agency cost risk management and capital structure
THE JOURNAL OF FINANCE • VOL. LIII, NO. 4 • AUGUST 1998
Agency Costs, Risk Management, and Capital Structure
HAYNE E. LELAND*
ABSTRACT
The joint determination of capital structure and investment risk is examined. Optimal capital structure ref lects both the tax advantages of debt less default costs
~Modigliani and Miller ~1958, 1963!!, and the agency costs resulting from asset substitution ~Jensen and Meckling ~1976!!. Agency costs restrict leverage and debt maturity and increase yield spreads, but their importance is small for the range of environments considered.
Risk management is also examined. Hedging permits greater leverage. Even when a firm cannot precommit to hedging, it will still do so. Surprisingly, hedging benefits often are greater when agency costs are low.
THE CHOICE OF INVESTMENT F INANCING, and its link with optimal risk exposure, is central to the economic performance of corporations. Financial economics has a rich literature analyzing the capital structure decision in qualitative terms. But it has provided relatively little specific guidance. In contrast with the precision offered by the Black and Scholes ~1973! option pricing model and its extensions, the theory addressing capital structure remains distressingly imprecise. This has limited its application to corporate decision making. Two insights have profoundly shaped the development of capital structure theory. The arbitrage argument of Modigliani and Miller ~M-M ! ~1958, 1963! shows that, with fixed investment decisions, nonfirm claimants must be present for capital structure to affect firm value. The optimal amount of debt balances the tax deductions provided by interest payments against the external costs of potential default.
Jensen and Meckling ~J-M ! ~1976! challenge the M-M assumption that investment decisions are independent of capital structure. Equityholders of a levered firm, for example, can potentially extract value from debtholders
by
Agency Costs, Risk Management, and Capital Structure
HAYNE E. LELAND*
ABSTRACT
The joint determination of capital structure and investment risk is examined. Optimal capital structure ref lects both the tax advantages of debt less default costs
~Modigliani and Miller ~1958, 1963!!, and the agency costs resulting from asset substitution ~Jensen and Meckling ~1976!!. Agency costs restrict leverage and debt maturity and increase yield spreads, but their importance is small for the range of environments considered.
Risk management is also examined. Hedging permits greater leverage. Even when a firm cannot precommit to hedging, it will still do so. Surprisingly, hedging benefits often are greater when agency costs are low.
THE CHOICE OF INVESTMENT F INANCING, and its link with optimal risk exposure, is central to the economic performance of corporations. Financial economics has a rich literature analyzing the capital structure decision in qualitative terms. But it has provided relatively little specific guidance. In contrast with the precision offered by the Black and Scholes ~1973! option pricing model and its extensions, the theory addressing capital structure remains distressingly imprecise. This has limited its application to corporate decision making. Two insights have profoundly shaped the development of capital structure theory. The arbitrage argument of Modigliani and Miller ~M-M ! ~1958, 1963! shows that, with fixed investment decisions, nonfirm claimants must be present for capital structure to affect firm value. The optimal amount of debt balances the tax deductions provided by interest payments against the external costs of potential default.
Jensen and Meckling ~J-M ! ~1976! challenge the M-M assumption that investment decisions are independent of capital structure. Equityholders of a levered firm, for example, can potentially extract value from debtholders
by
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