Finance Articles

304 The Journal of Finance

paribus, while firms with anti-takeover measures will have less debt. Fi- nally, firms whose value-increasing investment opportunities create more

value than the value-decreasing ones destroy will have less debt than firms in the opposite situation. The reason is that such firms are primarily con- cerned with not losing the value-creating opportunities.8

B. Conflicts between Equityholders and Debtholders

This subsection surveys two papers in which reputation moderates the asset substitution problem, i.e., the incentive of levered equityholders to choose risky, negative net-present-value investments.9 Diamond (1989) and Hirshleifer and Thakor (1989) show how managers or firms have an incen- tive to pursue relatively safe projects out of reputational considerations.10

Diamond's model is concerned with a firm's reputation for choosing pro- jects that assure debt repayment. There are two possible investment projects: a safe, positive NPV project and a risky, negative NPV project. The risky project can have one of two payoffs ("success" or "failure"). Both projects require the same initial investment which must be financed by debt. A firm can be of three, initially observationally equivalent types. One type has access only to the safe project, one type has access only to the risky project, and one type has access to both. Since investors cannot distinguish the firms ex ante, the initial lending rate reflects their beliefs about the projects chosen by firms on average. Returns from the safe project suffice to pay the debthold- ers (even if the firm is believed by investors to have only the risky project), but returns from the risky project allow repayment only if the project is successful.

Because of the asset substitution problem, if the firm has a choice of projects, myopic maximization of equity value (e.g., in a one-period situation) would lead the firm to choose the risky project. If the firm can convince lenders it has only the safe project, however, it will enjoy a lower lending rate. Since lenders can observe only a firm's default history, it is possible for a firm to build a reputation for having only the safe project by not defaulting.

8A similar approach is taken by Hart and Moore (1990) with similar results. In particular, Hart and Moore (1990) also focus on the agency problems of overinvestment by managers. There

are two major differences between the approach of Hart and Moore (1990) and that of Stulz (1990). First, Hart and Moore derive debt as an optimal security in this setting (see Harris and

Raviv (1990b)). Second, debt does not prevent overinvestment in the Hart and Moore approach

by reducing available free cash flows. Instead, the existence of senior debt constrains the amount of external funds that can be raised since the outstanding debt represents a prior claim on all assets, including new investments. For further discussion of the effects of seniority rules on the

under-and overinvestment incentives, see Berkovitch and Kim (1990). 9Another literature considers factors that alleviate the underinvestment cost of debt pointed

out by Myers (1977) (see footnote 5). Stulz and Johnson (1985) focus on collateral, John and Nachman (1985) focus on reputation, and Bergman and Callen (Forthcoming) consider renegotia-

tion with debtholders. Berkovitch and Kim (1990) and Kim and Maksimovic (Forthcoming) show how debt can be used to trade off the overinvestment and underinvestment effects.

10 Green (1984) offers another method of mitigating this agency cost. He points out that convertible bonds and warrants "reverse the convex shape of levered equity over the upper range of the firm's earnings" (p.115) and therefore reduce the asset substitution problem.

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The Theory of Capital Structure 305

The longer the firm's history of repaying its debt, the better is its reputation, and the lower is its borrowing cost. Therefore, older, more established firms find it optimal to choose the safe project, i.e., not engage in asset substitution to avoid losing a valuable reputation. Young firms with little reputation may choose the risky project. If they survive without a default, they will eventu- ally switch to the safe project. As a result, firms with long track records will have lower default rates and lower costs of debt than firms with brief histories. Although the amount of debt is fixed in Diamond's model, it is plausible that an extension of the model would yield the result that younger firms have less debt than older ones, other things equal.

Managers may also have an incentive to pursue relatively safe projects out

of a concern for their reputations. Hirshleifer and Thakor (1989) consider a manager who has a choice of two projects, each with only two outcomes-success or failure. Failure means the same for both projects, but from the point of view of the shareholders, the high-risk-high-return project

yields both higher expected returns and higher returns if it succeeds. Sup- pose that from the point of view of the manager's reputation, however, success on the two projects is equivalent, i.e., the managerial labor market can only distinguish "success" versus "failure." Thus the manager maxi- mizes probability of success while shareholders prefer expected return. If the safer project has a higher probability of success, the manager will choose it even if the other project is better for the equityholders. This behavior of managers reduces the agency cost of debt. Thus, if managers are susceptible to such a reputation effect, the firm may be expected to have more debt than otherwise. Hirshleifer and Thakor argue that managers of firms more likely to be takeover targets are more susceptible to the reputation effect. Such flrms can be expected to have more debt, ceteris paribus. Conversely, firms that have adopted anti-takeover measures will use less debt, other things equal.

