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The Theory of Capital Structure 319

pliers. Increases in leverage increase the extent of this insurance and there- fore increase the equity holders' threat point in negotiating with suppliers. As a result, debt can increase firm value. This implies that a firm should

have more debt the greater is the bargaining power and/or the market alternatives of its suppliers. Thus, Sarig predicts that highly unionized firms and/or firms that employ workers with highly transferable skills will have more debt, ceteris paribus.

C. Summary of Section III

Capital structure models based on product/input market interactions are in their infancy. These theories have explored the relationship between

capital structure and either product market strategy or characteristics of products/inputs. The strategic variables considered are product price and

quantity. These strategies are determined to affect the behavior of rivals, and capital structure in turn affects the equilibrium strategies and payoffs. Models involving product or input characteristics have focused on the effect of capital structure on the future availability of products, parts and service, product quality, and the bargaining game between management and input suppliers.

The models show that oligopolists will tend to have more debt than monopolists or firms in competitive industries (Brander and Lewis (1986)), and that the debt will tend to be long term (Glazer (1989)). If, however, tacit collusion is important, debt is limited, and debt capacity increases with the elasticity of demand (Maksimovic (1988)). Firms that produce products that are unique or require service and/or parts and firms for which a reputation for producing high quality products is important may be expected to have less debt, other things equal (Titman (1984) and Maksimovic and Titman (Forth- coming)). Finally, highly unionized firms and firms whose workers have easily transferable skills should have more debt (Sarig (1988)).

Models of capital structure based on industrial organization considerations have the potential to provide interesting results. For example, models similar to the ones surveyed above could delineate more specifically the relationship

between capital structure and observable industry characteristics such as demand and supply conditions and extent of competition. In addition, it would be useful to explore the impact of capital structure on the choice of strategic variables other than price and quantity. These could include adver- tising, research and development expenditure, plant capacity, location, and product characteristics. Such research could help in explaining inter-industry variations in capital structure.

IV. Theories Driven by Corporate Control Considerations

Following the growing importance of takeover activities in the 1980's, the finance literature began to examine the linkage between the market for

corporate control and capital structure. These papers exploit the fact that

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320 The Journal of Finance

common stock carries voting rights while debt does not. In this section, we

discuss three contributions. In Harris and Raviv (1988) and Stulz (1988),

capital structure affects the outcome of takeover contests through its effect on the distribution of votes, especially the fraction owned by the manager. In

Israel (Forthcoming), capital structure affects the distribution of cash flows between voting (equity) and nonvoting (debt) claimants.

The first models to exploit the differential voting rights of debt and equity are those of Harris and Raviv (1988) and Stulz (1988). These two models generate a relationship between the fraction of the equity owned by a firm's manager and the value of outside equity (equity held by noncontestants). This relationship follows from the dependence of firm value on whether the firm is taken over and, if so, how much is paid by the successful bidder. The

manager's equity ownership is determined in part by the firm's capital

structure. Thus, capital structure affects the value of the firm, the probabil- ity of takeover, and the price effects of takeover. In what follows, we explain the models in more detail and compare their implications.

Harris and Raviv (1988) focus on the ability of an incumbent firm manager to manipulate the method and probability of success of a takeover attempt by changing the fraction of the equity he owns. Since the incumbent and the rival have different abilities to manage the firm, the value of the firm

depends on the outcome of the takeover contest. The manager's ownership

share determines one of three possible outcomes: the rival takes over for sure, the incumbent remains in control for sure, or the outcome is determined by the votes of passive investors, and this results in the election of the better candidate. The optimal ownership share is determined by the incumbent manager who trades off capital gains on his stake against the loss of any personal benefits derived from being in control. Since the manager's owner- ship share is determined indirectly by the firm's capital structure, this tradeoff results in a theory of capital structure.

The following is a simplified version of the Harris and Raviv model. An

incumbent entrepreneur/manager I owns an initial fraction xo of an all- equity-financed firm. The remaining equity is held by passive investors who are not contenders for control. The incumbent obtains benefits of control of expected value B as long as he controls the firm. These benefits can be thought of as private control benefits or as the value of cash flows that he can

expropriate from the firm if he is in control. The value of the cash flows (not including B) generated by the firm depends on the ability of the manager. There are two possible ability levels, 1 and 2, and the corresponding values of the cash flows are denoted Y1 and Y2, with Y1 > Y2.

