Finance Articles

American Finance Association

The Theory of Capital Structure

Author(s): Milton Harris and Artur Raviv

Source: The Journal of Finance, Vol. 46, No. 1 (Mar., 1991), pp. 297-355

Published by: Wiley for the American Finance Association

Stable URL: http://www.jstor.org/stable/2328697

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THE JOURNAL OF FINANCE * VOL. XLVI, NO. 1 * MARCH 1991

The Theory of Capital Structure

MILTON HARRIS and ARTUR RAVIV*

ABSTRACT

This paper surveys capital structure theories based on agency costs, asymmetric

information, product/input market interactions, and corporate control considera-

tions (but excluding tax-based theories). For each type of model, a brief overview of

the papers surveyed and their relation to each other is provided. The central papers

are described in some detail, and their results are summarized and followed by a

discussion of related extensions. Each section concludes with a summary of the main implications of the models surveyed in the section. Finally, these results are

collected and compared to the available evidence. Suggestions for future research are provided.

THE MODERN THEORY OF capital structure began with the celebrated paper of Modigliani and Miller (1958). They (MM) pointed the direction that such theories must take by showing under what conditions capital structure is irrelevant. Since then, many economists have followed the path they mapped. Now, some 30 years later it seems appropriate to take stock of where this research stands and where it is going. Our goal in this survey is to synthesize

the recent literature, summarize its results, relate these to the known empirical evidence, and suggest promising avenues for future research.1

As stated, however, this goal is too ambitious to result in a careful understanding of the state of capital structure research. Consequently, we have chosen to narrow the scope of our inquiry. First, we focus on the theory of capital structure. Although we discuss the empirical literature as it relates to the predictions of theory, we make no attempt to give a comprehensive survey of this literature. We simply take the empirical results at face value and do not review or criticize the methods used in these papers. Second, we

*Harris is Chicago Board of Trade Professor of Finance and Business Economics, Graduate School of Business, University of Chicago. Raviv is Alan E. Peterson Distinguished Professor of

Finance, Kellogg Graduate School of Management, Northwestern University. We gratefully

acknowledge the financial support of the Bradley Foundation. Professor Harris wishes to

acknowledge partial financial support from Dimensional Fund Advisors. We also thank seminar

participants at the University of Chicago, UCLA, and Tel Aviv University and Michael Fish- man, Robert Hansen, Ronen Israel, Steven Kaplan, Robert McDonald, Andrei Shleifer, Ren6

Stulz (the editor), Robert Vishny, an anonymous referee, and especially Vincent Warther whose tireless research assistance was invaluable.

1Some other recent surveys include Taggart (1985), Masulis (1988), Miller (1988), Ravid (1988), and Allen (1990) and comments on Miller (1988) by Bhattacharya (1988), Modigliani

(1988), Ross (1988), and Stiglitz (1988). Taggart (1985) and Masulis (1988) are general surveys.

Allen (1990) focuses on security design, and Ravid (1988) concentrates on interactions between

capital structure and the product market.

297

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298 The Journal of Finance

arbitrarily exclude theories based primarily on tax considerations. While such theories are undoubtedly of great empirical importance, we believe that they have been adequately surveyed.2 Moreover, tax-based research is not our comparative advantage. Third, we systematically exclude certain topics that, while related to capital structure theory, do not have this theory as their central focus. These include literature dealing with the call or conver- sion of securities, dividend theories, bond covenants and maturity, bankruptcy law, pricing and method of issuance of new securities, and preferred stock. In short, we concentrate on nontax-driven capital structure theories.

Although the above considerations exclude many papers, a fairly large literature remains. To highlight the current state of the art, we consider mainly papers written since 1980. The only exception to this statement is the inclusion of papers written in the mid-to-late 1970's that serve as the foundation for the more recent literature. A diligent search of both published and unpublished research meeting the above criteria for inclusion resulted in over 150 papers. Obviously, we could not survey all these papers here in detail. Consequently, we were forced to pick and choose those papers that, in our opinion, are the most important or the most representative of a given stream of research. Naturally, this selection process is biased by our own tastes and interests. Thus, we tend to emphasize papers based on the eco- nomics of information, incentives, and contracting. We apologize to those authors whose papers were omitted or were not given the attention the authors believe them to deserve.

