Capital Structure in

the Modern World

Anton
Miglo
Capital Structure in the Modern World
 Anton Miglo

Capital Structure in
the Modern World
Anton Miglo
Nipissing University, Ontario, Canada

ISBN 978-3-319-30712-1 ISBN 978-3-319-30713-8 (eBook)

DOI 10.1007/978-3-319-30713-8

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To my parents Alla and Viktor.
 Preface

Capital structure is a very interesting and probably one of the most con-
troversial areas of finance. It is an area of permanent battles between dif-
ferent managers defending their favorite approaches, between theorists
and practitioners looking at the same problems under different angles,
and between professors and students since the area is complicated
and requires a superior knowledge of econometrics, microeconomics,
accounting, mathematics, game theory etc. Many of the results obtained
in capital structure theory over the last 50–60 years have been very influ-
ential and led their authors to great international recognition. Among the
researchers who contributed significantly to capital structure theory, note
Nobel Prize Award winners Franco Modigliani, Merton Miller, Joseph
Stiglitz, and most recently Jean Tirole. Although until recently capital
structure theories did not have strong support from practitioners and
were too complicated to teach at colleges and business schools, they are
quickly gaining recognition at universities and in the real world. This
field has become extremely intriguing to potential employees and stu-
dents. The roles of investment banker and corporate treasurer, which
require fundamental capital structure education, are very popular.
This book focuses on the microeconomic foundations of capital struc-
ture theory. Some areas are based on traditional cost-benefit analyses,
but most include analyses of different market imperfections, primarily
asymmetric information, moral hazard problems and, more recently
vii
viii Preface

developed, imperfections involving incomplete contracts. Knowledge of

game theory and contract theory prior to reading this book is beneficial
but I aim to present the material in the most accessible way possible,
with lots of examples for readers with different levels of knowledge. For
additional readings in the field of capital structure, I recommend Capital
Structure and Corporate Financing Decisions (edited by. Baker and Martin,
2011) and Financing Growth in Canada (edited by Halpern, 1997). Both
of these editions have a more applied approach to capital structure,
including empirical research and econometrics, and cover a lot of inter-
esting topics relating to capital structure and financing decisions. I would
also recommend the journalofcapitalstructure.com website dedicated to
capital structure discussions.
This book attempts to explain the basic concepts of capital structure
as well as more advanced topics in a consistent fashion. The first part
is focused on providing an introduction to the major theories of capi-
tal structure: Modigliani and Miller’s irrelevance result, trade-off theory,
pecking-order theory, asset substitution, credit rationing, and debt over-
hang. I think that the majority of the basic ideas in capital structure
compliment each other quite logically although significant disagreement
between researchers still exists about which theory is more important in
practice. Part II discusses such topics as capital structure and a firm’s per-
formance, capital structure and corporate governance, capital structure of
small and start-up companies, corporate financing versus project financ-
ing and examples of optimal capital structure analyses for some compa-
nies. Many advanced theories of capital structure discussed in Part II are
still growing areas of research. At the same time, the objective of the book
is not to cover as many topics of capital structure as possible but rather to
review the major theoretical concepts and provide basic tools to under-
stand the complicated area of capital structure.
Many of the existing ideas of capital structure were created by “inject-
ing” a new type of market imperfection into different capital structure
analyses. From my experience, the comprehension of this fact is crucial
to understanding the theory of capital structure. At the beginning of my
PhD studies I was spending a lot of time explaining to my adviser why
debt financing and equity financing create different degrees of risk for a
company. At the time, I was surprised not to see an extremely enthusiastic
 Preface ix

reaction to my “discoveries” from my PhD adviser who was mostly point-

ing to the importance of market imperfections in my research. When
teaching capital structure in my classes, I am always primarily concerned
with how well students understand the difference between perfect and
imperfect markets. The challenge for me has been to explain the impor-
tance of the marginal differences in models’ assumptions. These differ-
ences are often responsible for large variations in models’ predictions and
their capacities to explain existing empirical evidence. It has been a fasci-
nating experience for me to see how much progress students demonstrate
in understanding different financial concepts.
This book was inspired by over 20 years of my experience in capital
structure research. I was also inspired by my experience with teaching
finance courses at different universities in Europe and North America
including courses directly related to capital structure such as Financing
Strategies and Corporate Governance, Advanced Corporate Finance,
Financial Management II, and Entrepreneurial Finance. It was also
inspired by my working experiences in areas of capital structure man-
agement including issuing stocks and bonds in commercial banks. The
financial crisis of 2008 and 2009 also provided extra motivation. It
seemed that many companies faced problems that stemmed from their
financing policies. Some discussions in this book are devoted to this
topic.

Anton Miglo
North Bay, Ontario, Canada

References
Baker, H., & Martin, G. (Eds.). (2011). Capital structure and corporate
financing decisions, Robert W.  Kolb series in Finance. John Wiley and
Sons, Inc.
Halpern, P. (Ed.). (1997). Financing growth in Canada. University of
Calgary Press.
 Acknowledgements

For very helpful comments and suggestions regarding some topics I

would like to thank Rodrigo González, Finance professor in Pontificia
Universidad Católica de Chile. I would also like to thank Di An, Victor
Bruzon, Sean Coughlin, Benjamin Dilq, Fei Dio, Julian Dove, Sajal
Dutta, Athanasios Gouliaras, Shun Jiang, Jianfeng Lin, Ivana Nesterovic,
Sabilla Rafique Le Sheng, Milos Suljagic, Xumei Tan, Shuai Wang,
Heran Xing, and Joel Wood, for editorial assistance and comments. Last
but not least, I would like to thank Aimee Dibbens, Alexandra Morton,
and Ganesh Pawan kumar along with the design and editorial team from
Palgrave for their work on the cover design as well as the overall support
with the manuscript preparation.

xi
 Contents

Part I Basic Capital Structure Ideas 1

1 Introduction 3
1.1 The Capital Structure Problem 3
1.2 The Concept of Perfect Market and Some Stylyzed Facts 6
1.3 Capital Structure Choice Analysis: The Beginnings 9
References 17

2 Modigliani-Miller Proposition and Trade-off Theory 21

2.1 Three Ideas 21
2.2 Modigliani–Miller Theorem 23
2.3 Bankruptcy Costs 27
2.4 Corporate Income Taxes and Capital Structure 30
2.5 Trade-off Theory 32
2.6 Theory Predictions and Empirical Evidence 36
References 41

3 Asymmetric Information and Capital Structure 45

3.1 Finance and Asymmetric Information 45
3.2 Insiders and Outsiders 46

xiii
xiv Contents

3.3 Pecking Order Theory 47

3.4 When Incumbent Shareholders Are Risk-Averse 56
3.5 Is Asymmetric Information Behind the 2007 Crisis? 62
References 66

4 Credit Rationing and Asset Substitution 69

4.1 Shareholders Versus Creditors: Capital Structure Battle 69
4.2 Asset Substitution and Risk-Shifting 71
4.3 Credit Rationing 80
4.4 Other Related Ideas 83
Appendix 1: Stochastic Dominance 90
References 94

5 Debt Overhang 97
5.1 Debt Overhang 97
5.2 How Does the Type and the Level of Debt Affect
the Underinvestment Problem 100
5.3 Debt Overhang Implications and Prevention 102
5.4 Flexibility Theory of Capital Structure 107
5.5 Debt Overhang in Financial Institutions 108
References 111

Part II Different Topics 113

6 Capital Structure Choice and Firm’s “Quality” 115

6.1 Interesting Problem 115
6.2 The Role of Asymmetric Information 117
6.3 Capital Structure, Market Timing and Business Cycle 125
References 131

7 Capital Structure and Corporate Governance 135

7.1 Corporate Governance 135
7.2 Financing Strategy and Managerial Incentives:
Free Cash Flow Theory 137
 Contents xv

7.3 Financing Strategy, Incomplete Contracts and

Property Rights Allocation 140
7.4 Costly Effort, Capital Structure, and Managerial
Incentives 144
7.5 Earnings Manipulation 147
7.6 Other Works 153
References 157

8 Capital Structure of Start-Up Firms and Small Firms 163

8.1 Life Cycle Theory of Capital Structure 163
8.2 Capital Structure of Venture Firms 165
8.3 Debt Financing for Small Businesses 170
References 178

9 Corporate Capital Structure vs. Project Financing 183

9.1 Introduction 183
9.2 Moral Hazard Models 187
9.3 Asymmetric Information Models 194
9.4 Other Models 202
References 207

10 Capital Structure Analysis: Some Examples 211

10.1 Social Media and Airline Industries 211
10.2 Methodology 214
10.3 Capital Structure Analysis 215
References 225

Answers/Solutions to Selected Questions/Exercises 227

Index 251
 List of Figures

Fig. 1.1 Timeline 10

Fig. 1.2 Balance sheet changes and final income statement
under debt financing 11
Fig. 1.3 Balance sheet changes and final income statement
under equity financing 12
Fig. 1.4 Debt payments under limited liability 14
Fig. 1.5 Debt payments under unlimited liability 15
Fig. 2.1 Balance sheets of firms U and L 24
Fig. 2.2 Optimal level of debt under trade-off theory 33
Fig. 2.3 Optimal level of debt under trade-off theory
when B increases 35
Fig. 2.4 Optimal level of debt under trade-off theory
when I increases 38
Fig. 3.1 Sequence of events 48
Fig. 3.2 The Firm 1 owners’ payoff under imperfect information 49
Fig. 3.3 The sequence of events under imperfect information 58
Fig. 4.1 The sequence of events 72
Fig. 4.2 Credit rationing 80
Fig. 4.3 Sequence of events 82
Fig. 4.4 First-order stochastic dominance (FOD) 91
Fig. 5.1 Sequence of events 98
Fig. 5.2 Sequence of events 100
Fig. 6.1 Sequence of events 119

xvii
xviii List of Figures

Fig. 6.2 Sequence of events 126

Fig. 7.1 Sequence of events 138
Fig. 7.2 Sequence of events 142
Fig. 7.3 The rule of marginal revenues under debt financing 143
Fig. 7.4 Optimal effort under equity financing 145
Fig. 7.5 Optimal contract under costly state verification 149
Fig. 7.6 Optimal effort under debt financing 152
Fig. 8.1 Capital structure ideas across a firm’s life cycle 164
Fig. 8.2 Sequence of events 167
Fig. 8.3 The choice of financing 174
Fig. 9.1 Sequence of events 188
Fig. 9.2 Sequence of events 195
 List of Tables

Table 1.1 Debt ratios for selected industries 7

Table 1.2 Average IPO returns 8
Table 1.3 Average IPO returns in selected countries 8
Table 1.4 Average long run operating underperformance
of firms that issue equity 9
Table 1.5 Firms’ access to debt 9
Table 2.1 Investments and earnings from strategies 1 and 2 in
Example 2.1 26
Table 2.2 Largest bankruptcies in US history 28
Table 2.3 Corporate tax rates in selected countries 31
Table 3.1 Expected profits and variances in Example 3.2 58
Table 4.1 Projects and earnings in Example 4.1 74
Table 4.2 Shareholders’ payoff in Example 4.1 75
Table 4.3 Projects and earnings in Example 4.2 76
Table 4.4 New and existing project earnings 77
Table 4.5 Projects and earnings 81
Table 4.6 Projects and profits in Example 4.3 92
Table 4.7 Stochastic dominance analysis in Example 4.3 92
Table 4.8 Projects, outcomes and probabilities in Example 4.4 93
Table 4.9 Stochastic dominance analysis in Example 4.4 94

xix
xx List of Tables

Table 10.1 Results from Facebook analysis 2011 217

Table 10.2 Results from Facebook analysis 2015 217
Table 10.3 Results from United analysis 2015 222
Table 10.4 Information UHC ownership 223
 Part I
Basic Capital Structure Ideas

This section covers such topics as the  Modigliani—Miller proposition,

the role of bankruptcy costs and taxes, trade-off theory, the role of asym-
metric information, and the  role of moral hazard for capital structure
policy.
 1
Introduction

1.1 The Capital Structure Problem

Capital structure is a firm’s mix of debt and equity. For a long period of
time, capital structure was considered a very “technical” area that con-
cerned at most one or two employees in an average company. To a tra-
ditional business person, this area was unlikely to generate significant
revenue compared to other areas of finance such as rightly chosen invest-
ment projects. In recent years, the situation has changed significantly.
Capital structure has become an incredibly important and intriguing area
of theoretical and practical finance. Here are some examples.
In 2009, former Google CFO Patrick Pichette was asked by James
Manyika from McKinsey consulting firm: “On that point, to what extent
do considerations about capital structure factor into your thinking?” Mr.
Pichette said that capital structure matters a lot. He also connected the
problem of capital structure to the degree of business freedom: “If we
could predict the strategic flexibility we’ll need in such an uncertain envi-
ronment, we could optimize the balance sheet perfectly. But consider the
constraints: leverage [capital structure! A. Miglo], dividends, and so on.
Then call me the next day and say, ‘Hey, I need something. I’m inventing X.’

© The Editor(s) (if applicable) and The Author(s) 2016 3

A. Miglo, Capital Structure in the Modern World,
DOI 10.1007/978-3-319-30713-8_1
4 Capital Structure in the Modern World

But I can’t help—I don’t have the flexibility—and end up giving up what
could be the most important asset the company needs in order to change
over the next 10 years. We believe there’s an opportunity cost of not
having that flexibility….”1 As we will later learn, Mr. Pichette is talking
about the relatively recent flexibility theory of capital structure. Usually
it means keeping the amount of debt low.
Conversely, famous fast-food chain McDonald’s does not mind using
more debt. In July 2007, according to an article entitled “McDonald’s
reviews capital structure, CFO retiring”, McDonald’s announced the
retirement of CFO Mr. Paull and at the same time announced that they
were issuing more debt. They argued that it will help increase the return
to shareholders.2 Just recently, in 2015, McDonald’s again used a similar
strategy.3 Unlike Google, McDonald’s assets structure has a much higher
fraction of tangible assets, which, as we will later learn, usually makes
debt financing more affordable and meaningful. McDonald’s business
relies significantly on franchising and a lot of their investments depend
on their franchisees. They have a limited ability to raise equity capital
and therefore debt financing is a logical choice. Using debt may also be
related to the problem of providing additional financial discipline. As we
will later learn, this idea is called “debt and discipline” theory.
In the last 10 years there has been a growing interest in the capital
structure of start-up and small companies. Traditionally, it was assumed
that most financing comes from entrepreneurs’ friends and relatives and
the rest possibly from venture capitalists and angel investors. The role of
banks and external debt financing was not important. Recently, it was
discovered that firms that use external debt perform better than those
who do not. Kauffman Foundation, dedicated to entrepreneurial research
and support, in a publication entitled “The Capital Structure Decisions
of New Firms,” suggests that contrary to widely held beliefs that start-
up companies rely heavily on funding from family and friends, outside
debt (financing through credit cards, credit lines, bank loans, etc.) is the
most important type of financing for new firms, followed closely by the

1
Manyika (August 2011).
2
Groom (July 24, 2007).
3
Gandel (December 4, 2015).
 1 Introduction 5

owner’s equity. These two sources accounted for about 75 % of start-up

capital.4
What are other reasons for capital structure being a “hot” area in
finance? First, a series of surveys conducted among financial executives
revealed that a very significant gap exists between the theory and prac-
tice of capital structure. In one of the most notable works in corporate
finance Graham and Harvey (2001) wrote:

“In summary, executives use the mainline techniques that business schools
have taught for years, NPV and CAPM,5 to value projects and to estimate the
cost of equity. Interestingly, financial executives are much less likely to follow
the academically prescribed factors and theories when determining capital
structure. This last finding raises possibilities that require additional thought
and research. Perhaps the relatively weak support for many capital structure
theories indicates that it is time to critically reevaluate the assumptions and
implications of these mainline theories. Alternatively, perhaps the theories are
valid descriptions of what firms should do—but many corporations ignore
the theoretical advice. One explanation for this last possibility is that business
schools might be better at teaching capital budgeting and the cost of capital
than teaching capital structure. Moreover, perhaps the NPV and CAPM are
more widely understood than capital structure theories because they make
more precise predictions and have been accepted as mainstream views for
longer. Additional research is needed to investigate these issues.”6

Second, researchers have very different opinions.7 For example, Frank

and Goyal (2008, 2009) and Singh and Kumar (2008) lean towards the
trade-off theory as being the driving force of capital structure decisions
while Shyam-Sunder and Myers (1999), Bulan and Yan (2009, 2011)
and Lemmon and Zender (2010) lean towards the pecking-order theory.
Graham and Leary (2011) discuss whether the main problem in the field
4
The Capital Structure Decisions of New Firms, Kauffman Foundation (2009). http://www.kauff-
man.org/what-we-do/research/kauffman-firm-survey-series/the-capital-structure-decisions-
of-new-firms.
5
Net-present value and capital-asset pricing model.
6
For other surveys see Graham and Harvey (2002), Bancel and Mittoo (2004, 2011) and Brounen
et al. (2006).
7
For a review of capital structure theory see, for example, Harris and Raviv (1991), Klein et al.
(2002), Miglo (2011) and Khanna Srivastava and Medury (2014).
6 Capital Structure in the Modern World

is the lack of compelling theories or difficulties with empirical estimations

of facts related to capital structure including problems with exact measure-
ments of capital structure! They also suggest that the areas where interesting
results are expected include, among others, the supply side of capital, con-
nections between capital structure and labour contracts, financial contract-
ing, dynamic trade-off theory and capital structure speed of adjustments.
Third, asymmetric information and moral hazard problems between
investors and issuers of various securities played an important role in the
financial crisis of 2008 and 2009. As we will discuss in the book, some
researchers link this fact to capital structure problems. Hence, works like
Hennessy, Livdan, and Miranda (2010) and Acharya and Viswanathan
(2011) perhaps represent examples of new research related to asymmetric
information and moral hazard aspects of capital structure required in this
field.

1.2 The Concept of Perfect Market and Some

Stylyzed Facts
The perfect market is a theoretical concept that assumes a world with no
asymmetric information, no moral hazard, no bankruptcy costs, etc. This
concept predicts the following outcomes:

1. Capital structure does not matter (Modigliani and Miller 1958).

2. Prices of securities are equal to the expected value of future earnings.
3. Investment and capital structure decisions are independent (Fisher
separation theorem, 1930) and all investment projects with positive
NPV should be undertaken.

In the real world, we find empirical evidence that contradicts the pre-
dictions of a perfect market. For example, empirical evidence supports
the following:

1. Capital structure does matter.

2. Newly issued shares are underpriced.
 1 Introduction 7

3. Firms with positive NPV projects may have different levels of access to
credit.

Table 1.1 shows the average capital structure (debt to assets ratio)
of firms in different industries in the United States. One can observe
that capital structure does matter as firms with large amounts of tan-
gible assets (Trucking, Automotive, Air Transport, Water Utility) tend to
be financed with more debt than firms with large amount of intangible
assets (Computer Software, Internet, Educational Services, and Drugs).
The reasons behind this will be further covered in Chap. 2 in trade-off
theory.
Table 1.2 shows that prices of newly issued shares during IPOs (initial
public offerings) are below their market values. This creates a puzzle. If
the market prices correctly reflect the expected value of future earnings
why do firms leave money on the table? The latter is not consistent with
firm value-maximizing behavior. Also, prices that do not correctly reflect
the expected values of their earnings are not consistent with the price
efficiency prediction of the perfect market. There are many reasons for
this observation, which will be covered later in the book.

Table 1.1 Debt ratios for selected industries

Market value based debt Book value based debt ratio
Industry ratio (%) (%)
Air transport 37.14 68.51
Automotive 50.84 56.57
Computer software 6.15 20.51
Drug 12.89 31.03
Educational services 19.83 29.27
Electronics 18.34 29.89
Internet 2.24 10.73
Power 62.04 57.29
Steel 35.98 33.21
Trucking 29.74 56.51
Water utility 42.26 59.35
Source of data: Damodaran On-line
http://people.stern.nyu.edu/ADAMODAR/New_Home_Page/datafile/dbtfund.htm
(Many other sources of data usually confirm the link between the degree of
asset tangibility and capital structure. See Chap. 2 for more details)
8 Capital Structure in the Modern World

Table 1.2 Average IPO returns

Aggregate Aggregate number Gross proceeds Average first day
year of IPO’s (millions) return (%)
1960–1969 2,661 $7,988 21.2
1970–1979 1,536 $6,663 7.1
1980–1989 2,375 $60,380 6.9
1990–1999 4,205 $296,693 21.0
2000–2013 1,790 $402,306 22.3
Sources of data: Ritter (2014)
https://site.warrington.ufl.edu/ritter/files/2015/04/IPOs2013Underpricing.pdf
(Other sources of data also confirm that there are systematic differences
between prices of newly issued securities and their market prices. It includes
among others seasoned equity offerings. More discussions will be provided in
Chaps. 3 and 6)

Table 1.3 Average IPO returns in selected countries

Average first day
Country Time period return (%)
Australia 1976–2011 21.8
Brazil 1979–2011 33.1
Canada 1971–2013 6.5
China 1990–2014 113.5
France 1983–2010 10.5
Germany 1978–2014 23.0
India 1990–2014 88.0
United Kingdom 1959–2012 16.0
Sources of data: Loughran et al. (1994, updated 2015)
https://site.warrington.ufl.edu/ritter/files/2015/12/Int.pdf

The pattern presented in Table 1.2 holds not only for US firms but
international firms as well (Table 1.3).
Table 1.4 demonstrates that firms that issue equity underperform,
ceteris paribus (same risk, size, etc.), comparable firms in their indus-
tries in the long term. If, as the perfect market concept predicts, capital
structure does not matter, a systematic relationship between firms’ capital
structures and their operating performances should not exist.
From Table 1.5, one can observe that smaller firms do not have the
same access to debt as larger firms. This is another piece of evidence that
cannot be easily explained using the perfect market concept.
 1 Introduction 9

Table 1.4 Average long run operating underperformance of firms that issue
equity
Median industry-adjusted Median industry-adjusted
operating return on assets cash flow to assets ratio
Time change from year before from year before IPO to 3
Sample period IPO to 3 years after IPO (%) years after IPO (%)
682 US IPOs 1976– −6.8 −4.72
1988
555 IPOs by 1995– −3.44 −2.87
European 2006
firms
Sources of data: Jain and Kini (1994) and Pereira and Sousa (2015)

Table 1.5 Firms’ access to debt

Percentage of firms that never had
Size access to long-term debt
Smallest 50
Small 43.5
Large 26.5
Largest 9.1
Source: Schiantarelli and Jaramillo (2002, Table 7,
SC1 sample)

The perfect market model is an interesting starting point for capital

structure analysis. Realistically, however, only imperfect markets exist.
This book will investigate in depth the difference between perfect and
imperfect market models and the difference between the predictions of
perfect market and imperfect market models.

1.3 Capital Structure Choice Analysis:

The Beginnings
This section considers a hypothetical start-up firm that is about to
make its first capital structure decision. Some relevant concepts from
other disciplines will also be considered such as law, accounting, and
microeconomics.
10 Capital Structure in the Modern World

Investment/Profit –110 200

Year 0 1

Fig. 1.1 Timeline

A firm’s initial capital consists of $10 cash that was invested by the
firm’s founder who owns 1 share of stock, which currently means 100 %
of the company’s ownership. The firm has a project available. The project
is an expenditure that will generate future cash flows. It can be illustrated
using a timeline that indicates investments and revenues at different
points in time (Fig. 1.1).
The project costs 110 (throughout the text, if a currency is not indi-
cated then it is irrelevant). This amount represents investments in fixed
assets that will fully depreciate during the project. Aside from deprecia-
tion there are no other costs involved. The project will generate sales
in the amount of 200 at the end of the year. The firm has to find 100
to finance the difference between the total cost of the investment and
the amount of cash currently available. It has a choice of two strategies:
borrowing at an interest rate of 10% or issuing shares (10 shares of 10
each).

1. Under the first strategy, the following sequence of events occurs: bor-
rowing, investment, sales, payment to debtholders, and distribution
to shareholders. These events will be recorded using balance sheets and
income statements (recall that a balance sheet shows a firm’s assets (A)
and liabilities/capital (LC) at a given moment in time and an income
statement shows earnings/expenses for a given period of time).8 It is
illustrated in Fig. 1.2.

The above income statement shows the firm’s earnings between the
initial issue of shares (prior to undertaking the project) and the project’s
completion. Subtracting amortization from sales, we get the earnings,

8
For a review of accounting principles see, for example, Wild, Shaw, and Chiappetta (2014).
 1 Introduction 11

Inial situaon A LC

Cash 10 Capital 10

Borrowing A LC
Cash 110 Loan 100
Capital 10

Investment A LC
Fixed Assets Loan 100
110
Capital 10

Sales A LC
Cash 200 Loan 100

Capital (initial 10
plus earnings 90)
100

Payment to debtholders A LC
Cash 90 Loan 0
Capital 90

A LC
Distribuon to shareholders
0 0

Income statement

Sales 200
Amortization 110
Earnings 90
Interest 10
Net Earnings 80
Dividends 80
Retained Earnings 0

Fig. 1.2 Balance sheet changes and final income statement under debt
financing
12 Capital Structure in the Modern World

which are 90. Then we subtract interest, which equals 10, and we are left
with 80 net earnings that are distributed as dividends to shareholders.

2. When firms use equity to finance projects, the following sequence of

events occurs: issuing shares, investment, sales, and distribution to
shareholders (Fig. 1.3).

Inial situaon A LC
Cash 10 Capital 10

Issuing shares A LC
Cash 110 Capital 110

Investments A LC
Fixed Assets 110 Capital 110

Sales A LC
Cash 200 Capital 200 (ini-
tial 10 plus issue
100 plus earnings
90)

Distribuon to share- A LC
holders
0 0

Income statement

Sales 200
Amortization 110
Earnings 90
Net earnings 90
Dividends 90
Retained Earnings 0

Fig. 1.3 Balance sheet changes and final income statement under equity
financing
 1 Introduction 13

The new income statement looks similar to the previous one—the

only difference being the absence of interest payments since the firm used
equity instead of debt to finance the project. The new amount of shares
outstanding (often shown under the balance sheet) equals 1 + 10 = 11.
One can also calculate the fraction of shares belonging to the firm’s
founder after the issue of new shares: it equals 1/11.
Looking at the results of the two strategies described above, which
one should be chosen? Under strategy 1, the shareholders will receive
100. Under strategy 2, the shareholders will receive 200 but it must be
split between the founders and new shareholders. This is an example of
a capital structure choice problem that will be analyzed in this book. In
reality, the problems are more complicated. For example, how does the
uncertainty about sales affect the decision? If there are not enough sales
to cover the loan under strategy 1, what is going to happen? What is the
value of the founder’s shares under strategy 1, etc.?
The spectrum of potential capital structure strategies depends on the
organizational structure of the firm. Consider the different organizational
structures: sole proprietorship, partnership, and corporation. Sole pro-
priterships and partnerships cannot issue shares publicly so their choices
are limited to the founder’s own resources and raised debt, which is a
challenge in many cases. Corporations typically have a larger spectrum of
potential strategies including public issues of stocks and bonds.
The issue of potential bankruptcy, a situation when sales are not suf-
ficient to cover the firm’s debt, is directly related to a firm’s capital struc-
ture. Let D denote the face value of debt that has to be paid by the firm
and let V denote the firm’s value. If V ≥ D, the firm will use the available
cash, or sell its assets, to pay the debt and avoid bankruptcy. What hap-
pens when V < D ? Firms can be divided into two large groups depending
on the scenario at hand: firms with unlimited liability (usually includes
sole proprietorships and partnerships), where owners are not protected,
and may have to resort to selling their own assets to repay a debt; and
firms with limited liability (includes corporations and some types of part-
nerships) where owners’ assets are protected.
There is also literature about the advantages and disadvantages of dif-
ferent organizational structures and about corporations being subject to
“double taxation,” and how it is related to limited liability (see, for exam-
14 Capital Structure in the Modern World

12
10
8
Debt
6
payment
4
2
0
0 2.5 5 7.5 10 12.5 15
The firm's resources available

Fig. 1.4 Debt payments under limited liability

ple, Ewert and Niemann (2012), Horvath and Woywode (2005), Miglo
(2007) and Lindhe, Sodersten, and Oberg (2004)).
Recall that one of the major features of corporations is that sharehold-
ers have limited liability. This feature will frequently be used in the book
to demonstrate the patterns of payments of different claimholders in dif-
ferent scenarios.
In Fig. 1.4, the solid line represents the creditors’ payoffs and the
dotted line is the firm’s shareholders’ payoffs. The x-axis represents the
amount of available resources9 and the y-axis represents debt payments.
The original creditors have seniority and are entitled to payment up to
the value of the principal and interest (equal to 5 in Figs. 1.4 and 1.5). So
if the amount of available resources is less than 5, they belong to credi-
tors. However, if the firm’s revenue is greater than 5, the creditors will
receive 5 and the firm’s shareholders will receive the rest. In the case of
unlimited liability, the firm’s owners are mandated to pay creditors out of
their own pockets. This is illustrated in Fig. 1.5.
Assuming that the owners’ personal assets are sufficiently large, then
under unlimited liability the creditors will still be repaid fully regardless
of the firm’s resources. The owners’ net profit will be negative when the
firm’s resources are less than 5 and they will have to sell a part of their own
assets in order to repay the debt.
9
The amount of available resources depends on the specific debt contract. In most cases the pay-
ment of debt requires cash. However, the firm always has an opportunity to sell its assets. So in
most cases the amount of available resources is equal to the firm value as long it is expressed in
market values.
 1 Introduction 15

8
6
4
Debt 2
payment 0
–2 0 1 2 3 4 5 6 7 8 9 10 11 12
–4
–6
The irm's ressources available

Fig. 1.5 Debt payments under unlimited liability

As we have seen, interest on debt is paid prior to dividends on shares.

