{"doi":"10.1111/j.1540-6261.1984.tb03646.x","title":"The Capital Structure Puzzle","abstract":"Stewart C. Myers President of American Finance Association 1983 This paper's title is intended to remind you of Fischer Black's well-known note on “The Dividend Puzzle,” which he closed by saying, “What should the corporation do about dividend policy? We don't know.” 6 I will start by asking, “How do firms choose their capital structures?” Again, the answer is, “We don't know.” The capital structure puzzle is tougher than the dividend one. We know quite a bit about dividend policy. John Lintner's model of how firms set dividends 20 dates back to 1956, and it still seems to work. We know stock prices respond to unanticipated dividend changes, so it is clear that dividends have information content—this observation dates back at least to Miller and Modigliani (MM) in 1961 28. We do not know whether high dividend yield increases the expected rate of return demanded by investors, as adding taxes to the MM proof of dividend irrelevance suggests, but financial economists are at least hammering away at this issue. By contrast, we know very little about capital structure. We do not know how firms choose the debt, equity or hybrid securities they issue. We have only recently discovered that capital structure changes convey information to investors. There has been little if any research testing whether the relationship between financial leverage and investors' required return is as the pure MM theory predicts. In general, we have inadequate understanding of corporate financing behavior, and of how that behavior affects security returns. I do not want to sound too pessimistic or discouraged. We have accumulated many helpful insights into capital structure choice, starting with the most important one, MM's No Magic in Leverage Theorem (Proposition I) 31. We have thought long and hard about what these insights imply for optimal capital structure. Many of us have translated these theories, or stories, of optimal capital structure into more or less definite advice to managers. But our theories don't seem to explain actual financing behavior, and it seems presumptuous to advise firms on optimal capital structure when we are so far from explaining actual decisions. I have done more than my share of writing on optimal capital structure, so I take this opportunity to make amends, and to try to push research in some new directions. A static tradeoff framework, in which the firm is viewed as setting a target debt-to-value ratio and gradually moving towards it, in much the same way that a firm adjusts dividends to move towards a target payout ratio. An old-fashioned pecking order framework, in which the firm prefers internal to external financing, and debt to equity if it issues securities. In the pure pecking order theory, the firm has no well-defined target debt-to-value ratio. Recent theoretical work has breathed new life into the pecking order framework. I will argue that this theory performs at least as well as the static tradeoff theory in explaining what we know about actual financing choices and their average impacts on stock prices. I have arbitrarily, and probably unfairly, excluded “managerial” theories which might explain firms' capital structure choices.1 I have chosen not to consider models which cut the umbilical cord that ties managers' acts to stockholders' interests. I am also sidestepping Miller's idea of “neutral mutation.”2 He suggests that firms fall into some financing patterns or habits which have no material effect on firm value. The habits may make managers feel better, and since they do no harm, no one cares to stop or change them. Thus someone who identifies these habits and uses them to predict financing behavior would not be explaining anything important. The neutral mutations idea is important as a warning. Given time and imagination, economists can usually invent some model that assigns apparent economic rationality to any random event. But taking neutral mutation as a strict null hypothesis makes the game of research too tough to play. If an economist identifies costs of various financing strategies, obtains independent evidence that the costs are really there, and then builds a model based on these costs which explains firms' financing behavior, then some progress has been made, even if it proves difficult to demonstrate that, say, a type A financing strategy gives higher firm value than a type B. (In fact, we would never see type B if all firms follow value-maximizing strategies.) There is another reason for not immediately embracing neutral mutations: we know investors are interested in the firm's financing choices, because stock prices change when the choices are announced. The change might be explained as an “information effect” having nothing to do with financing per se—but again, it is a bit too easy to wait until the results of an event study are in, and then to think of an information story to explain them. On the other hand, if one starts by assuming that managers have special information, builds a model of how that information changes financing choices, and predicts which choices will be interpreted by investors as good or bad news, then some progress has been made. So this paper is designed as a one-on-one