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Capital Structure, Payout Policy, and Financial Flexibility Financial flexibility is the single most important determinant of capital structure according to CFOs (e, e.g., Graham and Harvey (2001) ), yet the only prominent theory to recognize its value---Myers and Majluf’s (1984) pecking order model---has rious empirical shortcomings. In fact, Fama and French (2005) conclude that the pecking order is “dead”as a stand-alone theory of capital structure becau of its inability to explain why equity issues are commonplace, and are not exclusively the financing vehicle of last resort. Extant trade-off theories of capital structure fare no better empirically, since they fail to explain (i) why firms do not “lever up” after large stock price increas, (ii) why many profitable firms maintain low debt, thus forego interest tax shields available at little distress risk, and (iii) why leverage rebalancing is difficult to detect and, when detected, why it occurs with a delay that is not plausibly explained by adjustment costs. The empirical corporate finance literature which, as Fama and French (2005, pp.580-581) note, in recent years has largely focud on running a “hor race” between the pecking order and trade-off theories, is now left with no empirically viable theory of capital structure.
段确
This paper argues that financial flexibility is the critical missing link for an empirically viable theory, but that the pecking order fails to deliver that theory becau its numerous restrictive assumptions narrow its focus sufficiently to preclude a meaningful analysis of the impact of financial flexibility on corporate financial policies. Specifically, the pecking order theory falls short becau it (i) focus on a “one-shot” financing decision, thus it rules out the inter-temporal trade-offs that are central to firms’debt capacity utilization decisions, (ii) assumes that asymmetric information allows lf-interested managerial behavior at curity issuance, but at no other time, thus it ignores the fact that asymmetric information also engenders agency costs, i.e., it allows managers to benefit themlves at outside stockholders’ expen by over-retaining corporate resources, (iii) assumes away any effect of corporate taxes
on optimal cash balances and debt levels, which is likely to be non-trivial, and (iv) ignores the inherent interdependence of capital structure and equity payout policies, a factor which we show has important implications for how firms build, prerve, and draw down financial flexibility over time.
Tax/distress cost trade-off theories fall short becau they ignore the importance of financial flexibility, even though distress costs are ultimately caud by the same informational asymmetry that underlies the pecking order’s curity valuat ion problems. Indirect and direct distress costs occ
ur only when firms that cannot meet extant promis to creditors are unable to access capital markets at terms acceptable to both managers and outside investors. If managers and outside investors had identical information, thus could readily agree on the values of the firm’s current and potentially-issued curities, they would always recapitalize the firm to replace debt with equity and avoid all direct or indirect distress costs (Coa (1960), Haugen and Senbet (1978) ). Importantly, the same information asymmetry that engenders distress costs that ex ante reduce optimal leverage also creates an ex ante value to financial flexibility, which reduces tho costs. By ignoring this linkage, distress cost theories fail to recognize that managers will lect ex ante financial policies that provide the ex post flexibility to mitigate the real resource costs caud by curity valuation problems, both in financial distress and in healthy firms that require outside capital. As we show, recognizing this linkage leads to capital structure decisions that differ radically from tho of traditional trade-off theories.
This paper remedies the deficiencies of the pecking order and trade-off theories by relaxing their restrictive assumptions to develop an internally consistent theory in which firms face agency costs and corporate taxes on cash holdings, which managers weigh against curity valuation costs to determine optimal financial policies. With agency costs and taxes, internal funds are costly, thus man
agers cannot rely on cash balances to fund unanticipated new investment opportunities and earnings shortfalls, but must now cultivate access to external capital markets. Debt no longer dominates equity issuance simply becau it is easier to value, since with multiple uncertain financing needs arriving over time, utilization of debt capacity today risks future
有关创新的名言investment distortions becau it can leave a firm hamstrung for capital tomorrow. Firms thus have low leverage targets, and so tho that generate FCF cannot rely on debt payments alone to limit their cash balances, rather they must substitute into equity payouts to control agency costs and avoid taxes on cash holdings. Equity payouts also help convince outside investors that managers will make substantial future payouts, and thereby reduce the firm’s curity valuation problems.
Importantly, firms’ex ante optimal financial policies provide flexible ex post access to both debt and equity markets to meet future funding needs caud by unanticipated earnings shortfalls or new investment opportunities. Mature firms limit internal funds by paying substantial dividends rather than making high debt payments, both becau low leverage provides unud debt capacity which can be tapped to mitigate investment distortions, and becau firms with strong dividend records develop reputations for generous payouts, enabling them to ll equity at prices clor to intrinsic value (Shleifer and Vishny (1997), La Porta et.al. (2000)). Optimal financial policies for mature firms thus c
onsist of low leverage, substantial ongoing dividends, and limited cash holdings. Low leverage is also optimal for growth firms, which ideally have higher cash balances than mature firms and pay lower (or no) dividends. Low leverage remains the long-run target for many (but not all) firms when interest is tax deductible, since firms cannot capture corporate tax benefits without reducing cash balances and utilizing debt capacity, actions that sacrifice financial flexibility and thereby risk future investment distortions.