There are other differences between debt and equity that further compli-
cate capital structure decisions. They are summarized below:

Debt

– No ownership interest
– Creditors do not have voting rights
– Interest is considered a cost of doing business and is tax deductible
– Creditors have legal recourse if interest or principal payments are
missed
– Excess debt can lead to financial distress and bankruptcy

Equity

– Ownership interest
– Common stockholders vote for the board of directors and other issues
– Dividends are not considered a cost of doing business and are not tax
deductible
– Dividends are not a liability of the firm and stockholders have no legal
recourse if dividends are not paid
– An all-equity firm cannot go bankrupt
In our example above, the founders may take into account that in
case of equity financing their control over the company will be reduced
16 Capital Structure in the Modern World

because new shareholders will get voting rights. Financing with debt may
bring tax advantage since interest is tax-deductible, etc.

Questions and Exercises

Answers/Solutions to Selected Questions/Exercises can be found at the
end of the book. Throughout the book we have four types of questions:
“multiple choice,” “true–false,” “problems,” or “mix.” For multiple choice
questions, choose a letter corresponding to your answer. For true–false
questions, the answer is “TRUE” if you agree with the sentence and
“FALSE” otherwise. A sentence without options for answers usually
represents a true-false question like question 1 below. Problems usually
require a complete solution.

1. A project is a firm’s obligation to pay a fixed amount of money to its

creditors.
2. Payments are usually promised and fixed for:
(a) Stocks
(b) Bonds
3. The following is not considered one of the differences between a
corporation and a general partnership:
(a) Limited liability rule
(b) Taxation
(c) Collective form of business
(d) Lifetime
4. All participants in large business organizations have limited liability.
5. Unlimited liability and small opportunities for external financing are
the disadvantages of a sole proprietorship.
6. X-tutoring is a sole proprietorship owned by Bill. What would be
likely to happen if the firm’s value was $20,000, the firm’s current
debt $50,000 and Bill’s personal wealth $100,000?
7. A corporation’s inability to pay off its creditors will usually result in
the sale of personal assets by a major shareholder.
8. The following is not one of the differences between debt and equity.
(a) Debtholders have legal recourse if interest or principal payments
are missed
(b) Debtholders do not have voting rights
 1 Introduction 17

(c) Equity is publicly traded

(d) Interest on debt is considered a cost of doing business and is tax
deductible
9. List out facts that seem to contradict a perfect market concept of
capital structure. Explain.
10. Financial flexibility is an important factor for Google when choosing
its capital structure.
11. McDonald’s does not rely on debt financing.
12. Project.

Choose a firm on Yahoo! Finance. You can find financial statement

information about the company on Yahoo! Finance. In addition, if you
choose to, you can obtain additional information, either from the com-
pany itself or from other websites.
The report should answer the following questions:
What is the total amount of the firm’s capital (book value)? What is the
market value of the shareholders’ capital? Hint: find the number of shares
outstanding and multiply it by the current share price.
What is the total amount of the firm’s liabilities? What is the total
amount of liabilities excluding current liabilities? How (if at all) does the
firm borrow money? What are the characteristics of the debt (maturity,
coupon, or stated interest rate, etc.)?
A bonus question. Find information about any derivative securities
issued by the firm including warrants, convertible bonds, etc.

References
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Brounen, D., De Jong, A., & Koedijk, K. (2006). Capital structure policies in
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abstract=1104886
Frank, M., & Goyal, V. (2009). Capital structure decisions: Which factors are
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us-mcdonalds-results-idUSN2442330320070724
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liability. Journal of Institutional and Theoretical Economics (JITE)/Zeitschrift
für die gesamte Staatswissenschaft, 161(4), 681–707.
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 1 Introduction 19

Klein, L., O’Brien, T., & Peters, S. (2002). Debt vs equity and asymmetric
information: A review. The Financial Review, 37(3), 317–350.
Lemmon, M., & Zender, J. (2010). Debt capacity and tests of capital structure
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 2
Modigliani-Miller Proposition and Trade-­
off Theory

2.1 Three Ideas

This chapter considers the three basic ideas of capital structure. The capi-
tal structure irrelevance idea, the debt tax shield, and the link between
expected bankruptcy costs and optimal capital structure. All of these
ideas attempt to provide an answer to the following question: can the
firm increase its value by changing its capital structure? Each idea pro-
vides a different answer, which makes capital structure a complicated yet
exciting topic at the same time.
The debt tax shield idea provides an interesting and powerfull tool to
business people all around the world: by increasing the amount of debt,
the firm creates a tax shield that can increase its value. Until recently it
was not uncommon to think (especially in academic literature) that the
debt tax shield, although theoretically important, does not seem to have
any significant importance in capital structure decisions in practice. The
situation is now changing. Faulkender and Smith (2014), for example,
discuss tax strategies of international companies. It is mentioned that
multinational groups are using significantly higher debt in high tax

© The Editor(s) (if applicable) and The Author(s) 2016 21

A. Miglo, Capital Structure in the Modern World,
DOI 10.1007/978-3-319-30713-8_2
22  Capital Structure in the Modern World

j­urisdictions, which is consistent with the tax shield idea, as we will see
later in the chapter.1
The bankruptcy cost idea points out that increasing debt in a firm’s
capital structure increases its probability of bankruptcy. Since bankruptcy
is a very costly process, the incentive to increase debt should depend on
potential future bankruptcy costs. An interesting example represents the
situation in the US oil and drilling industry in 2014/2015. Oil prices fell
quickly in the middle of 2014, weakening the futures of many companies
in the industry. Gara (2015) described the situation in the industry and
noticed that ”…junk bond markets [were] decisively closed to the drill-
ing industry and stock prices [were] trading at levels that [made] equity
offerings extremely dilutive.”2 This is a classic example of indirect bank-
ruptcy costs that, as we will see later, reduce the incentive for firms to
issue debt. Even if a firm is not bankrupt, the market anticipates financial
difficulties, which results in decreased credit conditions, reduced share
price, loss of customer, etc.
Williams (1938) noticed that if a single individual or institutional
investor owned all the bonds, stocks and warrants issued by a corpora-
tion, it would not matter to this investor what the company’s capitaliza-
tion was. Modigliani and Miller (1958) further developed this idea, for
which they won the 1985 Nobel Price in Economics, by proving the
Modigliani–Miller (MM) theorem which states that when markets are
perfect (no taxes and no bankruptcy costs among other things), the capi-
tal structure does not have any impact on the value of the firm. For exam-
ple, a firm financed with 60 % equity and 40 % debt has the same value
as a firm financed with 30 % equity and 70 % debt. The idea behind
the MM theorem is that capital structure does not alter the total cash
flows produced by a firm’s assets (such as equipment, buildings, technol-
ogy, patents, etc.) or their riskiness, and that financial securities can only
redistribute value and not create it.

 See also Loney (2015).

1

 Gara (November 25, 2015).

2
 2  Modigliani-Miller Proposition and Trade-off Theory  23

2.2 Modigliani–Miller Theorem

Assumptions underlying the MM (perfect market assumptions) analysis
are as follows:

1 . Perfect competition and minimal transaction costs

2. No asymmetric information among investors
3. No taxes
4. No bankruptcy costs
5. Contracts are easily enforced
6. No arbitrage opportunities

An arbitrage opportunity is a situation where an investor is able to

make a profit by simply selling and buying securities without incurring
any additional investment cost.

Proposition 2.1 (Modigliani–Miller Proposition) Under the above assump-

tions, firms cannot increase their value by changing their capital structure.
The value of the firm is independent of the debt ratio.

Proof
Suppose there are two identical firms with identical assets. The only dif-
ference between them is their capital structure. One firm is unlevered or
completely equity financed (firm U) and the other one has a mix of debt
and equity (firm L). Both firms produce the same earnings X. We will
prove MM by contradiction assuming that the firms’ values are different.
Two cases will be analyzed: Case 1, where the value of the unlevered firm
is greater than the value of the levered firm, and Case 2, where the value
of the levered firm is greater than the value of the unlevered firm.

Case 1
The value of the unlevered firm is greater than the value of the levered firm.
Vu > VL . Figure 2.1 shows the balance sheets of firms U and L using nota-
tions introduced in Chap. 1. Consider an investor that holds a fraction
α of firm U′s shares. What is his optimal strategy? Should he keep the
24  Capital Structure in the Modern World

Fig. 2.1  Balance sheets of firms U and L

original fraction of shares or sell them and purchase a fraction of the

shares of the levered firm?
Note that although X is risky (i.e. X is a random variable) debt is
assumed to be risk-free and the risk-free interest rate equals r. In addi-
tion, the credit market is frictionless, by assumption, and investors and
firms can borrow funds and invest them in bonds using the same interest
rate. Later an extension with risky debt will be considered (Example 2.1).
Consider the following strategy for this investor: sell the shares for

αEU (note that since firm U does not have any debt, EU = VU ), buy a
α VU α VU
fraction of company L′s shares and buy a fraction of com-
VL VL
pany L ' s bonds. This strategy requires a net investment equal to
α VU αV
α VU − EL − U D . Since VL = D + EL the investment has zero cost.
VL VL
It also offers earnings from firm L ' s shares and interest on firm L ' s bonds
 2  Modigliani-Miller Proposition and Trade-off Theory  25

α VU αV αV
that equal in total ( X − Dr ) + U Dr = U X . This is greater than
VL VL VL
αX (the investor’s expected earnings in the case of keeping firm U’s shares)
because by assumption VU > VL . Therefore, there is an arbitrage opportu-
nity. Thus, the assumption that VU > VL leads to a contradiction.

Case 2
The value of the levered firm is greater than the value of the unlevered firm.
Let VU < VL . Consider an investor holding a fraction α of firm L’s shares.
This investor can either choose to keep the fraction of the levered firm’s
shares or sell them and buy the unlevered firm’s shares.
Consider the following strategy: sell the shares for αVL, borrow αD,
buy a fraction αVL/VU of company U ' s shares. This strategy requires a net
α VL
investment equal to α (VL − D ) + α D − VU = 0 . It also offers earnings
VU
α VL  V 
equal to X − α Dr = α  X L − rD  . This is greater than α [ X − rD ]
VU  VU 
(the investor’s expected earnings in case of keeping firm L′s shares)
because by assumption VL > VU . Therefore, there is an arbitrage opportu-
nity. Thus, the assumption that VL > VU leads to a contradiction.
We have shown that any situation where VL Þ VU  leads to a contradic-
tion. One can also show that if VL = VU then any strategy with zero invest-
ment cost does not produce extra profit. Examples would be the two
situations described above. In either case, if VL = VU , an investor using
the strategies described above will not increase profits. The irrelevance of
capital structure is the result of the investor’s ability to undo any effects of
the differences in the firms’ capital structures when operating in a perfect
financial market.
The following is a summary of the main ideas behind MM:
–– If the shares of levered firms are priced too high, investors will bor-
row on their own and use the money to buy shares in unlevered
firms. This is sometimes called homemade leverage.
26  Capital Structure in the Modern World

–– If the shares of unlevered firms are priced too high, investors will
buy shares in levered firms and buy bonds.
–– In order for capital structure to matter, there must be some market
imperfections that create friction in the process of either selling or
buying securities.

Example 2.1
Suppose two firms have the same assets that generate the same annual
earnings and differ only in how they are financed: Firm U is unlevered
(Vu = 220, 000 ). Firm L is levered; it has a long-term debt of 80,000. Thus,
the value of the equity is equal to: EL = VL − D = VL − 80, 000 . Next year,
there are two possible economic scenarios: if growth is slow, earnings
will be 4,000; if the economy/growth is strong, then earnings will be
120,000. The interest rate is 10 %. Suppose that Vu > VL = 200, 000 . Note
that debt is not risk-free (the firm will not be able to repay the debthold-
ers if growth is slow).
Consider two strategies of an investor holding 10 % of firm U’s shares.
Strategy 1: To keep 10 % of firm U ' s shares. Strategy 2: Sell the shares
for 0.1 ∗ 220, 000 = 22, 000 , buy 11 % of company L’s shares (the value is
0.11 ∗ 120, 000 = 13, 200 ) and buy 11 % of company L′s bonds (the value
is 0.11 ∗ 80, 000 = 8800 ).
As shown in Table 2.1, earnings from strategy 1 include earnings from
holding firm U′s shares. Earnings from strategy 2 include earnings from
holding firm L′s shares and interest on firm L′s bonds. One can see that
strategy 2 provides higher earnings in each scenario and thus is definitely

Table 2.1  Investments and earnings from strategies 1 and 2 in Example 2.1
Strategy 1 Strategy 2
Investment 0 22, 000 − 13, 200 − 8800 = 0
Earnings if 400 = 0.1∗ 4000 440 = 0.11∗ 4000
economy is weak
Earnings if 12, 000 = 0.1∗ 120, 000 13, 200 = 0.11∗ (120, 000 − 0.1∗ 80, 000 )
economy is strong
+0.1∗ 8800
 2  Modigliani-Miller Proposition and Trade-off Theory  27

better than strategy 1.3 When the economy is weak, there are no earnings
from holding shares of firm U and interests on bonds are proportionally
split between the debtholders. In conclusion, there is an arbitrage oppor-
tunity, which means that the described situation is not an equilibrium.
Note that the arbitrage argument (and the MM proposition) still holds if
debt is not risk-free, assuming no bankruptcy costs.

2.3 Bankruptcy Costs

A firm that is having financial difficulties and that cannot meet its debt
obligations will usually organize a meeting (credit workout) with its cred-
itors to renegotiate the debt conditions.4 A credit workout is a contract
between a firm and its creditors that describes the conditions that allow
the firm to avoid bankruptcy, which would imply a reorganization or
liquidation of the firm’s assets to pay off the debt. If no deal is reached,
the firm may declare bankruptcy. Liquidation is the sale of a firm’s assets.
Reorganization is a restructuring of a firm’s financial claims to keep it
afloat; it involves keeping the firm as a going concern and compensating
the creditors with new securities, including equity.
In the United States, corporations can file for either Chapter 7 bank-
ruptcy, which leads to the liquidation of a firm’s assets through a settle-
ment of creditors’ claims, or Chapter 11 bankruptcy, which allows the
firm to restructure its debt and equity claims and continue to operate.5
In the former case, the assets are distributed to the debtholders and any
excess proceeds generated from the liquidation are distributed to the
shareholders. In the latter case, the debtholder and equityholders receive
new claims in exchange for their existing claims. Table 2.2 shows the larg-
est bankruptcies in US history.
Restructurings are often successful. For example, Air Canada, an air-
line company, restructured its debt obligations in 2003 and reduced its
3
 More precisely we should say that strategy 2 dominates strategy 1 by first-order dominance
(FOD). In Chap. 4 we discuss the concept of stochastic dominance in more detail.
4
 http://www.investopedia.com/terms/w/workout-agreement.asp
5
 US Securities and Exchange Commission, Investor publications.
https://www.sec.gov/investor/pubs/bankrupt.htm
28  Capital Structure in the Modern World

Table 2.2  Largest bankruptcies in US history

Type of
Company Date Value Industry bankruptcy
Lehman 2008 691,063,000,000 Investment bank Chapter 11
Brothers
Inc.
Washington 2008 327,913,000,000 Savings and loans Chapter 11
Mutual
Worldcom, 2002 103,914,000,000 Telecommunications Chapter 11
Inc
General 2009 82,290,000,000 Cars Chapter 11
Motors
CIT Group 2009 71,000,000,000 Banking Chapter 11
Enron Corp. 2001 65,503,000,000 Energy, gas Chapter 11
Source of data:
“The 10 largest U.S. bankruptcies.” CNNMoney.com (Cable News Network).
2009-06-01. p. General Motors. http://www.bankruptcydata.com/Research/
Largest_Overall_All-Time.pdf. Retrieved 2016-01-22
“Washington Mutual, Inc. Files Chapter 11 Case” (Press release). Washington
Mutual, Inc. 2008-09-26. Business Wire. http://www.businesswire.com/news/
home/20080926005828/en. Retrieved 2016-01-22
“WorldCom to emerge from collapse.” CNN. Monday April 14, 2003. http://
edition.cnn.com/2003/BUSINESS/04/14/worldcom/. Retrieved 2016-01-22
Stoll, John D., and Neil King Jr. (July 10, 2009).GM Emerges From Bankruptcy.
The Wall Street Journal. http://www.wsj.com/articles/SB124722154897622577.
Retrieved 2016-01-22
de la Merced, Michael J. (November 1, 2009). “CIT Files for Bankruptcy”. New
York Times. http://dealbook.nytimes.com/2009/11/01/cit-to-file-for-bankruptcy-­
soon/. Retrieved 2016-01-22
Benston, George J. (November 6, 2003). “The Quality of Corporate Financial
Statements and Their Auditors Before and After Enron.” Policy
Analysis (Washington D.C.: Cato Institute) (497): http://www.webcitation.
org/5tZ00 qIbE. Retrieved 2016-01-22

debt from $12 billion to $5 billion, thus allowing the company to con-
tinue operating.6 This is not always the case: sometimes restructuring
fails and the company is liquidated. Ideally, a firm should continue if it is
worth more as a going concern than it would be in liquidation. However,
a conflict of interest between the lenders and the company may lead to
a failure.

 McArthur et al. (August 28, 2004).

6
 2  Modigliani-Miller Proposition and Trade-off Theory  29

A company can be declared bankrupt by its owners (or directors) or it

can be forced into bankruptcy via a court order petitioned by creditors.
The assets of the firm are then sold by the company or by a trustee. The
proceeds of the sale (excluding liquiditor’s fees) are distributed to the
creditors. Creditors with the strongest claims are paid first and those with
the weakest claims are paid last.
The order of payments in the case of bankruptcy is: secured creditors,
unsecured senior debtholders, unsecured junior debtholders, preferred
stockholders, and common stockholders.
There are two types of bankruptcy costs: direct and indirect. Direct
bankruptcy costs are fees paid to the lawyers, liquidators and other agents
involved in the sale of the assets and the redistribution of the proceeds of
the bankrupt firms. Indirect bankruptcy costs are costs incurred while the
company is still in operation and stem from a general lack of stakeholder
confidence in the firm.
Some examples of indirect costs include: a firm may lose orders for its
products due to a possible inability to service them in the future, suppli-
ers may demand cash or reduce the amount of credit offered to a firm,
a firm may face high interest rates or be unable to secure debt financ-
ing, a firm’s managers may engage in actions that are harmful to their
debtholders.
The famous Enron scandal led to the bankruptcy of the Enron
Corporation, an American energy company based in Texas, at the end
of 2001. It was also the main cause of Arthur Andersen’s dissolution; the
firm was one of the five largest audit firms in the world. Enron's complex
financial strategies were not transparent enough to its shareholders and
market analysts. In mid-July 2001, Enron's share price had decreased by
more than 30 % since the same quarter of 2000. While the company at
that time was not bankrupt, the sharp decline in its stock price was an
example of an indirect bankruptcy cost. On October 27 the company
began buying back all of its commercial paper in an effort to calm inves-
tors. In addition, Enron financed the re-purchase by depleting its lines
of credit at several banks. The company's bonds were trading at levels
slightly less, which made future sales problematic. The worsening credit
line conditions, lower bond prices and worsening commercial paper sales
30  Capital Structure in the Modern World

represent other examples of indirect bankruptcy costs.7 Indirect bank-

ruptcy costs are usually high for firms with large intangible assets and
firms who sell products that require replacement parts and services.
Bhabra and Yao (2011) analyze the magnitude of indirect and total
bankruptcy costs in different sectors and industries three, two and one
year prior to bankruptcy. Technology firms are an example of firms with
large intangible assets and high indirect bankruptcy costs with total
bankruptcy costs reaching more than 25 % of the value of the assets one
year before the bankruptcy. Bankruptcy costs are also quite large in the
publishing industry.8
Intuitively, high bankruptcy costs should make borrowing more
expensive and less attractive since the parties involved should anticipate
these costs to arise at least with some probability, implying a potential
loss of revenue. Hence the value of levered firms (with risky debt and
bankruptcy costs) should be lower than the value of unlevered firms. This
means that in a market with only one imperfection, in the form of bank-
ruptcy costs, the optimal capital structure is 100 % equity. However, in
pratice, many firms use debt. One of the reasons for this is taxes. As we
saw in Chap. 1, in contrast to dividends, interest paid on debt reduces
the firm’s taxable income.

2.4 C
 orporate Income Taxes and Capital
Structure
Usually, interest on debt reduces a firm’s earnings and its amount of cor-
porate tax. There is a significant debate regarding the existence of cor-
porate taxes in the economy. In general, there are two major arguments
in favor of the tax. The first is a rent argument. The corporate tax can
principally capture the rent earned by owners of fixed factors without dis-
torting the investment decision. The second argument, the more popular
one in corporate finance literature, is that the corporate tax is the price
that corporations pay for limited liability of their shareholders. This leads

 For more details about Enron’s story see Palepu and Healy (2003).
7

 For more analysis of bankruptcy costs see, for example, Korteweg (2007).
8
 2  Modigliani-Miller Proposition and Trade-off Theory  31

2015 corporate tax

Country rate (%)
Australia 30.00
Canada 15.00
France 34.43
Germany 15.83
Ireland 12.50
Israel 26.50
Italy 27.50
Korea 22.00
Mexico 30.00
Norway 27.00
Switzerland 8.50
United Kingdom 20.00
United States 35.00
Table 2.3 Corporate tax Source of data: OECD.Stat. http://stats.oecd.org//
rates in selected Index.aspx?QueryId=58204
countries

to what is called “double taxation” for corporations: the result of taxation

at both the corporate and the household level. Meade (1978), for exam-
ple, says that the legal construct of limited liability is a special benefit to
incorporated firms and that it should be taxed. However, Musgrave and
Musgrave (1980) argue: “the privilege of operation under limited liability
is, of course, of tremendous value of corporations, but the institution of
limited liability as such is practically costless to society and hence does
not justify imposition of a benefit tax.”9
Since interest paid on debt (unlike dividends) reduces taxable income,
firms that use debt financing pay less taxes. This advantage is called the
debt tax shield. For each $1 of interest a firm pays, it saves T dollars in
taxes where T is the corporate tax rate. For example if T = 35 %, a firm will
save 35 cents for each dollar of interest it pays, etc. Note that the higher
the tax, the higher the tax savings.
Corporate tax rates vary widely by country, leading some corpora-
tions to shield earnings within offshore subsidiaries or to re-domicile
within countries with lower tax rates. Corporate tax rates across the

9
 More recent discussions about the link between limited liability and corporate taxation can be
found, for example, in Miglo (2007).
32  Capital Structure in the Modern World

Organization for Economic Cooperation and Development (OECD) are

shown in Table 2.3. Rates within the OECD vary from a low of 8.5 % in
Switzerland to a high of 35 % in the United States. The OECD average
is 22 %.10

2.5 Trade-off Theory

As mentioned before, in contrast to dividends, interest paid on debt
reduces the firm’s taxable income. Debt also increases the probability of
bankruptcy. The trade-off theory suggests that capital structure reflects a
trade-off between the tax benefits of debt and the expected costs of bank-
ruptcy (Kraus and Litzenberger 1973; Myers 1989).11 Under this theory,
the firm’s value equals the value of the unlevered firm (with the same
assets) plus the benefits of the tax advantage of debt minus the expected
bankruptcy costs.

V = VU + TS ( D, I , T ) − BC ( D, I , B )

Here VU is the value of the unlevered firm (no debt), TS is the value
of the firm’s tax shield, which depends on the level of debt D, the firm’s
earnings I and the corporate tax rate T, and BC is the expected value of
the bankruptcy costs, which depend on the level of debt, the firm’s earn-
ings and parameter B that reflects the magnitude of bankruptcy costs
(B is low for example if the firm belongs to an industry with relatively
low bankruptcy costs and vice versa). TS usually equals the amount of
taxes saved from the fact that interests, in contrast to dividends, are tax-­
deductible. In a dynamic version of this model, TS would represent the
present value of saved taxes over several periods of time. Usually it is
assumed that

10
 For more about corporate tax rates across different countries see, for example, Devereux,
Lockwood, and Redoano (2008).
11
 For a review see, for example, Frank and Goyal (2008), Miglo (2011) or Graham and Leary
(2011).
 2  Modigliani-Miller Proposition and Trade-off Theory  33

∂TS ( D, I , T ) ∂ 2TS ( D, I , T ) ∂TS ( D, I , T ) ∂ 2TS ( D, I , T )

≥ 0; ≤ 0; ≥ 0; ≥0 (2.1)
∂D ∂D 2 ∂I ∂D∂I


∂TS ( D, I , T ) ∂ 2TS ( D, I , T ) ∂BC ( D, I , B ) ∂BC ( D, I , B )
≥ 0; ≥ 0; ≥ 0; ≥0 (2.2)
∂T ∂D∂T ∂D ∂B
∂ 2 BC ( D, I , B ) 2
(
∂ BC D, I , B ) ∂BC ( D, I , B ) ∂ 2 BC ( D, I , B )
≥ 0; ≥ 0; ≤ 0; ≤ 0 (2.3)
∂D 2 ∂D∂B ∂I ∂D∂I

Explanations regarding conditions (2.1) to (2.3) are usually the fol-

lowing. More debt means greater amounts of interests and larger taxable
income reductions. This effect cannot last indefinitely, i.e. when taxable
profit is approaching zero, a further increase in debt financing saves less
taxes and in extreme cases, when there is no more taxable profit left, does
not increase the tax shield. This explains condition (2.1). A greater corpo-
rate tax rate means larger tax savings from increased debt, which explains
the first two conditions in (2.2). Higher debt increases the probability of
bankruptcy. This explains the third condition in (2.2). The last condition
in (2.2) comes from the definition of B. As debt increases, the probability
of bankruptcy, as well as bankruptcy costs, especially indirect bankruptcy,

Fig. 2.2  Optimal level of debt under trade-off theory

34  Capital Structure in the Modern World

have stronger effects since customers, banks, etc. tend to panic. The first
two conditions in (2.3) have a similar identity. An increase in the firm’s
income reduces the probability of bankruptcy. This explains the last two
conditions in (2.3).12
Figure 2.2 shows marginal TS and BC. When D exceeds D′ there is no
benefit from increasing debt (profit is zero and further reductions do not
make any contributions). The optimal level of debt D* is achieved when
the marginal benefit from a debt increase (marginal tax shield) equals the
marginal cost of a debt increase (marginal expected bankruptcy costs).

