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The dilution effect refers to the possible decrease in earnings per share from any
action that might lead to an increase in the number of shares outstanding. As evidenced in
table 7.8, managers, especially in the United States, weigh these potential dilution effects
heavily in decisions on what type of financing to use, and how to fund projects. Consider,
for instance, the choice between raising equity using a rights issue, where the stock is
issued at a price below the current market price, and a public issue of stock at the market
price. The latter is a much more expensive option, from the perspective of investment
banking fees and other costs, but is chosen, nevertheless, because it results in fewer
shares being issued (to raise the same amount of funds). The fear of dilution is misplaced
for the following reasons:
1. Investors measure their returns in terms of total return and not just in terms of stock
price. While the stock price will go down more after a rights issue, each investor will
be compensated adequately for the price drop (by either receiving more shares or by
being able to sell their rights to other investors). In fact, if the transactions costs are
considered, stockholders will be better off after a rights issue than after an equivalent
public issue of stock.
2. While the earnings per share will always drop in the immediate aftermath of a new
stock issue, the stock price will not necessarily follow suit. In particular, if the stock
issue is used to finance a good project (i.e., a project with a positive net present
value), the increase in value should be greater than the increase in the number of
shares, leading to a higher stock price.
Ultimately, the measure of whether a company should issue stock to finance a project
should depend upon the quality of the investment. Firms that dilute their stockholdings to
take good investments are choosing the right course for their stockholders.

There Is An Optimal Capital Structure
The counter to the Miller-Modigliani proposition is that the trade-offs on debt
may work in favor of the firm, at least initially, and that borrowing money may lower the
cost of capital and increase firm value. We will examine the mechanics of putting this
argument into practice in the next chapter; here, we will make a case for the existence of


an optimal capital structure, and looking at some of the empirical evidence for and
against it.

The Case for an Optimal Capital Structure

If the debt decision involves a trade-off between the benefits of debt (tax benefits
and added discipline) and the costs of debt (bankruptcy costs, agency costs and lost
flexibility), it can be argued that the marginal benefits will be offset by the marginal costs
only in exceptional cases, and not always (as argued by Miller and Modigliani). In fact,
under most circumstances, the marginal benefits will either exceed the marginal costs (in
which case, debt is good and will increase firm value) or fall short of marginal costs (in
which case, equity is better). Accordingly, there is an optimal capital structure for most
firms at which firm value is maximized.
Of course, it is always possible that managers may be operating under an illusion
that capital structure decisions matter when the reality might be otherwise. Consequently,
we examine some of the empirical evidence to see if it is consistent with the theory of an
optimal mix of debt and equity.

Empirical Evidence

The question of whether there is an optimal capital structure can be answered in a
number of ways. The first is to see if differences in capital structure across firms can be
explained systematically by differences in the variables driving the trade-offs. Other
things remaining equal, we would expect to see relationships listed in Table 7.9.
Table 7.9: Debt Ratios and Fundamentals
Variable Effect on Debt Ratios
Marginal Tax Rate As marginal tax rates increase, debt ratios
Separation of Ownership and Management The greater the separation of ownership
and management, the higher the debt ratio.
Variability in Operating Cash Flows As operating cash flows become more
variable, the bankruptcy risk increases,
resulting in lower debt ratios.


Debt holders™ difficulty in monitoring firm The more difficult it is to monitor the
actions, investments and performance. actions taken by a firm, the lower the
optimal debt ratio.
Need for Flexibility The greater the need for decision making
flexibility in future periods, the lower the
optimal debt ratio.
While this may seem like a relatively simple test to run, keeping all other things equal in
the real world is often close to impossible. In spite of this limitation, attempts to see if the
direction of the relationship is consistent with the theory have produced mixed results.
Bradley, Jarrell and Kim (1984) analyzed whether differences in debt ratios can
be explained by proxies for the variables involved in the capital structure trade-off. They
noted that the debt ratio is:
negatively correlated with the volatility in annual operating earnings, as predicted by

the bankruptcy cost component of the optimal capital structure trade off
positively related to the level of non-debt tax shields, which is counter to the tax

hypothesis, which argues that firms with large non-debt tax shields should be less
inclined to use debt.
negatively related to advertising and R&D expenses used as a proxy for agency costs;

this is consistent with optimal capital structure theory.
Others who have attempted to examine whether cross-sectional differences in capital
structure are consistent with the theory have come to contradictory conclusions.
A second test of whether differences in capital structure can be explained by
differences in firm characteristics involve examining differences in debt ratios across
An alternate test of the optimal capital structure hypothesis is to examine the
stock price reaction to actions taken by firms either to increase or decrease leverage. In
evaluating the price response, we have to make some assumptions about the motivation
of the firms making these changes. If we assume that firms are rational and that they
make these changes to get closer to their optimal, both leverage-increasing and
decreasing actions should be accompanied by positive excess returns, at least on average.
Smith(1988) notes that the evidence is not consistent with an optimal capital structure


hypothesis, however, since leverage-increasing actions seem to be accompanied by
positive excess returns while leverage-reducing actions seem to be followed by negative
returns. The only way to reconcile this tendency with an optimal capital structure
argument is by assuming that managerial incentives (desire for stability and flexibility)
keep leverage below the optimal for most firms and that actions by firms to reduce
leverage are seen as serving managerial interests rather than stockholder interests.

There is a data set on the web that summarizes, by sector, debt ratios and
averages for the fundamental variables that should determine debt ratios.