In organizing the survey, several options were available. One approach which has proved fruitful in other areas is to construct or identify a very general model and then examine how existing models specialize this frame- work. This approach has the advantage of showing clearly the interrelation- ships among models. In the case of capital structure, however, the set of features one must include in such a general model is so large and complicated that the resulting structure would not yield clear insights. A related ap- proach is to ask what issues might be resolved by theories of capital struc- ture. This "wish list" would include questions such as what the effect is on capital structure of changes in the volatility of cash flows, firm size, elasticity of demand for the product, the extent of insider private information, etc. The survey would then proceed to document the answers available in the litera- ture. The problem with organizing the survey in this way is that often a single model addresses several issues. Such a model would then require discussion in several places. Moreover, a closely related model focusing on a different issue would be presented separately, making a comparison of the two models difficult to exposit. Because of these difficulties, we have chosen instead to organize our survey based on the forces that determine capital structure.

Grouping models based on the force driving capital structure allows discus- sion of the model to be consolidated in one place and facilitates an examina-

2 In addition to those surveys mentioned in footnote 1, see Bradley, et al. (1984).

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The Theory of Capital Structure 299

tion of the relationships among similar models. We have identified four categories of determinants of capital structure. These are the desire to

. ameliorate conflicts of interest among various groups with claims to the firm's resources, including managers (the agency approach),

. convey private information to capital markets or mitigate adverse selec- tion effects (the asymmetric information approach),

. influence the nature of products or competition in the product/input market, or

. affect the outcome of corporate control contests.

Each of these four categories is discussed in a separate section. Many of the

papers we survey fit well in more than one category. We include these in the category corresponding to the most important driving force of the model.

In each topic, we first give a brief overview of the papers surveyed and their relation to each other. We then describe in some detail the central

papers and their results. This is generally followed by a discussion of related extensions. Note that we do not exposit all the subtleties of even the models on which we focus the most attention. Instead we try to present the main idea in its most stripped-down form. Each section concludes with a summary

of the main implications of the models surveyed in the section. Finally, we collect these results and compare them to the available evidence. Since each section is self-contained, readers not interested in the entire survey can pick and choose sections. Moreover, the summary subsection in each of Sections I through IV can also be read independently. Readers interested only in the overall summary and conclusions should read Sections V and VI.

In this survey, we consider only papers that deal with the determination of the relative amounts of debt and equity, taking these securities as exoge- nous. There is, however, an incipient literature that considers the more fundamental question of why corporate securities are designed the way they are. Many of these papers attempt to explain the allocation of both cash flows and control rights across securities. We review security design models in a separate paper (Harris and Raviv (199Gb)).

Briefly, our conclusions are as follows. First, the models surveyed have identified a large number of potential determinants of capital structure. The empirical work so far has not, however, sorted out which of these are important in various contexts. Second, the theory has identified a relatively small number of "general principles." Several properties of the debt contract have important implications for determining capital structure. These are the bankruptcy provision, convexity of payoffs of levered equity, the effect of debt on managerial equity ownership, and the relative insensitivity of debt pay- offs to firm performance. Third, the empirical evidence is largely consistent with the theory, although there are a few instances where the evidence seems to contradict certain models. These inconsistencies cannot, however, be re- garded as conclusive, because the empirical studies were not designed specifi- cally to test the models and were, therefore, not careful about satisfying the ceteris paribus conditions. With regard to further theoretical work, it appears

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300 The Journal of Finance

that models relating to products and inputs are underexplored, while the asymmetric information approach has reached the point of diminishing re- turns. Finally, with regard to further empirical work, it seems essential that empirical studies concentrate on testing particular models or classes of models in an attempt to discover the most important determinants of capital structure in given environments.

The plan of the paper is as follows. In Section I, we discuss models based on agency costs. Models using asymmetric information are considered in Section II. Interactions of capital structure with behavior in the product or input market or with characteristics of products or inputs are taken up in Section III. Section IV surveys models based on corporate control considerations. In Section V, we summarize the theoretical results and compare them with the evidence. Finally, our conclusions are presented in Section VI.

I. Models Based on Agency Costs

A significant fraction of the effort of researchers over the last 10 years has been devoted to models in which capital structure is determined by agency costs, i.e., costs due to conflicts of interest. Research in this area was initiated by Jensen and Meckling (1976) building on earlier work of Fama and Miller (1972).