Example 2.2
Consider a firm that generates a random cash flow R that is uniformly
distributed between 0 and 100. The firm faces a constant tax rate of
0.3 on its corporate income. If the earnings are insufficient to cover the
promised debt payment, D, (for simplicity D represents interests only
and the principal is equal to 0) there is a deadweight loss of 0.1 ∗ D that is
used up in the process. This loss can include direct bankruptcy costs such
as fees paid to lawyers and indirect bankruptcy costs such as losses due
to a general lack of confidence in the firm. If earnings are large enough
( R > D ), equityholders receive ( R − D ) * (1 − 0.3). Otherwise, they receive
nothing.
The value of unlevered firm can be found as follows: VU = 50 * (1 − 0.3 ) = 35.
Here 100 / 2 = 50, which are the average earnings of the firm and 50 * 0.7
equals the expected net income.
 100 − D D D  100 − D
TS = 0.3 *  *D+ * . is the probability that
 100 100 2  100
D
R > D and is the probability of default. If R > D , the debtholders
100
D
receive D (tax savings equal 0.3 * D) and they equal on average , if the
2
firm defaults.

12
 See Van Binsbergen, Graham and Yang (2010) about more details in constructing TS and BC
using empirical data. In some of their graphs, there is a flat area of the marginal benefit curve when
the level of debt is very low and the tax rate is not affected by marginal debt changes. Qualitatively
it does not affect our conclusions.
 2  Modigliani-Miller Proposition and Trade-off Theory  35

Fig. 2.3  Optimal level of debt under trade-off theory when B increases

D D * 0.1. Here, D/100 is the probability of default. The

BC = *
100 2 D * 0.1
bankruptcy costs equal, on average, if the firm defaults. The
2
firm’s value V equals

 100 − D D D  D D * 0.1
V = VU + TS − BC = 50 * 0.7 + 0.3 *  *D+ * − *
 100 100 2  100 2
36  Capital Structure in the Modern World

The firm’s choice of leverage is determined by maximizing V. The first-­

500 * 0.3
order condition with respect to=
D is D = 75 .
2

2.6 T
 heory Predictions and Empirical
Evidence
If B increases, then according to (2.3), the marginal cost of debt curve
moves up in Fig. 2.3 and the equilibrium level of D is lowered.

Proposition 2.2 Ceteris paribus, an increase in expected bankruptcy costs

should result in lower debt.
As the expected bankruptcy costs increase, the advantages of using
equity also increase. The value of tangible assets is more stable in the
case of distress compared to intangible assets. Therefore, firms with more
tangible assets, such as airplane manufacturers or real estate companies,
should have higher leverage compared to those that have more intangible
assets, such as research or growth firms. Indirectly, this analysis implies
that large conglomerates should have more debt than small entrepreneur-
ial firms because they are more diversified and have a lower default risk.13
Two remarks are noteworthy here. First, it has been found in recent years
that for small and start-up firms a positive relationship may exist between
the amount of external debt (and consequently total debt) and growth
opportunities (see, for example, Robb and Robinson (2012)). Secondly,
Bulan and Sanyal (2009) investigate the impact of growth opportunities
on the financing decisions of investor-owned electric utilities in the US
when the electricity sector was deregulated. They find that the relation-
ship between leverage and growth opportunities may be positive or nega-
tive, depending on the nature of the growth opportunity.
When T increases in (2.2), the marginal benefit of debt curve moves
up and debt should also increase because higher taxes lead to a greater tax
advantage of using debt.

 For empirical support of these predictions see, for example, Frank and Goyal (2009).
13
 2  Modigliani-Miller Proposition and Trade-off Theory  37

Proposition 2.3 Firms with higher tax rates should have higher debt ratios
compared to firms with lower tax rates.
As mentioned in Miglo (2011), the empirical evidence regarding
Proposition 2.3 is mixed. More recent literature (Wright 2004; Philippon
and Reshev 2012; Strebulaev and Yang 2013; DeAngelo and Roll 2015)
began to closely analyze historical patterns in capital structure and
whether or not they can be explained by the traditional conclusions of
trade-off theory, described above. For example, asset tangibility declined
on average in the 20th century but at the same time the leverage ratio
increased (Graham et  al. 2015). Taxes increased sharply between the
beginning of the 20th century (starting from 15 %) until 1950 when
they reached 50 % in the US. The leverage increase during that period
is consistent with the above predictions. In the 1980s, the corporate tax
rate reached around 35 % but leverage continued to grow. More research
is expected in this area.
As suggested in (2.3), if I increases, the marginal benefit curve moves
up, the marginal cost curve moves down and D should increase.

Proposition 2.4 More profitable firms should have more debt.

Intuitively, the expected bankruptcy costs are lower and interest tax
shields are more valuable for more profitable firms. Empirical studies,
however, typically find a negative relationship between profitability and
leverage (Titman and Wessels 1988; Rajan and Zingales 1995; Fama and
French 2002; Frank and Goyal 2009). A recent paper by Danis, Rettl,
and Whited (2014) suggests that a positive correlation between debt and
profitability may exist in times when firms are at or close to their optimal
level of leverage.
Let’s take a closer look at the last two conditions in (2.2). A firm’s
higher income definitely reduces the probability of bankruptcy, which
supports these conditions. On the other hand, an increase in income may
increase the value of potential losses for the firm in the case of bankruptcy.
It is similar to: “If I’m poor I have nothing to lose and if I’m rich I have
a lot to lose.” This implies that the marginal cost curve can theoretically
move in either direction depending on which effect is dominant (see Fig.
38  Capital Structure in the Modern World

Fig. 2.4  Optimal level of debt under trade-off theory when I increases

2.4). If the marginal cost curve moves up and if this move is stronger than
that of the marginal benefit curve, optimal debt may go down, which can
explain the negative correlation between debt and profitability. In fact,
Van Binsbergen, Graham, and Yang (2011) find that the marginal cost
of debt is positively related to the firm’s cash, which is consistent with
the curve moving up in Fig. 2.4. Overall it seems that more research is
required regarding the marginal cost of debt curve.
The major challenge of classical trade-off theory remains empirical
evidence about the negative correlation between debt and profitability
because it does not directly follow from the standard model. On the
empirical side, papers addressing historical capital structure patterns over
large periods of time with trade-off theory look interesting and promising.
 2  Modigliani-Miller Proposition and Trade-off Theory  39

The basic trade-off theory model does not include retained earnings,
transaction costs, and costs of raising funds. These factors are usually
important in what is called “dynamic trade-off theory.” Hennessy and
Whited (2005) analyze a model with equity flotation costs and show that
a negative correlation between debt and profitability may be observed
in some cases. Strebulaev (2007) analyzes a model where firms in dis-
tress have to sell their assets at a discount and therefore firms adjust their
capital structure infrequently. The model’s simulations can produce a
negative correlation between debt and profitability. Hackbarth, Miao,
and Morrellec (2006) and Bhamra, Kuehn, and Strebulaev (2010) pres-
ent costly adjustment models that can account for the dynamic relation
between leverage and macroeconomic characteristics. Danis, Rettl, and
Whited (2014) find that at times when firms are at or close to their opti-
mal level of leverage, the cross-sectional correlation between profitability
and leverage is positive. At other times, it is negative. Bolton, Cheng, and
Wang (2013) present a model of dynamic capital structure and liquidity
choice where debt adjustments are costly. The authors focus on the debt
servicing cost: debt payments drain the firm’s valuable precautionary cash
holdings and thus impose higher expected external financing costs on the
firm. The model can replicate a negative correlation between debt and
profitability.
In a recent review of empirical capital structure literature Graham and
Leary (2011) suggested the following directions for improving trade-­
off theory results: fixing mis-measurement, for example calculations of
marginal tax benefits and marginal bankruptcy costs should be signifi-
cantly improved; new models are required in the area of partial adjust-
ment towards optimal capital structure; dynamic trade-off theory models
should still prove that they are indeed the primary drivers of capital
structure changes; and the methods of value estimation for transactions
related to capital structure changes should be more developed.

Questions and Exercises

1. The MM proposition is the theory that the value of a firm is inde-
pendent of its capital structure.
40  Capital Structure in the Modern World

2. Indirect bankruptcy costs are very small for technology firms.

3. The tax shield decreases when the corporate tax rate increases.
4. In a world with bankruptcy cost and without taxes, the firm’s value is
maximized when the firm is financed by debt.
5. The proposition of Modigliani and Miller still holds if debt is risky
but bankruptcy costs do not exist.
6. In a world with corporate taxes but without any other market imper-
fections firms should use debt as much as possible.
7. The static version of trade-off theory cannot explain the negative cor-
relation between debt and profitability.
8. The trade-off theory predicts that the marginal tax benefit of debt
should be equal to the marginal expected bankruptcy cost.
9. The MM proposition states that levered firms have greater value than
unlevered firms.
10. Bankruptcy costs.

(a) Define direct bankruptcy costs and provide examples of direct

bankruptcy costs.
(b) Define indirect bankruptcy costs and provides examples (at least
five) of indirect bankruptcy costs
(c) Provide examples of firms with high indirect bankruptcy costs?
(Explanations are required.)

11. Trade-off theory.

(a) Describe the trade-off theory of capital structure (in words).

(b) According to this theory, which equation determines the firm’s
value?
(c) Describe empirical evidence that is consistent with the trade-off
theory (provide at least five points). Explanations are required.
(d) Describe empirical evidence that is not consistent with this the-
ory (provide at least four points). Explanations are required.

12. Suppose two firms have the same assets that generate the same earn-
ings and differ only in how the assets are financed: Firm U is unle-
vered (Vu = $100, 000). Firm L is levered; it has a debt of $40,000.
 2  Modigliani-Miller Proposition and Trade-off Theory  41

Next year, there are two possible economic scenarios: if growth is

slow, the earnings are $4000; if the economy/growth is strong, then
earnings are $150,000. The interest rate is 10 %. Suppose that
Vu > VL = $80, 000 and suppose an investor X holds 10 % of firm U
shares. Explain why MM holds.
13. Consider a firm that generates a random cash flow R that is uni-
formly distributed between 0 and 1000. The firm faces a constant tax
rate 0.2 on corporate income. If the earnings are insufficient to cover
the promised debt payment, D, (for simplicity D represents interests
only and the principal is equal to 0) there is a deadweight loss of
0.2 * D that is used up in the process. Find the optimal level of debt.

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 3
Asymmetric Information and Capital
Structure

3.1 Finance and Asymmetric Information

It has been recognized for over 40 years, since at least Akerloff’s (1970)
publication about the used car market, that asymmetric information
plays a role in the market. The resulting equilibrium, transactions and
prices depend on the degree of asymmetric information. Asymmetric
information exists naturally since the seller of almost any item on the
market has more information about the item than the buyer. The same is
true in financial markets.
Unlike theorists, practitioners often wonder whether this is a theoreti-
cal problem that has already been solved on a big scale by existing laws
of consumer protection, insider trading, etc., or a problem that is still
relevant and will remain relevant in the future. Izabella Kaminska, in her
article entitled “If you call it a blockchain, it’s not an OTC story anymore,”
talks about the blockchain-enabled platform introduced by NASDAQ.1
The platform facilitates the raising of equity by private companies. When
discussing the ideas behind this innovation, the author mentioned the
Stiglitz paradox. Stiglitz (along with Weiss, 1981) d ­ eveloped research, in
1
 Kaminska (October 30, 2015).

© The Editor(s) (if applicable) and The Author(s) 2016 45

A. Miglo, Capital Structure in the Modern World,
DOI 10.1007/978-3-319-30713-8_3
46  Capital Structure in the Modern World

line with Akerloff’s paper, with applications to credit markets with asym-
metric information.2 Applying this idea to the market for newly issued
shares, under asymmetric information, the market may collapse because
investors do not have enough information about the shares. Large com-
panies who are traded publicly in large organized public markets spend
a lot of money to inform the public about their companies: it is the
way they raise public equity. This is something that is fairly expensive
for small and private companies to do. NASDAQ’s idea is to help these
companies raise equity.
Another recent interesting topic is the IPO of a company called
Square. Square, Inc. deals with financial and merchant services; it is
an aggregator and mobile payment company based in California. The
company markets several software and hardware payment products,
including Square Register and Square Reader, and is expanding into
small business services such as Square Capital, a financing program,
and Square Payroll. The IPO price was $9. By the end of the day the
share price was $13. The $9 price was below the last round of funding
prices so it was a loss value for the company. Evan Niu discusses the
situation on Motley Fool.3 As he argues, the situation is not unusual for
IPO firms and by no means constitutes a sign of failure. As we will learn
later in the chapter, this phenomenon is caused by asymmetric informa-
tion between firms and investors and is called the “IPO underpricing”
phenomenon.

3.2 Insiders and Outsiders

Information asymmetries are characterized by one person or organization
having more information than another person or organization. Insiders
may have private (exclusive) information about a firm that is unavailable
to outsiders. In public corporations, insiders are typically managers; in
closely held corporations, insiders are often shareholders and managers.

2
 Akerloff and Stiglitz both won the Nobel Prize for their contributions to asymmetric information
research.
3
 Niu (November 21, 2015).
 3  Asymmetric Information and Capital Structure  47

Insiders may not be able to fully disclose their information to the firm’s
claimholders. Grinblatt and Titman (2001) argue that among the reasons
for this are that the information may be valuable to competitors; there is a
risk of being sued by investors if they make forecasts that later turn out to be
inaccurate;4 and managers may be reluctant to disclose “bad” information.
As a result, investors will try to incorporate indirect evidence in their
valuation, which is done through the analysis of information-revealing
actions (signals). These can include investment decisions, financing deci-
sions, dividend decisions, etc. This chapter discusses some of the major
ideas relating to the problem of asymmetric information.

3.3 Pecking Order Theory

Consider a firm that wants to raise money for a project. If it issues new
equity for this project, it invites outsiders to share not only the new proj-
ect but also all of its existing assets. Thus, outside investors will infer
that existing assets are not very valuable. So, not knowing for sure what
the firm is worth, outside investors will be unwilling to pay much for
this new equity. Therefore, if the firm is actually good, then its equity
will have been underpriced. Because of that, a good firm should always
rely on retained earnings to finance new projects. These ideas were put
forth by Myers (1984) and Myers and Majluff (1984). In the next exam-
ple, we will show how asymmetric information affects a firm’s financing
decisions.
Suppose a firm is raising funds for an investment project. The firm
has internal funds, i. The investment cost is k, k # i. The initial capital
structure is 100 % equity with n shares outstanding. Firms maximize the
wealth of their existing shareholders (owners). To finance the project, the
firm may use internal funds, issue debt or equity (Fig. 3.1).
To illustrate the idea we will assume that there are two types of firms
on the market (both with equal probability) labeled with subscript 1 and
2. Owners learn the type (future expected earnings) of their firm in the
beginning. The firm’s type is not publicly observable. The public only

 See Stempel (December 18, 2013) for a recent example with Facebook’s IPO.
4
48  Capital Structure in the Modern World

Firms decide
Earnings are
Owners learn whether to
realized and
their irm's use internal
distributed to
type funds, issue
claimholders
debt or equity

Fig. 3.1  Sequence of events

knows that there are two firms on the market and one of them has poten-
tial earnings c1 and the other c2.
To solve this situation, game theory is typically used as the main tool.
Players are: Firm 1, Firm 2 and the Investor. Firm 1 and 2 represent
the existing shareholders of each firm’s type. The Investor can provide
financing or buy securities as long as the expected earnings cover the
investment. It is usually justified by the assumption that the investor is
risk-neutral and that the risk-free interest rate is zero.5 What are the pos-
sible outcomes of this game? Usually the Nash equilibrium concept is
used. Famous mathematician John Forbes Nash received a Nobel Prize
for his work on game theory. A Nash equilibrium is a situation where no
participants have any incentive to deviate from the equilibrium given the
strategies played by the other players.
Since both firms have large amounts of internal funds available, a pos-
sible equilibrium is one where both firms use internal funds to finance
their projects. The payoff for the owners of firm t will be equal to
i + ct − k, t = 1, 2. The same holds for the situation where both firms use
debt. Note that debt is risk-free in our model since firms have enough
internal funds that can be used as an insurance fund to cover the initial
investment. Now consider equity issues. Does the situation where both
firms issue equity represent an equilibrium?
To answer this question, first consider a hypothetical situation where
the Investor knows the firm’s type (perfect information case) and Firm 1
issues equity. Since the Investor knows the firm’s expected earnings, the
Investor purchases Firm 1’s shares at fair value. What fraction of the firm’s
k
shares will be sold? The Investor will receive α = . In this case the
i + c1
 This assumption will be used in most models throughout the book unless otherwise specified.
5
 3  Asymmetric Information and Capital Structure  49

k
Investor’s payoff equals: α ( i + c1 ) = ( i + c1 ) = k . This equals the ini-
i + c1
tial amount of investment. The initial owners’ profit for Firm 1 is

(1 − α ) ( i + c1 ) = i + c1 − k
It is the same profit that the owners of Firm 1 could get by using internal
financing.
Now consider the case with imperfect information. What if the
Investor believes that the firm is type 2 instead? Then the Investor will
k
demand a fraction of equity equal to α = . The Firm 1 owners' pay-
i + c2
 k 
off in this case is (1 − α ) ( i + c1 ) = 1 −  ( i + c1 ) .
 i + c2 
As shown in Fig. 3.2 the payoff of the initial shareholders of Firm 1
depends on the expected earnings of Firm 2 and, respectively, the fraction
of shares the Investor will ask for in exchange for their investment in the
project. If c2 < c1, the Investor will perceive the firm to be of lower quality
than it really is. The Investor will ask for a large fraction of shares and the
payoff for the initial shareholders of Firm 1 will be lower than it would
be in the case of perfect information (that could be achieved for example
by using internal funds for financing the project).

Fig. 3.2  The Firm 1 owners’ payoff under imperfect information

50  Capital Structure in the Modern World

Below we argue that a firm with higher expected earnings never issues
equity in equilibrium. First consider a situation where firms use different
strategies (separating equilibrium). Suppose that c2 > c1 and Firm 2 issues
equity and Firm 1 uses internal funds or risk-free debt. Firm 1 owners�
payoff equals i + c1 − k . However, if Firm 1 decides to mimic Firm 2, its
owners’ payoff will increase as follows from Fig. 3.2. Therefore, this situ-
ation is not an equilibrium.
Now consider a situation where both firms issue shares (also called
pooling equilibrium since both firms use the same strategy) and suppose
that c1 > c2. As was argued above, Firm 1 will issue equity only if the
k
Investor is willing to buy shares for no more than α = fraction of
i + c1
equity. In this case, however, the Investor loses money. The Investor will
buy shares of Firm 1 with probability 50 % and make no losses in this
case, but with probability 50 % the Investor will buy shares of Firm 2 and
this will bring: k ( i + c2 ) , which is less than k because c2 < c1 . Therefore,
i + c1
the situation where both firms issue equity is not an equilibrium.
So far, we have assumed that a firm can issue risk-free debt or equity
with no cost. If we relax one of these assumptions, in order to avoid any
loss of value, the higher quality firm needs to use internal funds. This
leads to the following result.

Proposition 3.1  Under asymmetric information, good quality firms should

first use internal funds to finance new investments because this is at least as
good as external financing. If good quality firms use internal financing, the
financing strategy of bad quality firms is irrelevant.

If good quality firms use internal financing and if bad quality firms
choose their financing randomly, then, on average, internal funds will be
a dominant source of financing. On a large scale, this result appears to be
true. If one considers the aggregate balance sheet of American corpora-
tions, one can see that internal funds represent about 60–70 % of all invest-
ment financing sources. What about the debt/equity choice? To attack this
question, let us assume that in the above model firms do not have internal
 3  Asymmetric Information and Capital Structure  51

funds available or that i = 0 . Also, suppose that debt is still risk-free, i.e.
k < c2 < c1. Similarly to the previous case, one can show that there are no
equilibria where Firm 1 issues equity. In this case, Firm 1 will lose value.
Possible equilibria then include cases when both firms issue debt or Firm
1 issues debt and Firm 2 issues equity. This leads to the following result.

Proposition 3.2  Under asymmetric information, when internal funds

are not available and debt is risk-free, good quality firms should use debt
to finance new investments. The financing strategy of bad quality firms is
irrelevant.

What if debt is not risk-free, which is usually the case in real life?
Assume for example that c2 < k < c1. In this case, Firm 1 cannot avoid
losing value. Since debt is not risk-free and since the firm’s type is private
information, the Investor will charge a positive interest rate when provid-
ing debt financing. If the Investor provides a loan with zero interest rate
assuming that it faces Firm 1 (which would be the case under perfect
information), Firm 2 will mimic this strategy and ask for a loan with
an interest rate equal to zero and then the Investor will sustain a loss on
average. So the only candidates left to be the equilibrium are cases when
both firms issue debt or both firms issue equity. Some articles argue that
equilibria with debt usually dominate ones with equity since value loss
for a good quality firm is typically smaller in the case of debt than in the
case of equity. Intuitively, debt is a security that is less sensitive to value
fluctuation (Nachman and Noe, 1994).
Propositions 3.1 and 3.2 lead to the so-called pecking order theory
or POT (Myers and Majluff 1984 and Myers 1984): under asymmetric
information firms prefer to use internal funds, then debt, and equity is
only a last resort.

Example 3.1
Consider a firm that has the opportunity to undertake an investment
project. The project’s cost is 70. The project will bring a revenue of 90
and the firm will be liquidated. The risk-free interest rate is 0. The firm
has issued 100 shares outstanding. The firm has 100  in cash when it
makes the decision about the project. Since the firm has enough money
52  Capital Structure in the Modern World

to pay the cost of the new project, it can do so. It can also issue additional
equity to finance the project.

If the firm decides to use internal funds, the shareholders’ final profit
will be 100 − 70 + 90 = 120. The shareholders will be interested in pursu-
ing this strategy since their payoff is higher than in the case when the firm
does not undertake the new project (120 > 100). In other words, the net
present value of the new project is positive: NPV = 120 − 100 = 20 .
Now consider the case when the firm issues equity. Outside investors
know the amount of cash the firm has (100) and they also know the value
of the earnings from the new project (90). When they buy equity and
get a fraction α of the firm, their payoff is α190, which should be equal
to 70 (investment cost), which implies: α = 70 / 190 = 7 / 19 . The initial
shareholders’ payoff is (1 − α )190 = 120. Note that the initial shareholders’
payoff is the same under any strategy (120). This is consistent with the
spirit of the perfect market concept (capital structure irrelevance).
Now let us look at the asymmetric information case. Assume that earn-
ings from the project can either be high (90) or low (30). Outside inves-
tors believe that its value will be 90 with a prior probability of 50 %. Does
a situation where both firms issue equity, or one firm issues equity and
the other one uses internal cash for the project, represent an equilibrium?
If the shareholders use cash to finance the project, their final payoff
for the high earnings firm is 100 − 70 + 90 = 120 and for the low earnings
firm is 100 − 70 + 30 = 60. Now consider the case where the high earnings
firm issues equity and the low earnings firm uses cash for the project. The
fraction of equity sold to investors equals 7/19. The initial shareholders’
payoff for the high earnings firm is (1 − 7 / 19 ) * (100 + 90 ) = 120. However,
it cannot be an equilibrium. If the shareholders of the low earnings firm
decide to issue equity as well (and “mimic” the high earnings firm), their
4
payoff will be: (1 − 7 / 19 ) * (100 + 30 ) = 82 . This is definitely greater
19
than what they can get by using cash for the project.
Now consider the case where both firms issue equity. Investors will
rationally anticipate that they will invest in the high earnings firm with
only a 50 % probability. So the minimum fraction of shares acceptable
for outsiders is
 3  Asymmetric Information and Capital Structure  53

70 7
α= = d
100 + 0.5 * 30 + 0.5 * 90 16

In reality it should be even higher because there is no guarantee that the

firm with the good project will also issue equity. Now consider the deci-
sion of the initial shareholders if they are informed that the value of the
new project is 90. If they use internal funds their payoff is 120. If they
issue equity their fraction of shares will be at most 9/16 and therefore
their payoff will be 9/16 * (190), which is less than 120. Therefore, they
will use internal funds and not issue equity.
In conclusion, high quality firms will use internal funds and low
quality firms will either issue equity or also use internal funds. Equity
is dominated by internal funds: the basic idea of the pecking order
theory. Equity is considered “lemon” because it will only be issued by
low quality firms. The “lemon” problem was theorized by Akerloff, who
was awarded the Nobel Prize in 2001 for his research (see, for example,
Akerloff (1970)).
Consider the firm’s stock price reaction to an equity issue announce-
ment. As follows from the previous analysis, when Firm 2 issues equity
the fraction of equity that belongs to new investors is k . Denote the num-
i + c2
ber of newly issued shares by ∆n. We have: k = ∆n . This implies
i + c2 n + ∆n
kn
∆n = (3.1)
i + c2 − k

We also have p∆n = k , where p is the price of newly issued shares. Along
with (3.1) it implies:

i + c2 − k (3.2)
p=
n

Proposition 3.3  The market reaction on newly issued shares is negative.

54  Capital Structure in the Modern World

Indeed, initially, the market participants cannot distinguish between

firms’ types. They only know that firms have new projects and assets
in place with value i. With regard to new projects the market believes
that they will be high earnings projects with probability 50 % and low
­earnings projects with probability 50 %. So prior to the equity issue, the
share price is

0.5 ∗ ( i + c1 − k ) + 0.5 ∗ ( i + c2 − k )
(3.3)
n

However, after the issue is announced, the share price is given by (3.2)
since only Firm 2 can issue shares in equilibrium. The price determined
in (3.2) is smaller than in (3.2) because c2 < c1.

Proposition 3.4  There is a negative correlation between debt and

profitability.

POT is usually considered to be a theory that can explain the famous

negative correlation between debt and profitability (discussed in Chap.
2) that often fails the static trade-off theory. There are numerous inter-
pretations of different predictions in POT and trade-off theory, especially
with regard to empirical strategies of testing these predictions. Frank and
Goyal (2009) mentioned for example: “The theories are not developed
in terms of standard accounting definitions. To test the theories, it is
therefore necessary to make judgments about the connection between the
observable data and theory. While many of these judgments seem uncon-
troversial, there is room for significant disagreement in some cases.” The
simple model presented in this section is not an exception. One can find
very different interpretations of correlations between debt and profitabil-
ity. One approach that is probably the most popular in literature is the
following. Consider the link between the amount of assets-in-place (the
variable i in our model; this can include cash and hence it is positively
correlated with internal resources, retained earnings and ultimately with
the firm’s profitability) and its link to the equilibrium capital structure
choice. When i > k , the high quality firm uses internal funds to finance
 3  Asymmetric Information and Capital Structure  55

the project (recall that the capital structure choice of the low quality firm
does not matter). When i < k, the high quality firm will issue debt. So
one should observe a negative correlation between the value of i and the
amount of debt issued in this model, which proves Proposition 3.4.

Proposition 3.5  A higher extent of asymmetric information reduces the

incentive to issue equity.