competition of the static tradeoff and pecking-order stories. If neither story explains actual behavior, the neutral mutations story will be there faithfully waiting. A firm's optimal debt ratio is usually viewed as determined by a tradeoff of the costs and benefits of borrowing, holding the firm's assets and investment plans constant. The firm is portrayed as balancing the value of interest tax shields against various costs of bankruptcy or financial embarassment. Of course, there is controversy about how valuable the tax shields are, and which, if any, of the costs of financial embarassment are material, but these disagreements give only variations on a theme. The firm is supposed to substitute debt for equity, or equity for debt, until the value of the firm is maximized. Thus the debt-equity tradeoff is as illustrated in Fig. 1. Costs of adjustment. If there were no costs of adjustment, and the static tradeoff theory is correct, then each firm's observed debt-to-value ratio should be its optimal ratio. However, there must be costs, and therefore lags, in adjusting to the optimum. Firms can not immediately offset the random events that bump them away from the optimum, so there should be some cross-sectional dispersion of actual debt ratios across a sample of firms having the same target ratio. The static-tradeoff theory of capital structure. Large adjustment costs could possibly explain the observed wide variation in actual debt ratios, since firms would be forced into long excursions away from their optimal ratios. But there is nothing in the usual static tradeoff stories suggesting that adjustment costs are a first-order concern—in fact, they are rarely mentioned. Invoking them without modelling them is a cop-out. Any cross-sectional test of financing behavior should specify whether firms' debt ratios differ because they have different optimal ratios or because their actual ratios diverge from optimal ones. It is easy to get the two cases mixed up. For example, think of the early cross-sectional studies which attempted to test MM's Proposition I. These studies tried to find out whether differences in leverage affected the market value of the firm (or the market capitalization rate for its operating income). With hindsight, we can quickly see the problem: if adjustment costs are small, and each firm in the sample is at, or close to its optimum, then the in-sample dispersion of debt ratios must reflect differences in risk or in other variables affecting optimal capital structure. But then MM's Proposition I cannot be tested unless the effects of risk and other variables on firm value can be adjusted for. By now we have learned from experience how hard it is to hold “other things constant” in cross-sectional regressions. Of course, one way to make sense of these tests is to assume that adjustment costs are small, but managers don't know, or don't care, what the optimal debt ratio is, and thus do not stay close to it. The researcher then assumes some (usually unspecified) “managerial” theory of capital structure choice. This may be a convenient assumption for a cross-sectional test of MM's Proposition I, but not very helpful if the object is to understand financing behavior.3 But suppose we don't take this “managerial” fork. Then if adjustment costs are small, and firms stay near their target debt ratios, I find it hard to understand the observed diversity of capital structures across firms that seem similar in a static tradeoff framework. If adjustment costs are large, so that some firms take extended excursions away from their targets, then we ought to give less attention to refining our static tradeoff stories and relatively more to understanding what the adjustment costs are, why they are so important, and how rational managers would respond to them. But I am getting ahead of my story. On to debt and taxes. Debt and taxes. Miller's famous “Debt and Taxes” paper 27 cut us loose from the extreme implications of the original MM theory, which made interest tax shields so valuable that we could not explain why all firms were not awash in debt. Miller described an equilibrium of aggregate supply and demand for corporate debt, in which personal income taxes paid by the marginal investor in corporate debt just offset the corporate tax saving. However, since the equilibrium only determines aggregates, debt policy should not matter for any single taxpaying firm. Thus Miller's model allows us to explain the dispersion of actual debt policies without having to introduce non-value-maximizing managers.4 Trouble is, this explanation works only if we assume that all firms face approximately the same marginal tax rate, and that is an assumption we can immediately reject. The extensive trading of depreciation tax shields and investment tax credits, through financial leases and other devices, proves that plenty of firms face low marginal rates.5 Given significant differences in effective marginal tax rates, and given that the static tradeoff theory works, we would expect to find a strong tax effect in any cross-sectional test, regardless of whose theory of debt and taxes you believe. Figure 2 plots the net tax gain from corporate borrowing against the expected realizable tax shield from a future deduction of one dollar of interest paid. For