Jensen and Meckling identify two types of conflicts. Conflicts between shareholders and managers arise because managers hold less than 100% of the residual claim. Consequently, they do not capture the entire gain from their profit enhancement activities, but they do bear the entire cost of these activities. For example, managers can invest less effort in managing firm resources and may be able to transfer firm resources to their own, personal benefit, e.g., by consuming "perquisites" such as corporate jets, plush offices, building "empires," etc. The manager bears the entire cost of refraining from these activities but captures only a fraction of the gain. As a result managers overindulge in these pursuits relative to the level that would maximize firm value. This inefficiency is reduced the larger is the fraction of the firm's equity owned by the manager. Holding constant the manager's absolute investment in the firm, increases in the fraction of the firm financed by debt increase the manager's share of the equity and mitigate the loss from the conflict between the manager and shareholders. Moreover, as pointed out by Jensen (1986), since debt commits the firm to pay out cash, it reduces the amount of "free" cash available to managers to engage in the type of pursuits mentioned above. This mitigation of the conflicts between managers and equityholders constitutes the benefit of debt financing.3

3 Another benefit of debt financing is pointed out by Grossman and Hart (1982). If bankruptcy is costly for managers, perhaps because they lose benefits of control or reputation, then debt can create an incentive for managers to work harder, consume fewer perquisites, make better investment decisions, etc., because this behavior reduces the probability of bankruptcy.

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The Theory of Capital Structure 301

Conflicts between debtholders and equityholders arise because the debt contract gives equityholders an incentive to invest suboptimally.4 More specifically the debt contract provides that if an investment yields large returns, well above the face value of the debt, equityholders capture most of the gain. If, however, the investment fails, because of limited liability, debtholders bear the consequences. As a result, equityholders may benefit from "going for broke," i.e., investing in very risky projects, even if they are value-decreasing. Such investments result in a decrease in the value of the debt. The loss in value of the equity from the poor investment can be more than offset by the gain in equity value captured at the expense of debthold- ers. Equityholders bear this cost to debtholders, however, when the debt is issued if the debtholders correctly anticipate equityholders' future behavior. In this case, the equityholders receive less for the debt than they otherwise

would. Thus, the cost of the incentive to invest in value-decreasing projects created by debt is borne by the equityholders who issue the debt. This effect, generally called the "asset substitution effect," is an agency cost of debt financing.5

Jensen and Meckling argue that an optimal capital structure can be obtained by trading off the agency cost of debt against the benefit of debt as previously described.6 A number of implications follow. First, one would expect bond contracts to include features that attempt to prevent asset substitution, such as interest coverage requirements, prohibitions against investments in new, unrelated lines of business, etc. Second, industries in which the opportunities for asset substitution are more limited will have higher debt levels, ceteris paribus. Thus, for example, the theory predicts that regulated public utilities, banks, and firms in mature industries with few growth opportunities will be more highly levered. Third, firms for which slow or even negative growth is optimal and that have large cash inflows from operations should have more debt. Large cash inflows without good investment prospects create the resources to consume perquisites, build empires, overpay subordinates, etc. Increasing debt reduces the amount of "free cash" and increases the manager's fractional ownership of the residual

4Obviously, conflicts between security holders do not arise if each investor holds all securities in proportion to their values, i.e., if each investor holds a "strip." Consequently, this literature assumes that equityholders are disjoint classes of investors.

5 Myers (1977) points out another agency cost of debt. He observes that when firms are likely to go bankrupt in the near future, equityholders may have no incentive to contribute new capital even to invest in value-increasing projects. The reason is that equityholders bear the entire cost of the investment, but the returns from the investment may be captured mainly by the debtholders. Thus larger debt levels result in the rejection of more value-increasing projects. This agency cost of debt yields conclusions about capital structure similar to those of Jensen and Meckling.

6 Several authors have pointed out that agency problems can be reduced or eliminated through the use of managerial incentive schemes and/or more complicated financial securities such as convertible debt. See Barnea et al. (1985), Brander and Poitevin (1989), and Dybvig and Zender (1989). For a counter view, see Narayanan (1987) and the reply by Haugen and Senbet (1987).

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302 The Journal of Finance

claim. According to Jensen (1989) industries with these characteristics today include steel, chemicals, brewing, tobacco, television and radio broadcasting, and wood and paper products. The theory predicts that these industries should be characterized by high leverage.

All the theories based on agency problems surveyed in the remainder of this section use one of the conflicts introduced by Jensen and Meckling as a starting point. Consequently, we classify these papers into two subsections corresponding to the conflict between equityholders and managers and the conflict between equityholders and debtholders.

