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Capital structure: perspectives for managers.

Capital is that part of wealth which is devoted to obtaining wealth (Alfred Marshall).


Thursday, 13 July 1876: The man rode through the foothills of the Rocky Mountains. He had long believed his horse his greatest asset. Suddenly, a blur of movement. Instinct brought his response. He pulled, fired once, his single-action Colt revolver. The slug struck the mark, bringing down the mountain lion that had lunged from the rocks. The rider kept his horse. Now though, he was a believer in, had respect for, his Colt. Tuesday, 15 October 1985: Franco Modigliani received the Nobel Prize in Economics for his lifelong contribution to the field of economics and finance, including his pioneering work in the field of corporate capital structure. Friday, 18 July 1986: Colt Industries stock closed at $66.75 per share. That weekend, theory aimed at the mark. The managers of Colt announced a planned change in the capital structure of Colt Industries. The recapitalization plan called for shareholders to swap each share of Colt stock for $85 in cash plus one new share of stock in the new company. Colt explained it would finance the cash payments by taking on $1.5 billion in new debt. Wednesday, 8 November 1986: Colt Industries executed the capital restructuring plan. Theory hits the target. Existing shareholders received $85 of cash per share plus a new share of stock worth $11.75. Management had not touched any of the firm's assets. Colt shareholders now believed in the theory of capital structure.

Tuesday, 16 October 1990: The Nobel Academy honours Merton Miller for his work on the effect of capital structure on a firm's stock price.

Colt management understood capital structure theory and its implications. By changing the company's capital structure, the managers of Colt Industries created $30 per share ($85.00 + $11.75 - $66.75) of wealth for shareholders. Capital structure theory does matter in our imperfect world.

This paper defines capital structure and examines its influence on the cost of capital and the value of a company. Next, the paper sketches practical implications concerning the choices and management of capital structure. A conceptual and practical understanding of these relationships will support the professional manager in his/her efforts to garner added value for shareholders and society.


Theoretical foundations

Franco Modigliani and Merton Miller sired the theory of capital structure. Their original insights (1958) and continued developments (1963, 1965) laid the foundations of modern corporate finance. In a survey of Financial Management Association members in 1979, Cooley and Heck (1981) found that researchers judged the Modigliani and Miller article as having the greatest impact on the field of finance of any work published.

Numerous researchers have built careers on the foundation of their work. We acknowledge and recognize a sampling of these contributions. DeAngelo and Masulis (1980) analyse the effects of taxes on capital structure. Myers (1977) investigates the optimal levels of debt while Warner (1977) explores the relationship between bankruptcy costs and capital structure. Jensen and Meckling (1976) analyse how managers behave under varying levels of debt and equity. These and other contributions support the explanations in this paper.

A practical perspective: capital, its origins and use

How effectively a company purchases and uses raw materials and employs labour affects economic profits. Improvements in the production process that lower the costs of goods increase profits and value. These and other actions on the "operating side of the firm" add increments of value to the firm.

Capital is raw a material for a firm

A company takes financial capital and converts the capital into assets. It operates those assets to earn economic returns by fulfilling customer needs. The liability and equity side of a balance sheet records the origins of a company's capital.

Capital structure theory focuses on how firms finance assets

The capital structure decision centres on the allocation between debt and equity in financing the company. An efficient mixture of capital reduces the price of capital. Lowering the cost of capital increases net economic returns which, ultimately, increases firm value.

Unlevered and levered firms

An "unlevered firm" uses only equity capital. A levered firm uses a mix of equity and various forms of liabilities. Colt Industries utilized about 73 per cent equity and 27 per cent debt before recapitalization. After the change in capital structure, Colt's capital structure employed about 12 per cent equity and 88 per cent debt - representing a high level of financial leverage.

Managing capital structure

Aside from deciding on a target capital structure, a firm must manage its capital structure. Imperfections in capital markets, taxes, and other practical factors influence the managing of capital structure. Imperfections may suggest a capital structure less than the theoretical optimal.

Feedback effects

Operation of assets and the firm's financing of those assets jointly dictate firm value. For example, as a result of the selection and operation of assets yielding a long history of positive cash flows, Colt Industries stock increased $44 per share from 1982 to 1986. Years of diligent management of assets provided a history of robust cash flows from assets. These net operating income cash flows allowed Colt to exploit the tax advantages from adding more debt to their capital structure.