For example, if in the basic model c2 = c1 firms can issue equity without
the risk of being mis-valued: in this case, there is no negative reaction to
an equity issue announcement. However, when c2 Þ c1, Firm 1 will not
issue equity in equilibrium.
As mentioned in Miglo (2011), the empirical evidence regarding firms
following pecking order is mixed.6 The negative reaction to equity issues,
or in general to leverage reducing transactions, usually finds empirical
support. The negative correlation between debt and profitability usually
also finds empirical support as discussed in Chap. 2. The evidence regard-
ing the link between the extent of asymmetric information and capital
structure choice is mixed.
Among more recent articles note the following. De Jong et al. (2010)
test POT by separating the effects of financing surpluses, normal defi-
cits, and large deficits. Using a panel of U.S firms between 1971 and
2005, they find that POT works best for firms with surpluses and worst
for firms with large financing deficits. These findings highlight a puzzle
that small firms, although they have the highest potential for asymmetric
information, do not behave according to POT. The authors argue that
these results are consistent with the debt capacity in the pecking order
model. De Jong, Verbeek, and Verwijmeren (2011) test the static trade-­
off theory prediction that a firm increases leverage until it reaches its
target debt ratio, and the prediction of POT that debt is issued until the
debt capacity is reached. It is found that POT is a better descriptor of
firms’ issue decisions than the static trade-off theory. Dong et al. (2012)
study market timing and pecking order in a sample of debt and equity

 See, for example, Shyam-Sunder and Myers (1999), Frank and Goyal (2003), and Leary and
6

Roberts (2010).
56  Capital Structure in the Modern World

issues and share repurchases of Canadian firms from 1998 to 2007. They
find that only when firms are not overvalued do they prefer debt to equity
financing. Saumitra (2012) tests POT for an emerging economy through
a case study of the Indian corporate sector that includes 556 manufactur-
ing firms over the period 1997–2007. The study finds strong evidence in
favor of the pecking order hypothesis. Bhama et al. (2015) examine firms
(in India and China) with normal as well as large deficits and surpluses.
The study finds that Indian and Chinese firms frequently issue debt when
they have normal deficits. The pecking order results are less supportive
for Indian firms with large deficits. Mogilevsky and Murgulov (2012)
examine underpricing of private equity backed IPOs listed on a major US
stock exchange between January 2000 and December 2009. The authors
identify 265 private equity backed IPOs and compare these with concur-
rently listed venture capital (VC) backed and non-sponsored IPOs. The
results indicate that, on average, private equity backed IPOs experience a
significantly lower level of underpricing than venture capital backed and
non-sponsored IPOs.

3.4 W
 hen Incumbent Shareholders Are
Risk-Averse
In traditional pecking order models, like the one discussed in the previ-
ous section, good quality firms are forced to use internal funds if available
to avoid adverse selection problems and a loss in value. If internal funds
are not available, these firms will issue debt. In the latter case, they are
mimicked by low quality firms. Therefore, in either case, good quality
firms cannot signal their quality by changing their capital structures. The
following sections discuss models in which capital structure choice will
indeed serve as a signal of a firm’s quality (Leland and Pyle (1977) and
Ross (1977)).
In Leland and Pyle (1977) the incumbent shareholders are risk-averse.
It will be shown that if a firm’s future is favorable, the shareholders may
accept a bigger risk or a bigger fraction of ownership. This leads to a “risk-­
bearing” signaling idea.
 3  Asymmetric Information and Capital Structure  57

Consider a firm owned by a risk-averse entrepreneur. The entrepre-

neur’s expected utility is Ew − 1 / 2 ρVarw where w is the entrepreneur’s
wealth.7 The firm has assets in place that can bring a net return Rθ that
is normally distributed with a mean θ and standard deviation σ. θ is the
entrepreneur’s private information and σ is the public information. The
entrepreneur is considering selling shares on the market. Potential inves-
tors are risk-neutral. The risk-free interest rate is 0.

Perfect Information
In this case, the entrepreneur definitely benefits from selling the firm to
an investor. Since the investors are risk-neutral and the risk-free interest
rate is 0, the price of the transaction (the entrepreneur’s return) is: P = θ .
If the entrepreneur does not sell the firm, he will still have θ in expecta-
tion but it will involve some risk because the firm’s return is stochastic. It
is always better to sell the project because of risk aversion. The entrepre-
neur’s wealth in this case is w = θ and the expected utility is θ.

The entrepreneur’s wealth, if he sells α of the firm’s equity, is

w = P + (1 − α ) Rθ . Therefore Ew = P + (1 − α )θ , Varw = (1 − α ) σ 2 . Also,
2

since the information is perfect, the firm’s price correctly reflects the
firm’s expected earnings: P = αθ .
Thus, the entrepreneur’s expected utility is θ − 1 / 2 β (1 − α ) σ 2 . The
2

optimum is attained when α = 1.

Imperfect Information (Example)

Now consider the case when θ is the entrepreneur’s private information
(Fig. 3.3).

Example 3.2
To illustrate this idea, suppose there are two firms with the parameters of
return described in Table 3.1:
As was argued above, if the information about the expected profits were
public then Firm 1 would be sold for 100 and Firm 2 would be sold for

 E and Var denote the expected value and variance respectively.

7
58  Capital Structure in the Modern World

Investors
Entrepreneurs observe fractions
decide whether of equity offered
Entrepreneurs to sell the irm for sales by each
learn their irm's and what irm and select
type fraction of equity prices.
should be offered Entreprneurs
for sale expected utilities
can be calculated

Fig. 3.3  The sequence of events under imperfect information

Table 3.1  Expected profits and vari-

ances in Example 3.2
Expected
profit Variance
Firm 1 100 100
Firm 2 200 100

200. Suppose that the entrepreneurs sell their firms even if the informa-
tion about expected returns is private. The price in this case will be 150.
The investors will be ready to buy the firm for an average expected return.
Consider the entrepreneurs’ expected utilities. The entrepreneur of Firm
1 will obviously benefit from selling the firm for 150. His expected util-
ity will be 150. If he keeps the firm, his expected utility is less than 100.
What about the entrepreneur of Firm 2?
1
If he does not sell the firm, his expected utility is 200 − ρ100 = 200 − 50 ρ .
2
If he sells, then it is 150. The entrepreneur is only interested in selling the
firm if ρ > 1. Otherwise, he will keep his shares.
An implication of this result is that firms in industries with a high
degree of asymmetric information (for example, research firms) are often
characterized by entrepreneurs owning large fractions of equity.

Proposition 3.6  The larger the extent of asymmetric information in the

 3  Asymmetric Information and Capital Structure  59

industry the greater the probability of quality firms losing money.

Suppose there are two firms with expected profits θ1 and θ2, θ2 > θ1.
The market only knows that θ = θ1 with probability π1 (Firm 1) and θ = θ 2
with probability π2 (Firm 2). Similar to the argument in the above exam-
ple, Firm 1 is always interested in selling the firm. Suppose Firm 2 is also
sold. Since the market cannot distinguish between the firms, it will pay
the “average” price: P = θ1π 1 + θ2π 2 .
The incentive to sell the firm depends on the following condition for
1
the entrepreneur from Firm 2: θ1π 1 + θ2π 2 ≥ θ2 − ρσ 2, which can be
2
1
written as follows: π 1 (θ2 − θ1 ) ≤ ρσ 2. This condition is not necessarily
2
1
satisfied. Firm 2 will not be sold if π 1 (θ2 − θ1 ) > ρσ 2.
2
The larger the difference between the firms’ expected profits then
the greater the probability of this condition being satisfied. This proves
Proposition 3.6.

Proposition 3.7  The entrepreneur’s fraction of the firm’s shares increases the
higher the expected return of the assets, the lower the firm’s risk, and the lower
the entrepreneur’s degree of risk aversion.

Signaling
How can the market inefficiency described above be resolved? The idea
for the high profit type is to find actions that will not be mimicked by the
low profit type. The market will thus be able to distinguish the types and
pay a higher price for the shares of the high profit type. Consider partial
selling of the project. Denote the fraction of ownership retained by the
entrepreneur with α. Suppose that Firm 1 sells its shares completely while
Firm 2 sells only (1 − α ) of its shares. The payoff for the entrepreneur from
Firm 1 is θ1 while the wealth of the entrepreneur from Firm 2 is

(1 − α )θ2 + α Rθ 2
= θ 2 − 1 / 2 ρα 2σ 2 (3.4)

If Firm 1 decides to mimic Firm 2, it will be able to sell the frac-

60  Capital Structure in the Modern World

tion (1 − α ) of Firm 1’s shares for a higher price. However, the remain-
ing shares will have to be held, which implies some risk-sharing with
other shareholders. The separation condition (incentive for Firm 1 not
to mimic Firm 2) is: θ1 ≥ (1 − α )θ2 + αθ1 − 1 / 2 ρα σ . This condition can
2 2

be written as

α2 2 (θ 2 − θ1 )
≥ (3.5)
1−α ρσ 2

Note that according to (3.4) the payoff for the entrepreneur from Firm 2
is decreasing in α. Therefore, the optimal α for this entrepreneur would
be minimal α which satisfies (3.5). It is given by

α2 2 (θ 2 − θ1 )
=
1−α ρσ 2

Since the left part of this equation increases with α, there is a positive
correlation between θ2 and α. Similarly, there is a negative correlation
between α and the firm’s risk (σ2) and the entrepreneur’s degree of risk
aversion ρ. This proves Proposition 3.7.

Return to Example 3.2

Firm 1 sells all shares: P1 = 100. Firm 2 sells partially. To find α, we need to
solve the following equation: α = 2 ( 200 − 100 ) . Suppose that ρ = 0.5.
2

1−α ρ100
α 2
The condition becomes: = 4. Solving for α, given that 0 < α < 1,
1−α
gives: α ≈ 0.83. Therefore, the entrepreneur of Firm 2 should keep
approximately 83 % of the shares and sell 17 %.

Since high profit firms sell only partially, it can be interpreted as

debt financing! Indeed suppose that instead of considering the sale
of the entrepreneur’s shares on the secondary market, the firm has a
 3  Asymmetric Information and Capital Structure  61

new investment project available and it needs to raise external funds to

finance this project. Equity would be an optimal financing choice since
it would provide the largest reduction of risk for the entrepreneur. In
equilibrium, that would definitely be the choice for a low quality firm.
A high quality firm will be unable to use equity financing exclusively
since the share price will be below its true value and the value loss can
outweigh the gains from the risk reduction. So a probable solution will
be selling the shares partially and partially raising debt. Although a high
quality firm can lose some value when selling debt, this loss should be
less than that from selling shares (for more analysis on comparing sales
of debt and equity under asymmetric information see Nachman and
Noe (1994)).
Leland and Pyle’s (1977) idea that entrepreneurs signal the qualities
of their businesses by retaining larger fractions of equity is intuitively
appealing. It has been used by banks and other financial institutions
when screening entrepreneurs’ demands for loans. On the other hand,
the main application of signaling theories for capital structure choice
is that debt financing should serve as a positive signal for market par-
ticipants. The empirical evidence regarding this prediction is mixed.8 It
is also not consistent with the negative correlation between debt and
profitability.
The following papers are noteworthy. Garcia (2002) considers an opti-
mal contracting problem between an informed risk-averse agent and a set
of risk-averse principals. An informed entrepreneur approaches a group
of outside investors to sell them an equity share in the firm motivated
by risk-sharing gains. In contrast to the Leland and Pyle (1977) model,
outside investors have bargaining power, and the investors and the entre-
preneur also negotiate over a real investment decision in the firm. It is
shown that the fraction of shares retained by the entrepreneur may not be
increasing in the quality of private information. Varas (2014) analyzes a
dynamic model involving Leland and Pyle’s (1977) idea that an informed
seller can use partial retention of an asset to signal quality. Retention is a
credible signal only if the seller can commit not to trade again in the near

8
 See, among others, Eckbo (1986), Howton et al. (1998), Antweiler and Frank (2006) and Miglo
(2011).
62  Capital Structure in the Modern World

future. The model considers trading dynamics if such a commitment is

not possible. In equilibrium, the seller’s holdings and the length of the
trade delay are related and the expected delay between trades is a decreas-
ing function of the fraction of the assets owned by the seller. The trading
patterns are driven by the incentives to build a reputation of owning a
high quality asset.

3.5 Is Asymmetric Information Behind

the 2007 Crisis?
Many economists consider the financial crisis of 2007–2009, also
known as the Global Financial Crisis, to be the worst financial cri-
sis since the Great Depression of the 1930s. It threatened the collapse
of large financial institutions, only prevented by government bail-
outs of banks, and stock markets dropped worldwide. The Dow Jones
Industrial Average Index reached 14093 in October 2007 and fell down
to the level of the 1990s during the crisis: in March 2009 it was 6547.
In many areas, the situation in housing markets involved foreclosures
and unemployment. The crisis played a significant role in the failure of
key businesses, leading to the 2008–2012 global recession and contrib-
uting to the European sovereign-debt crisis. The burst of the US hous-
ing bubble, which peaked in 2004, caused the values of securities tied
to US real estate pricing to plummet, damaging financial institutions
globally.
Many researchers agree that the main triggers of the financial crisis
were the sharp increase in home ownership, easy access to loans for bor-
rowers, and overvaluation of bundled subprime mortgages. The last was
mainly based on the theory that house prices would continue to rise.
An interesting question is whether it was a total (symmetric!) misun-
derstanding of real values in real estate markets or a case of asymmetric
information when issuers or sellers of securities possess more (on aver-
age) information than the buyers of securities. If so, then it mirrors the
issues discussed previously in this chapter. Or perhaps the market was
not in equilibrium and investors were not rational?! Or did something
 3  Asymmetric Information and Capital Structure  63

else happen?
It is easy to assume that we indeed have a market with asymmetric
information. In the primary market for mortgages, banks may not have
a complete picture of the “quality” of their borrowers since the analysis
of private borrowers is usually based on their credit history and does
not take many other factors into consideration. In the secondary market,
it is a pretty obvious assumption that financial institutions, including
banks, have more information about the quality of mortgages in their
portfolios than potential buyers. In the primary market, as in any other
credit market with asymmetric information, interest rates should remain
relatively high to limit the number of low quality borrowers.9 Any politi-
cally motivated downward pressure on interest rates or problems in the
screening process will result in lower interest rates and a high number
of low quality borrowers. In the secondary market, when the extent of
asymmetric information is significant enough, there is no equilibrium
where good quality items remain on the market (or good quality shares as
in the pecking order model, or good quality cars as in the used car market
of Akerloff). As the “lemon” model predicts, there are no deals for good
quality items (mortgages in this case) that are pushed off the market by
bad quality items.
How should the market solve the problems of asymmetric informa-
tion? First, any political pressure in markets with a high degree of asym-
metric information can be very damaging and thus should be avoided.
Second, as we know, in the market for used cars, sellers can purchase
independent warrants or certificates that will describe the quality of their
cars. Only good cars will be able to pass a test like this. In the market for
new shares, there is a sophisticated due diligence process that involves
professional underwriters, auditors, independent analysts, etc. Similar
systems should probably exist in the market for mortgages and mortgage-­
backed securities.
Beltran and Thomas (2010) noted that a key feature of the 2007–
2008 financial crisis was that for some classes of securities trade ceased.
And where trade did occur, it appears that market prices were well below
their intrinsic values. The authors argue that one explanation for this is

 For more discussion, see the next chapter.

9
64  Capital Structure in the Modern World

that information is asymmetric, with the current holders having better

information than potential buyers. They show how the resulting adverse
selection problem can help explain why more complex securities trade
at significant discounts to their intrinsic values. Kirabaeva (2011) argues
that the complexity of structured financial products and the heterogene-
ity of the underlying asset pool gave their issuers an informational advan-
tage in their evaluations.

Questions and Exercises

1. The pecking order theory of capital structure suggests that firms
should use internal funds under symmetric information between
insiders and outsiders and they should issue equity when information
is asymmetric.
2. Stock prices tend to decrease following the announcement of a new
equity issue and tend to stay relatively stable following the announce-
ment of a new debt issue.
3. The pecking order theory of capital structure predicts negative correla-
tion between debt and profitability.
4. The entrepreneur’s fraction of a firm’s shares increases:
(a) the lower the expected return of the assets
(b) the higher the expected return of the assets
(c) the higher the firm’s risk
(d) the higher the entrepreneur’s degree of risk aversion
5. Consider a firm that has an opportunity to undertake an investment
project. The project requires an investment of $70 million. The proj-
ect will bring $90 million and then the firm will be liquidated. The
risk-free interest rate is 0. The firm has issued 12 million shares out-
standing. The firm has assets-in-place which will bring $100 million.
The firm needs to issue new equity to finance the new project.
(a) What would be the fraction of shares sold to new shareholders
and the share price if the investors know the value of assets-in-­
place and that of the new project?
(b) Should the firm undertake the project?
(c) Now let’s look at the asymmetric information case. Assume that
 3  Asymmetric Information and Capital Structure  65

the initial assets can take two values, $40 million and $160 mil-
lion. The true value of this is unknown in the beginning but is
soon known by the entrepreneur (insider). Outside investors have
a prior probability of 50 % that the value equals $160 million.
Analyze the situation where both types of firm issue equity and
invest.
(d) Now analyze the situation where only one type of firm issues
equity and invests.
(e) Describe the share price dynamics. Find the share price: (1) before
the information about the project is known to the public; (2) at
the moment when the market knows about the project but the
firms have not yet issued equity; (3) at the moment when the
firms issue equity.
(f ) Which two phenomena are illustrated here?
6. Consider a firm owned by a risk-averse entrepreneur. The entrepre-
neur’s expected utility is Ew − 1 / 2 ρVarw where w is the entrepreneur’s
wealth. The firm has assets-in-place that can bring a net return Rθ,
which is normally distributed with the mean θ and standard deviation
σ. θ is the entrepreneur’s private information and σ is the public infor-
mation. Potential investors are risk-neutral. The risk-free interest rate
is 0. There are two types of firms (the fraction of each type is 50 %):
one with θ = 20 (Firm 1) and the other with θ = 100 (Firm 2). σ 2 = 50
and it is publicly observable information.

(a) Assume that θ is common knowledge. Which strategy is the best

for the entrepreneur in this case? Explain.
(b) What is the entrepreneur’s utility? Calculate this separately for
each type.
(c) Now suppose that the firm’s type is the entrepreneur’s private
information. Suppose that the entrepreneurs of both types sell
shares in total. Find the condition for this equilibrium to exist.
(d) Provide an intuitive explanation for this condition.
(e) Suppose ρ = 1. Describe the possible equilibrium.
66  Capital Structure in the Modern World

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to corporate news stories? Working Paper, University of British Columbia
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 4
Credit Rationing and Asset Substitution

4.1 S
 hareholders Versus Creditors: Capital
Structure Battle
Agency problems exist between shareholders and managers. In this rela-
tionship, shareholders are the principals and they do not have direct
control over the managers’ actions (agent). This chapter analyzes the
shareholder–creditor agency problems where creditors (principal) can-
not control the actions of the shareholders (firm’s owners) responsible for
major decisions.
Recall that in a perfect market the firm undertakes projects with posi-
tive NPVs. Also, in a perfect market, contracts are easily enforceable and
shareholders’ decisions are easy to contract. So creditors and shareholders
write a contract according to which the creditors will get their investments
back and shareholders will choose projects with positive NPVs or, when
projects are mutually exclusive, the shareholders will choose the project
with maximal NPV. Both shareholders and creditors have the same goal:
to maximize the value of their investment. This goal is achieved when
firms use the policy described above. But this mutual goal is the cause of
their conflicting interests when markets are imperfect. Throughout this

© The Editor(s) (if applicable) and The Author(s) 2016 69

A. Miglo, Capital Structure in the Modern World,
DOI 10.1007/978-3-319-30713-8_4
70  Capital Structure in the Modern World

chapter, and the next chapter, we will discuss the reasons why creditors
and shareholders often support different corporate decisions in order to
maximize the values of their claims. Two kinds of distortions may arise
from agency problems between creditors and shareholders. This chapter
considers the shareholders’ tendency to invest in very risky projects, pos-
sibly even in projects with negative NPVs. The next chapter will look at
situations when the shareholder–creditor conflict leads to underinvest-
ment in positive NPV projects.
Potential conflicts between creditors and shareholders explain many
interesting phenomena in financial markets. One of them is called “credit
rationing.” Josef Stiglitz and Andrew Weiss described it in their 1981
article. Credit rationing is a situation where financial institutions, such as
banks, refuse to increase interest rates clearing the demand for loans, even
when the demand is coming from firms with profitable projects. This is
an unusual situation for market economies because, traditionally, prices
(interest rates in a market for loans) were supposed to be flexible enough
to equalize demand and supply. In November 2015, Ruth Simon pub-
lished an article in the Wall Street Journal entitled “Big Banks Cut Back
on Loans to Small Business.” The article argues that the biggest banks
in the US are making far fewer loans to small businesses than they did
a decade ago thus ceding market share to alternative lenders that charge
significantly higher rates. Together, 10 of the largest banks issuing small
loans to businesses lent $44.7 billion in 2014, down 38 % from a peak of
$72.5 billion in 2006, according to an analysis of the banks’ federal regu-
latory filings. The largest banks “have essentially abandoned the small
business market,” said Dr. Cole, DePaul University finance professor.
Some entrepreneurs had to borrow on-line where interest rates are as high
as 80%.1 This chapter will provide some insight into these phenomena.

 Simon (November 26, 2015).

1
 4  Credit Rationing and Asset Substitution  71

4.2 Asset Substitution and Risk-Shifting

Usually, a creditor’s claim is maximized when the probability of the claim
being honored is maximized. In most cases this means creditors prefer
lower risk. However, shareholders of high-leveraged firms may gain when
business risk, especially of firms with low equity value, increases. If the
project fails, the shareholders will not be worse off. But if the project suc-
ceeds, there will be more than enough earnings to pay off the debt, and
the surplus will go to the shareholders.
Investments are usually risky but sometimes conflicts of interests lead
shareholders to invest in overly risky projects. Investors demand high
returns in good times to offset the chance of low returns in bad times.
The degree of risk is different to investment and corporations have an
almost unlimited choice with regard to how much risk they want to take
on. Asset substitution arises when a firm takes on an investment that
transfers wealth from creditors to shareholders. This is done for the most
part by taking on a risky investment. Due to limited liability, sharehold-
ers are able to avoid most of the consequences of a bad investment and
reap much more reward when an investment works out compared to
the creditors. This incentivizes the shareholders to take on more risk.
Creditors are never paid more than the principal plus interest, so when
a risky investment pays off, they are unable to receive any excess profit.
When the same investment fails and the firm is forced into bankruptcy,
creditors have no insurance against being paid less than their principal
plus interest. As a result, creditors desire investments with low risk.
Therefore, when a firm takes on a risky project, it can create wealth for
the shareholders and take away wealth from the creditors. The effects of
asset substitution and risk shifting were first introduced by Jensen and
Meckling (1976). This is considered to be one of the most important
concepts in corporate finance. Many authors consider some leveraged-
buyouts in the 1980s to be examples of risk-shifting, including the case
of RJR Nabisco, which was one of the largest buyouts in history. When
the firm entered financial distress in the late 1980s, the share price went
down and the firm’s managers undertook a risky investment in the form
of a leveraged buyout. It made many of the existing debtholders furious.
72  Capital Structure in the Modern World

Earnings are
A irm's Shareholders
realized and
capital select an
distributed
structure is investment
to
determined project
claimholders

Fig. 4.1  The sequence of events

The result was quite surprising for many analysts. Nabisco’s share price
went up and its bond’s price went down: reflecting the negative impact of
the risky investment on the creditors’ value.2
There are quite a few ways to measure risk. The main theoretical way is
with the mean preserving spread criterion (MPS) or increasing risk domi-
nance (IR).3 If one stochastic variable dominates another by the MPS or
IR criterion, then it is considered less risky.
To illustrate the idea of asset substitution, consider a company that is
deciding between two projects. A project j brings cash flow Rj, j = 1, 2 .
The company has debt with a face value D. R1 is distributed according to
the distribution function F and density function f and R2 is distributed
according to the distribution function G and density function g.
The timing of events in this situation (and most other situations con-
sidered in this chapter and Chap. 5) is shown in Fig. 4.1. The key aspect
of this model is that creditors do not have direct control over the share-
holders’ actions. Even if the firm gets financing from creditors, it is up
to the shareholders to make the final decisions. In contrast to the models
with asymmetric information from Chap. 3 this chapter and Chap. 5
analyze models with moral hazard.
The shareholders’ payoff is 0 when R < D and it is R − D otherwise.
Then the difference between the shareholders’ expected payoffs from
undertaking projects 1 and 2 are

2
 See Warga and Welch (1993) about wealth shifting during 1980s buyouts. Also see http://www.
investopedia.com/articles/stocks/09/corporate-kleptocracy-rjr-nabisco.asp
3
 See the Appendix for more information about stochastic dominance, mean-preserving spread
condition etc.
 4  Credit Rationing and Asset Substitution  73

R R R
∆T = ∫ ( R − D ) f ( R ) dR − ∫ ( R − D ) g ( R ) dR = ∫ ( R − D ) ( f ( R ) − g ( R ) ) dR
D D D
Let v = R − D and du = ( f ( R ) − g ( R ) ) dR . Then
R
∆T = ( R − D ) ( F ( R ) − G ( R ) ) |R
D ∫ ( F ( R ) − G ( R ) ) dR
−
D
R
= ∫ ( G ( R ) − F ( R ) ) dR (4.1)
D

If F(R) dominates G(R) by FOD then G ( R ) ≥ F ( R ) for any R and

therefore DT ≥ 0 .

Proposition 4.1 If Project 1’s cash flow distribution first-order dominates

that from Project 2, then Project 1 is at least as good as Project 2 for the
shareholders regardless of firm debt level.
Now suppose that F(R) dominates G(R) by increasing the risk criterion
R D

(IR). We can rewrite (4.1) as ∫ ( G ( R ) − F ( R ) ) dR − ∫ ( G ( R ) − F ( R ) ) dR.

0 0
From the definition of IR it follows that the first term equals 0 and
the second term is non-negative implying DT # 0 . It means that in most
cases the shareholders will choose Project 2, which has greater risk. In
some cases they will be indifferent between the two projects. Galai and
Masulis (1976) and Green (1984) were one of the first to analyze a lever-
aged firm’s investment choice when dealing with two projects with equal
expected earnings one of which has lower variance or dominates the other
by the MPS condition.
Since in many cases ∆T is strictly negative, the above conclusions may
hold even if the expected cash flow from Project 2 is lower than that from
Project 1.

