Capital Structure
Global Markets
Liability Strategies Group
January 2006
Corporate Capital Structure
Authors
Henri Servaes
Professor of Finance London Business School
The Theory and Practice of Corporate Capital Structure
Peter Tufano
Sylvan C. Coleman Professor of Financial Management Harvard Business School
Editors
James Ballingall
Capital Structure and Risk Management Advisory Deutsche Bank +44 20 7547 6738 james.ballingall@db.com
Adrian Crockett
Head of Capital Structure and Risk Management Advisory, Europe & Asia Deutsche Bank +44 20 7547 2779 adrian.crockett@db.com
Roger Heine
Global Head of Liability Strategies Group Deutsche Bank +1 212 250 7074 roger.heine@db.com
The Theory and Practice of Corporate Capital Structure
January 2006
Executive Summary
This paper discusses the theory and practice of corporate capital structure, drawing on results from a recent survey. Theoretical Considerations A firm could use three methods to determine its capital structure: Trade off Theory: There are various costs and benefits associated with debt financing. We would expect firms to trade off these costs and benefits to come up with the level of debt that maximizes the value of the firm or the value accruing to those in control of the firm. The most significant factors are listed below, together with the impact on the optimal level of debt. indicates that the factor is a benefit of debt and leads to a higher optimal debt level, while indicates a cost of debt that reduces the optimal level. For some factors the impact is not clear and these are indicated as /
Variable Taxes Corporate tax rate Personal tax rate on equity income Personal tax rate on debt income Financial Distress Costs Direct Indirect Debt Mispricing Interest rates on my debt are too low Interest rates on my debt are too high Positive market sentiment towards debt financing Negative market sentiment toward debt financing Information Signalling firm quality Signalling aggressive
Liability Strategies Group
January 2006
Corporate Capital Structure
Authors
Henri Servaes
Professor of Finance London Business School
The Theory and Practice of Corporate Capital Structure
Peter Tufano
Sylvan C. Coleman Professor of Financial Management Harvard Business School
Editors
James Ballingall
Capital Structure and Risk Management Advisory Deutsche Bank +44 20 7547 6738 james.ballingall@db.com
Adrian Crockett
Head of Capital Structure and Risk Management Advisory, Europe & Asia Deutsche Bank +44 20 7547 2779 adrian.crockett@db.com
Roger Heine
Global Head of Liability Strategies Group Deutsche Bank +1 212 250 7074 roger.heine@db.com
The Theory and Practice of Corporate Capital Structure
January 2006
Executive Summary
This paper discusses the theory and practice of corporate capital structure, drawing on results from a recent survey. Theoretical Considerations A firm could use three methods to determine its capital structure: Trade off Theory: There are various costs and benefits associated with debt financing. We would expect firms to trade off these costs and benefits to come up with the level of debt that maximizes the value of the firm or the value accruing to those in control of the firm. The most significant factors are listed below, together with the impact on the optimal level of debt. indicates that the factor is a benefit of debt and leads to a higher optimal debt level, while indicates a cost of debt that reduces the optimal level. For some factors the impact is not clear and these are indicated as /
Variable Taxes Corporate tax rate Personal tax rate on equity income Personal tax rate on debt income Financial Distress Costs Direct Indirect Debt Mispricing Interest rates on my debt are too low Interest rates on my debt are too high Positive market sentiment towards debt financing Negative market sentiment toward debt financing Information Signalling firm quality Signalling aggressive
References: Welch, I. 2004. Capital structure and stock returns. Journal of Political Economy 112, 106–131. We follow the logic outlined by Brealey and Myers (2005). Start with the general formula for the present value of a cashflow: ∞