In 1986, Colt Industries followed the prescriptions of capital structure theory. Almost immediately it enhanced firm value by $30 per share by changing its capital structure.

Conceptual issues

Supporting background

A review of concepts support the discussion of capital structure theory.

Key assumptions

We assume interest payments on debt are tax deductible. Notice in the statement of income in Figure 1 the subtraction of interest payments on debt before calculating taxes. Second, today's stock price reflects expectations about a firm's future. For example, net income is really expected net income.

Debt or liabilities

Represent the value of the creditors' stake in the firm. The value of debt represents the discounting and summing of all current and future payments the company has promised to creditors. These liabilities take various forms and have different claim positions with regard to the cash flows and assets of the company. At this stage recognize that creditors have claims against the company and these claims always are ahead of the stockholders.


Represents the value of the shareholder interests. Stockholders always have last claim on the results of economic activities. Stockholders are residual claimants. Equity value represents the discounted summation of all current and future residual cash flows of the company.

Total capital

Equals the amount of financing from all sources. Total capital on an economic balance sheet is the sum of equity capital and debt capital of all forms. This total equals the sum of all assets on the balance sheet.

Capital structure

Represents the proportion of capital from different sources. In a simplified context, it is the proportion of financing from debt and from equity capital. Common ratios such as debt-to-total capital or debt-to-equity quantify this relationship.

Decomposing risk

Understanding capital structure calls for an examination of certain aspects of risk, return, and value. Let us discuss the business, financial, and total risk related to the economic statement of income shown in Figure 1.

Business risk (BR)

Reflects all sources of risk that affect revenues, costs, and asset operation. Business risk influences the first section of the economic statement of income as shown in Figure 1. Some of the factors affecting business risk are:

* An efficiency improvement in the manufacturing process.

* More effective advertising.

* Changes in interest rates that influence product demand.

* Government actions that create uncertainty in a company's operation.

Financial risk (FR)

Results from commitments to use expected cash flows to service creditors and taxing authorities. Creditors stand in line ahead of stockholders. The additional risk in the section of the ESI labelled FR results from promises and requirements resulting from the use of debt and the tax environment. Examples of financial risk include:

* Uncertainty about interest rates and a change in the interest payments if the company has variable rate debt or if it plans to raise debt in the future.

* The risk that taxing authorities will change tax rates.

Total risk

The stockholder bears the total risk (TR) associated with expected net income (ENI). The aggregate effects of all factors that influence business and financial risk ultimately determine the total risk borne by the stockholders.

Risk and borrowing

Risk affects the expected level and uncertainty of the economic net operating income (ENOI). The ENOI is the normal source of cash flow for the payment of interest and principal on debt[1]. The level and uncertainty in ENOI affects the amount the company can borrow and the terms of borrowing. In general:

* The greater the level of ENOI, the greater the borrowing capacity.

* The lower the risk in ENOI, the greater the borrowing capacity.

* For a given level of ENOI and a given amount of borrowing, the lower the risk of the ENOI the lower the cost of borrowing.

A detailed explanation of the relationships between risk, operating and net income, borrowing, and stock price appear in Groth (1992).


A rigorous academic examination of capital structure theory involves many assumptions. With practical application the ultimate goal, we take liberties and limit assumptions to:

* Interest is a tax-deductible expense.

* Bankruptcy has costs.

* Mistakes in financing a company may affect its operations.

* Mistakes in financing may affect value by affecting the choice and timing of new investments.

* The company seeks to create value in a risky environment.

* The environment is dynamic. For example, interest rates, the economic environment, and other factors that influence value may change.

* Somehow market participants assign value to risky assets. We do not understand the process fully. We assume people favour:

* Less rather than more risk, return held constant.

* More return rather than less return, risk held constant.

* Returns now rather than later in time, returns held constant.

* If the company does what people like (dislike), the stock price increases (increases), other factors constant.

Figure 2 provides a simplified depiction of balance sheets for unlevered and levered firms. Total financing is the same under both situations, $100. Our discussions assume a fixed amount of financing because our focus is on the debt-equity choice each firm makes and not on the amount of financing they require.

We examine the effect of using different proportions of debt and equity in financing, as for instance, employing 60 per cent debt versus 40 per cent debt in the capital structure.

The focal point

Understanding why the correct proportion of debt in the capital structure lowers the cost of capital and increases stock price holds our attention. Others have provided elegant and detailed approaches as proofs of the theory. Our explanation rests on the astuteness of people.

