Capital Structure Essay

Pages: 5 (1510 words)  ·  Style: Harvard  ·  Bibliography Sources: 2  ·  File: .docx  ·  Level: College Senior  ·  Topic: Economics

¶ … Managers have Capital Structure Targets? attempts to determine the degree to which managers aim for a target capital structure. The authors begin with the basic theories of capital structure -- the tradeoff theory and the pecking order theory. They study capital structure through spinoffs. The theory is that with spinoffs, the managers have direct control over the capital structure of the two firms and therefore this provides insight into the capital structure decision making process.

The authors attempt to answer the question by examining the capital structure vs. A variety of variables. These variables include the portion of fixed assets on the balance sheet, the level of profitability and the variability of cash flows. The authors tested their hypothesis against each of these variables by running regression analyses to determine what relationship if any there was between the different variables and the post-spinoff capital structure. If specific trends emerged, that would indicate that managers do actively seek capital structure targets. Moreover, it would be evidence of some of the decision-making criteria that managers use when attempting to hit these targets. The authors tested 98 spinoffs from 1979 to 1997. They eliminated a small handful of spinoffs from the study. These included incomplete spinoffs and ones with book value leverage below -1.0 or above 1.0.

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The authors found as a result of their study that there is a relationship between certain aspects of the firm's balance sheet and cash flows and the capital structure that management chose for the spinoff company. This answers the basic question, that yet managers do seek target capital structures. In some cases, the target capital structure was more for the parent corporation, as was the case for Marriott, wherein the company wanted to free the hotel business from the debt burden in order to pursue growth by acquisition. In other cases, the decision regarding capital structure was guided more by the desired capital structure of the spinoff firm.

Essay on Capital Structure Assignment

The authors found that there were three main relationships between different variables and the capital structures chosen by management. The first is that the higher the fixed asset ratio, the higher the leverage of the spinoff firm. This was attributed to the fact that fixed assets such as plants, property and equipment typically can be liquidated. This lowers the default risk, which in turn lowers the cost of debt for the spinoff company. The second relationship identified is that the cash profitability of the spinoff entity was positively related to the amount of leverage. Higher cash profits mean a better times interest earned ratio, which again lowers the default risk. So thus far the authors have identified two deliberate moves by managers to use spinoffs to lower the total cost of debt for the firm.

The last relationship is that a negative relationship was identified between the debt and the variability of the cash flows. The more variable the cash flows, the lower the level of debt assigned. This falls in line with the other two findings because higher variability of cash flows is associated with higher default risk. This in turn results in a higher cost of debt. For all three variables, firms tended to choose a capital structure for the spinoff company that resulted in a lower cost of debt.

The main contribution of the paper is that it provides evidence that managers use the tradeoff theory in selecting a target capital structure. At the outset of the article, the authors make mention of the fact that managers typically utilize the pecking order theory. The key to this finding was that there was a negative relationship between cash profitability and leverage. This suggests that managers of less profitable firms must turn to debt more than managers of more profitable firms, who can use retained earnings to finance their business. The authors of this study show that when given the option to explicitly design a capital structure for a firm, managers to lean towards the tradeoff theory. This is evidenced by the finding that there is a positive relationship between the profitability of a spinoff and its leverage. This indicates a tradeoff based on cost of capital considerations and runs contrary to the pecking order theory.

The authors feel that they have also shown that managers actively set a target capital structure. However, the scenario chosen for study -- a spinoff -- is one in which managers have no choice but to select a target capital structure. The question of whether or not managers select target capital structures is typically applied to ongoing entities. Thus, by not studying ongoing entities but rather by taking the easy way out and studying spinoffs, the authors have not proven that managers routinely set target capital structures.

In the Capital Structure Puzzle, Barclay and Smith attempt to determine two things. First, they attempt to determine whether or not there is a means of dividing a company's capital structure between debt and equity that can be expected to maximize firm value. This refers to the tradeoff theory, asking if the ideal capital structure under the tradeoff theory is even identifiable or attainable. The authors next seek to solve the question of what the critical factors are in determining the target leverage ratio (capital structure) for each company.

To answer these questions, the authors first undertook a survey of contemporary capital structure literature. They discussed three main theories of corporate financial policy, framed in terms of cost drivers -- taxes, contracting costs and information costs. These costs, the authors argue, are used by managers when making capital structure decisions. The authors tested contracting costs by measuring the leverage ratio against the firm's market-to-book ratio, which is used as a proxy for investment opportunities. The authors also tested the relationship between past profitability and leverage, to determine the impact of information costs of capital structure. Lastly, the relationship between leverage and taxes was studied. This was an external analysis of the value that debt adds to the company -- evidence that debt is used to add value to the company is evidence that taxes play a role in capital structure decision making.

Barclay and Smith find that of the three variables, information costs have the weakest relationship with leverage. From this they draw the conclusion that the pecking order theory does not in general hold. They also find that taxes play a role to some extent, based on a finding that 5-10% of the average firm's value is attributable to tax savings from debt. Lastly they also find that contracting costs has a strong relationship with leverage. As the growth opportunities increased the amount of leverage decreased.

The conclusions they draw from this are that firms do aim for a desired capital structure. They make decisions based on the costs of adjusting the capital structure vs. The cost of deviating from it. Firms often make such adjustments away from the ideal capital structure, and then gradually work back towards it. This occurs because as the larger the adjustment costs, the bigger will be the adjustment. The authors also essentially disprove the pecking order theory, although they do this by making certain assumptions about pecking order theory outputs that may not be fair. They seem to operate on the assumption that all firms have the same pecking order, when even their paper itself is concerned with determining the variables used. Presumably, even the decision-making process under pecking order theory will differ from firm-to-firm as each uses different criteria for selecting the pecking order against which financing decisions will be weighed.

Both papers come to similar conclusions, that managers do attempt to find a specific ideal capital structure. Barclay's paper concludes, however, that firms can and do deviate from that structure. They merely use the ideal capital structure as a frame of reference, and… [END OF PREVIEW] . . . READ MORE

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