Chapter 13 Capital Structure and Leverage 423bankruptcy-related costs become increasingly important; and they begin to off-
set the tax bene! ts of debt. In the range from D 1 to D 2 , bankruptcy-related costs
reduce but do not completely offset the tax bene! ts of debt; so the! rm’s stock
price continues to rise (but at a decreasing rate) as its debt ratio increases. How-
ever, beyond D 2 , bankruptcy-related costs exceed the tax bene! ts; so from this
point on, increasing the debt ratio lowers the stock price. Therefore, D 2 is the
optimal capital structure, the one where the stock price is maximized. Of course,
D 1 and D 2 vary from! rm to! rm depending on business risk and bankruptcy
costs, and they can change for a given! rm over time.- While theoretical and empirical work supports the general shape of the curves
in Figures 13-8 and 13-9, these graphs must be taken as approximations, not as
precisely de! ned functions. The numbers in Figure 13-8 are rounded to two
decimal places, but that is merely for illustrative purposes—the numbers are
not nearly that accurate since the graph is based on judgmental estimates. - Another disturbing aspect of capital structure theory expressed in Figure 13-9
is the fact that many large, successful! rms such as Intel and Microsoft use far
less debt than the theory suggests. This point led to the development of signal-
ing theory, which is discussed in the next section.
13-4d Signaling Theory
MM assumed that everyone—investors and managers alike—has the same infor-
mation about a! rm’s prospects. This is called symmetric information. However,
in fact, managers often have better information than outside investors. This is
called asymmetric information, and it has an important effect on the optimal capi-
tal structure. To see why, consider two situations, one where the company’s man-
agers know that its prospects are extremely favorable (Firm F) and one where the
managers know that the future looks unfavorable (Firm U).
Now suppose Firm F’s R&D labs have just discovered a nonpatentable cure
for the common cold. They want to keep the new product a secret as long as possi-
ble to delay competitors’ entry into the market. New plants must be built to make
the new product, so capital must be raised. But how should Firm F raise the needed
capital? If it sells stock, when pro! ts from the new product start " owing in, the
price of the stock will rise sharply and purchasers of the new stock will make a bo-
nanza. The current stockholders (including the managers) also will do well, but
not as well as they would have done if the company had not sold stock before the
price increased. In that case, they would not have had to share the bene! ts of the
new product with the new stockholders. Therefore, we would expect a! rm with very
favorable prospects to avoid selling stock and instead raise any required new capital by
using new debt even if this moved its debt ratio beyond the target level.^17
Now consider Firm U. Suppose its managers have information that new orders
are off sharply because a competitor has installed new technology that improved the
quality of its products. Firm U must upgrade its own facilities at a high cost just to
maintain current sales. As a result, its return on investment will fall (but not by as
much as if it took no action, which would lead to a 100% loss through bankruptcy).
How should Firm U raise the needed capital? Here the situation is just the reverse of
that facing Firm F—Firm U will want to sell stock so that some of the adverse conse-
quences will be borne by new investors. Therefore, a! rm with unfavorable prospects would
want to! nance with stock, which would mean bringing in new investors to share the losses.^18
Symmetric Information
The situation where
investors and managers
have identical information
about firms’ prospects.Symmetric Information
The situation where
investors and managers
have identical information
about firms’ prospects.
Asymmetric
Information
The situation where
managers have different
(better) information about
firms’ prospects than
investors.Asymmetric
Information
The situation where
managers have different
(better) information about
firms’ prospects than
investors.(^17) It would be illegal for Firm F’s managers to personally purchase more shares on the basis of their inside knowl-
edge of the new product. They could be sent to jail if they did.
(^18) Of course, Firm U would have to make certain disclosures when it o$ ered new shares to the public, but it might
be able to meet the legal requirements without fully disclosing management’s worst fears.