[An updated version of this article can be found at Corporate Financial Structure in the 2nd edition.]
The eighties were the decade of corporate debt. Tremendous changes in corporate financing occurred. The phenomenal growth in the use of junk bonds, the onslaught of debt-financed hostile takeovers and leveraged buyouts, and massive corporate restructuring dominated news stories and discussions about U.S. business. Many commentators warned that these debt-bloated companies and an economic downturn could turn the nineties into the decade of bankruptcy.
In determining how much debt to use, corporate managers have reacted rationally to taxes. Indeed, the U.S. tax code may be the number one explanation for high debt levels. By allowing corporations to deduct interest payments from income before taxation, the U.S. government essentially subsidizes every dollar paid in interest. So instead of asking why the use of corporate debt has increased, perhaps the question should be why it has taken so long for the increase to occur.
For many financial economists the efforts of corporate managers to dramatically change the amount of debt on their balance sheets simply confirms the validity of a seminal 1958 paper by Franco Modigliani and Merton Miller. The paper is so well-known that financial economists now refer to the theory it elaborates as "the M&M theory." This paper arguably began the study of finance as its own discipline.
M&M showed that the value of a firm (and of its cash flows) is independent of the ratio of debt to equity used by the firm in financing its investments. This stunning conclusion was based on certain assumptions that are not true of the real world: there are no corporate or personal taxes; people have perfect information; individuals and corporations can borrow at the same rates; and how you pay for assets does not affect productivity. Still, it provides a jumping off point for a better understanding of corporate debt.
First, consider the assumption that how you pay for assets does not affect their productivity. In a simplified example, how you pay for a feather, a stone, and a vacuum chamber does not affect the basic law of physics that the stone and the feather will fall at the same rate in a vacuum. Whether the inputs are paid for with cash (equity) or credit (debt) cannot affect the results or the productivity of the inputs.
M&M extend this simple illustration with their famous arbitrage proof. Since we assume that capital structure cannot affect the productivity of assets, capital structure can affect the value of the firm only if investors are willing to pay more (or less) for the leveraged—highly indebted—firm. With the arbitrage proof M&M show that the leveraged and unleveraged firm must have the exact same value. An example shows why.
First, think of two firms that are identical in all respects except that one is financed completely with equity while the other uses some combination of equity and debt. Let Ms. E. buy 10 percent of the all-equity firm; she buys 10 percent of the outstanding shares. Mr. D. buys 10 percent of the leveraged firm; he buys 10 percent of the shares and 10 percent of the debt.
Now we want to determine what Ms. E. and Mr. D. get back for their investments. In the all-equity firm Ms. E. has a claim on 10 percent of the total profits of the firm. In the leveraged firm, however, the debt holders must receive their interest payments before the shareholders receive the remaining profits. Thus, for his share holdings, Mr. D. gets 10 percent of the profits after interest payments to debt holders are subtracted. But because Mr. D. also holds 10 percent of the bonds, he receives 10 percent of the profits that were paid out as interest payments. The net result for Mr. D? He receives 10 percent of the total profits, just as Ms. E. does.
This reasoning led M&M to argue that the leveraged firm and the all-equity firm must have the exact same value. The value of the all-equity firm is the value of the outstanding stock. The value of the leveraged firm is the value of the outstanding stock plus the value of the outstanding debt. Since the firms are identical in the level of total profits and identical in the cash payouts paid to the investors, Ms. E. and Mr. D. would pay identical amounts for their respective holdings. M&M went on to show that if the leveraged and all-equity firms do not have the exact same value, arbitragers can make a guaranteed risk-free profit by selling the overvalued firm and buying the undervalued firm.
The proposition that the ratio of debt to equity is irrelevant to the value of the company is known as the "irrelevance" proposition. Many commentators quickly rejected the irrelevance proposition because its restrictive assumptions separated it from the real world. In 1963 Modigliani and Miller modified their discussion of corporate debt to specifically recognize corporate taxes. Under current tax regulations, interest payments made to bondholders are deducted from corporate income before computation of taxes owed. In a real sense, therefore, the government subsidizes those interest payments. If the corporate tax rate is 34 percent, for every dollar paid in interest payments, 34 cents in corporate taxes is avoided, though those receiving the interest must pay taxes on it. In contrast, if income is paid out as dividends to shareholders, that income is taxed twice—once at the corporate level and once at the personal level. The implication, well-known to students of corporate finance, is that every corporation should minimize its taxes and maximize the cash available to bond- and stockholders by financing its investments with close to 100 percent debt.
