Academic journal article Economic Quarterly - Federal Reserve Bank of Richmond

Corporate Capital Structure: The Control Roles of Bank and Public Debt with Taxes and Costly Bankruptcy

Academic journal article Economic Quarterly - Federal Reserve Bank of Richmond

Corporate Capital Structure: The Control Roles of Bank and Public Debt with Taxes and Costly Bankruptcy

Article excerpt

Corporate finance theory studies the way that firms choose to raise funds. Traditionally, this theory focused on the effect of capital structure on income tax payments and exogenously specified administrative costs of bankruptcy. More recently, this theory has emphasized the effect of capital structure on the control of subsequent investment decisions of the firm, in settings where managers' and investors' incentives are not perfectly aligned. Both the tax-oriented approach and the control-oriented approach capture important aspects of the decision that firms make when they choose a method of finance. To date, however, the insights from the two theories have not been integrated. Tax-oriented theories typically ignore issues of corporate control, while control-oriented theories typically ignore taxes. In addition, tax-oriented theories consider only a firm's choice between debt and equity, while some of the control-oriented theories study the importance of the source of debt finance: the choice between bank loans (privately placed debt) and bonds (publicly issued debt).

This article combines traditional tax-based capital structure theory with an analysis of the control and incentive effects of debt. It presents a model of both the firm's choice of the amount of debt and equity and its choice between bank loans and publicly traded debt. Following the traditional approach, capital structure choice is framed as a trade-off between tax savings of debt and costs of bankruptcy. Accounting for the control roles of bank loans and public debt emphasized in more recent work then allows for the endogenous determination of bankruptcy costs. The model shows how the costs of bankruptcy can sometimes be negative (so bankruptcy becomes a net benefit), when bankruptcy allows claim holders to prevent a borrower from undertaking an unprofitable investment.

Endogenous bankruptcy costs depend on the type of debt used and the characteristics of the borrower. One relevant borrower characteristic is the correlation between the return from past investments and the profitability of new investment. If this correlation is high, then the borrower will be unable to refinance debt only when its old and new investments are both unprofitable, so inability to refinance indicates that new investment is unprofitable and bankruptcy desirable. If the correlation is low, then the inability to refinance is not a clear indicator of poor prospects for new investment, and bankruptcy due to the inability to refinance will sometimes be quite costly.

Modigliani and Miller (1958) established the framework for studying capital structure by finding apparently reasonable conditions rendering a firm's capital structure irrelevant to its value. The earliest generalization was Modigliani and Miller (1963), which viewed capital structure as an attempt to reduce taxes. They studied the implications of a tax advantage to debt over equity that still exists in the United States. Corporate taxes are avoided for interest payments but not for dividends. If there are no other advantages to equity over debt, the conclusion is that firms should issue no equity and should issue debt with face value equal to the highest possible future value of the firm. Such all-debt firms would almost always default on their debt. Modigliani and Miller assumed that there was no cost associated with frequent default.

The next generalization in the literature assumes that there is an exogenous cost of default--a bankruptcy cost. This bankruptcy cost is a disadvantage of issuing too much debt that is traded off against the taxes saved. This forms the basis for the traditional "trade-off" approach to capital structure in Robichek and Myers (1965) and Kraus and Litzenberger (1973). This approach does not analyze the source of such bankruptcy costs or allow any non-tax benefits of debt. It identifies volatility of firm value as a force that limits debt. It predicts that firms with high-variance cash flow distributions will choose less debt and more equity than those with low variance. …

Search by... Author
Show... All Results Primary Sources Peer-reviewed

Oops!

An unknown error has occurred. Please click the button below to reload the page. If the problem persists, please try again in a little while.