Clever people in line principle

Creditors have very carefully organized and specified claims against a company's cash flows during normal operations as well as during bankruptcy. Equity holders are always last in line, behind all creditors.

The position of each claimant in the line affects the riskiness of their cash flows. Those first in-line claim the most certain cash flows - and their removal of the most certain cash flows increases the risk of the cash flows that remain for those behind them.

Creditors and equity holders are clever. Claimants further back in-line demand higher returns to compensate themselves for the additional risk that they bear. Thus, shareholders require higher returns for the added financial risk of creditors.

However, shareholders know another very important facet about debt; they can make money from its use. In fact, the focal point of capital structure theory hinges on shareholders recognizing that debt use can add to their returns. Shortly, we will see that on an after-tax basis, the use of the appropriate amount of debt adds value if the company enjoys a tax deduction for interest payments.

Figure 3 depicts the weighted cost of capital (WCOC) and price per share for a company on the vertical axis. The horizontal axis depicts how much debt the company uses in its capital structure relative to the total debt and equity. Remember that this graph always depicts relationships that result from a change in the financing of the company. At every point in the figure, the company has the same amount of total financing, e.g. $100 million.

At the extreme left, total capital is $100 million and all from equity. As we move to the right:

* Total capital is still $100 million.

* Debt increases. Financial risk increases.

* Total risk increases since financial risk is increasing.

* Equity decreases. The number of shares of stock decreases. The company does not need as much equity financing because debt is replacing equity in the capital structure.

* Expected earnings per share (EPS) increase since fewer shares exist and the expected tax benefits of using debt contribute to the EPS.

Unlevered company (no debt)

People are not in line. Only shareholders as a group have a claim on expected net income (ENI) and they bear the risk associated with the expected net income (ENI). Total risk consists of business risk and the risk associated with the tax environment.

Figure 4 depicts the expected level of earnings per share (EPS) and an arbitrarily assumed price-earnings ratio (P/E ratio) for the EPS. The P/E ratio changes as the risk of EPS changes. Moving to the right in the figure, the risk of EPS increases due to the added use of debt and resultant increase in financial risk and increased risk in ENI.

Recall the P/E ratio is the market price of a share divided by the earnings. In this case we are using market price and economic net earnings. Since this is a ratio, the P/E indicates the price a person will pay for one dollar of expected earnings given the perceived risk associated with that dollar. An increase in the risk of earnings is akin to lowering the quality of the dollar and hence, its price and P/E ratio.

Price versus risk

Logical people pay less for a dollar of earnings if the risk of a dollar of earnings increases. Hence, the decline in the P/E ratio.

Levering the firm

Adding debt to the firm in place of equity moves us to the right in Figure 4. Adding debt places additional creditors ahead of stockholders. Creditors have the right to take the most certain dollars of pre-tax earnings for interest. Creditors are entitled to the most certain after-tax dollars for the repayment of principle. If creditors take the best dollars generated by the operations of the company, the quality of the remaining dollars must be lower. The risk of the economic net income must be higher. Adding creditors ahead of shareholders adds financial risk and thus increases the total risk of ENI, and decreases how shareholders value a dollar of expected earnings - thus decreasing the P/E ratio. The greater the claims of creditors, the greater the risk for shareholders of a dollar of net income. To understand the relation between share price and debt, we focus on:

* The after tax cost of debt.

* The expected economic earnings per share EPS.

The after-tax cost of debt

The ability to deduct interest charges for tax purposes affects the after-tax cost of debt. An illustration:

Assume: The company borrows money at a 12 per cent annual rate and writes a cheque to the creditor actually paying the 12 per cent rate of interest. Tax time arrives. If the tax rate is 40 per cent and the company deducts the 12 per cent interest paid, the after-tax cost to the company is 7.2 per cent[2].

The deductibility of interest and the government essentially paying for part of the interest by allowing its deduction from pre-tax income does not change the cash flows to creditors. Creditors still get the 12 per cent. Consequently, the benefits of the tax deductibility must flow to the company and, ultimately, to the stockholders.

Economic earnings per share

As we move from the left to the right in Figure 4, the expected earnings per share increase for two reasons:

1 Since debt replaced some equity, the number of shares outstanding is less.

2 The tax benefits of the deductibility of debt contribute to the expected earnings per share - so long as the contribution to earnings from the use of debt exceeds interest charges on debt.