Proposition 4.2 If Project 1 dominates Project 2 by the mean-preserv-

ing spread condition, then Project 2 is at least as good as Project 1 for the
shareholders.
74  Capital Structure in the Modern World

Example 4.1
The following example will illustrate the shareholders’ incentive to under-
take projects with low or even negative NPVs. Consider a company that
is deciding between two one-year projects, A and B. Both projects have
the same investment cost, 70,000, but are expected to generate different
earnings. The amount of earnings depends on the state of nature. There
are two states of nature: good (g) and bad (b), with equal probability. For
simplicity, assume that there are no bankruptcy costs. Also assume that a
banker exists that is ready to finance the firm’s investment by providing a
70,000 one-year loan with 5 % interest so the company has a debt due in
one year with a face value of 73,500.
The payoffs from the projects and their expected earnings are indicated
in Table 4.1. Clearly, Project B has higher expected earnings and a higher
NPV because both projects have the same investment cost. Furthermore,
the NPV of Project A is negative regardless of the interest rates because
the expected earnings are smaller than the investment cost. Nevertheless,
the project that is undertaken by the firm is the one that will yield the
greatest payoff to the shareholders (see Table 4.2).
Therefore, Project A will be chosen even though Project B has a higher
NPV. The reason is that Project A has more risk. Its cash flow is either
too high or too low. It is the “too high” situation that made this project
attractive to shareholders. The projects are such that given the firm’s debt,
both projects bring nothing to shareholders in bad times while in good
times Project A is definitely better.
Note that if Project A brings 25,000 in state b, Project B dominates
Project A by the MPS condition: the projects’ expected earnings are equal
but Project A has a higher risk. The shareholders will choose Project A,
which illustrates Proposition 4.2. Alternatively, suppose that in the initial
situation, Project B brings 125,000 in state g. One can check that in this
case Project B dominates Project A by FOD.  One can also check that

Table 4.1  Projects and earnings in Example 4.1

b (Pr = 0.5) g (Pr = 0.5) Expected earnings
Project A 5000 125,000 65,000 = 1/2*5000 + 1/2*125,000
Project B 65,000 85,000 75,000 = 1/2*65,000 + 1/2*85,000
 4  Credit Rationing and Asset Substitution  75

Table 4.2  Shareholders’ payoff in Example 4.1

b Expected payoff to the
(Pr = 0.5) g (Pr = 0.5) shareholders
Project A 0 51,500 = 125,000–73,500 25,750
Project B 0 11,500 = 85,000–73,500 5750

in this case, the shareholders would choose Project B, which illustrates

Proposition 4.1.
Finally, note that if one investment dominates another investment
by the second-order dominance criterion, no conclusions regarding the
shareholders’ incentive for asset substitution can be reached without fur-
ther analysis. The reason for this is that G(R) can be larger than F(R) for
some values of R and vice versa for other values of R and therefore the
sign of the expression in (4.1) depends on each individual case.

Debt Level and Assets Substitution

What are the implications of the assets substitution effect to capital
structure? An interesting question, for example, is how the sharehold-
ers’ incentive to choose riskier projects depends on the level of the firm’s
debt? As was noted above, if one project dominates another by FOD,
asset substitution will never take place. In the case of MPS, the firm
will always substitute assets. What about other cases? To analyze this
question, let us note that common sense in finance suggests that riskier
projects should have a higher probability of bankruptcy compared to
safer projects. In other words, G ( D ) > F ( D ). Let us now return to (4.1).
We have ∂∆T = G ( D ) − F ( D ) > 0 suggesting that the likelihood of asset
∂D
substitution increases when debt increases.4 This leads to the following
proposition.

Proposition 4.3 As long as the probability of bankruptcy with a riskier proj-

ect exceeds that with a safer project, a higher level of debt increases the likeli-
hood of asset substitution.

 See Gavish and Kalay (1983) and Green and Talmor (1986) for further analysis of this topic.
4
76  Capital Structure in the Modern World

This result implies that by changing the level of debt firms can con-
trol the incentive for an asset substitution problem. So one would expect
that firms with a greater potential to have an asset substitution problem
should have smaller debt.

Example 4.2
There are two states of nature: g with probability p and b with probability
1 − p . Consider a firm with two investment projects available with earn-
ings along with their expected earnings shown in Table 4.3.
Projects are mutually exclusive. We make the following assumptions:
(1) Y2 > X 2 > X1 > Y1 ; (2) X 2 + (1 − p ) X1 > pY2 + (1 − p ) Y1 (the interpreta-
tion of these assumptions is that Project A has a higher NPV and Project
B is riskier); and (3) The company has issued debt with a face value D.
If D < Y1 , the shareholders will select Project A. Their payoff in this case is
pX 2 + (1 − p ) X1 − D which is greater than Project B’s: pY2 + (1 − p ) Y1 − D.
Consider D such that X1 > D > Y1. The shareholder’s payoff if A is
chosen is pX 2 + (1 − p ) X1 − D and if B it is p (Y2 − D ) . The latter can be
written as: pY2 + (1 − p ) Y1 − D + (1 − p ) D − (1 − p ) Y1. This is greater than
pX 2 + (1 − p ) X1 − D because D > Y1. We can then conclude that Project B
will be chosen. The conclusion is the same for the case when X 2 > D > X1 .
The shareholder’s payoff if A is chosen is p ( X 2 − D ) and if B it is p (Y2 − D ) .
Project B will be chosen since Y2 > X 2. This illustrates Proposition 4.3.
Note that the case D > X 2 does not make too much sense since Project
A cannot be considered a safer project because the probability of bank-
ruptcy with Project A is 100 %.
In conclusion, we find that when the debt level is low there is no incen-
tive for asset substitution. When the debt level increases, then it changes.

Table 4.3  Projects and earnings in Example 4.2

b (Pr= 1− p ) g (Pr= p) Expected earnings

Project A X1 X2
pX 2 + (1 − p ) X1
Project B Y1 Y2 pY2 + (1 − p ) Y1
 4  Credit Rationing and Asset Substitution  77

Anticipating an asset substitution problem, the creditors will charge a

higher than normal interest rate. This leads to a loss for the shareholders
(agency cost of debt).

Debt Seniority and Overinvestment

A special case of the risk shifting problem is overinvestment. In the exam-
ple below, a firm has debt with a face value of 50 and has assets in place
that will generate 20  in the bad state and 100  in the good state. The
firm is able to take on a project in the first period that costs 10 and will
generate the payoffs according to Table 4.4. As one can see the project
has a negative NPV: 0.5 * 0 + 0.5 * 18 − 10 = −1. Let us consider now that
the shareholders will be willing to undertake the project. Assume that to
finance the new project, the firm can only offer a senior debt with a face
value of 10.
If the firm does not undertake the new project, the shareholders’
payoff will be 0.5 * (100 − 50 ) + 0.5 * 0 = 25 . If the firm undertakes the
project then it will be: 0.5 * 58 + 0.5 * 0 = 29 (note that 58 represents the
shareholders’ earnings in the good state: 100 + 18 − 10 − 50 ). Hence, the
shareholders will choose to undertake the project even though it has
a negative NPV.  Note that everybody is happy in this scenario except
the initial debtholders. Without the project, their expected payoff is
0.5 * 50 + 0.5 * 20 = 35. With the project it is: 0.5 * 50 + 0.5 * 10 = 30.
In conclusion, the shareholders’ decision will dilute the initial (junior)
creditors’ claims. They will only receive 10 in the bad state when they
could potentially have received 20.
We have seen in this section that the asset substitution or risk shift-
ing problems can potentially damage a firm’s investment decisions and
reduce its value. This can be caused by either investing in projects that
have too much risk or investing above the optimal level (the overinvest-
ment problem). How can this situation be prevented? In general, how
can the firm mitigate the negative effect of the asset substitution problem

b (Pr = 0.5) g (Pr = 0.5)
Table 4.4  New and exist- Existing Project 20 100
ing project earnings New Project 0 18
78  Capital Structure in the Modern World

on its value? First we need to understand that the problem arises not
because the shareholders are “bad” people by definition and do not care
about creditors’ money. The shareholders undertake actions from a ratio-
nal decision-maker point of view, i.e. actions that maximize the value
of their claims. A distortion here comes from the fact that markets are
imperfect, there is a moral hazard problem between different economic
agents, and it is virtually impossible to write comprehensive contracts
that cover all possible circumstances.
The asset substitution theory explains the usage of some financing strat-
egies. All strategies listed below help prevent asset substitution problems.
These strategies are: using debt with financing covenants, using debt with
dividend covenants, asset covenants or binding covenants, using loans
with protective loan covenants, using bank debt, and using convertible
debt or warrants (for more analysis of this issue see Green (1984)).
The idea of convertible debt is that if shareholders undertake a strat-
egy that can potentially shift value from creditors to shareholders, the
creditors can threaten to convert bonds into shares. Bank debt is usu-
ally accompanied by better monitoring from the lender: therefore, the
shareholders’ ability to undertake value diminishing projects decreases.
Some corporations have limited the asset substitution problem by issuing
warrants and options. In some cases, firms split off the safe part of the
business.
Protective loan covenants are restrictions placed on the firm by the
debtholders and can include: prohibition of new debt financing, the
maintenance of certain financial ratios, etc. Sometimes covenants restrict
firms from selling their assets, undertaking new businesses and taking
new loans. Firms that violate these covenants are in technical default and
debtholders are allowed to intervene in the company’s business. Loan
covenants make debts safer, and therefore increase their values. This
undermines the whole idea of asset substitution consisting of value shift-
ing from equityholders to debtholders.
There is evidence that risk-shifting incentives of insolvent banks can
significantly deplete assets. For example, Barrow and Horvitz (1993)
studied insolvent savings and loans operated by the, now defunct, Federal
Savings and Loan Insurance Corporation from 1985 to 1988. The firms
 4  Credit Rationing and Asset Substitution  79

that operated under government conservatorship adopted much less

risky strategies and on average depleted the deposit insurance fund less
than insolvent savings and loans that were allowed to continue operating
under their existing management.
During the recent financial crisis, many companies and banks were
saved via bailouts by the government. The US executed two stimulus
packages, totaling nearly $1 trillion during 2008 and 2009.5 Wilson and
Wu (2010) studied bank incentives for risk shifting. If a bank is facing
insolvency, it will be tempted to reject good loans and accept bad loans so
as to shift risk onto its creditors. If bailing out banks deemed “too big to
fail” involves buying assets at above fair market values, then these banks
are encouraged ex ante to purchase bad assets. The authors argue that
buying up common (preferred) stock is always the most (least) efficient
type of capital infusion.
Note that empirical evidence about asset substitution is ambiguous.
For example, Graham and Harvey (2001) found that the majority of
finance executives do not think that asset substitution is a very important
factor in capital structure decisions.
Recent attempts have been made to incorporate asset substitution into
capital structure analysis along with other factors. For example, Ikeda
(2005) demonstrates that equityholders’ risk-shifting incentives are not
necessarily monotonically increasing in leverage in a stochastic inter-
est rate environment. Equityholders will substitute less risky negative-
net-present-value projects for riskier positive-net-present-value projects
if the correlation coefficient between the firm value and interest rate is
sufficiently negative. Tsuji (2009) analyzes the joint effect of the bank-
ruptcy cost of debt and agency cost of debt including asset substitution.
The results are consistent with the capital structure behavior of Japanese
firms.

5
 “BBC—Stimulus Package 2009”. BBC News. February 14, 2009. http://news.bbc.co.uk/2/hi/
business/7889897.stm. Retrieved January 22, 2016.
80  Capital Structure in the Modern World

4.3 Credit Rationing

As was mentioned above, Stiglitz and Weiss (1981) is a famous article on
credit rationing (which is closely related to asset substitution) that was
part of Stiglitz’s Nobel Prize package in 2001! Their idea was that banks
ration credit rather than increase borrowing rates.
In contrast to a classical upward-slopping supply curve, the loans
supply curve may not necessarily be like that. At some point, a further
increase in the interest rate may cause biased investment decisions by
borrowers, which can result in a loss for the financial institution. Figure
4.2 illustrates this point.
Banks will not increase the interest rate above r* and as a result some
firms will not get loans. The following example demonstrates this idea.
Assume that a firm can choose between two projects, A and B, both
costing 50. The firm seeks debt to finance the project. There are two states
of nature (bad, good) with equal probability. The risk-free rate is 0. What
is the link between the interest rate and the choice of project?
The earnings in the two states are as follows (Table 4.5):

Fig. 4.2  Credit rationing

 4  Credit Rationing and Asset Substitution  81

Table 4.5  Projects and earnings

b (Pr = 0.50) g (Pr = 0.50) Expected earnings
Project A 90 90 90
Project B 0 125 62.5

Consider a debt with face value 50. The shareholders’ payoffs are as
follows. If A: 0.5 * 40 + 0.5 * 40 = 40 . If B: 0.5 * (125 − 50 ) + 0.5 * 0 = 37.5.
Therefore, Project A will be chosen. The creditors will be interested in
providing the firm with the needed funds because debt is essentially
when the firm takes Project A.
Now suppose that the -free interest rate is 50 %. In order to be able
to raise debt, the firm needs to convince potential creditors that they can
earn at least 50 % (on average). Otherwise the creditors would prefer to
invest in risk-free government bonds. If the debt face value is 75 (the
debt face value plus 50 % interest), the shareholders’ expected payoffs
will be as follows. If A: 0.5 * 15 + 0.5 * 15 = 15. If B: 0.5 * 0 + 0.5 * 50 = 25.
Therefore, Project B will be chosen. In this case, the creditors’ expected
payoff is 0.5 * 75 + 0.5 * 0 = 37.5, which is less than the cost of the invest-
ment. As a result, they will not be willing to lend the money. In fact, the
maximal possible face value of debt is 125 (otherwise the shareholders
do not receive any profit). Therefore the maximal expected payoff to the
creditors is 0.5 * 125 = 62.5 < 75. So there is no equilibrium where credi-
tors can count on earning at least a minimal expected rate of return.
We have seen some positive NPV projects that were very attractive
from the creditors’ point of view but that were not undertaken in favor of
riskier projects. Creditors could charge higher interest rates on their debt.
This leads to a vicious cycle where creditors keep charging higher interest
rates and firms keep taking on riskier projects. Instead, some creditors
will refuse to lend to firms when interest rates are too high, regardless of
the interest payments the firm agrees to make. This phenomenon is called
credit rationing (it can also exist because of asymmetric information).6

6
 It can also exist because of asymmetric information. Bester (1985) argues that collateral by high
quality borrowers can be used as a screening device by banks. Some recent papers analyze credit
rationing under both asymmetric information and agency problems and argue that adverse selec-
tion is less important (Coco 1997; Arnold and Riley 2009; Su and Zhang 2014).
82  Capital Structure in the Modern World

Date 1:
A irm's capital Shareholders Date 2:
Shareholders
structure and rollover can switch to Earnings are
initial exisiting debt another realized and
investment
Firms sell/buy investment distributed to
proejct/asset
existing project claimholders
are determined
projects/assets

Fig. 4.3  Sequence of events

When interest rates are below their equilibrium level, there is an exces-
sive demand for credit. Banks, however, will not necessarily increase
the interest rate in order to equalize demand and supply. Perhaps this
explains why bankers are often described as “very conservative people”.
Perhaps this also explains why the volume of credit seems to be much
less than necessary in developing countries where demand for credit is
very high but the average quality of borrowers is low. It can also explain
why more loans are collateralized when treasury rates rise (banks expect a
decrease in the quality of borrowers). The model of credit rationing was
also used by Kaufman (1996) to explain aspects of Argentina’s economic
crisis of 1995–1996.7
Acharya and Viswanathan (2011) build a model of the financial sec-
tor to explain why an adverse asset shock can lead to a sharp decrease in
the level of cash. Financial firms raise short-term debt in order to finance
asset purchases. When market conditions worsen, debt provides an incen-
tive for asset substitution, which can lead to credit rationing by banks.
Firms then may sell assets to better-capitalized firms in order to reduce
leverage. Short-term debt is relatively cheap to issue in good times. As a
result many firms with high leverage and low capital can be created in the
financial industry. The following illustrates this point.
We will continue with Example 4.2. This time suppose that each
project has its own probability of success denoted pA and pB and also
X=1 Y=
1 0 . We consider a firm that initially invested in Project A. The
cash flow from projects will be realized in Date 2. The sequence of events
is presented in Fig. 4.3.

 See Hashi and Toçi (2010) for credit rationing analysis in south-European countries.
7
 4  Credit Rationing and Asset Substitution  83

Also assume that initially the firm has some debt outstanding. On
Date 1, the firm has to rollover existing debt because liquidating projects
on Date 1 is not profitable. Also, on Date 1 the firm can switch to Project
B. Banks have no control over the project choice. As was mentioned in
the previous subsection, the project choice depends on the level of debt
after Date 1. The critical level of debt is determined by the following
pA X 2 − pBY2
equation: pA ( X 2 − D ) = pB (Y2 − D ). Let D* = . A firm with
p A − pB
a level of debt below this will not shift to a riskier project and vice versa.
What is then the critical level of debt in Date 1 that can be rolled over?
The bank will have to provide financing D to cover the firm’s period 1
debt but the expected payoff on Date 2 is D* pA (assuming that the firm
does not change projects). So the critical level of the Date 1 debt is D* pA.
As was mentioned above, the inability to rollover debt on Date 1 is
damaging to the firm. Assume that the firm can partially sell its assets/
projects on Date 1. Suppose that the asset price is p. If the firm can sell
the project for a price higher than a certain level, p, it would be able to
rollover the debt. Suppose the firm sells a fraction x of the project. Then
the firm’s debt capacity is xp + (1 − x ) D* pA . And it should be equal to the
initial debt: xp + (1 − x ) D* pA = D . It follows that the fraction of the proj-
D − D* p A
ect that should be sold is: x = . This fraction decreases with the
p − D* p A
price of asset p, and increases with the initial level of debt D. The latter
result leads to the point that although the probability of a financial crisis
is lower in good times, its severity in terms of potential asset sale and
evaporation of market liquidity can be greater. This is because in good
times the ability to accumulate debt is high.

4.4 Other Related Ideas

Since the shareholders get nothing when a leveraged company is liqui-
dated and the firm’s asset value is smaller than the value of the debt, the
shareholders may have an incentive to continue the firm’s operations in
84  Capital Structure in the Modern World

the hope of miracle luck or recovery. Even the slightest probability of

success can make not liquidating the company a rational decision. This
can happen even if the liquidation, as a project, has the highest NPV
compared to the other options. In this sense the idea is similar to the
asset substitution idea since continuation is obviously the riskier option
compared to liquidation.8
The following example illustrates this idea. A firm has debt with face
value D = 110, 000. The firm has two options. One is to liquidate the com-
pany for a value L = 100, 000 . The firm can also continue business in the
next period and receive R = 150, 000 in the good state of economy or 0 in
the bad state with a probability of 0.5. What will the shareholders do?
Liquidation has a higher value for debtholders. If the firm liqui-
dates, they will receive 100,000; however, if they choose to continue,
the expected value of the debt will be 0.5 * 110 + 0.5 * 0 = 55, 000 , which
is much less than 100,000. If there is a liquidation in the first period,
shareholders receive nothing since the liquidation value is less than the
debt value; however, if they continue, the expected payoff for the share-
holders will be 0.5 * (150 − 110 ) + 0.5 * 0 = 20 . Therefore, the sharehold-
ers will choose to continue even though it is detrimental to the senior
debtholders.
Real-life examples of this problem include a prolonged liquidation of
Eastern Airlines during the recession of 1989.9 A more recent example is
the case of Cyprus bank FBME, where the shareholders were seemingly
resisting the bank’s liquidation.10 In fact, Bernie Madof ’s Ponzi scheme
can also be seen as a variation of the situation described above. The com-
pany was never voluntarily liquidated but instead continued to support
its risky investments without actually informing investors about the real
destinations of their investments. Some other examples can be found in
the recent credit crisis in 2008. Not many companies wanted to end their
operations and liquidate. For example, General Motors (just like many
other car producers, banks, and financial companies) had a continuation
8
 See, for example, Titman (1984).
9
 Grinblatt and Titman (2001). Also see “Eastern Airlines”. US Centennial of Flight Commission.
http://www.centennialofflight.net/essay/Commercial_Aviation/EasternAirlines/Tran13.htm.
Retrieved 22 January 2016.
10
 http://in-cyprus.com/hope-for-fbme-deposits/
 4  Credit Rationing and Asset Substitution  85

strategy and it was looking for a sponsor to get through the recession.
Finally it received some support from the government.
Although the idea of liquidation resistence is appealing theoretically,
it seems that after the series of large-scale corporate scandals related to
the misuse of corporate funds and miscommunication of information to
investors, corporate managers of companies in financial distress are not
just trying to “fool” investors by investing in riskier and riskier projects
but are trying to deal with debt renegotiations and debt restructuring,
which we consider in the next chapter.
Brander and Lewis (1986) show that issuing risky debt induces firms
to be more aggressive in the product market. This effect of risky debt can
be considered a special form of the asset substitution effect. Brander and
Lewis consider the traditional Cournot model. The firms choose simul-
taneously their respective output levels and, given these quantities, the
price of the good is determined in the product market according to the
demand curve. Quantities in the Cournot model are strategic substitutes:
when firm 1 becomes more aggressive, firm 2 becomes softer, and vice
versa. It is beneficial for each firm to commit itself to an aggressive behav-
ior in the product market by adopting a strategy that will shift its reac-
tion curve outward (i.e. commit the firm to produce a larger quantity for
each quantity produced by the rival). Increasing output in equilibrium
also increases the variance of the firm’s profit. Since the marginal ben-
efit increases in a good state, the shareholders gain significantly in good
states. On the other hand, marginal losses are highest in bad states. It is
similar to the asset substitution effect where what matters most for the
shareholders are the gains in good states.
Brander and Lewis’ (1988) follow-up paper included bankruptcy costs
and produced similar results. Subsequent theoretical and empirical lit-
erature produced mixed results regarding connections between debt level
and a firm’s production strategy. Maksimovic (1988) argued that the
firms become more aggressive while Chevalier and Scharfstein (1996)
argued that they become less aggressive. Povel and Raith (2004) analyze
the interaction of financing and output market decisions in a duopoly in
which one firm is financially constrained. Unlike most previous work,
debt is derived as an optimal contract. Compared with a situation in
which both firms are unconstrained, the constrained firm produces less
86  Capital Structure in the Modern World

while its unconstrained rival produces more. Empirical literature finds

that industrial concentration is an important variable in the interaction
between the financial market and the product market (see, for exam-
ple, Kovenock and Phillips (1997)). It also finds that the close rivals can
increase their market share while the leveraged firms lose out both in
terms of investments and market shares (see, for example, Opler and
Titman (1994)). Chowdhury (2006) argues that the relation between
debt and firm competitive behavior is not monotonic.

Questions and Exercises

1. There are two projects available to a firm, F and S. The cost is the
same for each project: B = 50. Project F will generate cash flows of
60 in both the bad and good state, and project S will generate 20 and
90 in the bad and good states, respectively.
(a) What is the NPV of each project?
(b) Suppose the firm can raise the 50 by issuing a bond with a face
value of 50. Which project would the shareholders prefer and
what are the payoffs to the creditors?
(c) Now suppose the debt face value is 80, which project will the
company select?
2. Consider a corporation that has two projects available. Project 1 gen-
erates 10 with probability 1. Project 2 yields a random return: 15 in
a good state of economy (with probability ½) and 3 otherwise. The
projects are mutually exclusive. To finance one of the projects, the
firm issues debt (denote its face value by D). The lenders are not able
to control the project’s choice by shareholders. Assume that the
shareholders are risk-neutral.
(a) Which project will be chosen?
(b) Explain your answer in (a) intuitively.
(c) Which phenomenon is illustrated in this example?
(d) Comment on some of your answers by using your knowledge of
stochastic dominance and the link between stochastic domi-
nance and the phenomenon illustrated in this exercise.
(e) Suppose that the investment cost is 6 for each project. Lenders
are risk-neutral. Find D.
 4  Credit Rationing and Asset Substitution  87

(f ) What is the shareholders’ expected payoff?

(g) Continue to assume that the investment cost is 6, that financing
was provided by creditors, and that a project was chosen by the
shareholders. Suppose that after all these decisions have been
made but before cash flow from the project is realized, a firm gets
an unpredictable opportunity to make an additional investment.
The cost of this investment is 2 and the return is 3 in the good
state and 0 otherwise. Explain the problem that may arise if debt
raised for financing the first project was junior.
3. A corporation has two projects available. The projects are mutually
exclusive. Each project costs B. If Project 1 is undertaken, the cash flow
is K if the project is unsuccessful and it is R1 otherwise, R1 > B > K .
The probability of success is p1. If Project 2 is undertaken, the cash
flow is K if the project is unsuccessful and it is R2 otherwise, R2 > B.
The probability of success is p2. Everybody is and the risk-free inter-
est rate is f. Finance is provided by a standard debt contract. There
exists perfect competition among lenders and they have a competi-
tive payoff in equilibrium. The firm acts in the shareholders’
interests.
(a) Suppose the debt face value is D. Write the condition that deter-
mines whether Project 1 or Project 2 will be chosen.
(b) Further, use K = 100 , B = 200, R1 = 260, p1 = 80%, R2 = 300,
p2 = 20%. What is the NPV of each project?
(c) Write the condition that determines whether Project 1 or Project
2 will be chosen.
(d) Find D as a function of f if the lenders know that Project 1 will
be chosen.
(e) Find D as a function of f if the lenders know that Project 2 will
be chosen.
(f ) Now suppose that the lenders can’t control the choice of the
project by the shareholders. Find the maximum value of f when
the firm will make an investment.
(g) Which phenomenon is illustrated here?
4. The following is not one of the ways a firm can mitigate an asset
substitution problem:
(a) Protective loan covenants
88  Capital Structure in the Modern World

(b) Better monitoring

(c) Convertible debt
(d) Callable bonds
5. Asset substitution
(a) Describe (in words) the asset substitution problem.
(b) Which facts or empirical data can illustrate this problem?
(c) Suppose the firm has two mutually exclusive projects available.
The probability of success is p in both of them. The first project
generates F2 in the case of success and F1 otherwise. F1 < F2 ; the
second one generates cash flow S2 in the case of success and S1
otherwise, S1 < S2 < F2. Also, pF2 + (1 − p ) F1 = pS2 + (1 − p ) S1.
Projects have the same investment cost. Prior to making the
decision as to which project to undertake, the firm borrowed
funds sufficient for financing one project. The face value of the
debt is D. Assume risk neutrality and that the firm acts in the
interests of its existing shareholders. Which project will be cho-
sen if:
(c1) D is very small? (For simplicity, suppose that D = 0 )
(c2) max {F2 , S2 } > D > max {F1 , S1 }?
(d) Now assume that F2 decreases by a marginally small amount ε. It
means the first project produces F2new in the good state:
F2 new = F2 − ε > S2. Which project will be chosen if:
(d1) D = 0 ? Comment.
(d2) max {F2 new , S2 } > D > max {F1 , S1}? Comment.
(e) Consider a more general setup. Suppose the first project gener-
ates cash flow R1, where R1 is distributed according to the distri-
bution function F(R1); the second project generates cash flow R2,
where R2 is distributed according to the distribution function
G(R2). The firm has debt equal to D > 0. Describe (in words) the
asset substitution problem when:
(e1) F(R1) first order dominates G(R2);
(e2) F(R1) dominates G(R2) by MPS;
(e3) F(R1) dominates G(R2) by second-order stochastic
dominance.
(f ) How can a firm prevent an asset substitution problem?
 4  Credit Rationing and Asset Substitution  89

6. Consider two projects which cost 90 each but have different proba-
bilities of success and different cash flows. Projects’ cash flows and
the probabilities of success are shown in the table below. Which proj-
ect will the firm choose (assume risk-neutrality)?
Cash flow
Failure Success Pr(success)
Project A 80 130 0.8
Project B 0 140 0.2

( a) Which project has higher NPV?

(b) Which project will be chosen if the risk-free interest rate is 0?
(c) Analyze the situation if the risk-free interest rate is 30 %.

7. Assume that a firm will go bankrupt if it has insufficient cash flows

to meet its debt obligation or it is unable to borrow a sufficient
amount to meet its debt obligations. The firm has a senior debt of
1,150 including a coupon payment worth 150 due immediately. The
firm can either choose to liquidate for a value of 1,100 or continue
operating by borrowing an additional 150 to repay the senior debt to
the bank and promise it 250 next year; and it will have a cash flow of
either 1,500 or 500 with equal probability. Assume that all investors
are risk-neutral and the risk-free interest rate is 10 %. Which option
will the firm choose?
8. Consider a firm with two potential projects: F and S. The cost is the
same for each project: B = 20. There are two states of nature b = bad
and g = good and the discount rate is 0.
b (Pr = 0.5) g (Pr = 0.5) Expected cash flow
Project F 60 60 60
Project S 20 90 55

A bank considers a potential loan to the firm. What is the link

between the interest rate and the project choice? What is optimal
loan policy for the bank?
9. Assume that a firm can choose between two projects, A and B, both
costing 40. The firm seeks debt to finance the project. There are two
states of nature (bad, good) with equal probability. The risk-free rate
is 0.
90  Capital Structure in the Modern World

The earnings in the two states are as follows:

b (P = 0.50) g (P = 0.5) Expected earnings
Project A 80 80 80
Project B 0 110 55

( a) What project has higher NPV?