A. Conflicts between Equityholders and Managers

The two papers surveyed in this subsection share a common concern with manager-shareholder conflicts but differ according to the specific way in which this conflict arises. More importantly, they also differ in how debt alleviates the problem and in the disadvantages of debt.

In Harris and Raviv (1990a) and Stulz (1990), managers and investors disagree over an operating decision. In particular, in Harris and Raviv managers are assumed to want always to continue the firm's current opera- tions even if liquidation of the firm is preferred by investors. In Stulz, managers are assumed to want always to invest all available funds even if paying out cash is better for investors. In both cases, it is assumed that the conflict cannot be resolved through contracts based on cash flow and invest- ment expenditure. Debt mitigates the problem in the Harris and Raviv model by giving investors (debtholders) the option to force liquidation if cash flows are poor. In Stulz, as in Jensen (1986), debt payments reduce free cash flow. Capital structure is determined by trading off these benefits of debt against costs of debt. In Harris and Raviv, the assertion of control by investors through bankruptcy entails costs related to the production of information, used in the liquidation decision, about the firm's prospects. The cost of debt in Stulz's model is that debt payments may more than exhaust "free" cash, reducing the funds available for profitable investment. This comparison of Harris-Raviv and Stulz is summarized in Table I where the relationship of these two models to Jensen and Meckling (1976) and Jensen (1986) is also shown.7

The optimal capital structure in Harris and Raviv trades off improved liquidation decisions versus higher investigation costs. A larger debt level improves the liquidation decision because it makes default more likely. In the absence of default, incumbent management is assumed not to liquidate the firm even if the assets are worth more in their next best alternative use.

7 Another approach that involves manager-investor conflicts is taken by Williamson (1988). In his view, the benefits of debt are the incentives provided to managers by the rules under which debtholders can take over the firm and liquidate the assets. The costs of debt are that the inflexibility of the rules can result in liquidation of the assets when they are more valuable in the firm. Thus, Williamson concludes that assets that are more redeployable should be financed with debt.

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The Theory of Capital Structure 303

Table I

Comparison of Agency Models Based on Manager-Shareholder Conflicts

Benefit of Cost of Model Conflict Debt Debt

Jensen and Managerial Increase managerial Asset substitution Meckling (1976) perquisites ownership

Jensen (1986) Overinvestment Reduce free cash Unspecified Harris and Raviv Failure to liquidate Allows investors option Investigation costs (1990a) to liquidate

Stulz (1991) Overinvestment Reduce free cash Underinvestment

Following a default, however, investors control the liquidation decision, and they expend resources to obtain additional information pertinent to this decision. Since investors choose an optimal liquidation decision based on their information, default improves this decision. More frequent default, however, is more costly as resources are expended investigating the firm when it is in default.

The Harris and Raviv model predicts that firms with higher liquidation value, e.g., those with tangible assets, and/or firms with lower investigation costs will have more debt and will be more likely to default but will have higher market value than similar firms with lower liquidation value and/or higher investigation costs. The intuition for the higher debt level is that increases in liquidation value make it more likely that liquidation is the best strategy. Therefore, information is more useful and a higher debt level is called for. Similarly, decreases in investigation costs also increase the value of default resulting in more debt. The increase in debt results in higher default probability. Harris and Raviv also obtain results on whether a firm in bankruptcy is reorganized or liquidated. They show that the probability of being reorganized decreases with liquidation value and is independent of investigation costs. Using a constant-returns-to-scale assumption they show that the debt level relative to expected firm income, default probability, bond yield, and the probability of reorganization are independent of firm size. Combining these results, Harris and Raviv argue that higher leverage can be expected to be associated with larger firm value, higher debt level relative to expected income, and lower probability of reorganization following default.

The optimal capital structure in Stulz is determined by trading off the benefit of debt in preventing investment in value decreasing projects against the cost of debt in preventing investment in value increasing projects. Thus, as in Jensen (1986), firms with an abundance of good investment opportuni- ties can be expected to have low debt levels relative to firms in mature, slow-growth, cash-rich industries. Moreover, Stulz argues that, in general, managers will be reluctant to implement the optimal debt levels but are more likely to do so the greater is the threat of takeover. Thus, firms more likely to be takeover targets can be expected to have more debt, ceteris

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