The price of the stock at any point in Figure 4 is the product of the expected earnings per share (EPS) and the price-earnings ratio (P/E).

Price of stock - EPS x P/E

The market price of the stock continues to increase with the increased use of debt so long as the expected increase in EPS is sufficient to overpower the effects of the decline in the P/E ratio. However, the P/E ratio declines at an increasing rate with the increase in the use of debt. This behaviour has its origin in investors' concerns about a host of factors associated with the use of "too much debt" including:

* Pre-tax income may not be sufficient to allow the deduction of interest. If so, the tax advantages of debt no longer exist. In fact, if the company has a loss, the loss on a per share basis grows at a faster rate if the company is using debt. This happens for two reasons. The company is not earning enough on its assets to pay creditors: the shareholders must make up the difference. The shareholders effectively pay the full cost of borrowing money absent an effective tax deduction.

* The possibility of creditors disrupting operations or, in the worse case, creditors initiating bankruptcy proceedings.

From the shareholder's point of view, the optimal capital structure results in the maximum share price. Increasing the proportion of capital from debt increases share price until reaching the optimal capital structure. Additional debt beyond this point causes share price to decline. Stock price begins to decline when the value in today's dollars or present value of expected tax advantages of incremental debt no longer are attractive enough to compensate investors for the additional financial risk associated with the incremental debt.

Conclusions and implications

In a tax environment allowing the deduction of interest:

* Capital structure does affect the value of a firm and its stock price.

* An optimal way to finance the firm exists.

* Capital structure theory is of value even if the array of assumptions in the theory do not hold.

* An environment characterized by changes in economic variables, e.g. changes in interest rates, recessions, the price of bearing risk, ..., does influence the choice and management of capital structure.

* Reasonable practical approaches to the management of capital structure exist. Not all theorists would agree with our conclusions, related implications, or comments.

Important definitions

A few important definition are given below to help in following discussion:

* Debt capacity. The amount of money a company currently could borrow. It is not the amount it should borrow.

* Unused debt capacity. Capacity to borrow more.

* Good debt. Debt that adds increments of value to share price is "good debt".

* Unused good capacity. Incremental borrowing that would add to share value. Unused debt capacity exceeds good debt capacity. A company can borrow more than it should in terms of shareholders' interests.

Practical implications

The "optimal structure"

No equation exists to determine the optimal capital structure for a company. Clues and judgement guide the decision.

Useful clues. Several clues that emanate from the market offer guidance on the approximate optimal debt ratio. Practical guidelines or "rules of thumb" on the optimal debt ratio might include one or more of the following:

* Increases in debt levels that result in a disproportional large jump in the cost of debt.

* A suggestion that bond rating agencies may lower debt ratings below an investment grade rating. Some - including the authors - propose the loss of the "single A rating" signals movement past the optimal debt point.

* Comments by analysts offer guidance. "The company can comfortably handle its debt obligations" would suggest the capital structure is at or short of the optimal ratio. In contrast, concerns about the company's ability to service its debt clearly signal the company already has exceeded the optimal ratio.

* The reaction of the market to the capital structure of other companies with similar business risk.

* The eagerness of underwriters to handle a new issue of incremental debt on an underwritten basis.

The flexibility argument

The authors and others contend that shareholders value flexibility in financing possibilities. The flexibility argument recognizes that the option to quickly obtain additional financing through unused good debt capacity is of significant value to shareholders. The degree of flexibility is a function of several variables including the business risk of the company, the cyclical nature of its business, the likely opportunity set facing the company, and characteristics of the company's existing financing.

A company benefits by having access to a reasonable amount of incremental debt regardless of economic and capital market conditions. Unused good debt capacity provides the opportunity to obtain capital short order - perhaps with just a phone call. This may allow the company to take advantage of unusual opportunities or avoid being forced to take actions it deems undesirable. If shareholders share this view, keeping unused good debt capacity in reserve adds to share price.

Managing the capital structure

An example will illustrate a number of practical issues. The management of CSI Corporation (CSI) has concluded it should alter its capital structure to include more interest bearing debt. Interest rates on long-term debt are low compared to historical rates. CSI has and expects to obtain future equity from "internally generated funds." To minimize information risk uncertainty, management is careful to communicate its intentions and actions to the investment community.

