Principles of Corporate Finance_ 12th Edition

486 Part Five Payout Policy and Capital Structure

bre44380_ch18_460-490.indd 486 10/05/15 12:53 PM

The pecking order is a consequence of asymmetric information. Managers know more about

their firms than outside investors do, and they are reluctant to issue stock when they believe the

price is too low. They try to time issues when shares are fairly priced or overpriced. Investors

understand this, and interpret a decision to issue shares as bad news. That explains why stock price

usually falls when a stock issue is announced.

Debt is better than equity when these information problems are important. Optimistic managers

will prefer debt to undervalued equity, and pessimistic managers will be pressed to follow suit. The

pecking-order theory says that equity will be issued only when debt capacity is running out and

financial distress threatens.

The pecking-order theory stresses the value of financial slack. Without sufficient slack, the

firm may be caught at the bottom of the pecking order and be forced to choose between issuing

undervalued shares, borrowing and risking financial distress, or passing up positive-NPV invest-

ment opportunities.

There is, however, a dark side to financial slack. Surplus cash or credit tempts managers to over-

invest or to indulge an easy and glamorous corporate lifestyle. When temptation wins, or threatens

to win, a high debt ratio can help: It forces the company to disgorge cash and prods managers and

organizations to try harder to be more efficient.

The research literature on capital structure is enormous. We cite only a few of the most important and

interesting articles. The following review articles give broader surveys.

M. Harris and A. Raviv, “The Theory of Capital Structure,” Journal of Finance 46 (March 1991), pp.

297–355.

S. C. Myers, “Financing of Corporations,” in G. M. Constantinides, M. Harris, and R. Stulz (eds.),

Handbook of the Economics of Finance (Amsterdam: Elsevier North-Holland, 2003).

The Winter 2005 issue of the Journal of Applied Corporate Finance contains several articles on capital

structure decisions in practice.

The following paper surveys chief financial officers’ views about capital structure:

J. Graham and C. Harvey, “How Do CFOs Make Capital Budgeting and Capital Structure Decisions?”

Journal of Applied Corporate Finance 15 (Spring 2002), pp. 8–23.

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FURTHER

READING

Select problems are available in McGraw-Hill’s Connect.

Please see the preface for more information.

BASIC

1. Tax shield The present value of interest tax shields is often written as TcD, where D is the
   amount of debt and Tc is the marginal corporate tax rate. Under what assumptions is this pres-
   ent value correct?


2. Tax shield Here are book and market value balance sheets of the United Frypan Company
   (UF):

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PROBLEM

SETS

Market

Net working capital $ 20 $ 40 Debt

Long-term assets 140 120 Equity

$160 $160

Book

Net working capital $ 20 $ 40 Debt

Long-term assets 80 60 Equity

$100 $100