Introduction to Corporate Finance

13: Capital Structure

explains why highly profitable companies might retain earnings. (Apple and Google are classic examples.)

Such companies are building both financial slack and financial flexibility.

The pecking-order theory also explains share-market reactions to leverage-increasing and leverage-

decreasing events. Companies with valuable investment opportunities find a way to finance their projects

internally, or they use the least risky securities possible (debt) if financing must be obtained externally.

Therefore, only managers who consider the company’s shares to be overvalued will issue equity. Investors

understand these incentives, and also realise that managers are better informed about a company’s

prospects. Hence investors always greet the announcement of a new equity issue as bad news: a sign

that management considers the company’s shares to be overvalued.^9

finance in practice

WHAT MATTERS FOR CAPITAL CHOICES

Graham and Harvey (2001) asked US CFOs to rate

the importance of several factors in setting capital

structures. The figure below shows their findings.

Number one on the list is financial flexibility, which

at first glance seems to support the pecking-order

theory. However, Graham and Harvey find that the

types of companies that value financial flexibility are

not necessarily the ones predicted by the pecking-

order theory – namely, companies with severe

asymmetric information issues. The authors also

asked CFOs if they issued equity only when issuing

debt was not an option (as the pecking-order theory

predicts), but CFOs did not indicate that inability to

issue debt was the reason they issued equity.

FIGURE 13.6 WHAT FACTORS DO US COMPANIES CONSIDER WHEN CHOOSING DEBT POLICY?

0% 10%20% 30% 40% 50% 60% 70%

Customer/supplier comfort

Bankruptcy (Insolvency)/distress costs

Comparable firm debt levels

Equity undervaluation/overvaluation

Transactions costs and fees

Interest tax savings

Level of interest rates

Insufficient internal funds

Earnings and cash flow volatility

Credit rating

Financial flexibility

Per cent of CFOs identifying factor as

important or very important

Source: Reprinted from Graham and Harvey, ‘The Theory and Practice of Corporate Finance: Evidence From the Field’, Journal of Financial Economics,

Vol. 60, Issue 2-3, May/June, pp. 187–243, Copyright 2001, with permission from Elsevier. Other surveys are summarised in Miglo, Anton,

“Trade-Off, Pecking Order, Signaling, and Market Timing Models” in Baker, H Kent, and Gerald S Martin, Capital Structure and Corporate

Financing Decisions Theory, Evidence, and Practice (New Jersey: John Wiley & Sons, 2011) pp. 171–189.

9 This works in reverse, too. The CFO of a Fortune 500 company with billions in cash reserves has been quoted as saying that his company
wanted to distribute some of the cash to investors, but management did not want to force investors to pay taxes on high dividend payments
and were reluctant to repurchase shares because they thought the company’s stock was overvalued.

Keith Woodward, Vice

President of Finance,

General Mills

‘In General Mills

we have lots of

discussions about what

is the optimal capital

structure.’

See the entire interview on

the CourseMate website.

Source: Cengage Learning

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