(b) What project will be chosen if the debt face value is 40?
(c) Now suppose that the risk-free interest rate is 50 %. Describe the
scenario if the lenders offer a loan with a 50 % interest rate.
(d) Is there any equilibrium in this case?
10. Explain the idea in Acharya and Viswanathan (2011).

4.5 Appendix 1: Stochastic Dominance

Stochastic Variable
A stochastic (random, probabilistic) variable X is characterized by a
cumulative distribution function (CDF) F(x) such that F ( x ) = Pr ( X < x ) .
A discrete variable can take values x1, x2, … … xn with probabilities
p1, p2, … … pn, respectively. For a discrete variable, we have

F ( x ) = ∑ p ( xi )
xi ≤ x

A continuous variable has a density function f(x). For a continuous

variable,
−∞
F ( x) = ∫ f ( z ) dz
x

where f is the density function. The expected value of X is determined as

follows:
−∞
EX = ∫ xf ( x ) dx
∞
 4  Credit Rationing and Asset Substitution  91

1.2 F(z)
G(z)
1

0.8
G(z) F(z)
0.6

0.4

0.2

0 z
-10 -8 -6 -4 -2 0 2 4 6 8 10

Fig. 4.4  First-order stochastic dominance (FOD)

First-Order Stochastic Dominance

Consider the stochastic variable X with distribution function F(x) and Y
with G(y). X dominates Y in the first-order sense (Fig. 4.4) if:

F ( z ) ≤ G ( z ) , ∀z

The possible payoffs (z) are along the x-axis and the values of the
cumulative distribution functions are on the y-axis. The dotted line (G)
lies above F. Hence, X first-order dominates Y.

Example 4.3
Example with discrete variables. Consider the following projects X and Y,
which are subject to the following profit scenarios with the given prob-
abilities. How would one find which project dominates the other by first-
order dominance? (Table 4.6).
To compare X and Y, we build the following table (Table 4.7):
The probabilities for each value of z are taken from the previous table;
F(z) is the cumulative probability (or CDF) for X; G(z) is CDF for Y, and
92  Capital Structure in the Modern World

Table 4.6  Projects and profits in Example 4.3

Probability of outcomes
Low profit Average profit High profit
=1 =2 =3
X 0 0.1 0.9
Y 0.9 0.1 0

Table 4.7  Stochastic dominance analysis in Example 4.3

z Prob. X Prob. Y F(z) G(z) Δ
1 0 0.9 0 0.9 –0.9
2 0.1 0.1 0.1 1 –0.9
3 0.9 0 1 1 0

∆ is the difference between F and G. If ∆ is non-positive (non-negative),

then X dominates Y (Y dominates X) by FOD.11

Second-Order Dominance
We saw that FOD is a very strong criterion. All investors immediately
chose options that dominate others by FOD. Unfortunately, not all cases
involve FOD between available alternatives. In order to solve the problem
where the differences between the two cumulative probability functions
can be both negative and positive, we have to rely on the second-order
stochastic dominance. The second-order stochastic dominance criterion
(SOD) helps rank distributions according to relative riskiness in terms of
the spread of the probability mass of the cumulative density functions.
Consider stochastic variables X with distribution function F(x) and Y
with G(y). X dominates Y in the second-order sense if

S ( x ) = ∫  F ( z ) − G ( z )  dz ≤ 0, ∀x

11
 This method works if one keeps the same lag for values of z in the table.
 4  Credit Rationing and Asset Substitution  93

Increasing Risk
Consider the stochastic variables X with distribution function F(x) and Y
with G ( y ) , X < b, Y < b . X dominates Y in the increasing risk sense (IR) if

S ( x ) = ∫  F ( z ) − G ( z )  dz ≤ 0, ∀ x

S ( b ) = 0

It can be shown mathematically that IR is similar to SOD graphically.

However, under IR two lotteries have the same expected outcome.

Example 4.4
Example with discrete variables. Consider the following projects X and Y,
which are subject to the following outcomes with the given probabilities
(Table 4.8).
To compare X and Y, we build the following table (Table 4.9):
Here, ∑F ( z )∑G ( z ) are sums of the numbers in columns F(z)
and
and G(z) and ∆ = ∑F ( z ) − ∑G ( z ). If ∆ is non-positive (non-negative),
then X dominates Y (Y dominates X) by SOD.
If ∆ is non-positive (non-negative) and ∆ ( zmax ) = 0 , then X dominates
Y (Y dominates X) by IR (note that it also dominates by SOD).
Finally note the following rules regarding the different types of sto-
chastic dominance: FOD implies SOD (compare definitions of SOD
and FOD); SOD does not imply FOD; IR implies SOD; SOD does not
imply IR.
For more analysis of the stochastic dominance approach see Abhyankar,
Ho, and Zhao (2006) and Levi (1992).

Table 4.8  Projects, outcomes and probabilities in Example 4.4

Probabilities of outcomes
Outcomes 1 2 3 4
X 0 0.3 0.7 0
Y 0.1 0.2 0.6 0.1
94  Capital Structure in the Modern World

Table 4.9  Stochastic dominance analysis in Example 4.4

z Prob.X Prob.Y F (z) G (z) ∑F ( z ) ∑G ( z ) D

1 0 0.1 0 0.1 0 0.1 –0.1
2 0.3 0.2 0.3 0.3 0.3 0.4 –0.1
3 0.7 0.6 1 0.9 1.3 1.3 0
4 0 0.1 1 1 2.3 2.3 0

References
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Bester, H. (1985). Screening versus rationing in credit markets with imperfect
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 5
Debt Overhang

5.1 Debt Overhang

The asset substitution problem occurs when firms invest in projects with
negative NPVs, while the debt overhang problem occurs when firms do
not invest in projects with positive NPVs. Equityholders may underin-
vest: pass up profitable investments because the firm’s existing debt cap-
tures most of the project’s benefits (Myers 1977).
This can happen in different ways. Shareholders may decide to distrib-
ute large dividends instead of investing in profitable projects. Or they
can decide to transfer assets away from companies with large amounts of
debt to other companies. The latter is often accompanied by legal battles
between shareholders and creditors who claim that the shareholders arti-
ficially reduce the values of their claims.
Famous Caesars Entertainment Corp. was struggling to deal with its
high level of debt after it was purchased in a $30.7 billion leveraged buy-
out put together by Apollo Global Management LLC and TPG Capital
at the peak of the last takeover boom in 2008. It created a debt over-
hang, or distressed debt problem, as described by Sridhar Natarajan and

© The Editor(s) (if applicable) and The Author(s) 2016 97

A. Miglo, Capital Structure in the Modern World,
DOI 10.1007/978-3-319-30713-8_5
98  Capital Structure in the Modern World

Christopher Palmeri in an article from April 2014 entitled: “Caesars Uses

$100 Million Lure for Asset Shift: Distressed Debt.”1
Caesars offered $100 million to negotiate with lenders to finance a
plan that would transfer the most valuable casino assets to a unit called
Caesars Growth Partners. Caesars had $1.18 billion worth of term loans
due in March 2021. Some debtholders were very unhappy with this
transaction; they argued that the shift of assets would exert pressure on
the existing lenders, enabling Caesars’ management to carry out a favor-
able restructuring of its high cost bonds.
Debt overhang may also be a result of large investments (including
the repurchasing of a firm’s own shares) in the recent past and together
with large amounts of debt it may lead to a loss of financial flexibility. As
reported by Amey Stone, too many acquisitions and share repurchases
caused Standard & Poor’s Ratings Services to downgrade the debt of
famous cereal producer Kellogg.2 Its investment grade rating dropped
to BBB from BBB+. Some examples of Kellogg’s recent activities include
paying $450 million to buy a 50 % stake in Multipro, a sales and distri-
bution company in Nigeria and Ghana, and buying Mass Food Group,
Egypt’s leading cereal company.
To better understand the debt overhang phenomenon, let’s consider a
firm with an investment opportunity available. The firm has some debt
outstanding. The timing of events is as follows (Fig. 5.1).

Date 1: A irm
Date 2: The
with debt has Shareholders If the project is
irm is
some cash and decide rejected,
liquidated and
receives whether to shareholders
its assets are
information accept or distribute the
distributed to
about an reject the available cash
the
investment project as dividends
cliamholders
opportunity

Fig. 5.1  Sequence of events

 Natarajan and Palmeri (April 2, 2014).

1

 Stone (November 5, 2015).

2
 5  Debt Overhang  99

Proposition 5.1  In some cases, a firm with debt may pass up positive NPV
investments.

To prove this proposition, simply consider the following example.

Consider a firm with 5000 debt due at Date 2. The firm’s available cash at
Date 1 is 3000. The firm has the opportunity to undertake a project costing
3000 that will generate a cash flow of 4000 at Date 2. Will the firm under-
take this positive NPV project or distribute 3000 as dividends at Date 1?
If the firm distributes dividends at Date 1, shareholders receive 3000.
If the firm undertakes a new project, shareholders get zero at dates 1 and
2. So the project will not be undertaken.
Debt overhang arises when shareholders refuse to invest in positive
NPV projects because the existing debt captures most of the project’s
benefits. Recall that the NPV of a project is sometimes different for
shareholders and creditors. Since the board of directors usually acts in
the interest of the shareholders, a firm will choose projects with the high-
est earnings for shareholders. The problem is that projects with positive
NPVs (for the firm as a whole) sometimes have low payoffs to the share-
holders and junior creditors. By its very nature debt has priority over
equity in cases when earnings are not sufficient to satisfy every claim-
holder and senior debt has priority over junior debt. In the real world,
debt typically has covenants preventing issues of new debt of the same or
higher seniority as the existing debt. Although one would think that the
existing creditors would be willing to renegotiate these terms, since the
investment makes everyone better off, it does not usually happen.
Financially distressed firms represent a good practical implication of
the debt overhang problem. It is very difficult for firms to obtain new
funds when they are in financial distress and the existing debtholders
have a high risk of losing their money. These firms have to cut capital
expenditures and R&D. It has been found that firms that are financially
constrained may have a harder time responding to competition because
firms with higher leverage cannot respond to competitors’ price changes.3
This is because any price decrease is in fact an investment because the
firm loses funds in the short term. Evidence of this can be found in stud-
ies of the supermarket industry and the trucking industry.
 Opler and Titman (1994).
3
100  Capital Structure in the Modern World

5.2 H
 ow Does the Type and the Level
of Debt Affect the Underinvestment
Problem
In this section, we demonstrate how the level of debt influences the
underinvestment problem. Suppose a firm owns the following project
(project-in-place). At t = 1 , cash flow from the project may be equal to
R > 0 with probability p1 or 0 otherwise. At t = 0 , the firm is given the
opportunity to make an investment B that increases the probability of p1
to p2. This investment has a positive NPV, i.e. ( p2 − p1 ) R − B > 0 . The
firm has issued senior debt with total amount D. The timing of events is
presented in Fig. 5.2.

Proposition 5.2  Higher debt increases the likelihood of debt overhang.

The following illustrates the proof of Proposition 5.2. Without the

new project the shareholders’ expected profit is p1 ( R − D ) . If the firm
invests in the new project, the shareholders’ expected profit will be:
p2 ( R − D ) − B . This is equal to the firm’s expected cash flow (the new
probability of success multiplied by the net income, i.e. earnings reduced
by the amount of payment to the senior debtholders) minus the pay-
ment to the outside investors, which will be either junior debt or equity.
In any case the expected payment to investors should be equal to the
cost of the investment. Comparing the shareholders’ payoff without the
investment and with the investment we find that the firm will invest
if ( p2 − p1 ) ( R − D ) − B > 0. Since p2 > p1 , the left side of the above

A irm with
debt and Shareholders
If the project is
project-in- decide Earnings are
accepted, the
place receives whether to realized and
irm issue new
information accept or distributed to
debt to inance
about a new reject the claimholders
the project
investment project

Fig. 5.2  Sequence of events

 5  Debt Overhang  101

i­nequality is negatively correlated with D. If D increases, the likelihood

of debt overhang increases. This is because the presence of existing risky
claims reduces the incentives for existing shareholders to invest in that
project since it increases the value of the existing debt and not the value
of the shares, which is the essence of the debt overhang problem.

Example 5.1
A firm has a project-in-place that can generate earnings R = 10, 000 with
probability p1 = 0.5. There is a new project available. The cost of the proj-
ect is B = 1000. If the investment is undertaken, the probability increases
by 0.2. Will the new project be undertaken if the firm’s debt equals D?

First, note that the NPV of this project is positive for the firm. The
firm’s expected earnings increase by 10, 000 * 0.2 = 2000 which is greater
than the 1000 investment cost. So the NPV of the project for the firm
equals 10, 000 ∗ 0.2 − 1000 = 1000 .
The answer to the question in Example 5.1 depends on the value
of D. Consider two different debt levels: D = 3000 and D = 6000.
Proposition 5.2 predicts that the project will not be undertaken if
( p2 − p1 ) ( R − D ) − B < 0. Or 0.2 * D > 1000 . And this is the case when
D = 6000.
Without the new project, the shareholders’ earnings are:
(10, 000 − D ) * 0.5 . If D = 3000, the shareholders’ expected earnings are
(10, 000 − 3000) * 0.5 = 3500 . If the firm undertakes the new project the share-
holders’ expected payoff will be (10, 000 − 3000 ) ∗ 0.7 − 1000 = 3900 > 3500
so the project will be undertaken.
Consider D = 6000. Without the new project the sharehold-
ers’ expected earnings are (10, 000 − 6000 ) * 0.5 = 2000 . If the firm
undertakes the new project the shareholders’ expected payoff will be
(10, 000 − 6000) ∗ 0.7 − 1000 = 1800 < 2000 so the project will not be
undertaken.
Let us now analyze whether the debt overhang problem depends on
the type of the existing debt. Consider a firm with an amount D of debt
(senior) due at date 1. The firm’s cash flows at date 1 are stochastic and
depend on the state of nature. In the good state they will be R2; in the
bad state they will be R1, R2 > D > R1 ; the probability of the good state
102  Capital Structure in the Modern World

is p. The firm has an opportunity to undertake a project costing B that

will generate cash flows of X in both states. X > B and D > R1 + X . This
means that the new project has a positive NPV but earnings in the bad
state are not sufficient to cover the existing debt. Will the firm undertake
this positive NPV project?

Proposition 5.3  In some cases a senior debt will lead to debt overhang but
junior debt will not.

Without the new project, the shareholders’ expected payoff is: p ( R2 − D ) .

Now consider the new investment opportunity. The cost is 1500 and cash
flow is 2000 in each state. Suppose the project is financed with debt (junior
since the initial debt is senior). Will the firm undertake the project?
Let F be the face value of the new debt. Since the initial debt is senior
and D > R1 + X , the new (junior) debtholders receive nothing in the bad
state. Hence, the expected payoff to new debtholders equals pF, which
implies F = B / p . The shareholders’ payoff is p ( R2 + X − D − B / p ) . If
X < B / p , the shareholders’ payoff with the new project is less than with-
out the new project. Thus, the project will not be undertaken.
Now suppose the initial debt is junior and the firm can issue senior
debt to finance the new project. The face value of the new senior debt
is B (since the total earnings are greater than B in both states). So the
shareholders’ expected payoff, if the new project is undertaken, is:
p ( R2 + X − D − B ) . This is greater than the shareholders’ payoff without
the new project because X > B . So the new project will be undertaken.

5.3 D
 ebt Overhang Implications
and Prevention

Renegotiating with Existing Creditors

We have seen that a firm’s shareholders are unwilling to finance positive
NPV projects with funds (in the form of junior debt) provided by out-
side creditors. The same conclusion holds if the firm issues new equity
to outside investors or when the firm uses internal financing. But what
 5  Debt Overhang  103

about other kinds of financing? The firm can, for example, ask existing
(incumbent) creditors for additional financing.

Proposition 5.4  In some cases a debt overhang problem can be solved via
renegotiation with existing creditors.

Let us return to the set-up of Proposition 5.3. Suppose the incum-

bent debtholders agree to finance the new project with a new (junior)
debt with a face value (including principal and interests) B + i, B + i < X .
Recall that without the new project, the shareholders’ expected payoff
is: p ( R2 − D ) . Now suppose the shareholders accept financing from
the incumbent creditors. The cost is B and cash flow is X in each state. The
shareholders’ payoffs with the new project will be p ( R2 + X − D − i − B ) .
This is greater than p ( R2 − D ) because X > B + i. Hence the share-
holders will be interested in having a deal with  the incumbent credi-
tors. Now consider the incentive of the  creditors. Without the new
project their expected payoff is pD + (1 − p ) R1 . With the project it is:
p ( D + B + i ) + (1 − p ) ( R1 + B + i ) − B = pD + (1 − p ) R1 + i. So the deal is
beneficial for both shareholders and creditors.
The example below illustrates Propositions 5.3 and 5.4.

Example 5.2
Consider a firm with a 5000 debt (senior) due at date 1. The firm’s cash
flows in the good state will be 8000; in the bad state they will be 3000; each
state has an equal probability. The firm has the opportunity to undertake
a project costing 1500 that will generate cash flows of 2000 in both states.

Without the new project, the shareholders’ expected payoff is:

0.5 * (8000 − 5000 ) + 0.5 * 0 = 1500. Now consider the new project. Let
F be the face value of the new debt. The expected payoff to the new
debtholders equals 0.5 * F = 1500, which implies F = 3000 . The share-
holders’ payoff is 0.5 ∗ (10, 000 − 5000 − 3000 ) = 1000 . This is less than the
shareholders’ payoff without the new project. Thus, the project will not
be undertaken.
Now suppose the initial debt is junior and the firm can issue a senior
debt to finance the new project. The face value of the new senior debt
104  Capital Structure in the Modern World

is 1500 (since the total earnings are at least 2000  in both states). So
the shareholders’ expected payoff, if the new project is undertaken, is:
0.5 ∗ (10, 000 − 5000 − 1500 ) = 1750 . This is greater than 1500. So the new
project will be undertaken. This illustrates Proposition 5.3.
Now suppose the initial debt is senior but the incumbent debt-
holders agree to finance the new project with a new (junior) debt
with a face value (including principal and interests) of 1500. Recall
that without the new project, the shareholders’ expected payoff is:
0.5 * (8000 − 5000 ) + 1.2 * 0 = 1500. Now suppose the shareholders accept
financing from the incumbent creditors. The cost is 1500 and cash flow is
2000 in each state. The shareholders’ payoffs with the new project will be
0.5 ∗ (10, 000 − 5000 − 1500 ) = 1750. This is greater than 1500 and hence
the shareholders will be interested in making a deal with incumbent
creditors. Now consider the incentive for the creditors. Without the new
project their expected payoff is 0.5 ∗ 5000 + 0.5 ∗ 3000 = 4000. With the
project it is: 0.5 ∗ (5000 + 1500 ) + 0.5 ∗ 5000 − 1500 = 4250. So the deal is
beneficial for both the shareholders and the creditors.
Similarly, lenders can commit to additional financing when the first
loan is granted. This can also help resolve debt overhang problems.

Costly Renegotiation
Why can’t the firm always avoid costs of financial distress by renegotiating
with creditors? The firm could negotiate with creditors to write down a
new debt, postpone interest, or ease covenants in exchange for additional
interest or some equity in the company. However, these negotiations are
costly and sometimes not feasible.4 The reasons for this are that creditors
are often dispersed, making it hard for all of them to negotiate, and that
they face conflicts of interest among themselves. One other problem that
occurs is that creditors have doubts that their funds will be used for a
“good” project.

To illustrate this, let us again consider Example 5.2. The sharehold-

ers can rationally realize that the new project is valuable to incumbent
creditors; they can calculate that the creditors will accept the deal even

 See, for example, Gertner and Scharfstein (1991).

4
 5  Debt Overhang  105

if the face value of the new debt is below 1500, for example, 1250. The
creditors’ expected payoff is 4125, in this case, which is still higher than
4000  in the case without the new project. However, if the number of
initial debtholders is large, then the free-rider problem can appear: it is
in the interest of the initial debtholders to put up the money collectively,
but it is not in the interest of any one of them to do it alone because the
new debt has a negative NPV (face value of debt is below the cost of
investment). So the shareholders may find it hard to convince the credi-
tors to invest in the new project.
Pawlina (2010) shows that the shareholders’ option to renegotiate debt
in a period of financial distress exacerbates the underinvestment problem
at the time of the firm's expansion. This result is a consequence of a
higher wealth transfer from the shareholders to the creditors occurring
upon investment in the presence of the option to renegotiate. This addi-
tional underinvestment is eliminated when the bargaining power belongs
to the creditors.
Favara et  al. (2015) focus on connections between bankruptcy laws
and debt renegotiation frictions. They develop a model that includes
firms’ choices of investments, asset sales, and risk-taking. It is shown that
bankruptcy laws favoring debt renegotiation reduce underinvestment,
limit asset sales, and decrease incentives for risk-taking when firms are
near insolvency. The model is tested on a panel of 19,466 firms across 41
countries with different bankruptcy codes and finds and a good amount
of support.

Other Implications of the Debt Overhang Problem

A special case of the debt overhang problem arises when firms are inef-
ficiently biased towards short-term earnings for shareholders instead of
investing in more profitable long-term projects. This may take place when
a firm has long-term risky debt and investing in a long-term project would
create value for long-term creditors and not for shareholders. An example
of this phenomenon is inefficient dividend policy. The ­shareholders may
choose to distribute large dividends and to pass up this positive NPV
project if future earnings from the project will be mostly used to pay
back existing (long-term) debt. Similarly, the shareholders may prefer to
invest in a less profitable shorter term project rather than invest in a more
106  Capital Structure in the Modern World

profitable long-term project if the firm has issued long-term debt and
investing in long-term projects is more beneficial to creditors.

Opler and Titman (1994) suggest that highly levered firms lose market
share to their less levered rivals during industry downturns for several
reasons. Distressed firms that face underinvestment problems (debt over-
hang) are forced to sell off assets and reduce their selling efforts. Low
levered firms, assumed to have deep pockets, can engage in predatory
practices especially in a highly competitive environment designed to
financially exhaust highly levered rivals and drive them out of the market.
A highly levered firm might be vulnerable to predation from low levered
competitors because low levered competitors can purposefully reduce
their prices and keep this strategy for a long time to drive the highly
levered firm out of business.
A way to prevent inefficient dividend policy is to have dividend cov-
enants, which are restrictions that do not allow dividends to be paid until
the claim is paid to debtholders. Other ways to prevent a debt overhang
problem in general include using bank and privately placed debt and
using project financing and the debtor-in-possession rule in the US
Chapter 11 Bankruptcy Code. We will discuss this in detail in Chap. 9.
Firms can also use short-term debt to mitigate debt overhang.
Rajan (1992) argues that while informed banks make flexible financial
decisions that prevent a firm’s projects from going away, the cost of this
credit is that banks have bargaining power over the firm’s profits once
the projects have begun (the hold-up problem). Vilanova (2004) argues
that a bank with a senior claim at the onset of financial distress benefits
from having strong bargaining power in subsequent debt restructurings
and can exploit this enhanced power to hold up other claimants (the firm
and junior lenders). It allows the senior bank with an initial impaired
claim to rule out the repayment risk. The concentration of liquidation
rights in the hands of the bank also leads to more favorable debt restruc-
turings for low quality borrowers. On the contrary, the ex-post strong
bargaining power of a senior bank might lower its incentives to monitor
at the early stages of financial distress.
With regard to links between debt maturity and the debt overhang
problem, Gertner and Scharfstein (1991) show that, conditional on ex-­
 5  Debt Overhang  107

post financial distress, making a fixed promised debt payment due earlier
(i.e. shorter-term) raises the market value of the debt and thus the firm’s
market leverage, leading to more debt overhang ex-post. Diamond and
He (2015) show that reducing maturity may increase or decrease over-
hang. With an immediate investment, shorter-term debt typically imposes
lower overhang. Future overhang is more volatile for shorter-­term debt.

5.4 Flexibility Theory of Capital Structure

Firms in the development stage need financial flexibility. There is great
uncertainty because they need to consider several investment projects,
including their financing strategies, which requires a lot of flexibility.
Having too much debt in capital structure will not help here (similar to a
debt overhang problem). In addition, firms in the development stage have
little favorable track records (i.e. credit ratings) of borrowing (Diamond
1991) and are most likely to be turned down for credit when they need
it the most. Thus, firms in the development stage that have little finan-
cial flexibility will abstain from issuing risky debt and will instead issue
equity. Firms in the maturity stage begin generating positive earnings and
have more financial flexibility than developing firms. Accordingly, these
firms rely more on debt financing to fund their investments as they face
less financing constraints as they expect to repay their debt with their
growing future earnings.
Flexibility theory finds a lot of support in empirical studies (Byoun
2008) and managers’ surveys (Graham and Harvey 2001). This theory
helps explain why small and risky firms issue equity and why these firms
do not follow the pecking-order theory. Gamba and Triantis (2008)
develop a theoretical model that analyzes optimal capital structure policy
for a firm that values flexibility in the presence of personal taxes and
transaction costs. The importance of financial flexibility, as compared to
major theories of capital structure, remains an open question. More work
that compares flexibility theory with other theories is expected. It was
also noted that many young firms, especially venture firms, do not issue
common equity but rather convertible preferred equity which resembles
debt more than equity.
108  Capital Structure in the Modern World

The life cycle theory of capital structure argues that besides finan-
cial flexibility there are other factors that can explain financing patterns
of firms in different stages of their developments (Damodaran 2003).
Start-up firms do not have much profit, so the tax advantage of debt is
not as important to them as it is for a mature firm. Start-up firms do not
require incentives for managers since there is no large separation between
ownership and management as in the case of big public corporations.
This leads to the idea that mature firms value debt more than start-up
firms. To what extent the life cycle theory represents a separate theory of
capital structure rather than a combination of arguments from other the-
ories remains an open question. More discussions about life cycle theory
will be provided in Chap. 8.
Among recent papers note Sundaresan et  al. (2015) who analyze a
growing firm that represents a collection of growth options and assets
in place. The firm trades off tax benefits with the potential financial dis-
tress and endogenous debt-overhang costs over its life cycle. The authors
argue that the firm consistently chooses conservative leverage in order to
mitigate the debt-overhang effect on the exercising decisions for future
growth options. It is also shown that debt seniority and debt priority
structures have both important implications on growth-option exercis-
ing and leverage decisions as different debt structures have very different
debt-overhang implications.

