Finance Articles

The Theory of Capital Structure 349

Table VII-(Continued)

Panel D. Corperate Control Models

Theoretical Result [source] Empirical Evidence

Leverage increases with potential gains to takeover and reductions in their costs [Israel (Forthcoming)]

Leverage is positively correlated with target

premium [Stulz (1988)]

Leverage increases with extent to which the firm is a takeover target or lack of anti-takeover measures

[Harris & Raviv (1988), Stulz (1988), Israel

(Forthcoming)]

Leverage is negatively correlated with target

premium [Israel (Forthcoming)]

Targets of an unsuccessful tender offer have more

debt than targets of proxy fights or successful tender

offers [Harris & Raviv (1988)]

Targets of successful proxy fights have more debt

than targets of unsuccessful proxy fights [Harris & Raviv (1988)]

Targets of proxy fights have more debt than targets

of successful tender offers [Harris & Raviv (1988)]

' weak or statistically insignificant relationship.

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350 The Journal of Finance

equity as given is based on four important properties of the debt contract:

. Bankruptcy, i.e., debt provides for a costly takeover of the firm by

debtholders under certain conditions. This fact is exploited in Ross (1977), Grossman and Hart (1982), Titman (1984), Jensen (1986), Harris and Raviv (1988, 1990a), Maksimovic and Titman (Forthcoming), Poitevin (1989), Stulz (1990), and others.

. Cash flow to levered equity is a convex function of returns to the firm. This fact leads to the asset substitution effect which is central in Jensen and Meckling (1976), Brander and Lewis (1986), Sarig (1988), Diamond (1989), and others.

. Leverage increases the manager's equity ownership share. This effect works in two ways: it forces manager's payoffs to be more sensitive to firm performance, and, since debt is nonvoting, it concentrates voting power. These properties are exploited in Jensen and Meckling (1976), Leland and Pyle (1977), Harris and Raviv (1988), Stulz (1988), and others.

. The value of debt is relatively insensitive to firm performance. Thus, debt is priced more accurately than equity in situations involving asym- metric information. This fact is used by Myers and Majluf (1984) among others.

Since the survey shows that theory has identified numerous potential determinants, it is not surprising that the models have a wealth of different implications (very few opposing, however) (see Table II). Models within a given type (e.g., agency), however, have many common predictions (see Table VII). Moreover, models of almost all types share the prediction that stock price will increase on announcement of leverage-increasing capital structure changes (see Table II, Panel B). This is probably because the models were designed to produce this prediction, since this effect is so well documented by event studies. Although the event studies have generally been interpreted as evidence that announcements of security offerings, exchanges, and repur- chases contain new information about the firm's future cash flows, i.e., as evidence for signaling models, in fact they support at least three of the four types of models.

From Tables V and VII it is clear that the empirical evidence thus far accumulated is broadly consistent with the theory. It is perhaps unfortunate that there seem to be no significant empirical anomalies to guide further theoretical work. Indeed, it would be difficult to reject any models based on the available evidence.44 Note, however, that many of the theoretical impli-

44 Inspection of Table VII produces only the following candidates: the signaling models listed in Panel B, line 3 (see also line 8); the free cash flow models listed in Panel A, line 7 and Harris

and Raviv (1990a) (Panel A, line 3). In each case, the empirical studies were not designed

specifically to test the model and hence generally do not meet the ceteris paribus conditions

demanded by the theory.

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The Theory of Capital Structure 351

cations have not yet been tested (as evidenced by the empty cells in Tables V and VII).

While recommendations for further work are always tentative, it seems clear that certain areas are underexplored. In our view, models which relate capital structure to products and inputs are the most promising.45 This area is still in its infancy and is short on implications relating capital structure to industrial organization variables such as demand and cost parameters, strategic variables, etc. On the other hand, it seems to us that models exploiting asymmetric information have been investigated to the point where diminishing returns have set in. It is unlikely that further effort in this area will lead to significant new insights. With regard to empirical work, Table V (or VII) provides a list of theoretical predictions that have not been tested. Of course, testing these results (or any of the others) is complicated by the wealth of ceteris paribus conditions each requires. Nevertheless, it is essen- tial that empirical work be directed specifically at sorting out which effects are important in various contexts.

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