some firms this number is 46 cents, or close to it. At the other extreme, there are firms with large unused loss carryforwards which pay no immediate taxes. An extra dollar of interest paid by these firms would create only a potential future deduction, usable when and if the firm earns enough to work off prior carryforwards. The expected realizable tax shield is positive but small. Also, there are firms paying taxes today which cannot be sure they will do so in the future. Such a firm values expected future interest tax shields at somewhere between zero and the full statutory rate. In the “corrected” MM theory 28 any tax-paying corporation gains by borrowing; the greater the marginal tax rate, the greater the gain. This gives the top line in the figure. In Miller's theory, the personal income taxes on interest payments would exactly offset the corporate interest tax shield, provided that the firm pays the full statutory tax rate. However, any firm paying a lower rate would see a net loss to corporate borrowing and a net gain to lending. This gives the bottom line. There are also compromise theories, advanced by D'Angelo and Masulis 12, Modigliani 30 and others, indicated by the middle dashed line in the figure. The compromise theories are appealing because they seem less extreme than either the MM or Miller theories. But regardless of which theory holds, the slope of the line is always positive. The difference between (1) the tax advantage of borrowing to firms facing the full statutory rate, and (2) the tax advantage of lending (or at least not borrowing) to firms with large tax loss carryforwards, is exactly the same as in the “extreme” theories. Thus, although the theories tell different stories about aggregate supply and demand of corporate debt, they make essentially the same predictions about which firms borrow more or less than average. The net tax gain to corporate borrowing. So the tax side of the static tradeoff theory predicts that IBM should borrow more than Bethlehem Steel, other things equal, and that General Motors' debt-to-value ratio should be more than Chrysler's. Costs of financial distress. Costs of financial distress include the legal and administrative costs of bankruptcy, as well as the subtler agency, moral hazard, monitoring and contracting costs which can erode firm value even if formal default is avoided. We know these costs exist, although we may debate their magnitude. For example, there is no satisfactory explanation of debt covenants unless agency costs and moral hazard problems are recognized. The literature on costs of financial distress supports two qualitative statements about financing behavior.6 Risky firms ought to borrow less, other things equal. Here “risk” would be defined as the variance rate of the market value of the firm's assets. The higher the variance rate, the greater the probability of default on any given package of debt claims. Since costs of financial distress are caused by threatened or actual default, safe firms ought to be able to borrow more before expected costs of financial distress offset the tax advantages of borrowing. Firms holding tangible assets-in-place having active second-hand markets will borrow less than firms holding specialized, intangible assets or valuable growth opportunities. The expected cost of financial distress depends not just on the probability of trouble, but the value lost if trouble comes. Specialized, intangible assets or growth opportunities are more likely to lose value in financial distress. Firms prefer internal finance. They adapt their target dividend payout ratios to their investment opportunities, although dividends are sticky and target payout ratios are only gradually adjusted to shifts in the extent of valuable investment opportunities. Sticky dividend policies, plus unpredictable fluctuations in profitability and investment opportunities, mean that internally-generated cash flow may be more or less than investment outlays. If it is less, the firm first draws down its cash balance or marketable securities portfolio.7 If external finance is required, firms issue the safest security first. That is, they start with debt, then possibly hybrid securities such as convertible bonds, then perhaps equity as a last resort. In this story, there is no well-defined target debt-equity mix, because there are two kinds of equity, internal and external, one at the top of the pecking order and one at the bottom. Each firm's observed debt ratio reflects its cumulative requirements for external finance. The pecking order literature. The pecking order hypothesis is hardly new.8 For example, it comes through loud and clear in Donaldson's 1961 study of the financing practices of a sample of large corporations. He observed 13 that “Management strongly favored internal generation as a source of new funds even to the exclusion of external funds except for occasional unavoidable ‘bulges’ in the need for funds.” These bulges were not generally met by cutting dividends: Reducing the “customary cash dividend payment… was unthinkable to most managements except as a defensive measure in a period of extreme financial distress” (p. 70). Given that external finance was needed, managers rarely thought of issuing stock: Though few companies would go so far as