This result was more controversial than the first. Casual empiricism shows that firms do not finance their investments with 100 percent debt and that there are clear patterns in financing decisions. Young firms in high-growth industries, for example, tend to use less debt, and firms in stable industries with large quantities of fixed assets tend to use more debt. The ensuing study of capital structure and corporate debt has focused on explaining these patterns and explaining why corporations are not 100 percent debt financed.
Financial economists have singled out three additional factors that limit the amount of debt financing: personal taxes, bankruptcy costs, and agency costs. In a 1977 article, Miller extended his earlier work with Modigliani to show that considering corporate taxes in isolation was incorrect.
Transferring interest payments to individuals to avoid corporate taxes does not make investors any better off if they then have to pay higher personal taxes on that income than the corporation and investors would have owed if the corporation had not used debt. Miller argues that because taxes owed on capital gains are (at many points in our history) lower than taxes owed on dividend and interest income, the firm might lower the total tax bill paid by the corporation and investor combined by not issuing debt. Moreover, taxes owed on capital gains can be deferred until the realization of those gains, further lowering the effective tax rate on capital gains.
The important thrust of Miller's argument is that one must look at the interaction of both corporate and personal taxes to determine the optimal level of corporate debt. Miller showed that because of this interaction, there is an optimal level of debt (less than 100 percent) for the economy as a whole. That said, however, he also showed that, for any given firm within the economy, the level of debt is again irrelevant as long as the economy-wide average is at the optimal level.
Financial distress or bankruptcy costs may also keep firms from loading up on debt. These financial distress costs take two forms—explicit and implicit. Explicit financial distress costs include the payments made to lawyers, accountants, and so on in filing for Chapter 11 protection from creditors or in liquidation of the firm. These costs can represent a significant portion of corporate assets. Corporations must also consider the indirect costs of bankruptcy. These include the costs of low inventories, higher costs of inputs from suppliers who fear the company might not pay its bills next month, and the loss of customers who desire a long-term relationship with the firm. The reluctance of travelers to buy airplane tickets from airlines in financial distress or Chapter 11 certainly illustrates these indirect costs.
The costs of financial distress are dead-weight losses to the investors of the firm: they reduce the cash flows that will eventually be paid to the bondholders and stockholders. Clearly, investors would prefer that firms stay out of financial distress so that these losses are not incurred. As the firm takes on more and more debt, however, the probability of bankruptcy increases. The chance that the firm will not be able to meet interest payments in any given year and will be forced into default goes up as the amount of debt and corresponding interest increases. These costs prevent firms from maintaining exceptionally high levels of debt.
A third factor limiting the use of debt is "agency costs." Michael Jensen and William Meckling, in a 1976 article, noted differences between the firm that is 100 percent manager owned and one where the equity is owned partially by managers and partially by outsiders. The managers, in the latter case, act as agents for the outside shareholders. Agents should run the firm to maximize its value. But Jensen and Meckling recognize that managers may not be perfect agents and that they may make some decisions in their own interests rather than those of shareholders.
The concept of agency costs is readily applied to shareholder-bondholder relations also. The shareholders, through the managers, have the right to make most decisions about how to run the firm. The firm owes the bondholders fixed payments equal to the amount of money loaned to the firm and the interest payments going along with those payments. Shareholders may adopt policies that benefit themselves at the expense of the bondholders. The possibility for such self-serving behavior is strongest when it is not clear that the firm will have sufficient cash flow to cover its interest and principal loan payments.