Figure 5 aids in our discussion of the management of capital structure. The vertical axis is expected cost in percentage. The horizontal axis is the ratio of debt to (debt + equity). Notice the weighted cost of capital curve (WCOC) declines, is shallow as it approaches the minimum point, and increases relatively quickly once past the minimum or optimal point. We use the term shallow to denote that the curve does not steeply slope at and to the left of the optimal point. Rather, the curve is gently, or shallowly sloped which means changes in capital structure do not have a large impact on WCOC.

The asterisk marks the minimum point in the WCOC. This company's strategy calls for normally maintaining its capital structure in the shallow portion of the curve between points A and B. The additional debt associated with moving from point B to the minimum point on the WCOC represents unused good debt capacity. The company keeps this in reserve for unanticipated needs. In this graph, if the company:

* Moves to the right, it increases the use of debt and utilizes some of its debt capacity.

* Moves to the left, it decreases the use of debt and restores debt capacity.

* Generates and retains earnings within the company, it moves to the left since earnings represent equity, increasing the denominator in the D/(D + E) ratio.

* Issues debt and uses the proceeds to buy back some stock, it moves to the right.

Suppose CSI issued long-term debt and used the proceeds to repurchase some of its common stock, perhaps moving from A to B on the WCOC curve. Issuing debt and buying equity affects both the numerator and denominator in the D/(D + E) ratio. This results in:

* An increase in cost of equity due to increased financial risk.

* A lower weighted cost of capital as the company moved to the right on the graph.

* An increase in share price. This increase stems from an interaction of fewer shares outstanding, greater expected earnings per share, and a decrease in the price-earnings ratio due to the increased risk of a dollar of earnings.

To continue the discussion:

* The investment in good projects results in the generation of economic profits. CSI retains part of these profits in the company. The retention of economic profit rather than payment of the full amount in dividends represents additions to equity. These additions to equity increase equity in the denominator of the Debt to Debt + Equity. With the passage of time the generation and retention of profits increases the equity base and results in CSI moving back to the left on the WCOC curve towards A.

* If with time CSI also is paying down the principle on its debt, this reduces the numeration in the D to (D + E) ratio and further accelerates the movement to the left on the axis.

* Since the WCOC curve is shallow as one approaches the optimal ratio, moving back to the left has little effect on the WCOC. If one accepts the flexibility argument and its potential value, financing in the shallow portion of the curve may not adversely affect the WCOC.

* With time, CSI restores its borrowing base for "good debt." At a future time, it issues another chunk of debt. This moves CSI to the right, again towards B, on the axis in Figure 2. CSI can use this debt to finance incremental investments. Since its equity base has grown, it is in effect financing part of these investments with equity - the financing of incremental projects with this combination of debt and equity approximately in the proportional of the long-term capital structure of CSI. New, good projects, will contribute to the equity base. If CSI has excess funds and wants to move towards the optimal capital structure, it can repurchase some of its own stock with attendant increase in share value.

Emerging and transition economies

Several factors complicate the capital structure decision and management in emerging and transition economies compared to more developed economies. We suggest factors and offer a sampling of potential implications:

* A perception of greater uncertainty in the taxes and tax rates that may prevail.

* Existing or potential impediments to cross boundary flows of capital may inhibit the availability and affect the cost of capital.

* Higher perceived risk of realization of the actual benefits of projects. A project may attain expected cash flows. Higher political risks influence perceptions (and often reality) of confiscatory acts by governments that diminish the net cash benefits to the company or investors. This influences the perceptions of the likelihood of future generations of and contributions to equity.

* Relatively high costs of capital. The tax deductibility of interest payments can be less in developed economies. This results from differential premiums of equity compared to debt that exist in some economies. As a consequence, the expected value to equity holders of the tax deductibility of debt contributes proportionally less to total expected returns compared to developed economies.

* The volatility in equity markets affects perceptions of the risk of availability of future new equity.

* The absence of capital markets for long-term capital particularly debt. The adverse effects on the cost and availability of capital is the transparent effect[3]. Other effects exist that have a feedback effect on the development of the economy and the availability and cost of capital. The absence of markets for long-term capital and debt results in:

* A mismatch of asset life with financing life.

* A truncation of the investment set by companies. The shortage of long-term financing results in the selection of projects with short lives. This short-life project phenomenon may adversely affect the long term availability of cash flows.

