We mentioned in the last chapter that according to theory, firms should create all-debt capital structures under corporate taxation. Because firms generally employ moderate amounts of debt in the real world, the theory must have been missing something at that point. We stated in this chapter that costs of financial distress cause firms to restrain their issuance of debt. These costs are of two types: direct and indirect. Lawyers' and accountants' fees during the bankruptcy process are examples of direct costs. We mentioned four examples of indirect costs:
Impaired ability to conduct business.
Incentive to take on risky projects.
Incentive toward underinvestment.
Distribution of funds to stockholders prior to bankruptcy.
Because financial distress costs are substantial and the stockholders ultimately bear them, firms have an incentive to reduce costs. Protective covenants and debt consolidation are two common cost reduction techniques.
Because costs of financial distress can be reduced but not eliminated, firms will not finance entirely with debt. Figure 16.1 illustrates the relationship between firm value and debt. In the figure, firms select the debt–equity ratio at which firm value is maximized.
Signaling theory argues that profitable firms are likely to increase their leverage because the extra interest payments will offset some of the pretax profits. Rational stockholders will infer higher firm value from a higher debt level. Thus investors view debt as a signal of firm value.
Managers owning a small proportion of a firm's equity can be expected to work less, maintain more lavish expense accounts, and accept more pet projects with negative NPVs than managers owning a large proportion of equity. Because new issues of equity dilute a manager's percentage interest in the firm, such agency costs are likely to increase when a firm's growth is financed through new equity rather than through new debt.
The pecking-order theory implies that managers prefer internal to external financing. If external financing is required, managers tend to choose the safest securities, such as debt. Firms may accumulate slack to avoid external equity.
Berens and Cuny argue that significant equity financing can be explained by real growth and inflation, even in a world of low bankruptcy costs.
The results so far have ignored personal taxes. If distributions to equityholders are taxed at a lower effective personal tax rate than are interest payments, the tax advantage to debt at the corporate level is partially offset.
Debt–equity ratios vary across industries. We present three factors determining the target debt–equity ratio:
Taxes: Firms with high taxable income should rely more on debt than firms with low taxable income.
Types of assets: Firms with a high percentage of intangible assets such as research and development should have low debt. Firms with primarily tangible assets should have higher debt.
Uncertainty of operating income: Firms with high uncertainty of operating income should rely mostly on equity.