C. Summary of Section I

Agency models have been among the most successful in generating inter- esting implications. In particular, these models predict that leverage is positively associated with firm value (Hirshleifer and Thakor (1989), Harris

and Raviv (1990a), Stulz (1990)), default probability (Harris and Raviv (1990a)), extent of regulation (Jensen and Meckling (1976), Stulz (1990)), free cash flow (Jensen (1986), Stulz (1990)), liquidation value (Williamson (1988), Harris and Raviv (1990a)), extent to which the firm is a takeover target (Hirshleifer and Thakor (1989), Stulz (1990)), and the importance of manage- rial reputation (Hirshleifer and Thakor (1989)). Also, leverage is expected to

be negatively associated with the extent of growth opportunities (Jensen and Meckling (1976), Stulz (1990)), interest coverage, the cost of investigating firm prospects, and the probability of reorganization following default (Harris and Raviv (1990a)). Some other implications include the prediction that bonds will have covenants that attempt to restrict the extent to which

equityholders can pursue risky projects that reduce the value of the debt

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306 The Journal of Finance

(Jensen and Meckling (1976)) and that older firms with longer credit histo- *ries will tend to have lower default rates and costs of debt (Diamond (1989)). Finally, the result that firm value and leverage are positively related follows

from the fact that these two endogenous variables move in the same direction with changes in the exogenous factors (Hirshleifer and Thakor (1989), Harris and Raviv (1990a), Stulz (1990)). Therefore, leverage increasing (decreasing) changes in capital structure caused by a change in one of these exogenous

factors will be accompanied by stock price increases (decreases).

II. Asymmetric Information

The introduction into economics of the explicit modeling of private informa- tion has made possible a number of approaches to explaining capital struc- ture. In these theories, firm managers or insiders are assumed to possess private information about the characteristics of the firm's return stream or investment opportunities. In one set of approaches, choice of the firm's capital structure signals to outside investors the information of insiders. This stream of research began with the work of Ross (1977) and Leland and Pyle (1977). In another, capital structure is designed to mitigate inefficiencies in the firm's investment decisions that are caused by the information asymme- try. This branch of the literature starts with Myers and Majluf (1984) and Myers (1984). We survey the various approaches in the following subsections.

A. Interaction of Investment and Capital Structure

In their pioneering work, Myers and Majluf (1984) showed that, if investors

are less well-informed than current firm insiders about the value of the firm's assets, then equity may be mispriced by the market. If firms are required to finance new projects by issuing equity, underpricing may be so severe that new investors capture more than the NPV of the new project, resulting in a net loss to existing shareholders. In this case the project will be rejected even if its NPV is positive. This underinvestment can be avoided if the firm can finance the new project using a security that is not so severely undervalued by the market. For example, internal funds and/or riskless debt involve no undervaluation, and, therefore, will be preferred to equity by firms in this situation. Even (not too) risky debt will be preferred to equity. Myers (1984) refers to this as a "pecking order" theory of financing, i.e., that capital structure will be driven by firms' desire to finance new investments, first internally, then with low-risk debt, and finally with equity only as a last resort. 11

11 Strictly speaking, Myers and Majluf show only that debt whose value is not sensitive to the private information is preferred to equity (e.g. riskless debt). Moreover, if such debt is available, the theory implies that equity never be issued by firms in the situation of extreme information asymmetry they model. Consequently, the "pecking order" theory requires an exogenous debt constraint in the Myers and Majluf model. Note also that there can be a pooling equilibrium in which all firms issue securities, because the project's NPV exceeds the worst underpricing. This equilibrium would not have the properties of the separating equilibrium mentioned in the text.

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The Theory of Capital Structure 307

To understand why firms may pass up positive NPV projects, suppose there are only two types of firms. The current assets of the firm are worth either H or L < H, depending on type. Initially, the firm's type is known only to the firm's managers whose objective is to maximize the true value of the current shareholders' claim.12 Outside investors believe the firm is of type H with probability p and type L with probability 1 - p. Both types of firm have access to a new project that requires an investment of I and has NPV of v (I and v can be assumed to be common knowledge). The firm must decide whether to accept the project. If the project is accepted, the investment I must be financed by issuing equity to new shareholders. Consider the follow-

ing candidate equilibrium. A type H firm rejects the project and issues no

equity while a type L firm accepts the project and issues equity worth I. Investors believe that issuance of equity signals that the firm is of type L. To verify that this is an equilibrium, first notice that investor beliefs are rational. Second, given these beliefs, the equity issued by type L firms is

fairly priced by the market, i.e., current shareholders give up a fraction fi = I/(L + v + I) of the firm to new shareholders. Their payoff from taking the project and issuing equity is (1 - f)(L + v + I) = L + v. Consequently, the current shareholders of type L firms capture the NPV of v in the new project by issuing equity. They would not prefer to imitate type H firms since this would require passing up the project along with its positive NPV with no compensating gain in valuation of the existing assets, i.e., their payoff would be L. Third, if a type H firm passes up the project, the payoff to current