to rule out a sale of common under any circumstances, the large majority had not had such a sale in the past 20 years and did not anticipate one in the foreseeable future. This was particularly remarkable in view of the very high Price-Earnings ratios of recent years. Several financial officers showed that they were well aware that this had been a good time to sell common, but the reluctance still persisted. (pp. 57–58). Of course, the pecking order hypothesis can be quickly rejected if we require it to explain everything. There are plenty of examples of firms issuing stock when they could issue investment-grade debt. But when one looks at aggregates, the heavy reliance on internal finance and debt is clear. For all non-financial corporations over the decade 1973–1982, internally generated cash covered, on average, 62 percent of capital expenditures, including investment in inventory and other current assets. The bulk of required external financing came from borrowing. Net new stock issues were never more than 6 percent of external financing.9 Anyone innocent of modern finance who looked at these statistics would find the pecking order idea entirely plausible, at least as a description of typical behavior. Writers on “managerial capitalism” have interpreted firms' reliance on internal finance as a byproduct of the separation of ownership and control: professional managers avoid relying on external finance because it would subject them to the discipline of the capital market.10 Donaldson's 1969 book was not primarily about managerial capitalism, but he nevertheless observed that the financing decisions of the firms he studied were not directed towards    and that   to explain  decisions would have to start by  the “managerial  of corporate finance.  This  is  given the  of finance theory in the   it is not so  that financing by a pecking order  against  interests.  financing with   I  to  the pecking order story because I could think of no theoretical  for it that would  in with the theory of modern finance. An  could be made for internal financing to avoid issue costs, and if external finance is needed, for debt to avoid the still higher costs of  But issue costs in  do not seem large enough to  the costs and benefits of leverage  in the static tradeoff story. However, recent work based on  information gives predictions  in line with the pecking order  The    is based on a   paper by  and    although I will   down that paper's  to    the firm has to    in order to  some  valuable investment    be this  net  value  and  be what the firm will be  if the opportunity is   The firm's   what  and  are, but investors in capital markets do  they see only a   of  values        The information  is  as   from the information  capital markets are  and    MM's Proposition I  in the sense that the stock of debt  to  assets is  if information  to investors is  constant. The  to    by a security issue is  the  of the firm's investment  There is also a   the firm may have to sell the securities for less than they are really   the firm issues stock with an aggregate market  when  of   will consider debt issues in a  However, the   the  are really     That is,   is what the new  will be  other things equal, when investors  the  special   and I     managers might  in this  The one we think makes the most sense is  the  or  value of the firm's   That is, the   about the value of the    in the firm.  investors know the  will do  In  the  investors who  any stock issue will assume that the  is not on their  and will   the  they are  to  If the   information is   is  and the firm will always  even if the only good  for the funds  is to  them in the    If the  information is   the firm may   a  investment opportunity  than issue   Thus, given   and  and given that stock is  the greater the  per  the less value is given  to new  and the less   The cost of relying on external  We usually think of the cost of external finance as administrative and  costs, and in some cases  of the new securities.  information  the  of a different  of  the  that the firm will choose not to  and will therefore   a   This cost is  if the firm can  enough internally-generated cash to  its  opportunities. The advantages of debt over equity  If the firm   external  it is  off issuing debt than equity securities. The  rule is,  safe securities before   This   is  explaining   that the firm issues and  if  the  of its investment  is greater than or  to  the  by which the new  are   if      or   if       For example, suppose the investment       but in order to  that  the firm must issue  that are really    It will go ahead only if   is at least   If it is  only   the firm  to  the  for  the   value of the firm is  by   but the   are     The  could have  this  by   the firm's cash  that is  The only  he can do now is to  the security issue to   For example, if  could be cut to   the investment  could be  without  the  value of   The way to   is to issue the safest    securities whose future value changes least when the   information is  to the  Of course,  is  so it is loose  to  of the   it. However, there are  cases in which the  value of  is always less for debt than for  For example, if the firm can issue   debt,  is  and the firm never   a valuable investment  Thus, the  