How Firms Choose their Capital Structures
We have argued that firms should choose the mix of debt and equity by trading
off the benefit of borrowing against the costs. There are, however, three alternative views
of how firms choose a financing mix. The first is that the choice between debt and equity
is determined by where a firm is in the growth life cycle. High-growth firms will tend to
use debt less than more mature firms. The second is that firms choose their financing mix
by looking at other firms in their business. The third view is that firms have strong
preferences in for the kinds of financing they prefer to use, i.e. a financing hierarchy, and
that they deviate from these preferences only when they have no choice. We will argue
that, in each of these approaches, firms still implicitly make the trade off between costs
and benefits, though the assumptions needed for each approach to work are different.

Financing Mix and a Firm™s Life Cycle

Earlier in this chapter, we looked at how a firm™s financing choices might change
as it makes the transition from a start-up firm to a mature firm to final decline. We could
look at how a firm™s financing mix changes over the same life cycle. Typically, start-up
firms and firms in rapid expansion use debt sparingly; in some cases, they use no debt at
all. As the growth eases, and as cash flows from existing investments become larger and
more predictable, we see firms beginning to use debt. Debt ratios typically peak when
firms are in mature growth.


How does this empirical observation relate to our earlier discussion of the benefits
and costs of debt? We would argue that the behavior of firms at each stage in the life
cycle is entirely consistent with making this trade off. In the start-up and high growth
phases, the tax benefits to firms from using debt tend to be small or non-existent, since
earnings from existing investments are low or negative. The owners of these firms are
usually actively involved in the management of these firms, reducing the need for debt as
a disciplinary mechanism.
On the other side of the ledger, the low and volatile earnings increase the
expected bankruptcy costs. The absence of significant existing investments or assets and
the magnitude of new investments makes lenders much more cautious about lending to
the firm, increasing the agency costs; these costs show up as more stringent covenants or
in higher interest rates on borrowing. As growth eases, the trade off shifts in favor of
debt. The tax benefits increase and expected bankruptcy costs decrease as earnings from
existing investments become larger and more predictable. The firm develops both an
asset base and a track record on earnings, which allows lenders to feel more protected
when lending to the firm. As firms get larger, the separation between owners
(stockholders) and managers tends to grow, and the benefits of using debt as a
disciplinary mechanism increase. We have summarized the trade off at each stage in the
life cycle in figure 7.10.
As with our earlier discussion of financing choices, there will be variations
between firms in different businesses at each stage in the life cycle. For instance, a
mature steel company may use far more debt than a mature pharmaceutical company,
because lenders feel more comfortable lending on a steel company™s assets (that are
tangible and easy to liquidate) than on a pharmaceutical company™s assets (which might
be patents and other assets that are difficult to liquidate). Similarly, we would expect a
company like IBM to have a higher debt ratio than a firm like Microsoft, at the same
stage in the life cycle, because Microsoft has large insider holdings, making the benefit of
discipline that comes from debt a much smaller one.


Figure 7.10: The Debt-Equity Trade off and Life Cycle
Stage 1 Stage 2 Stage 4 Stage 5
Stage 3
Start-up Rapid Expansion Mature Growth Decline
High Growth

$ Revenues/



Zero, if Low, as earnings Increase, with High High, but
Tax Benefits losing money are limited earnings declining

Declining, as firm
Added Disceipline Low, as owners Low. Even if Increasing, as High. Managers are
does not take many
of Debt run the firm public, firm is managers own less separated from
new investments
closely held. of firm owners

Bamkruptcy Cost Very high. Firm has Very high. High. Earnings are Declining, as earnings Low, but increases as
no or negative Earnings are low increasing but still from existing assets existing projects end.
earnings. and volatile volatile increase.

Very high, as firm High. New High. Lots of new Declining, as assets
Agency Costs Low. Firm takes few
has almost no investments are investments and in place become a
new investments
assets difficult to monitor unstable risk. larger portion of firm.

Very high, as firm High. Expansion High. Expansion Low. Firm has low Non-existent. Firm has no
Need for Flexibility looks for ways to needs are large and needs remain and more predictable new investment needs.
establish itself unpredicatble unpredictable investment needs.

Costs exceed benefits Costs still likely Debt starts yielding Debt becomes a more Debt will provide
Net Trade Off Minimal debt to exceed benefits. net benefits to the attractive option. benefits.
Mostly equity firm


Financing Mix based on Comparable Firms

Firms often try to use a financing mix similar to that used by other firms in their
business. With this approach, Bookscape would use a low debt to capital ratio because
other book retailers have low debt ratios. Bell Atlantic, on the other hand, would use a
high debt to capital ratio because other phone companies have high debt to capital ratios.
The empirical evidence about the way firms choose their debt ratios strongly
supports the hypothesis that they tend not to stray too far from their sector averages. In
fact, when we look at the determinants of the debt ratios of individual firms, the strongest
determinant is the average debt ratio of the industries to which these firms belong. While
some would view this approach to financing as contrary to the approach where we trade
off the benefits of debt against the cost of debt, we would not view it thus. If firms within
a business or sector share common characteristics, it should not be surprising if they
choose similar financing mixes. For instance, software firms have volatile earnings and
high growth potential, and choose low debt ratios. In contrast, phone companies have
significant assets in place and high and stable earnings; they tend to use more debt in
their financing. Thus, choosing a debt ratio similar to that of the industry in which you
operate is appropriate, when firms in the industry are at the same stage in the life cycle
and, on average, choose the right financing mix for that stage.
It can be dangerous to choose a debt ratio based upon comparable firms under two
scenarios. The first occurs when there are wide variations in growth potential and risk


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