The most obvious action shareholders might take to benefit themselves is to pay out all of the firm's assets as dividends to themselves, leaving an empty shell for the bondholders to claim when the firm is then unable to repay its debt. Shareholders might also follow more subtle strategies. One has been called "risk shifting." A football analogy illustrates the risk-shifting concept. Woody Hayes, the legendary Ohio State University football coach known for grinding out yardage on the ground, used to say that three things can happen when you pass the ball, and two of them are bad. His philosophy is sound in a close game; in that case it is best to play conservatively and avoid the risk of incompletion or interception. But if you're down by three touchdowns in the fourth quarter, a conservative strategy will not get you back into the game quickly. Instead, you should throw a bomb—a long pass. True, the ball might be intercepted or fall incomplete, but if you were going to lose anyway, the downside is not that bad. On the upside is the chance of a big payoff—a touchdown.
How does this relate to shareholders and bondholders? If it looks as if the firm will not be able to cover its obligations and thus the equity claim is worthless, shareholders may throw the bomb, i.e., take on risky projects that have big payoffs but high probability of failure. If the project does fail, bondholders lose, but the shareholders are no worse off since their claims were worthless anyway. But if the project succeeds, the shareholders will be the major beneficiaries.
A third strategy that may be costly to bondholders is underinvestment on the part of stockholders. If the firm is close to being unable to meet its obligations to bondholders, shareholders may not be willing to put more equity into the firm to fund money-making projects. The reason is that any profits from the new projects are likely to go to bondholders rather than being returned to stockholders. While bondholders would be better off if the projects were undertaken, stockholders will not be willing to pay for them.
All three strategies—paying out large dividends, risk shifting, and underinvestment—are more likely the more indebted is the firm. Lenders know this. Therefore, those who organize the firm, wanting to attract lenders, rationally limit the debt.
Bond covenants exist to restrict these games that shareholders might play, but bond contracts cannot restrict against all eventualities. An interesting development of the eighties, however, was the development of the "poison put." In reaction to the large leveraged buyouts of the eighties, many companies began to introduce these poison puts to protect bondholders in the event of a leveraged transaction. Bondholders generally have the right to "put" the bonds to the company and have them repurchased at face value or plus some small premium if the company takes on a lot of new debt that reduces the chance that the current bondholders will be paid off. These recent developments illustrate the dynamic nature of corporate finance.
There is no crystal ball to predict whether the increased levels of corporate debt of the eighties will be maintained. When junk bond king Michael Milken was convicted on charges of security-market manipulation, many feared that the absence of the man who had provided much of the important liquidity in the junk bond market would lead to lower levels of corporate debt. Recent news, however, suggests that the junk-bond market is reviving and other investment banking firms are providing the much-needed markets for these securities. The U.S. tax code still encourages the use of large amounts of debt, though the tendency to high debt is counterbalanced by bankruptcy and agency costs. Whether firms do have too much leverage and whether we are facing a decade of bankruptcy are questions that can be answered only in time. If there has been an "overleveraging" of corporate America and investors come to believe that corporate debt is too high, they will demand higher and higher interest rates until corporations can no longer afford to issue debt. In this way any overleveraging in an unregulated market will be self-correcting.
Annette Poulsen holds the Augustus H. "Billy" Sterne Chair of Banking and Finance and is an associate professor of finance at the University of Georgia's Terry College of Business. She was formerly acting chief economist at the Securities and Exchange Commission.
Jensen, Michael, and William Meckling. "Theory of the Firm: Managerial Behavior, Agency Costs and Ownership Structure." Journal of Financial Economics 3 (October 1976): 305-60.
Lehn, Kenneth, and Annette Poulsen. "Contractual Resolution of Bondholder-Stockholder Conflicts in Leveraged Buyouts." Journal of Law and Economics 34 (October 1991): 645-73.
Miller, Merton. "Debt and Taxes." Journal of Finance 32 (May 1977): 261-76.
Miller, Merton. "Leverage." Journal of Finance 46 (June 1991): 479-88.
Modigliani, Franco, and Merton Miller. "The Cost of Capital, Corporation Finance and the Theory of Investment." American Economic Review 48 (June 1958): 261-97.
Modigliani, Franco, and Merton Miller. "Corporate Income Taxes and the Cost of Capital: A Correction." American Economic Review 53 (June 1963): 433-43.
Warner, Jerold B. "Bankruptcy Costs: Some Evidence." Journal of Finance 32 (May 1977): 337-48.