In addition to the incumbent and passive investors, there is also a rival for control of the firm, R. If the rival takes over, he also obtains benefits of control. The abilities of the incumbent and rival are unobservable by all parties, but it is common knowledge that one is of higher ability than the other. That is, everyone knows that, with probability p, the incumbent has ability 1 and, with probability 1 - p, the rival has ability 1. The other has ability 2. Thus the value of the firm's cash flows if the incumbent controls is

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The Theory of Capital Structure 321

YI, and if the rival controls it is YR, where

YI = PY1 + (1 - p)Y2 and YR = (1 - p)Y1 + pY2

When the rival appears, the incumbent first chooses a new fraction a of the equity of the firm (this change in ownership is the result of a change in capital structure; see below). The rival then acquires equity from the passive investors. The takeover contest is decided by a simple majority vote (ties go to the incumbent) where the two contestants each vote for themselves, and the fraction 7r of the passive investors vote for the incumbent (the rest vote for the rival).32

Depending on the choices of equity ownership by the incumbent and rival, the takeover contest can have one of three possible outcomes. First, the incumbent's stake may be so small that, even if the rival is of lower ability, he still succeeds in taking over. Harris and Raviv (1988) refer to this case as that of a successful tender offer. The value of the cash flows in this case is

YR. Second, the incumbent's stake may be so large that even if he is of lower ability, he still remains in control. This is referred to as the case of an

unsuccessful tender offer, and the value of the cash flows in this case is YI. Finally, for intermediate values of a, the incumbent will win if and only if he is of higher ability. This case is called a proxy fight, since the identity of the winner is uncertain until the vote is actually taken. Note, however, that in this case, the best candidate wins for sure, and hence the value of the cash flows is Y1. The value of the firm's cash flows Y(a) is determined by the incumbent's stake a through its effect on which of the above three cases prevails. Since Y1 is larger than either YI or YR if the objective were to maximize the value of the cash flow to outside investors, then a in the proxy fight range would be optimal. This would result in a model more similar to that of Stulz (1988) as will be seen below.

The objective in choosing the incumbent's share a is to maximize his expected payoff. This payoff is the value of his equity stake plus the value of his control benefits if he remains in control. The value of the incumbent's equity stake is a0 Y(a), where a0 is his initial equity stake, since any transactions in which he engages to change his stake have zero net present value. Therefore, the incumbent's payoff V(a) is a 0 YR if there is a successful tender offer (benefits of control are lost), a0 YI + B if there is an unsuccessful

tender offer (benefits retained for sure), and ao Y1 + pB if there is a proxy fight (benefits retained with probability p). The optimal ownership share for the incumbent rnaximizes V(u). The tradeoffs are apparent from the descrip- tion of V. In particular, as a is increased, the probability that the incumbent retains control and its benefits increases. On the other hand, if a is increased too much, the value of the firm and the manager's stake are reduced.

In Harris and Raviv, a is determined indirectly through the firm's capital structure. In particular, the incumbent is assumed to have a fixed amount of

wealth represented by his initial stake co. He can increase his stake by

32 In the Harris and Raviv paper, 7r is derived from a model of passive investors' information.

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322 The Journal of Finance

having the firm repurchase equity from the passive investors, financing the repurchase by issuing debt. Debt decreases the value of the equity allowing

him to purchase a larger fraction with his given wealth. Maximizing the

manager's payoff is actually accomplished by choosing the debt level that

determines the optimal share a. Since Harris and Raviv assume that the expected benefits of control B decrease with the debt level, within any of the

three cases described above, it is optimal to choose the lowest debt level consistent with that case.33

It follows from the above arguments that if the case of successful tender

offer is optimal, the firm will have no debt. It is also shown that generally, proxy fights require some debt, and guaranteeing that the tender offer is

unsuccessful requires even more debt. Thus, takeover targets will increase their debt levels on average and targets of unsuccessful tender offers will issue more debt on average than targets of successful tender offers or proxy fights. Also, firms that increase leverage either have unsuccessful tender

offers or proxy fights. In the former case, firm value remains at YI on average, while in the latter it increases to Y1. Thus, on average, debt issues are accompanied by stock price increases.