* A desire for projects that generate cash flow earlier in time.


Decisions that involve risk call for common sense. One rule of risk management: with respect to a position of risk, position the company so it can choose to take an action rather than have circumstances compel it to take action. The use of debt does add risk to a company. Apply this rule:

Position the company so you can choose to borrow or pay off debt. Never position the company so circumstances compel it to borrow or pay off debt.

General and specific guidelines have import depending on circumstance.


If a company generates cash in excess of its needs, it has free cash flow. Free cash flow companies enjoy an enviable position of generating sufficient equity internally so that the company does not have to raise equity in markets. Instead, the company can focus on finding attractive uses for its cash, use the cash to manage its capital structure, or return the cash to shareholders.

Free cash flow companies have an expanding economic equity base. This expanding base changes the debt to capital ratio. The company can repurchase equity and issue additional debt as necessary to pursue the desired capital structure. Free-cash generating companies enjoy the luxury of choosing the timing of interaction with capital markets. For example, if stock prices are low, the company might decide this is an opportune time to repurchase some of its own stock to restore the desired equity-to-total capital ratio.

A company having cash generation less than its equity capital needs must resort to raising equity and debt in the appropriate ratios to pursue its target capital structure. Companies needing capital from external sources face the risk of changing capital market conditions. Common sense suggests issuing equity and restoring a cushion of equity during times of market euphoria rather than having the lack of good debt capacity and financing needs compel the issuance of equity during downturns in the market.

Non-cyclical industry

Companies in non-cyclical industries can operate closer to the optimal debt ratio. The range of the shallow portion of the curve over which they operate is sensitive to several factors including:

* The need to have unused good debt capacity during downturns in the economy to take advantage of opportunities.

* The relationship between issue size for debt and equity and the costs of issuing new financial securities. An issue of sufficient size spreads the fixed costs of issuing securities over large dollar amounts.

* Particular needs which may exist during recessions or downturns in an economy For example, utilities often must meet commitments for new services regardless of economic conditions to comply with the requirements of the grant of monopoly

Cyclical industry

A company in a cyclical business normally should manage its capital structure over a broader range of the shallow portion of the WCOC curve. Economists and others have a dismal record of predicting recessions and the extent and length of the business downturn. Management of capital structure is sensitive to the following:

* Cash flow patterns of the company as it enters a recession. Some companies generate cash during a recession by reducing inventories. Such a company may have the ability to operate in a narrower range of capitals structure than another company.

* The need for cash at a company as the economy emerges from a recession, perhaps to fund the building of products and the restoration of inventory levels.

* The prospect that interest rates follow a historical pattern of being low during recessions. This allows a company to move towards it optimal debt ratio using long term debt at attractive rates.

* The attractiveness of refunding existing debt when interest rates are low.

* The merits of paying down principle on debt during good times to restore "good" borrowing capacity.

* Pockets of opportunity. Good borrowing capacity during a recession may allow the company to take advantage of opportunities that result from the failure of other companies to prudently manage their financial needs. Unused good capacity permits borrowing quickly and on favourable terms. Issuing equity during a recession normally is disadvantageous due to market conditions. In addition, usually an equity issue takes a relatively long time.

Special factors

The strategy of a firm may influence the choice of capital structure. For example, the nature of future capital investments may call for an adjustment in target capital structure. Examples:

* Investments that will increase the business risk of the company will shift the optimal debt ratio to the left. Since the company does not want to find itself to the right of the optimal ratio, management should adjust the target capital structure.

* The company may anticipate acquisitions or divestitures. Either may alter the business risk of the company, calling for an attendant adjustment in capital structure.

* Relative privacy of borrowing to take advantage of opportunities. Unused good debt capacity during boom or recession times offers the ability to quickly and privately obtain financing for an unusual opportunity. The opportunity may be fleeting, subject to influence by third parties, or available only on a private basis. The issuance of equity with normal full disclosure requirements precludes a private transaction.


Capital structure reflects the manner of financing a company. The tax deductibility of interest in some tax environments makes the use of the appropriate amount of debt beneficial to shareholders and share price. The use of the right amount of debt lowers the companies weighted cost of capital. Lowering the cost of financial resources improves net economic returns and increases share value. Consequently, an optimal capital structure exists.

