CP

Capital Structure Theory 491

3 .While theory and empirical work support the general shape of the curve in Fig-

ure 13-3, this graph must be taken as an approximation, not as a precisely defined

function.

Signaling Theory

MM assumed that investors have the same information about a firm’s prospects as its

managers—this is called symmetric information.However, in fact managers often

have better information than outside investors. This is called asymmetric informa-

tion,and it has an important effect on the optimal capital structure. To see why, con-

sider two situations, one in which the company’s managers know that its prospects are

extremely positive (Firm P) and one in which the managers know that the future looks

negative (Firm N).

Suppose, for example, that Firm P’s R&D labs have just discovered a non-

patentable cure for the common cold .They want to keep the new product a secret as

long as possible to delay competitors’ entry into the market .New plants must be built

to make the new product, so capital must be raised .How should Firm P’s management

raise the needed capital? If it sells stock, then, when profits from the new product start

flowing in, the price of the stock would rise sharply, and the purchasers of the new

stock would make a bonanza .The current stockholders (including the managers)

would also do well, but not as well as they would have done if the company had not

sold stock before the price increased, because then they would not have had to share

the benefits of the new product with the new stockholders.Therefore, one would expect

a firm with very positive prospects to try to avoid selling stock and, rather, to raise any required

new capital by other means, including using debt beyond the normal target capital structure.^12

FIGURE 13-3 Effect of Leverage on Value

Value

Value Added by

Debt Tax Shelter

Benefits

MM Result Incorporating the

Effects of Corporate Taxation:

Value if There Were No

Bankruptcy-Related Costs

Value Reduced by

Bankruptcy-Related Costs

Actual Value

Value if the Firm

Used No Financial

Leverage

0DD 12 Leverage

Value with

Zero Debt = $20

Threshold Debt Level

Where Bankruptcy

Costs Become Material

Optimal Capital Structure:

Marginal Tax Shelter Benefits =

Marginal Bankruptcy-Related Costs

(^12) It would be illegal for Firm P’s managers to personally purchase more shares on the basis of their inside
knowledge of the new product. They could be sent to jail if they did.

Capital Structure Decisions 487