Finally, note that the fraction of passive investors who vote for the incum-

bent is determined by the information that these passive investors receive regarding the relative abilities of the two candidates. A larger fraction will vote for the incumbent if the passive investors' prior probability that he is more able, p, increases. Consequently, less debt is required to effect a proxy fight if the incumbent is more likely to be of higher ability. Since winning a proxy fight is positively related to the probability of being more able, the

incumbent's winning is also associated with less debt. Therefore, in a sample

of firms experiencing proxy fights, one would expect to observe less leverage among firms in which the incumbent remains in control.34

Stulz (1988) also focuses on the ability of shareholders to affect the nature of a takeover attempt by changing the incumbent's ownership share. In particular, as the incumbent's share a increases, the premium offered in a tender offer increases, but the probability that the takeover occurs and the shareholders actually receive the premium is reduced. Stulz discusses how the ownership share of the incumbent is affected by capital structure (as well as other variables).

The basic idea of Stulz's model can be presented simply as follows. As in Harris and Raviv (1988), there is an incumbent manager of a firm, a potential rival, and a large number of passive investors. The incumbent owns the fraction a of the shares and obtains private benefits of control. Stulz assumes the incumbent will not tender his shares in any takeover attempt.

33 Expected benefits may decrease with the debt level because the benefits are lost in bankruptcy, higher debt results in more monitoring by creditors, and/or less free cash flow allows the manager less discretion.

34 The model also has a number of other testable implications regarding stock price changes of takeover targets classified by the type of takeover attempt (proxy fight or tender offer) and the outcome (successful or unsuccessful).

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The Theory of Capital Structure 323

The rival can obtain a random benefit of control B from taking over. Initially, B is unknown to all parties. The value of the benefit becomes known to the rival before he must decide what premium to offer sharehold- ers. To acquire control, the rival must purchase 50% of the shares. These shares are purchased from the passive investors. This reflects the assumption that the passive investors vote for the incumbent in any takeover contest. The passive investors are assumed to have heterogeneous reservation prices for selling their shares. In particular, let s(P) be the fraction of passive investors who tender if the total premium paid by the rival (above the value

under the incumbent) is P. The supply function s is assumed to be increasing in P. Then the minimum price that the rival must offer to purchase 50% of

the votes, P*(4), satisfies the condition

s(P*(o))(1 - a) = 1/2.

Since s is increasing in P, this condition implies that the offer premium P* is increasing in the incumbent's share a. Intuitively, the larger the incum- bent's stake, the larger the fraction of the passive investors' shares that must be acquired by the rival, hence the more he must pay. The rival will bid P* if and only if his benefit B exceeds P*. Therefore, the probability that the passive investors actually obtain the premium P* is

Pr(B 2 P*(o()) [P* (a)]. Since P* increases with a and ir is a decreasing function, the probability of a takeover declines with a. The expected gain to the passive investors is

Y(U) = P*(U)X[P*(a)]

The incumbent's share a is chosen to maximize Y. As mentioned above, increases in a increase the takeover premium given success but decrease the probability of success.

As in Harris and Raviv, a can be increased by increasing the firm's leverage.35 Therefore, Stulz obtains the result that takeover targets have an optimal debt level that maximizes the value of outside investors' shares. Targets of hostile takeovers will have more debt than firms that are not

targets. Since becoming a takeover target is good news, one would expect exchanges of debt for equity that accompany such an event to be associated with stock price increases. Moreover, the probability of a takeover is nega- tively related to the target's debt/equity ratio, and the takeover premium is positively related to this ratio.

A similar approach was taken by Israel (Forthcoming). In his model, as in Stulz (1988), increases in debt also increase the gain to target shareholders if a takeover occurs but lower the probability of this event. The reason that increases in debt increase the gain to target shareholders is different from

35 Stulz also considers a number of other methods for changing ae such as ESOP's, voting trusts, supermajority rules, and differential voting rights. Results derived from these considera- tions are not directly relevant to the topic at hand.