天行健君子当自强不息In our theory, today’s borrowing cost is the opportunity cost of an inability to borrow tomorrow when the firm may need to issue debt to avoid investment distortions (becau managers with superior information are reluctant to ll stock at the market price that manifests tomorrow). Although this opportunity cost is an ex ante impediment to leverage, it embodies an inter-temporal dependence in borrowing that distinguishes it from the ex post dead-weight costs of debt in traditional trade-off theories, and which is responsible for generating entirely new leverage rebalancing predictions. Simply put, low leverage is desirable today becau it provides the option to borrow tomorrow and deviate temporarily from the long-run target. Hence low方脸
leverage is ex ante optimal, but managers fully expect to deviate deliberately from target ex post as circumstances dictate and to rebalance back to target as firm-specific and market conditions permit.
鸭胸
Transactions costs of adjustment are zero in our theory, thus they have no impact on the time path of deviations from and rebalancing to target leverage, a path that is determined by the ex-post quence of realized capital needs and market-pricing conditions.
Leverage dynamics unfold as follows. Depending on firm-specific and market conditions, firms issue debt or equity when faced with a near-term need for external capital, and marginal financing decisions do not follow the (strict or modified) pecking order. Firms do not “stockpile” issuance proceeds becau, abnt obviously profitable investment opportunities that can be executed only with a lag, that strategy is functionally equivalent to visible excess FCF retention. Debt issuances are deliberate, temporary departures from the low leverage optimum, and not movements toward a higher leverage optimum as in tax/distress cost theories. Firms do not “lever up” after a share price increa, unless that increa reflects an unanticipated need for external capital and debt is more attractively priced than equity, which is now less likely (unless the share price increa is exceeded by a greater concomitant increa in intrinsic value). Rebalancing to the low leverage target occurs with a lag, even though adjustment costs are zero. The speed of rebalancing depends on the firm’s subquent earnings, investment needs, and the (current and expected future) relation between market and intrinsic values.
五言绝句Becau optimal capital structure, payout policy, and corporate cash holdings are jointly determined, there are multiple moving parts to our analysis, thus we initially ignore taxes and develop (in ctions 2 and 3) the financial policy implications of curity valuation and agency costs. Section 4 discuss departures from and rebalancing to target leverage, and explains why our predicted leverage dynamics differ from tho of extant trade-off theories. Section 5 adds corporate taxes to the theory, and identifies additional testable implications of this generalization. Section 6 concludes.
Conclusion:
Optimal financial policies limit cash balances and provide flexible access to external (debt and equity) capital when (i) firms face curity valuation costs, agency problems, and corporate taxes, and (ii) capital structure, payout policy, and cash balances are jointly determined. Abnt taxes, low leverage and substantial ongoing dividends are ex ante optimal for FCF-generating firms becau they enable managers to accomplish three objectives they cannot jointly accomplish through any other means. First, substantial ongoing dividends limit cash balances, thereby reducing agency costs. Second, they facilitate future access to equity capital at advantageous terms becau they demonstrate managers’commitment to continued high equity payouts. Third, using dividends instead of debt payments to control cash accumulation prerves debt capacity for future borrowing. The ex
ante optimal financial strategy builds/prerves the option to issue either debt or equity when a need for capital materializes, while the ex post choice between debt and equity trades off debt’s relative ea of valuation against the loss of future financial flexibility from using debt capacity now. Low leverage remains optimal for many (but not all) firms when interest is tax deductible becau firms cannot capture tax benefits without carrying positive “net debt” and thereby sacrificing future financial flexibility.
Our analysis shares with extant trade-off theories the prediction of a target leverage optimum but, becau financial flexibility per is valuable, our predicted leverage dynamics differ radically from tho of such theories, in which debt issuances always move a firm toward its leverage target, whereas a failure to issue debt after an exogenous leverage decrea reflects either prohibitive adjustment costs or rejection of the theory. In our theory, debt issuances are intentional movements away from the long-run (low) leverage optimum, and a failure to issue debt after a stock price increa reflects a deliberate managerial decision to rebalance leverage toward the target. Low leverage is ex ante optimal precily becau it provides the option to temporarily deviate ex post from that ideal by issuing debt when capital needs ari. Even when transactions costs of adjustment are zero, subquent adjustments back to target are never instantaneous, rather they become possible and attractive following positive FCF realizations and changes in capital market