5.5 Debt Overhang in Financial Institutions

Since the financial crisis of 2007–2009, regulators have been pushing
for an increase in capital requirements for banks, so that a greater share
of their investments is funded by equity (Basel Committee on Banking
Supervision 2009). The advantage of more equity funding is that it can
reduce agency costs of debt, which is especially important for banks
that have large amounts of debt on their balance sheets. Bankers have
strongly resisted increased capital requirements because equity is expen-
sive. Admati et al. (2015) discuss these issues and explain why banks may
not be interested in reducing leverage with more equity. A simple debt
repurchase via the issue of new shares or selling assets may not always be
 5  Debt Overhang  109

interesting for existing shareholders. An attempt to reduce leverage by

selling assets, for example, increases a firm’s cash but, as we saw before,
one of the implications of debt overhang is the shareholders’ incentive to
increase dividends in some cases instead of investing in productive assets/
projects or returning money to existing debtholders.
The following example demonstrates Admati et al.’s (2015) point that
shareholders may not be interested in repurchasing debt by selling new
equity. It follows the examples from this chapter closely but this time
corporate taxes are considered. Consider a firm with a 5000 debt due at
date 1. The firm’s earnings at date 1 are stochastic and depend on the state
of nature. In the good state they will be 8000; in the bad state they will
be 0; both states have an equal probability. The corporate tax rate is 30 %.
The firm has an opportunity to issue new shares in order to repurchase
the existing debt. As usual, assume that investors are risk-neutral and the
risk-free interest rate is 0.
Debtholders will sell their debt for 2500. To see this, note that in the
current situation debtholders will receive: 0.5 * 5000 + 0.5 * 0 = 2500.
Will shareholders repurchase the debt? Currently, the share-
holders’ expected payoff (given that corporate tax is 30  %) is:
0.5 * (8000 − 5000 ) * (1 − 0.3) + 0.5 * 0 = 1050. The new shareholders will
be able to pay 2500 for newly issued shares if they get 25/28 of the
firm’s equity. To see this note that the firm’s net income after the debt
repurchase in the bad state will still be 0 and in the good state it will be
8000 * 0.7 = 5600 . Since this occurs with a 50 % probability, new share-
holders will need 5000 in that state. So their fraction should be equal to
5000/5600. The initial shareholders’ fraction of equity is then 3/28 and
their expected payoff is 3 / 28 * 5600 = 600 , which is less than 1050.
Note that if the government provides a subsidy in the case of bank-
ruptcy, a share repurchase will further reduce the shareholders’ expected
benefit.
Wilson (2012) shows that when a bank is subsidized (“too big to fail”)
by regulators, it may be tempted to buy risky assets. The paper analyzes
bank bailouts involving the purchases of toxic assets, preferred stock, and
common stock when the government wants to encourage efficient lend-
ing. It finds that preferred stock recapitalizations are the least efficient
method of correcting debt overhang problems from both an ex post and
110  Capital Structure in the Modern World

ex ante perspective. In contrast, efficient lending and voluntary participa-

tion can be best achieved without the subsidy by purchasing either toxic
assets or common stock. Nevertheless, troubled banks must be subsidized
if they are to voluntarily participate in any recapitalization.
Admati et al. (2012, 2015) argue that in the absence of prior commit-
ments or regulations, shareholder–creditor conflicts give rise to a leverage
ratchet effect, which induces shareholders to resist debt reductions. In
a dynamic context, since leverage becomes effectively irreversible, firms
may limit leverage initially but then ratchet it up in response to shocks.
The authors study shareholders’ preferences of different ways to adjust
leverage. A benchmark result gives conditions for shareholder indiffer-
ence, but generally, shareholders have clear rankings of the alternatives.
For example, shareholders often prefer reducing leverage by selling assets
even at distressed prices.

Questions and Exercises

1. A firm has assets-in-place that can generate earnings R = 100, 000 with
probability p1 = 0.4 . There is a new project available. The cost of the
project is B = 30, 000 . If the investment is undertaken, the probability
increases by 0.4. Initially, the firm has debt (senior) with face value
D = 20, 000 . Everybody is risk-neutral in this economy. The risk-free
interest rate is zero.

(a) Find the NPV of new project

(b) Will the new project be undertaken?
(c) Now suppose that D = 60, 000 . Same question.
(d) What phenomena are illustrated in this example?

2. Consider a firm with a 6000 debt (senior) due at date 1. The firm’s
cash flows in the good state will be 10,000; in the bad state they will
be 4000; each state has an equal probability. The firm has an opportu-
nity to undertake a project costing 2000 that will generate cash flows
of 3000 in both states. The investors are risk-neutral and the risk-free
interest rate is 0.
 5  Debt Overhang  111

(a) Find the new project NPV?

(b) Will the firm undertake new investment?
(c) Now suppose the initial debt is junior. The same question.
(d) Now suppose the initial debt is senior but the incumbent debt-
holders agree to finance the new project with a new (junior) debt.
The same question.
(e) Find the minimal acceptable face value of new debt for creditors.
Find the maximal acceptable face value of debt for shareholders.
(f ) What can prevent this situation happening?

3. Consider a firm with a 10,000 debt due at date 1. The firm’s earnings
at date 1 depend on the state of nature. In the good state they will be
18,000; in the bad state they will be 0; both states have an equal prob-
ability. The corporate tax rate is 40 %. The firm has an opportunity to
issue new shares in order to repurchase the existing debt. As usual,
assume that investors are risk-neutral and the risk-free interest rate is
0. Are shareholders interested in repurchasing the firm’s debt by selling
equity?

4. Debt overhang

(a) Briefly describe (in words) a debt overhang problem.

(b) Provide examples of the debt overhang problem.
(c) In general, how can a firm prevent a debt overhang problem?

References
Admati, A., DeMarzo, P., Hellwig, M., & Pfleiderer, P. (2012). Debt overhang
and capital regulation. Rock Center for Corporate Governance at Stanford
University Working Paper No. 114; MPI Collective Goods Preprint, No.
2012/5. Available at SSRN: http://ssrn.com/abstract=2031204
Admati, A., DeMarzo, P., Hellwig, M., & Pfleiderer, P. (2015). The leverage
ratchet effect. Preprints of the Max Planck Institute for Re-search on
Collective Goods, Bonn 2013/13; Rock Center for Corporate Governance at
Stanford University Working Paper No. 146. Available at SSRN: http://ssrn.
com/abstract=2304969.
112  Capital Structure in the Modern World

Basel Committee on Banking Supervision. (2010). Strengthening the resilience

of the banking sector. http://www.bis.org/publ/bcbs164.pdf
Byoun, S. (2008). Financial flexibility and capital structure decision, working
paper. Available at SSRN: http://ssrn.com/abstract=1108850
Damodaran, A. (2003). Corporate finance: Theory and practice. Hoboken, New
Jersey: Wiley Series in Finance.
Diamond, D. (1991). Monitoring and reputation: The choice between bank
loans and directly placed debt. Journal of Political Economy, 99(2), 689–721.
Diamond, D., & He, Z. (2015). A theory of debt maturity: The long and short
of debt overhang. Working paper, Chicago Booth.
Favara, G., Morellec, E., Schroth, E., & P. Valta. (2015). Debt Enforcement,
Investment, and Risk Taking Across Countries. Forthcoming in Journal of
Financial Economics.
Gamba, A., & Triantis, A. (2008). The value of financial flexibility. Journal of
Finance, 63(5), 2263–2296.
Gertner, R., & Scharfstein, D. (1991). A theory of workouts and the effects of
reorganization law. The Journal of Finance, 46(4), 1189–1222.
Graham, J., & Harvey, C. (2001). The theory and practice of corporate finance:
Evidence from the field. Journal of Financial Economics, 60(2–3), 187–243.
Myers, S. (1977). Determinants of corporate borrowing. Journal of Financial
Economics, 5, 147–175.
Natarajan, S., & Palmeri, C. (2014, April 2). Caesars uses $100 million lure for asset
shift: Distressed debt. BloombergBusiness. http://www.bloomberg.com/news/
articles/2014-04-02/caesars-uses-100-million-lure-for-asset-shift-distressed-debt
Opler, T., & Titman, S. (1994). Financial distress and corporate performance.
Journal of Finance, 49(3), 1015–1040.
Pawlina, G. (2010). Underinvestment, capital structure and strategic debt
restructuring. Journal of Corporate Finance, 16(5), 679–702.
Rajan, R. (1992). Insiders and outsiders: The choice between informed and
arm’s-length debt. Journal of Finance, 47(4), 1367–1400.
Stone, A. (2015, November 5). Kellogg downgraded due to too much debt. Barron’s.
http://blogs.barrons.com/incomeinvesting/2015/11/05/
kellogg-downgraded-due-to-too-much-debt/
Sundaresan, S., Wang, N., & Yang, J. (2015). Dynamic investment, capital
structure, and debt overhang. Review of Corporate Finance Studies, 4(1), 1–42.
Vilanova, L. (2004). Bank seniority and corporate debt restructuring. EFA 2004
Maastricht Meetings Paper No. 2880. Available at SSRN: http://ssrn.com/
abstract=554602
Wilson, L. (2012). Debt overhang and bank bailouts international. Journal of
Monetary Economics and Finance, 5(4), 393–414.
 Part II
Different Topics

This section covers such topics as capital structure choice and firm per-
formance, capital structure and corporate governance, capital structure
of small companies and start-up companies, corporate financing versus
project financing and others.
 6
Capital Structure Choice and Firm’s
“Quality”

6.1 Interesting Problem

One of the most interesting questions for me throughout the years has
been what capital structure choices can say about a firm’s quality? Do
“good” firms issue shares rather than bonds or vice versa? If there is no
strict rule then are there any average correlations between capital struc-
ture choice and a firm’s quality?
As we discussed in Chap. 3, according to the “pecking-order theory of
capital structure”, equity should only be used as a last resort by firms who
need capital for their investments. Good quality firms especially should
not issue equity to avoid underpricing. Yet, in a December 2015 article,
Shira Ovide mentioned an issue of shares by the seemingly very success-
ful company Atlassian.1 Atlassian made good efforts to increase its share
price prior to its IPO with the first day after the IPO seeing prices trading
even higher. At the same time, Ovide mentioned that although Atlassian
was currently showing signs of success, its profitable business model
might not work as well in the future. Another topic that is discussed in
the article is the situation with start-up IPOs in general in 2015.

 Ovide (December 10, 2015).

1

© The Editor(s) (if applicable) and The Author(s) 2016 115

A. Miglo, Capital Structure in the Modern World,
DOI 10.1007/978-3-319-30713-8_6
116  Capital Structure in the Modern World

Many ideas/topics from the article mentioned above will be discussed

in this chapter. Why do successful firms issue shares even though the
traditional theory does not favor it? What information is signaled by
the firm to market participants when it discusses the issuance of shares?
Finally, when do firms prefer to issue shares?
In his 2012 article Michael Sivy discusses several interesting ideas
related to IPOs.2 One is that an IPO by a firm may signal bad news.
Therefore firms sell shares before any bad news comes out. This can be
true even for successful companies. Another point is that an IPO can
signal information about the future of the market or the future of the
economy. Sivy mentioned that firms could sell shares to avoid possible
downturns in the economy. As an example, hospital-management com-
pany HCA Holdings went ahead with an offering in 2011 because of a
variety of uncertainties about health care reform and future tax policy.
Sivy also discusses whether the famous Facebook’s IPO could send simi-
lar negative signals about the market’s future. The experts that advise
potential issuers employ many of the world’s top economists. Often they
have access to knowledge that is unavailable to most market participants.
There is no guarantee, of course, that advisers know where the stock mar-
ket and the economy are going. But they possess better information than
most investors.
In a December 2015 article, John Ficenec describes an issue of bonds
by Entertainment 1.3 The company was built on the sales of the hugely
successful children’s cartoon character Peppa Pig. The first warning
sign was the exit of one of their major supporting investment groups,
Marwyn, in July of 2015. The next sign was the surprise rights issue in
September when the company asked investors to find almost £200 mil-
lion to fund the buyout of the Peppa Pig rights. The final straw was a
poorly communicated issue of £285 million bonds in early December.
It was very unclear to investors why an expensive debt was needed. The
negative free cashflow and net debt levels rising to £264 million at the
end of September put investors at risk. An interesting point of Ficenec’s
article is that a bond issue does not necessarily signal good news as would

 Sivy (May 30, 2012).

2

 Ficenec (December 21, 2015).

3
 6  Capital Structure Choice and Firm’s “Quality”  117

be predicted by early capital structure theories, for example by standard

trade-off theory discussed in Chap. 2.
This chapter analyzes the link between capital structure and firm qual-
ity. In most cases, the firm’s quality is measured by its operating perfor-
mance. As mentioned above it is important to look at the link between
capital structure and not only current operating performance but future
performance as well. Also note that this question is probably one of the
most difficult to answer in capital structure theory. For example, as was
mentioned in Chap. 2, traditional trade-off theory predicts a positive cor-
relation between debt and profitability, which is not quite what empirical
evidence shows.

6.2 The Role of Asymmetric Information

In Chap. 3 we learned about the “pecking-order theory” (POT) put forth
by Myers and Majluf (1984). According to the theory, firms will use
internal funds, if available, to finance profitable projects. If internal funds
are not available they will issue debt. Equity is dominated by internal
funds and debt in POT.  Low quality firms will use equity as much as
internal funds but high quality firms will prefer internal funds. If high
quality firms issue equity they will be undervalued by investors because of
their lack of information. Similarly, equity is dominated by debt. Suppose
that the firm can finance the project with risk-free debt. Then the high
quality firm can issue debt to avoid any mispricing. If debt issued by the
firm is risky, the situation does not change appreciably. The same holds if
the firm has available assets-in-place. Hence a “pecking-order” emerges:
internal funds, debt, and equity (Myers and Majluf 1984). The authors
state (Myers and Majluf 1984: 208): “In our model, the firm never issues
equity. If it issues and invests it always issues debt.” As we mentioned in
Chap. 3 (also see Miglo 2011), the empirical evidence is mixed about
whether or not firms follow POT.
In the pecking-order model, good quality firms have to use internal
funds to avoid adverse selection problems and loss of value. These firms
cannot signal their quality by changing their capital structure. The sig-
naling theory of capital structure offers models in which capital structure
118  Capital Structure in the Modern World

serves as a signal of private information (Ross 1977; Leland and Pyle

1977). Usually in these models, the market reaction on debt issues is
positive. However, as we mentioned in Chap. 3, empirical evidence is
mixed regarding the predictions of signaling theory about firms’ oper-
ating performances after issuing equity. Long-term underperformance
of firms issuing equity compared to non-issuing firms (Jain and Kini
1994; Loughran and Ritter 1997) seems to be consistent with the spirit
of signaling theory while the better operating performance of firms issu-
ing equity before or shortly after the issue compared to non-issuing
firms does not support the theory. According to Jain and Kini (1994:
Fig. 1), and Pereira and Sousa (2015) the operating return on assets is
higher for IPO firms in the first years after the issue and the operating
cash flow on assets is higher in year “0” (immediately after the issue).
In Loughran and Ritter (1997), profit margins are higher in years 0
and +1, although there is different evidence about operating returns. In
Mikkelson, Partch, and Shah (1997:, Table 3), IPO firms have higher
performances in year 0. Shah (1994) reports that business risk falls after
leverage-increasing exchange offers but rises after leverage-decreasing
exchange offers.
A rich set of new predictions arises when a dynamic environment is
analyzed. Hennessy, Livdan, and Miranda (2010) examine investment
and financing decisions in a model with repeated signaling. They show
that good firms can separate themselves from bad firms by changing their
investment policy. For example, by accelerating investments (and reduc-
ing the values of the projects at the time of the investments) good firms
can avoid being mimicked by other firms. They also show that equity
can be better than debt. Halov (2006) proposes a model that consid-
ers a firm without internal funds where the choice of security depends
not only on the current adverse selection cost of a security but also on
its future cost. Halov finds that future adverse selection costs negatively
affect the debt component of new external financing and positively affect
the cash reserves of the firm. He explains why companies may at times
prefer equity to debt. Morellec and Shurnoff (2011) develop a dynamic
model of corporate investment and financing decisions and show that
information asymmetries may not translate into a financing hierarchy or
pecking order over securities.
 6  Capital Structure Choice and Firm’s “Quality”  119

Miglo (2012) suggests that multi-stage investments and long-term

asymmetric information can affect corporate capital structure. In con-
trast to the standard POT, firms may issue equity as a signal. He also
analyzes the link between the debt-equity choice and the performance of
the company following the issue (short-term versus long-term). The fol-
lowing illustrates the idea.
Consider a model with asymmetric information that focuses on a
firm’s performance profile over time and its effect on capital structure.
Suppose a firm considers equity financing for a two-period investment
project with cost Ct in period t, t = 1, 2 . In each period the project may
be successful or unsuccessful. In the latter case the cash flow equals 1 and
in the former case the cash flow equals 0. A firm’s insiders have private
information about the probability of success in each stage. The firms are
of two types, type g and type b, with respective probabilities of success pgt
and pbt at stage t. Type g has a higher overall value: pg1 + pg 2 > pb1 + pb 2 .
The NPV of the investment in stage t for type j is p jt − Ct , j = g, b . The
sequence of events is shown in Fig. 6.1.

Earnings from stage

Firms learn
Firms raise 1 are realized and
information about
inancing for stage 1 distributed to
their projects
claimholders

Earnings from stage

Firms raises 2 are realized and
inancing for stage 2 distributed to
claimholders

Fig. 6.1  Sequence of events

The focus of our analysis is on the firm’s choice of financing for stage
1. The big question is whether the firm with the higher value will issue
equity contrary to the prediction of the standard POT. Hence the focus
of our analysis is on the separating equilibrium where the higher valued
firm issues equity. In a separating equilibrium, all uncertainties about a
120  Capital Structure in the Modern World

firm’s type are resolved in stage 1, which means that the financing choice
in stage 2 is based on perfect information. For simplicity, suppose that a
firm issues debt for stage 2 with face value D. We get:

pg2 D = C2 (6.1)

At stage 1, investors require an s1 fraction of equity such that:

s1 pg1 + s1 pg 2 (1 − D ) = C1 (6.2)

Now consider the payoff of the shareholders of b in case b decides

to mimic g, which equals (1 − s1 ) pb1 + (1 − s1 ) pb 2 (1 − D ) . If a signaling
equilibrium exists, the shareholders’ payoff for type b will be
pb1 + pb 2 − C1 − C2 (the present value of b).4 Thus, a separating equilib-
rium exists if

(1 − s1 ) pb1 + (1 − s1 ) pb2 (1 − D ) < pb1 + pb2 − C1 − C2 (6.3)

In order to analyze this equation, let us denote the total expected cash
flow for type j over both periods to be v j = p j1 + p j 2 . Also let rj denote
the rate of earnings growth (pj2/pj1). The probabilities of success at each
stage are then:

vj v j rj
p j1 = ; pj2 = (6.4)
1 + rj 1 + rj

Equation (6.3) can be rewritten as

4
 In signaling models it is usually not a problem for a low value type of firm to find a strategy that
cannot be mimicked by a high value type. This can be some kind of debt with covenants, for
example, where the payoffs depend on the firm’s total earnings over two periods. Since g has higher
total value it would not be interested in mimicking b.
 6  Capital Structure Choice and Firm’s “Quality”  121


−
C1   vb vr
+ bb 1 −
(
 C2 1 + rg )  < v − C1 − C2
 1     b (6.5)
 v g − C 
2  1 + rb 1 + rb vg rg 

Miglo (2012) argues that this equation holds and a separating equilib-
rium, where g issues equity, exists if and only if the difference between the
firms’ values is sufficiently small, and the difference between the rates of
earnings growth is sufficiently high. It should also be true if pg1 > pb1 and
pg 2 < pb 2 . As an example suppose that vg = vb . Equation (6.5) becomes
pg 2 < pb 2 .

Proposition 6.1  A separating equilibrium exists when the extent of the

asymmetric information is sufficiently small regarding the firms’ total values
and sufficiently large regarding the firms’ earnings profile over time.

Proof Given vb and rb, the amount of earnings that firm b can get by
mimicking firm g (the left side of inequality (6.5)) depends on the frac-
C1
tion of equity sold at stage 1, which equals and the face value of
vg − C2
debt at stage 2, which equals
(
C2 1 + rg ) . Given r , the fraction of equity
g
vg rg
sold at stage 1 and the face value of debt at stage 2 both decrease with vg.
On the other hand, given vg, the fraction of equity sold at stage 1 does
not depend on rg and the face value of debt at stage 2 decreases with rg
(
 C2 1 + rg
∂
)
 vg rg 
because < 0 . So in order to reduce the incentive for b to
∂rg
mimic g, both vg and rg need to be as small as possible. Since vg > vb , the
minimal incentive case is when vg is close to vb and when rg is as small as
possible compared to rb.
The pecking-order model arises as a special case here. Suppose
pg1 = pg 2 and pb1 = pb 2 . Then (6.5) becomes vg < vb . This does not hold.
122  Capital Structure in the Modern World

Hence a separating equilibrium does not exist.5 The result is not sur-
prising because the rates of growth are identical for every type of firm
( p=g 2 / pg 1 p=
b 2 / pb1 1 ) and Proposition 6.1 predicts that a separating
equilibrium can only exist if the difference between firms’ rates of growth
is large enough. In this case, however, the firms’ rates of growth are iden-
tical and the firms only differ in their overall values. Thus the case is
one-dimensional like the classical POT case. More generally, a separating
equilibrium will never exist and POT holds if pg1 > pb1 and pg 2 > pb 2 .
Also, POT holds if one considers a one-stage investment with short-term
(one stage) private information. This is the case with c2 = p j 2 = 0 .6
On an intuitive level, Proposition 6.1 is straightforward. First, it is well
known that in a separating equilibrium each financing strategy is chosen
by the worst possible type of firm for that strategy (from the investor’s
viewpoint).7 So if type g decides to issue equity in equilibrium and has
high earnings over two periods, with higher second-period earnings, other
firms would find it attractive to mimic this strategy. High total earnings
would imply a high share price at stage 1 and high second-period earn-
ings would imply a low face value of debt at stage 2. Proposition 1 makes
sure that it does not happen and a separating equilibrium exists.

Firm’s Performance After Issue The above analysis implies that the

adverse selection cost of equity is negatively related to the rate of earnings
growth for firm g and negatively related to its total value. For any firm,
the incentive to issue equity diminishes when the firm’s value increases,
or its rate of earnings growth increases, because it increases the chances
of being mimicked by other firms and thus increases the cost of issuing
equity.

Example 6.1  Consider the following example that is based on the model
described above and the sequence of events in Fig. 6.1. Let pg1 = 0.8 ,
pg2 = 0.3 , pb1 = 0.2 , pb2 = 0.85 and Ct = 0.2 , t = 1, 2 .

5
 Cooney and Kalay (1993) demonstrate that POT can fail if projects have negative NPV.
6
 In Goswami, Noe, and Rebello (1995) a firm receives earnings for two periods and private infor-
mation is long-term but investment is one-staged.
7
 Brennan and Kraus (1987).
 6  Capital Structure Choice and Firm’s “Quality”  123

Suppose g issues equity at stage 1 and issues debt at stage 2. We have:

0.3 D = 0.2 . Hence D = 2 / 3 . At stage 1 investors require a fraction of
equity s1 such that: s1 0.8 + s1 0.3 (1 − 2 / 3) = 0.2 . Therefore s1 = 2 / 9 .
The payoff of the shareholders of b, in case b decides to mimic g, equals
7 7  2  203
* 0.2 + * 0.85  1 −  = . If a signaling equilibrium exists, the
9 9  3  540
shareholders’ payoff for type b is pb1 + pb 2 − C1 − C2 = 0.65 (the present
value of b). Thus, a separating equilibrium exists where the firm type with
a higher value issues equity because 203/540<0.65 and b has no incentive
to mimic g.
To further illustrate Proposition 6.1 consider the same example but this
time assume that pg1 = 0.3 , pg2 = 0.8 . Now we have: 0.8 D = 0.2 . Hence
D = 1 / 4 . At stage 1 investors require a fraction of equity s1 such that:
s1 0.3 + s1 0.8 (1 − 1 / 4 ) = 0.2 . Therefore s1 = 2 / 9 . (Note that s1 is the same
as it is in the previous case because the total value of the type g firm remains
the same and as was mentioned before the share price at stage 1 depends
only on the total value of the firm.) The payoff for the shareholders of
7 7  1  469
b, in case b decides to mimic g, equals * 0.2 + * 0.85 *  1 −  = .
9 9  4  720
If a signaling equilibrium exists, the shareholders’ payoff for type b is
0.65 as in the previous case. Thus, a separating equilibrium does not exist
469
where the firm type with higher value issues equity because > 0.65
720
and b has an incentive to mimic g.
Ultimately, the main result of the above analysis is the link between the
capital structure choice and the firm’s performance after the issue. A sepa-
rating equilibrium, where only high value firms issue equity, implies that
firms issuing equity have a better operating performance at the moment
of issue or soon after the issue. These firms also have a lower operating
performance in the long run.
We mentioned previously that the results presented above are consis-
tent with early works like Jain and Kini (1994). Note the following works
in recent research. Pereira and Sousa (2015) study the post-IPO operat-
ing performances of a sample of 555 European firms that went public
124  Capital Structure in the Modern World

between 1995 and 2006. They found a decline in post-issue operating

performances of IPO firms. Firms located in emerging European coun-
tries performed even worse after the IPO than firms located in developed
European countries. They also find that operating performances, in abso-
lute terms, are higher for IPO firms prior to the IPO and in some cases
immediately after the IPO.
Eldomiaty and Mohamed (2009) examine the links between firms’
debt financing structures and operating performances. The results show
that in medium-debt firms, both short-term debt and long-term debt
help adjust the firms’ performance measures to a target level. In low
debt firms, long-term debt in particular has a negative effect on operat-
ing income/sales. In general, a relatively high correlation between debt
financing and operating performance is found.
Jiahui (2015) analyzes the link between the capital structure and the
firm’s performance for small and medium size companies in China. The
results show that capital structure and corporation performance have
an interactive relationship and capital structure, growth ability, equity
concentration, board and corporation scale will significantly influence
corporation performance. Profitability, growth ability, debt paying abil-
ity, collateral value of assets and enterprise scale will significantly influ-
ence capital structure. Profitability is negatively correlated with debt and
growth is positively correlated with debt.
Other interesting directions of research involving asymmetric infor-
mation are security design models, in particular those that involve situa-
tions where investors have different amounts of information and recent
research about operating performances of mergers.
Sometime investors such as banks may be able to obtain information
about a firm’s quality or produce analytical information. Fulghieri and
Lukin (2001) show that good firms want to partition their securities so
that some of the claims are information sensitive. If the cost of becoming
informed is low and the degree of asymmetric information is high, firms
may prefer a more information sensitive security to promote information
production by “specialized” outside investors. This explains the negative
correlation between debt and firm value because firms with low profit-
ability do not need to issue equity, which is sensitive to a firm’s value.
Fulghieri and Lukin also predict that younger firms with good growth
 6  Capital Structure Choice and Firm’s “Quality”  125

opportunities are more likely to be equity financed. These firms can be

particularly interested in acquiring information from outside investors.
Axelson (2007) argues that an important friction in the issuance of
financial securities is that potential investors may be privately informed
about the value of the underlying assets as opposed to the case when
firms have more information than investors. Axelson shows how ­security
design can help overcome this friction. In the single asset case, it is shown
that debt is often an optimal security when the number of potential
investors is small, while equity becomes optimal as the degree of com-
petition increases. In the multiple asset case, debt backed by a pool of
assets is optimal if the number of assets is large relative to the degree of
competition, while equity backed by individual assets is optimal when
the number of assets is small relative to the degree of competition. He
uses the theory to interpret security design choices in financial markets.
An interesting new research direction is the performance of IPO firms
involved in MA activities.8 These firms are growing as opposed to firms
who are targets and use IPOs as exit strategies. Bessler and Zimmerman
(2011) find that MA IPOs outperformed exit IPOs. MA IPOs also have
more leverage (see Celikyurt et al. 2010) after the IPO since they need
cash resources for merger activities. These results are consistent with the
idea that higher debt signals better performance in the long term.

6.3 C
 apital Structure, Market Timing
and Business Cycle
The market timing theory of capital structure (MT) suggests that the
decision to issue equity depends on stock market performance (Lucas
and McDonald 1990; Korajczyk et al. 1992; Baker and Wurgler 2002).
Financial managers prefer to issue shares when prices are relatively high.
When the stock market is not doing well, firms do not issue equity. Since
the equity market performance often moves in unison with the economy
as a whole, an alternative interpretation of MT is that when the economy
is bad, firms do not issue equity. When the economy is average, some

 MA: mergers and acquisitions.