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324 The Journal of Finance

that in Stulz (1988), however. Israel observes that debt commands a contrac- tually fixed share of any gains from takeover. Target and acquiring share- holders bargain only over that portion of the gains that is not previously committed to debtholders. The more debt, the less gain is left for target and

acquiring shareholders to split and the smaller is the portion of the gain captured by acquiring shareholders. Moreover, target shareholders can cap- ture the gains accruing to target debtholders when the debt is issued. Thus, they capture all of the gain not going to acquiring shareholders. Since debt

reduces the gain captured by acquiring shareholders, the payoff to target shareholders, given that a takeover occurs, is increased by increased debt levels. The optimal debt level is determined by balancing this effect against the reduced probability of takeover resulting from the reduced share of the

gain that accrues to acquiring stockholders. The essence of Israel's (Forthcoming) model is the following. Suppose that

a takeover can generate a random total gain G in firm value, but a takeover will cost T. Further, suppose the firm has issued risky debt of face value D, and, in the event of a takeover, this debt increases in value by b(D, G). If the takeover occurs, the acquiring and target shareholders can then split the remaining net gain G - 6 - T. Assume that target shareholders obtain the fixed fraction 1 - -y of this net gain and acquiring shareholders capture the remaining fraction -y (-y can be thought of as measuring the acquirer's bargaining power). Thus, a takeover will occur if and only if -y(G - 6 - T) > 0

or G - b(D, G) 2 T, and the probability of a takeover is the probability of this event, denoted -r(D, T). In addition, when issuing the debt, target shareholders also capture the expected gain to debtholders. Consequently, target shareholders' total expected payoff is

Y(D) = E[{(1 - y)[C- b(D,G) - T]

+6(D, G)} I G - 6(D, G) > T] 'r(D, T)

= E[ {(1 - oy) [CG - T] + yb(Dg Gx) I iOG - b(Dg Gx) > T] -(D9 T).

As can be seen from this last expression, target shareholders capture the fraction 1 - -y of the net total gains to takeover plus an additional fraction -y of the gain to target debtholders. The optimal debt level is obtained by maximizing Y(D). This involves trading off the increase in amount extracted from the acquirer represented by the term in braces against the decrease in

the probability that takeover occurs, -.36 Israel (Forthcoming) obtains several interesting comparative statics re-

sults. First, an increase in the costs of mounting a takeover contest T results in a decrease in leverage but an increase in the appreciation of target equity if a takeover occurs. Second, if the distribution of potential takeover gains

36 In a related paper, Israel (1989) notes that increases in leverage reduce the capital loss suffered by an incumbent manager if he resists a value-increasing takeover. As a result, the manager can extract a larger share of the surplus for the firm's shareholders. Debt is limited by

the amount of the surplus to be extracted.

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The Theory of Capital Structure 325

shifts to the right, debt level increases. Such a shift could result from a decrease in the ability of the incumbent manager. Third, the optimal debt level increases, and the probability of takeover and the gain to target equity in the event of a takeover decrease with the rival's bargaining power -y.

A. Summary of Section IV

The papers discussed in this section provide a theory of capital structure related to takeover contests. The major results are as follows. First, all three papers conclude that takeover targets will increase their debt levels on average, and this will be accompanied by a positive stock price reaction.

Second, all three show that leverage is negatively related on average to whether the tender offer succeeds. Third, Harris and Raviv (1988) also show that targets of unsuccessful tender offers will have more debt on average than targets of proxy fights. They also show that among firms involved in proxy fights, leverage is lower on average when the incumbent remains in control. Fourth, with regard to the relationship between fraction of the

takeover premium captured by the target's equity and the amount of debt, Stulz (1988) and Israel (Forthcoming) obtain opposite results. In Stulz, the premium paid to target shareholders increases with increases in the target's debt level. In Israel, as the bargaining power of the target shareholders decreases, the target optimally issues more debt, and the fraction of the takeover premium captured by the target equity falls. Fifth, Israel shows that targets that are more costly to take over have less debt but capture a larger premium if a takeover occurs. Sixth, Israel predicts that firms that have greater potential takeover gains will have more debt.37

Two important observations should be noted here. First, the theories surveyed in this section should be viewed as theories of short-term changes in capital structure taken in response to imminent takeover threats, since the optimal capital structure derived in these models can be implemented in response to hostile takeover activity. As a result, theories based on corporate control considerations have nothing to say about the long run capital struc- ture of firms. Second, these papers take as given the characteristics of the securities issued by firms. In particular, both the cash flow aspects and the assignment of voting rights and other control-related features are treated as exogenous.

V. Summary of Results

The purpose of this section is to present the collected lessons of the literature surveyed. These lessons are presented in three subsections. In the first, we discuss the theoretical predictions of the models surveyed above. In the

37 Similar results are undoubtedly available from Stulz's model although he does not derive them. One can view B in Stulz's model as takeover benefits net of takeover costs. Then any increase in potential benefits or decrease in costs is simply a rightward shift of the distribution of B.

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