The optimal capital structure is a function of several variables including the business risk of a company and the tax rate. The higher the tax rate, the greater the benefits of using a given amount of debt. The lower (higher) the business risk of a company, the greater (less) the proportion of debt it should use in its financial structure. Changes in business risk result in changes in the optimal capital structure.

The effectiveness of managing assets and deriving economic returns from the market for goods and services influences the optimal financing of a company. For example, a reduction in business risk without a decrease in economic operating income allows the company to use more "good debt" with attendant additions to value stemming from the tax benefits of incremental debt.

Several factors prompt the adoption of a management strategy for capitals structure:

* The presence of issuance costs, economies of scale in new financing, the need for underpricing new issues of stock, taxes on dividends, regulations, variance in market conditions, and other factors make it impractical to raise incremental capital in the exact proportions of the target capital structure.

* Shareholders may prefer and hence value a management scheme for structure that provides for flexibility in financing - particularly for companies in cyclical industries.

* The weighted cost of capital curve is shallow at debt to equity ratios less than the optimal capital structure. Hence, the gain in flexibility has a small cost in terms of the weighted cost of capital. In fact, shareholders may value this flexibility in which case the optimal use of debt is less than the theoretical amount.

These factors prompt a management strategy for capital structure. The authors assert that strategy should focus on providing for capital needs while remaining in the shallow portion of the weighted cost of capital curve. In addition, they suggest reserving some unused good debt capacity to provide flexibility that probably pleases shareholders - and hence, increases share price.

Proper selection and management of capital structure offer the prospect of enhancing value for shareholders. At the same time, the reduction in cost of capital to the company has potentially favourable influences on the economy and the standard of living. Theory is nice. Application is important. Managers have the responsibility for creating value for shareholders. Application of capital structure theory in some tax environments will create value, for shareholders and for society.

We thank anonymous reviewers and Paul Strong for their assistance and acknowledge the benefit of the editor's touch.


1 Creditors normally expect a company to generate cash flow from operations to pay interest and repay principal. A company might sell assets to generate cash or engage in other financing to meet obligations. A company can only sell an asset once to raise cash. A company has a limit on alternative financing available. Hence, creditors expect companies to generate cash flow to "service" debt.

2 The higher the tax rate, the greater the value of the tax deductibility of the debt and the more important it is to use the appropriate capital structure. This does not mean we favour higher tax rates. In fact, a zero tax rate would be optimal for shareholders - but there no longer would be a reason to use debt in the financing of a firm.

3 The authors currently are examining factors that inhibit the development in emerging and transition economies of capital markets for long-maturity financial instruments.

References and further reading

Cooley, P.L. and Heck, J.L. (1981), "Significant contributions to finance literature", Financial Management, Tenth Anniversary Issue, pp. 23-33.

DeAngelo, H. and Masulis, R. (1980), "Optimal capital structure under corporate and personal taxation", Journal of Financial Economics, March, pp. 3-30.

Groth, J.C. (1992), "The operating cycle: risk, return and opportunities," Management Decision, Vol. 30 No. 4, pp. 3-11.

Groth, J.C. and Byers, S.S. (1996), "Creating value: economics and accounting-perspectives for managers", Management Decision, Vol. 34 No. 10, pp. 56-64.

Jensen, M. and Meckling, W. (1996), "Theory of the firm: managerial behavior, agency costs, and ownership structure", Journal of Financial Economics, October, pp. 305-60.

Modigliani, F. and Miller, M.H. (1958). "The cost of capital, corporation finance, and the theory of investment", American Economic Review, June, pp. 261-97.

Modigliani, F. and Miller, M.H. (1963), "Corporate income taxes and the cost of capital", American Economic Review, June, pp. 433-43.

Modigliani, E and Miller, M.H. (1965), "Reply", American Economic Review, June, pp. 524-7.

Myers, S.C. (1977), "Determinants of corporate borrowing", Journal of Financial Economics, November, pp. 147-76.

Warner, J.B. (1977), "Bankruptcy, absolute priority, and the pricing of risky debt claims", Journal of Financial Economics, May, pp. 239-76.

Application questions

1 Describe the capital structure of your organization using the taxonomies discussed by the authors.

2 Are there any underlying principles of what a "good" or a "bad" capital structure would be, or is it mostly situational, i.e. a good capital structure is determined by the operating context and the predilections of the stakeholders?
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Author:Groth, John C.; Anderson, Ronald C.
Publication:Management Decision
Date:Jul 1, 1997
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