Topics n 12 The Capital Structure Puzzle Michael

Topics n 12. The Capital Structure Puzzle Michael F. Barclay and Clifford W. Smith, Jr. 10/16/2021 Hu - Financing Decision I 1

The Capital Structure Puzzle Theories - Taxes n Corporate income taxes n Interest expenses deduction n n 10/16/2021 Tc: Corporate tax tc: corporate tax rate EBIT: Earnings before interest and tax I: Interest expense Hu - Financing Decision I 2

The Capital Structure Puzzle Theories - Taxes n Corporate income taxes n 10/16/2021 EBIT-Tc (distribute to bondholders and stockholders) is higher when I is larger Hu - Financing Decision I 3

The Capital Structure Puzzle Theories - Taxes n Individual income tax n If individuals are both shareholder and bondholder, personal income before tax will be n n Personal tax will be： n 10/16/2021 I + (EBIT-I-Tc) = I + (1 -tc) (EBIT-I)。 Tp is personal tax, t. D is tax rate for interest income, t. E is tax rate for income as stockholder Hu - Financing Decision I 4

The Capital Structure Puzzle Theories - Taxes n Individual income tax n n 10/16/2021 Personal income after tax: (1 -t. D)I + (1 -t. C)(1 -t. E)(EBIT-I)。 To get $1 as a bondholder, income after tax is (1 -t. D) To get $1 as a stockholder, income after tax is (1 t. C)(1 -t. E) Hu - Financing Decision I 5

The Capital Structure Puzzle Theories - Contracting issues n Cost of financial distress n Underinvestment because benefit will go to someone else n n 10/16/2021 Especially for growth firms Growth firms should use less debt Hu - Financing Decision I 6

The Capital Structure Puzzle Theories - Contracting issues n Benefit of debt financing n Control agency cost of overinvestment n n 10/16/2021 Especially for mature firms Mature firms should use more debt Hu - Financing Decision I 7

The Capital Structure Puzzle Theories – Information costs n Signalling of future cash flow n How can it be credible? n n 10/16/2021 Issue debt commits the firm to pay future cash flow Issue debt conveys good information Hu - Financing Decision I 8

The Capital Structure Puzzle Theories – Information costs n Issue equity conveys bad information n n 10/16/2021 When a firm is overvalued, equity is more overvalued than debt, company will sell equity Therefore, stock price will drop when a company issues equity Hu - Financing Decision I 9

The Capital Structure Puzzle Theories – Information costs n n The information cost is the highest when issue equity Pecking order n n n 10/16/2021 1 st priority is to use internal funds 2 nd priority is to issue debt Last priority is to issue stock Hu - Financing Decision I 10

The Capital Structure Puzzle Evidence n High leveraged firms are mature and asset-intensive n n Cement, Steel, Paper, Textiles, Petroleum refining Low leveraged firms are growth industries n 10/16/2021 Cosmetics, drugs Hu - Financing Decision I 11

The Capital Structure Puzzle Evidence n Growth companies use less long-term debt, use more high-priority securities 10/16/2021 Hu - Financing Decision I 12