of

our invariance proposition was understandable

given the almost daily reports

in the financial press, then as now, of

spectacular increases in the

value of firms after changes

in capital structure. But the

view that capital structure is

literally irrelevant or that

"nothing matters" in corporate

finance, though still

sometimes attributed to us

(and tracing perhaps to the

very provocative way we made our

point), is far from what we ever actually

said about the real-world applications of

our theoretical propositions. Looking

back now, perhaps we should have put

more emphasis on the other, upbeat side

of the "nothing matters" coin: showing

what doesn't matter can also show, by

implication, what does.

Much of the financial literature over the past four decades has revolved around different theories that try to explain just exactly what does matter in determining capital structure. This article attempts to summarize and evaluate the major points of this literature, with an emphasis on the contributions made in the last 15 years.

Many interesting questions have been raised over the years: Is there really an optimal capital structure for any individual firm or industry? Does that ratio stay constant over time? Why have corporate leverage ratios not fluctuated in tune with changes in the corporate tax rate? How can one explain the sudden run-up in leverage during the 1980s? Why do leverage-altering transactions (stock and/or debt offerings, swaps, buybacks) have such consistent effects on firm stock price? Although most of the literature on the topic points to the existence of optimal capital structures, no one theory has emerged to explain all these phenomena. Research from Taggart (1977), Jalilvand and Harris (1984), and others suggest that managers do pursue a target debt ratio. Campbell (1988) showed that market reactions to leverage-altering transactions, such as convertible bond calls and equity-for-debt swaps, were related to whether the transaction moved the firm closer to or farther away from industry norms. That is why, according to Myers and Majluf (1984), "a full description of corporate financing and investment behavior will no doubt require telling several stories at once."

Tax Advantages of Debt

MM Proposition I stated that capital structure was irrelevant in a world without taxation. Five years later, Modigliani and Miller (1963) argued that introducing corporate taxes into the model created tax shield benefits to debt that could, in the limit, lead to an optimal capital structure for any company of 100 percent debt financing. This raised the question of whether corporations were wasting billions of dollars in tax payments by underusing debt (assuming moderate costs of bankruptcy), or whether other factors could mitigate the tax advantage of debt.

Personal-Corporate Tax Interactions. One factor that could help explain the relately low observed levels of debt was the differential treatment of equity and debt income on the personal level. The corporate tax advantage of interest deductibility was partially offset by the personal tax disadvantage of interest payments, as shown in Miller (1977). This analysis is internally consistent with both Modigliani and Miller's articles. If there were no personal tax disadvantage to debt income, then Miller's tax advantage of debt would return to the level originally identified in 1963. On the other hand, consistent with MM, the advantages to debt would be completely eliminated if the personal equity tax was eliminated, the personal interest income tax equaled the marginal corporate rate, and there were full loss offsets at the corporate level.