shareholders is simply H. On the other hand, if a type H firm imitates a type L firm by issuing equity, this equity will be priced by the market as if the firm were type L. In this case, the current shareholders' payoff is (1 - fl)(H + v + I). The underpricing of the new equity can be so severe that current shareholders of the type H firm give up claims to the existing assets as well as the entire NPV of the new project. They are thus worse off by taking the project. This will happen when the above expression is less than H, or (H - L)f > v. Consequently, for parameters satisfying this inequality, in equilibrium, only type L firms will accept the positive NPV project. The left hand side of the inequality is the value transferred to the new equity holders

who acquire the fraction ,B of the firm at the bargain price of L instead of the true value H. The inequality then states that underinvestment occurs if this transfer exceeds the NPV of the project.

What are the empirical implications of Myers' "pecking order" theory? Probably the most important implication is that, upon announcement of an equity issue, the market value of the firm's existing shares will fall. Prior to the announcement, the firm's market value (of current shares) is pH + (1 -

12 This objective function assumes that outside investors will discover the true value of the firm's existing assets soon after the decision to invest is made and that current shareholders will not sell their stakes before this occurs. Dybvig and Zender (1989) point out that optimal

contracts with managers could completely resolve the underinvestment problem rendering capital structure irrelevant. The papers surveyed in this section thus implicitly assume that

such contracts are ruled out.

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308 The Journal of Finance

p)(L + v), reflecting prior beliefs about firm type and the equilibrium behav- ior of the firm. Upon announcement of an equity issue, investors realize that

the firm is of type L, so firm value becomes L + v. For parameter values

satisfying the above inequality, pH + (1 - p)(L + v) > L + v, i.e., announce- ment of the equity issue results in a fall in the price of current shares.

Moreover, financing via internal funds or riskless debt (or any security whose value is independent of the private information) will not convey information

and will not result in any stock price reaction. A second implication is that new projects will tend to be financed mainly from internal sources or the proceeds of low-risk debt issues.'3 Third, Korajczyk, et al. (1990b,c) argue that the underinvestment problem is least severe after information releases such as annual reports and earnings announcements. Therefore equity issues will tend to cluster after such releases and the stock price drop will be negatively related to the time between the release and the issue announce- ment."4 Finally, suppose firms with comparatively little tangible assets relative to firm value are more subject to information asymmetries. For such firms, then, the underinvestment problem will occur more often than for similar firms with less severe information asymmetries. These firms can be expected to accumulate more debt over time, other things equal.

A number of authors have extended the basic Myers-Majluf idea. Krasker (1986) allows firms to choose the size of the new investment project and the

accompanying equity issue. He confirms the results of Myers and Majluf in this context and also shows that the larger the stock issue the worse the signal and the fall in the firm's stock price.

Narayanan (1988) and Heinkel and Zechner (1990) obtain results similar to Myers and Majluf using a slightly different approach. They show that

when the information asymmetry concerns only the value of the new project, there can be overinvestment, i.e., some negative NPV projects will be taken. The reason is that full separation of firms by project NPV is impossible when the only observable signal is whether the project is taken. The equilibrium involves pooling of firms with projects of various NPV with the equity issued by all such firms being priced at the average value. Firms whose projects have low NPV will benefit from selling overpriced equity. This may more than compensate for a negative project NPV. The result is a negative cut-off NPV such that all firms with project NPV above the cut-off accept the project. In Narayanan's model, because (risky) debt is less overpriced than equity, the cut-off level is higher when projects are financed by debt issues.

13 For example, Bradford (1987) shows that if managers are allowed to purchase the new equity issued by firms in the situation described by Myers and Majluf (1984), then the underinvestment problem is mitigated.

14 Lucas and McDonald (1990) consider a model in which Myers-Majluf type informational asymmetries are temporary and firms can delay the adoption of projects. They show that firms with private information that current earnings are low will not delay projects, while firms whose current earnings are high will delay until this information becomes public. The result is that, on average, equity is issued after a period of abnormally high returns to the firm and to the market. They also obtain the result that, on average, stock price drops in response to stock issues.

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The Theory of Capital Structure 309

In Heinkel and Zechner, existing debt makes investment less attractive (as in Myers (1977)) and increases the cut-off level. Thus new (Narayanan) or existing (Heinkel and Zechner) debt reduces the overinvestment problem relative to all equity financing. The models imply that when a firm accepts a new project, the firm's stock price will increase since the market discovers that the firm's new project's NPV is above the cut-off level. Narayanan shows that when firms are allowed to issue either debt or equity, all firms either issue debt or reject the project. In this sense, his results are consistent with the "pecking order" theory. Since project acceptance is associated with issuing debt, debt issues are good news, i.e., result in an increase in the firm's stock price. This implication is the opposite of Myers and Majluf (1984). Debt is not a signal in Heinkel and Zechner since it is issued before firms have private information. Also, internal funds can substitute for debt in Heinkel and Zechner. Note that it is crucial to the results of both Narayanan and Heinkel-Zechner that acceptance or rejection of the project is the signal. If investors could observe only whether the firm issues securities, firms with negative NPV projects could imitate good firms by issuing the same security but investing the proceeds in Treasury bills.