to issue   debt is as good as cash in the   if default risk is  the  value of  will be less for debt than for equity if we make the   of    Thus, if the  has  information        it is  to issue debt than  This  assumes that new  or  debt would be   if the managers'  information is  so that any  security issue would be  In this   the firm want to make  as large as  to take  advantage of new  If  stock would seem  than debt     The  rule seems to   debt when investors  the  and equity, or some other   when they   The trouble with this strategy is   you   in investors'  If you know the firm will issue equity only when it is  and debt  you will  to  equity unless the firm has   its   is, unless the firm has  so much debt  that it would face   costs in issuing  Thus investors would   the firm to follow a pecking   this is  too  The model just  would need  of  out before it could   actual behavior. I have  it just to  how models based on  information can predict the two   of the pecking order   the  for internal    the  for debt over equity if external financing is  I will now  what we know about financing behavior and try to make sense of this  in  of the two    I  with   about financing behavior, and then  a few  from   evidence or personal  Of  even  based on  good statistics have been  to  away under   so  with    external   investment  are   by debt issues and internally-generated   stock issues  a relatively    as  has  this is what many managers  they are  to  This  is what  the pecking order hypothesis in the first  However, it might also be explained in a static tradeoff theory by adding significant  costs of equity issues and  the  tax  of capital gains  to  This would make external equity relatively  It would explain why companies  target dividend  low enough to avoid having to make  stock  It would also explain why a firm whose debt ratio   target  not immediately issue   back debt, and  a more  debt-to-value ratio. Thus firms might take extended excursions  their debt    that the static tradeoff hypothesis as usually  rarely  this  of adjustment  But the  costs of   seems  small. It is thus hard to explain extended excursions  a firm's debt target by an  static tradeoff  firm could quickly issue debt and  back   if personal income taxes are important in explaining firms' apparent  for internal equity, then  difficult to explain why external equity is not strongly  is, why most firms  gradually  to  lower target payout ratios and  the  cash to    of security  Firms  try to  stock issues when security prices are  Given that they  external  they are more likely to issue stock  than   stock prices have  than  they have  For example, past stock   were one of the  variables in  study  of  firms' choices between new debt and new equity    and  have  similar behavior in the   This  is  to static tradeoff  If firm value  the debt-to-value ratio  and firms ought to issue debt, not equity, to  their capital  The  is   to the pecking order  There is no reason to  that the   information is  more  when stock prices are   if there were such a  investors would have learned it by  and would  the firm's issue   There is no way firms can  take advantage of  of new equity in a rational    against  and growth opportunities. Firms holding valuable intangible assets or growth opportunities  to borrow less than firms holding  tangible assets. For example,  and    a significant  relationship between  of investment in  and research and     and the  of borrowing. They also  a significant positive relationship between the rate of capital     and  and the  of borrowing.    the same  by a different    for a firm's  and growth opportunities was the difference between the market value of its debt and equity securities and the  cost of its tangible assets. The higher this  he  the less the firm's debt-to-value ratio. There is plenty of  evidence  that the  of borrowing is determined not just by the value and risk of the firm's  but also by the type of assets it  For example, without this  the static tradeoff theory would specify all target debt ratios in  of  not book  Since many firms have market values far in  of book values  if  book values are  in current  we ought to see at least a few such firms operating  at very high book debt  of  we do  This   to make   as  as we  that book values reflect assets-in-place  assets and    values reflect  and growth opportunities as well as  Thus, firms do not set target book debt ratios because   the    values are  for the values of assets in    Masulis   has  that stock prices  on average, when a firm","journal":"The Journal of Finance","year":1984,"id":6531,"datarank":26.04615362057833,"base_score":8.93260863037757,"endowment":8.93260863037757,"self_citation_contribution":1.3398912945566357,"citation_network_contribution":24.706262326021694,"self_endowment_contribution":1.3398912945566357,"citer_contribution":24.706262326021694,"corpus_percentile":95.6,"corpus_rank":2547,"citation_count":7574,"citer_count":198,"citers_with_citation_signal":198,"citers_with_endowment":198,"datacite_reuse_total":0,"is_dataset":false,"is_oa":true,"file_count":0,"downloads":0,"has_version_chain":false,"published_date":"1984-07-01","authors":[{"id":5726,"name":"Stewart C. 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