Brennan and Kraus (1987), Noe (1988), and Constantinides and Grundy (1989) cast doubt on the "pecking order" theory. These papers enrich the set of financing choices that a firm may make when faced with the situation modeled by Myers and Majluf (1984).15 They conclude that firms do not necessarily have a preference for issuing straight debt over equity and that the underinvestment problem can be resolved through signaling with the richer set of financing options.

Brennan and Kraus offer an example similar to those in Myers and Majluf. There are two types of firms, say L and H, as above. Here, each type of firm has debt outstanding initially. In equilibrium, firm type H issues enough equity to finance the new project and retire its outstanding debt at face value. Firm type L issues only enough equity to finance the new project. Investors infer the firm type correctly. The debt of type H firms is risk free in this example. Therefore, type H firms obtain a "fair" deal on both their equity issue and debt repurchase. Type H firms do not imitate type L firms because by so doing the type H firm's equity would be underpriced. Type L firms do not imitate type H firms because repurchase of their debt at full face value entails an overpayment (i.e., for type L firms, the debt is risky). The cost of this overpayment for the debt exceeds the benefits available from selling overpriced equity. Thus, in equilibrium, both types of firms issue equity and accept the positive NPV project. Obviously, the underinvestment result of Myers and Majluf does not obtain in this example. Moreover, firms are allowed to issue debt but do not. This is inconsistent with the "pecking order" theory. Finally, issuing equity in the Brennan and Kraus model is a

15 Brennan-Kraus and Constantinides-Grundy use a method similar to one fi'rst introduced by Heinkel (1982) to obtain costless signaling (see Section ILB).

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310 The Journal of Finance

negative signal, but simultaneously issuing equity and using part of the proceeds to repurchase debt is a positive signal.

Constantinides and Grundy (1989) allow firms to issue any type of security and to repurchase existing equity. Another variation from the basic Myers- Majluf setup is that managers are assumed to have an equity stake in the firm whose true value they maximize. Constantinides and Grundy show that there is a fully separating equilibrium (even with a continuum of firm types) in which all types of firm take the positive NPV investment financed by an issue of a security that is neither straight debt nor equity. The new security is issued in an amount sufficient to finance the new investment and repur- chase some of the firm's existing equity. This issued security is locally convex in firm value at the true value and locally concave for at least some firm

value below the true value (see their (1989) Theorem 3). Constantinides and Grundy interpret these characteristics as being those of convertible debt. The basic idea is that the repurchase of equity makes it costly for firms to overstate their true value while the issuance of a security that is sensitive to firm value makes it costly to understate true value. Separation is attained by the design and size of the new issue so that, at the true value of the firm, these effects balance at the margin. In this model, the underinvestment problem is costlessly resolved. Although firms may issue some form of debt,

the model does not support the "pecking order" rule. That is, there is no overriding reason to finance using internal funds or riskless debt.

Noe (1988) allows firms to issue either debt or equity. He presents an example with three firm types, say L, M, and H. In equilibrium all types accept the positive NPV project, but types L and H issue debt while type M issues equity. Investors revise their beliefs about firm type using Bayes' rule

(e.g., they correctly identify type M). Either security issued by type L would be overpriced as a result of being confused either with type M or type H. Debt is less sensitive to firm type than equity, but, since firm type H is much better than firm type M in this example, L's debt is more overpriced than its equity. Consequently, type L chooses to "imitate" type H. Debt issued by type M is actually risk free, but, if it is confused with debt of type L, will be perceived to be risky by investors. Consequently, if type M issues debt, the debt will be underpriced. Therefore, type M prefers to issue fairly priced equity. Either security issued by type H would be underpriced. In the example, firm type H's debt is less underpriced both because it is less sensitive to firm quality and because the probability that a firm is of type L (the only type whose debt is risky) is low. Consequently, type H prefers to "imitate" type L and issue debt. Notice that all three types accept the project, that one type actually prefers to issue equity, and that the equity issuing firm is not the lowest quality.16

16 Nachman and Noe (1989) consider a similar situation in which firms have private informa- tion about the value of a new investment. They assume, however, that firms can issue any monotone increasing security in a broad class. They show, under certain assumptions on the

ordering of firm types, that the only equilibrium is one in which all firms issue debt.

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