8
126  Capital Structure in the Modern World

firms will issue equity. When the economy is booming, equity issues are
large. Therefore there is a positive relationship between equity issues and
the business cycle. Miglo (2011) noticed that empirical evidence often
provides support for MT (see, for example, Choe et al. (1993) and Baker
and Wurgler (2002)).
An interesting question is whether investors overpay for shares or not.
Some researchers argue that investors tend to be excessively optimistic
during new issues of shares. Other researchers prefer “rational investor”
arguments. In recent research, note the following. Bolton, Chen, and
Wang (2013) combine the firm’s precautionary cash hoarding and mar-
ket timing motives. Firms value financial slack and build cash reserves
to mitigate financial constraints. The finitely lived, favorable, financing
condition induces them to rationally time the equity market. This mar-
ket timing motive may cause investments to decrease (and the marginal
value of cash to increase) in financial slack, and may lead a financially
constrained firm to gamble.
To illustrate the basic idea about the connection between capital
structure and macroeconomic conditions, consider the following simple
model with asymmetric information in the spirit of a standard POT. A
firm has an investment project. It has some assets in place that generate
earnings A. To finance the new project, the firm needs to raise B. The
cash flow of the firm is A + R if the investment is made ( R > B ), and A
if it is not. There are two types of firms. For type 1, A = A1 + m and for
type 2, A = A2 + m , A2 > A1 . The publicly available parameter m depends
on the macroeconomic situation. As usual, we assume that everybody is
risk-neutral and the risk-free interest rate is zero. The sequence of events
is presented in Fig. 6.2.

Entrepreneurs
learn their irms' Firms decide
Earnings are
types. whether to issue
realized and
equity and
Macroeconomic distributed to
undertake the
parameter m project
claimholders
becomes known

Fig. 6.2  Sequence of events

 6  Capital Structure Choice and Firm’s “Quality”  127

Suppose the market believes that the fraction of type 1 firms among
firms issuing equity is x. The investors’ expected return should be equal
to the investment cost. This implies that B = α ( xA1 + (1 − x ) A2 + m + R ) ,
where α is the fraction of equity requested by investors. We have

B
α=
xA1 + (1 − x ) A2 + m + R

The earnings of initial shareholders are:

(1 − α ) ( A + m + R ) (6.6)

Type 1 will issue shares regardless of the value of x. To see this, let’s
compare (6.6) for type 1 and earnings for type 1 if no new investment is
B ( A1 + m + R )
made that is A1 + m . Then (6.6) is greater if R > .
xA1 + (1 − x ) A2 + m + R

It always holds because R > B and A2 > A1 . Consider the incentives

B ( A2 + m + R )
for type 2. It’s optimal choice depends on R > .
xA1 + (1 − x ) A2 + m + R
Since A2 > A1 , this condition depends on m. It is more likely to hold if m
increases. This leads to the following proposition.

Proposition 6.2  Equity issues are procyclical.

The analysis of the basic model reveals the following ideas. Low qual-
ity firms always issue equity and undertake investments. The incentives
for high quality firms depend on the macroeconomic situation. If the
economy is in contraction (low m), high quality firms prefer not to issue
new equity, whereas if the economy is growing they will certainly issue
new equity. Thus, equity issues are procyclical.
128  Capital Structure in the Modern World

Example 6.2  To finance the new project, the firm needs to raise B = 0.16 .
For type 1, A = 0.2 + m and for type 2, A = 0.5 + m . The publicly avail-
able parameter m depends on the macroeconomic situation. Also R = 0.2 .

Suppose that the fraction of type 1 firms issuing equity is 0.5. Consider
a pooling equilibrium where both firms issue equity. We have

0.16 0.16
α= =
0.5 * 0.2 + 0.5 * 0.5 + m + 0.2 0.55 + m

Consider the incentives for type 2 firms. Their optimal choice depends
0.16 (0.7 + m )
on 0.2 > . This condition depends on m. It holds if
0.55 + m
0.02
m> = 0.5.
0.04
The model predicts that when the economy is bad (m is low), firms do
not issue equity. When the economy is booming (m is high), equity issues
are large. Empirical work by Choe et al. (1993), Bayless and Chaplinsky
(1996), and Baker and Wurgler (2002) suggest a positive relationship
between equity issues and the business cycle.
To relate MT to the evidence about operating performances, some lit-
erature focuses on non-rational aspects of investors’ behavior. However, as
mentioned above, the evidence related to investors’ irrationality is mixed.
The literature, based on rational investors, is able to argue why firms may
be interested in issuing equity in periods when market prices are high
but is not focused on explaining the link between the debt-equity choice
and the changes in the operating performance after the issue (long-term
versus short-term).

Share Price and Equity Issue  A higher m implies a higher share

price. Let n denote the initial number of shares outstanding and
let Δnt denote the number of shares issued by type a in period
t in the case where a separating equilibrium exists. Let p be the
 6  Capital Structure Choice and Firm’s “Quality”  129

share price in period 1. From the previous example we know that

B ∆n1
s1 = . By definition it is also equal to .
xA1 + (1 − x ) A2 + m + R n + ∆n1

Also p∆n1 = B . Solving these equations we find

xA1 + (1 − x ) A2 + m + R
p= (6.7)
n

From the previous section we know that issuing equity is more likely
when m is large. From (6.7) it follows that equity issues are more likely
when the share price is high.
Another interpretation of this result looks at stock returns before the
equity issue. If the arrival of growth opportunities occurs independently
of price history, then firms issuing equity will have average performances
before the issue. Firms with a low share price will have above-average
­performances as they wait for the price to improve before they issue
equity. Thus, on average, positive abnormal returns precede equity issues.
The evidence confirms this prediction (Korajczyk et al. 1990; Loughran
and Ritter 1995).
Choe, Masulis, and Nanda (1993) find that equity issues are more
frequent when the economy is doing well. Thus they predict that equity
issues are procyclical. Clementi (2002) provides a model predicting
that the IPO coincides with an increase in sales and capital expendi-
tures. Hackbarth, Miao, and Morellec (2006) find that for their base
parameters the value-maximizing leverage ratio is higher in a recession
than in a boom. Thus, Hackbarth et al.’s (2006) model predicts that debt
is counter-cyclical. In Bhamra et al. (2010) the risk-free rates of return
vary pro-cyclically and the optimal market leverage ratio evolves pro-­
cyclically over the business cycle. In related work, Chen (2010) reaches
the same conclusion of pro-cyclical market leverage dynamics. Halling
and Zechner (2015) show that, on average, target leverage ratios evolve
counter-cyclically. These counter-cyclical dynamics are robust to differ-
ent subsamples of firms, data samples, empirical models of leverage, and
definitions of leverage.
130  Capital Structure in the Modern World

Angelo et  al. (2010) analyze whether SEO decisions are better
explained by timing opportunities or by the lifecycle theory, where firms
sell stock primarily in the early stages of their lifecycle, when growth
opportunities exceed internally generated cash flow. It is found that both
timing and lifecycle theories have a significant influence, with the life-
cycle effect being quantitatively stronger, but neither adequately explains
SEO decisions.
Many MT predictions seem to be consistent across different countries.
For example, Chichti and Bougatef (2010) investigate the relevance of
market timing considerations on the debt-equity choice using a panel
of Tunisian and French listed firms. Consistent with the market timing
theory, they find that firms tend to issue equity when their market valu-
ations are relatively high and after a market performance improvement.
The impact of equity market timing on capital structure persists beyond
eight years. Dong et al. (2012) study market timing and pecking order
in a sample of debt and equity issues and share repurchases of Canadian
firms from 1998 to 2007. They find evidence that firms issue ­(repurchase)
equity when their shares are overvalued (undervalued) and that overval-
ued issuers earn lower post-announcement long-run returns only when
the firms are not financially constrained. Similarly, they find that firms
prefer debt to equity financing only when they are not overvalued. These
findings highlight an interaction between market timing and pecking-
order effects. Setyawan and Frensidy (2013) find that the market to book
ratio is negatively correlated with market leverage for Indonesian IPO
firms. This result is consistent with MT.  On the other hand, Khanna
et al. (2015) analyze MT for Indian firms and find that firms rely more
on profitability than MT when issuing equity.

Questions and Exercises

1. Firms issuing equity usually underperform compared to non-issuing
firms, in the long run.
2. Signaling theory usually suggests that debt issues are a good signal of
a firm’s operating performance while empirical evidence finds negative
correlation between debt and profitability.
3. Multistage investment and long-term asymmetric information can
explain why higher quality firms can be interested in issuing equity.
 6  Capital Structure Choice and Firm’s “Quality”  131

4. Consider a setup from Sect. 6.2. Suppose a firm considers equity

financing for a two-period investment project with cost 0.1 in period
1, 2. In each period the project may be successful or unsuccessful. In
the latter case the cash flow equals 1 and in the former case the cash
flow equals 0. A firm’s insiders have private information about the
probability of success in each stage. The firms are of two types, type a
and type b, with respective probabilities of success in period 1 and 2
as follows:
pa1 = 0.7, pa2 = 0.25, pb1 = 0.1 and pb2 = 0.8 .
Describe signaling equilibrium.
5. To finance the new project, the firm needs to raise B = 0.1 . For type 1,
A = 0.1 + m and for type 2, A = 0.3 + m . The publicly available param-
eter m depends on the macroeconomic situation. Also R = 0.12 .
Suppose that the fraction of type 1 firms issuing equity is 0.3.
Describe possible equilibria. Provide interpretation.

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signal-a-market-top/
 7
Capital Structure and Corporate
Governance

7.1 Corporate Governance

Corporate governance broadly refers to the mechanisms, processes and
relations by which corporations are controlled and directed.1 As we know,
corporations are owned by their shareholders whose objective is usually
to maximize the value of their investments. However, in a typical corpo-
ration, relationships between interested parties often involve asymmetric
information and moral hazard problems. Corporate governance is often
seen as a mechanism to ensure that corporations act in the interests of
their shareholders.2 This chapter covers several topics related to corpo-
rate governance: managerial incentives, links between levels of debt and
managerial effort, the free cash flow theory, control rights allocation,
earnings management, and links between capital structure and earnings
manipulation.

This chapter is coauthored with Victor Miglo.

1
 For a review see, for example, Becht, Bolton, and Roell (2003).
2
 Some definitions use the term stakeholders to also include customers, employees, etc. http://www.
investopedia.com/terms/c/corporategovernance.asp

© The Editor(s) (if applicable) and The Author(s) 2016 135

A. Miglo, Capital Structure in the Modern World,
DOI 10.1007/978-3-319-30713-8_7
136  Capital Structure in the Modern World

Capital structure affects relationships between interested parties in

a corporation. In Chaps. 4 and 5 we focused on shareholder–creditor
agency problems. We begin this chapter by analyzing the shareholder–
manager conflict and how capital structure can help resolve it. The topic
of managerial incentives is very popular in corporate finance literature
including academic literature, news, and magazines. The list of possible
problems is long and contains, among others, earnings manipulations,
inefficient levels of effort, “empire-building”, information manipula-
tion, etc. Although managerial incentives were analyzed by theorists for
decades, they became particularly relevant in the early 2000s due to the
high number of corporate scandals including some cases that became
famous worldwide such as Enron, WorldCom, etc.
Financial contracts are very complex because a lot of information in
the business world is hard to verify, as we discussed in Chap. 3, and many
contingencies are difficult, if not impossible, to specify and enforce. An
interesting example is the story of Nortel, a multinational telecommu-
nications and data networking equipment manufacturer. At its height,
Nortel accounted for more than a third of the total valuation of all the
companies listed on the Toronto Stock Exchange (TSX).3 In late October
2003, Nortel announced that it intended to restate approximately $900
million worth of liabilities carried on its previously reported balance
sheet as of June 30, 2003, following a comprehensive internal review
of these liabilities. A dozen of the company’s most senior executives
returned $8.6 million of bonuses they were paid based on the erroneous
accounting. Investigators ultimately found about $3 billion in revenue
had been booked improperly in 1998, 1999, and 2000.4 In 2007 both
the U.S. Securities and Exchange Commission and the Ontario Securities
Commission pressed charges against the former senior financial officials
of Nortel for fudging the company’s revenue.5 Finally, In June 2009, the
company announced it would cease operations and sell off all of its busi-
ness units.6

3
 Hasselback and Tedesco (September 27, 2014).
4
 http://buzzspotr.com/accounting-scandal-at-nortel/
5
 Erman (March 13, 2007).
6
 Gillies (June 20, 2009).
 7  Capital Structure and Corporate Governance  137

Richard Milne, in his November 2015 article, analyzes the situation at

Volkswagen (VW) that was recently hit with an emission system problem
scandal.7 The article points out that the pattern of overspending in good
times could potentially be one of the company’s problems. VW’s admin-
istrative costs have almost tripled since 2007. In both 1993 and 2005 the
German carmaker faced scandals and almost non-existent profit margins
thanks to overspending. Capital structure may affect the company’s deci-
sions relating to spending/cuts. Large amounts of debt put a significant
pressure on management and create an incentive to cut spending.8
These two stories represent examples of two important aspects of
shareholder–manager conflicts: information manipulation and cash over-
use. In this chapter we will look at these situations as well as many others
more closely. Special focus will be on the role of capital structure in creat-
ing/resolving shareholder–manager conflicts.

7.2 F inancing Strategy and Managerial

Incentives: Free Cash Flow Theory
In this section, we focus on the role of debt contracts in corporate gov-
ernance. How does leverage affect the level of investment? Consider a
model of a firm where the manager’s decisions are explained by a trade-­
off between the threat of losing his job due to bankruptcy and the perks
from shirking (Grossman and Hart 1982; Jensen 1986). The basic setup
consists of two periods; in the first period, the firm issues debt (with face
value D) and equity to raise B to invest. After the funds are received,
the manager decides how they are spent. More specifically, the manager
should choose between two projects. Project j generates non-negative
earnings Rj, j = 1, 2 . Rj is distributed according to the distribution func-
tion Fj. If project j is chosen, the manager’s non-cash/private benefit is
mj. These benefits can include providing jobs to family members, invest-
ments in friends’ companies, establishing new personal connections,
etc. By assumption, R1 first-order dominates R2. However, m2 > m1 . The

 Milne (November 20, 2015).

7

 Bryant, Milne and Sharman (October 13, 2015).

8
138  Capital Structure in the Modern World

Earnings If the
from the company is
A irm's Manager
project are not bankrupt,
capital selects an
realized and the manager
structure is investment
distributed receives
determined project
to private
claimholders. beneits.

Fig. 7.1  Sequence of events

manager’s official benefits are approximately equal for these projects. For
the sake of simplicity we assume that they are negligibly small. A possible
interpretation of these assumptions is that project 2 does not have the
same value for the firm as project 1 does but it extends the amount of
resources under the manager’s control. This phenomenon is often called
“empire-building”. Also, bankruptcy is very costly for the manager! If
the firm is bankrupt the manager’s total benefit is zero. For example, the
manager loses his job and his reputation, etc. The sequence of events is
presented in Fig. 7.1.

Proposition 7.1 Under equity financing, the manager will choose the inef-
ficient project. Debt financing may, in some cases, improve managerial
incentives.

Since project 1 first-order dominates project 2, the expected earnings

and the NPV of project 1 are greater than those of project 2. So from the
firm’s point of view, the manager should choose project 1. The manager’s
expected payoff, if project j is chosen, equals m j (1 − Fj ( D ) ) . Note that
the expression in brackets shows the probability of “no bankruptcy” for
company j or that R j ≥ D . D = 0 implies Fj ( D ) = 0 . In this case, the
manager’s expected payoff, if project j is chosen, equals mj. The manager
chooses project 2 since m2 > m1 .
If D > 0 , several situations may exist where the manager will choose
project 1. For example, if the difference between m1 and m2 is sufficiently
small, m1 (1 − F1 ( D )) > m2 (1 − F2 ( D )) because project 1 first-order domi-
nates project 2 implying F2 ( D ) > F1 ( D ). Another example is a situation
where R1max > D > R2max (Rjmax is the maximal Rj with positive density). In
this case m2 (1 − F2 ( D )) = 0 and the manager chooses project 1.
 7  Capital Structure and Corporate Governance  139

In conclusion, debt financing can be used to mitigate the tendency

for “empire-building”. Jensen (1986, 1989) argued that debt financing
is an important way to resolve agency problems between managers and
investors. It would limit managerial discretion by minimizing the “free
cash-flow” available to managers and thus provide protection to inves-
tors. Sometimes in the literature this idea is referred as “debt and disci-
pline” theory.9
A related result is the costly state-verification theory (see Townsend
(1979) and Gale and Hellwig (1985)). It considers an environment
where a firm’s earnings are unobservable by investors, the verification of
earnings is costly and managers can report the earnings at their discretion
(ex-post moral hazard). The optimal contract is called the standard debt
contract. It specifies that the firm that is able to make its scheduled pay-
ments is not audited. As soon as the firm misses a payment, however, it
is audited and all of its assets are seized. In this type of contract, it is not
optimal for the firm to miss a payment that it is able to make.
As we know, using debt as the major source of financing incurs sub-
stantial costs of financial distress. Firms may face direct bankruptcy costs
or indirect costs in the form of debt-overhang or asset substitution (see
Chaps. 4 and 5). To reduce the risk of financial distress, it may be desir-
able to have the firm rely partly on equity financing. Also, the role of
debtholders differs between countries. Countries where debt regulation
is subject to political intervention and lobbying have weaker bases for
using debt as a commitment device. Some research suggests that this was
the case in the United States in the early 2000s. For more analysis of this
issue see Franks and Sussman (2005) and Berglöf and Rosenthal (1999).
DeMarzo and Fishman (2007) consider a dynamic model where a
firm’s manager can divert the firm’s cash flow. It is shown that the optimal
mechanism can be implemented by combining equity, long-term debt
and a line of credit.
Zheng (2013) analyzes the effect of a firm’s capital structure on mana-
gerial incentives and controlling the free cash flow agency problem and
compares it to incentives provided by compensation contracts. It was
found that debt and executive stock options act as substitutes in attenuat-
ing a firm’s free cash flow problem. It was also found that firms trade off

 See, for example, Kale, Ryan, and Wang (2015).

9
140  Capital Structure in the Modern World

the adjustment of their capital structure and compensation structure to

control overinvestment.
Edmans (2011) suggests that the option to terminate a manager early
minimizes the investors’ losses if the manager is unskilled. It also deters
a skilled manager from undertaking efficient long-term projects that
risk low short-term earnings. This paper demonstrates how risky debt
can overcome this tension. Leverage concentrates equityholders’ stakes,
inducing them to learn the cause of low earnings. Unlike traditional
theories, a non-paying manager is not automatically fired. The firm is
liquidated only if the cause of the weak earnings is low managerial skill.

7.3 F inancing Strategy, Incomplete Contracts

and Property Rights Allocation
As we have seen in previous chapters, the allocation of decision-making
rights is very important because in many cases different claimholders may
have different incentives and make different decisions. An important idea
in the area of optimal control rights and other rights allocation is the
“property rights approach” (Grossman and Hart 1986; Hart and Moore
1990; Hart 1995). This approach relies on incomplete contracts. Under
standard moral hazard problems the parties cannot write a contract that
will describe some of the decision-maker’s actions. The incomplete con-
tracts approach takes things one step further: the parties cannot write a
contract that will describe some of the decision-maker’s actions nor can
they write contracts (financial contracts) that will be contingeant on a
firm’s profit. The firm’s profit is observable but not verifiable! So in many
situations, the only contracts that can be written are to do with property
rights allocation.
Related literature has presented several ideas about capital structure.
Early examples of such analysis predicted that a combination of debt
and equity is optimal because it allows an efficient distribution of con-
trol rights.10 A typical rule is that if a firm performs well, control goes to
the shareholders; otherwise the control passes to the creditors. It can be

 Aghion and Bolton (1992), Dewatripont and Tirole (1994), and Hart (1995).
10
 7  Capital Structure and Corporate Governance  141

found in empirical literature that real financial contracts are more com-
plicated than standard debt and equity. Also the parties involved usu-
ally make separate determinations for the allocation of various kinds of
property rights. These rights include residual cash flow rights, liquidation
rights, board rights, etc.11
Nobel Prize winners Maskin and Tirole (1999a, b) discuss the major
idea of the property rights approach, which is that some actions are
observable but non-contractable. They suggest that observable informa-
tion could be made verifiable by the use of cleverly designed revelation
mechanisms. That is, the contracting parties can agree in advance to play
a game where they have the appropriate incentives to reveal truthfully
their private information in equilibrium. However, these mechanisms are
rarely observed in practice. Aghion, Bloom and Van Reenen (2013) fur-
ther discuss the robustness of the incomplete contracts/property rights
approach and suggest possible avenues for future research.
Miglo (2009) suggests that in firms where moral hazard is an impor-
tant issue, a simple rule (“the rule of marginal revenues”) may exist that
describes the property rights allocation of the holders of securities based
on the analysis of cash flow patterns for different types of contracts (secu-
rities). To illustrate the idea, consider a firm with assets in place that are
expected to generate earnings in two periods. After observing the inter-
mediate earnings R10 and R20, the firm’s decision-maker makes a decision
(select I) that affects the final earnings in both periods. After the decision
is made, the firm’s earnings in period 1 are R1 = R10 − I and in period 2
they are R2 = R20 + I + R ( I ) . I may be interpreted as an amount of invest-
ment in a project. But in fact, I can be negative too. In this case it can be
interpreted as borrowing or increasing sales with discount.
A difference exists between period 1 and period 2  in terms of con-
tractability conditions (in the spirit of the property rights approach).
Period 1 earnings will be distributed according to contracts Tj(R1), which
may include a large variety of contracts (securities). However, the only
possible contract in period 2 is a property rights allocation that will be
contingeant on period 1 earnings. They are denoted αj(R1). We assume

 See, for instance, Kaplan and Stromberg (2003) and Elfenbein and Lerner (2003) with regard to
11

venture capital contracts and Gilson (1990) for corporate contracts.

142  Capital Structure in the Modern World

Intermediate
earnings Final
Capital
become The earnings are
structure is
known and decision- realized and
selected and
property maker distributed
securities
rights selects to
are issued.
become claimholders
known

Fig. 7.2  Sequence of events

that the resulting fractions of ownership entitle each party to the right
corresponding to the fraction of the firm’s earnings period 2. Tj(R1) are
monotonic. Only piece-wise linear contracts are considered since they
are the most common type of contract observed in reality. Property rights
should provide the decision-maker with the optimal incentive to choose s.
The sequence of events is as shown in Fig. 7.2.
Optimal situations occur when property rights are distributed accord-
ing to the current marginal revenues of existing securities. For instance,
if the current marginal cash flow rights of the decision-maker are 10 %
(if the firm’s value increases by $ 1, the payoff to the agent will increase
by 10c), his optimal fraction of ownership in the future business should
also be 10 %. This provides decision-makers with the optimal incentives
to make decisions.

Proposition 7.2 If contracts are piece-wise linear, s is sufficiently small, and

T j′ ( R10 ) = α j ( R10 ) , then the interests of each claimholder and the firm’s value
maximization are aligned.

Let I* be the optimal decision from the firm’s point of view, i.e. R(I)
(total change in firm’s earnings after the decision is made) is maximized
when I* is selected. Assuming that R(I) is concave and differentiable, it
implies R′ ( I * ) = 0 . Suppose that claimholder j is the decision-maker. The
payoff of j equals Pj ( s ) = T j ( R10 − I ) + α j ( R10 ) ( R20 + I + R ( I ) ) .

When I is sufficiently small, it equals (since Tj is piece-wise linear):

( ) ( ) ( )( R
Pj (s ) = T j R10 − T j′ R10 I + α j R10 0
2 + I + R( I ) )
 7  Capital Structure and Corporate Governance  143

It implies: Pj′ ( s ) = α j ( R10 ) − T j′ ( R10 ) + α j ( R10 ) R′ ( I ) . And j will make

optimal decision for the firm when Pj ′ ( I * ) = 0 . As was mentioned above
( ) ( )
R ′ I ∗ = 0 . It implies that Pj ′ I * = 0 if T j ′ ( R10 ) = α j ( R10 ) .

The “rule of marginal revenues” is consistent with standard securi-

ties. Suppose, for example, that there are two claimholders: A and B. B’s
contract is debt with a face value D and A’s contract is levered equity:
T2 ( R1 ) = min { R1 ,D} and T1 ( R1 ) = max {0, R1 − D} (see Fig. 7.3). If cash
flow is greater than the face value of debt, then residual property rights
belong to the equityholder ( T1′ ( R1 ) = 1 ), and if cash flow is less than the
face value of debt, the creditors own it ( T2′ ( R1 ) = 1 ). Miglo (2009) also
considers other contracts including three-part linear contracts and situa-
tions where earnings shifts are large.
A number of other studies have considered the role of debtholders
(or more generally called fixed claimholders) in corporate governance.
Among others let us mention Zender (1991), Dewatripont and Tirole
(1994), and Berglöf and von Thadden (1994). All of these studies analyze
different scenarios of transferring control to debtholders when perfor-
mance is bad. Since debtholders receive a large part of the liquidation

Fig. 7.3  The rule of marginal revenues under debt financing

144  Capital Structure in the Modern World

value and only a small part of the potential continuation value, they have
more incentive to liquidate their firms than shareholders, who are often
reluctant to liquidate, as we saw in Chap. 4. The more dispersed the debt
of a firm is, the stronger the commitment to liquidate because it makes
debt restructuring in the event of continuation more difficult (similar to
the free-rider problem that we discussed in Chap. 5).

7.4 C
 ostly Effort, Capital Structure,
and Managerial Incentives
Jensen and Meckling (1976) argue that when the decision-maker’s effort
is costly, then under equity financing the decision-maker should control
100 % of the equity in order to mitigate moral hazard problems. If the
decision-maker controls less than 100 % of equity, there will be a distor-
tion in the effort because the decision-maker bears 100 % of his effort’s
cost and receives less than 100 % of the benefits. Innes (1990) further
shows that debt financing can improve the manager’s effort.
Consider a firm totally financed with equity. The firm’s founder/man-
ager/entrepreneur (E) is risk-neutral. The firm’s expected first-period
earnings r depend on E’s effort e ∈[ 0,1] . For simplicity we assume that
the expected value of r equals e or Er = e . The cost of effort is e2.
E will choose the level of effort where his marginal revenue equals his
marginal cost. Since his individual marginal revenue is below the firm’s
marginal revenue, the chosen level of effort is less than first-best.

Proposition 7.3 If the manager owns less than 100 % of equity, the level of
effort is below the first-best level.

Formally, the first-best effort maximizes the firm’s value: e − e2 .

Socially optimal e* = 1 / 2. However, E will maximize ke − e2 , where k
is the fraction of equity that belongs to E. Optimal e′ = k / 2 . For any
k < 1, e′ < e* .
Now we consider an example that illustrates that debt can be a better
contract. Suppose earnings can have three values (all with equal prob-
abilities): 0, e and 2e. One can see that Er = e . Suppose the firm has an
 7  Capital Structure and Corporate Governance  145

investment project with cost b = 1 / 8 . If the firm is financed with equity

the manager’s choice of effort is e′ = k / 2 .
Figure 7.4 illustrates the optimal effort under equity financing. The
manager’s profit is then k2/4. To find the optimal contract, we have to
find the value of k that will maximize the entrepreneur’s profit under
the condition that the investor’s expected profit is not less than b. This
condition is e (1 − k ) = k (1 − k ) / 2 ≥ 1 / 8 . The left side of this inequality
reaches its maximum at k = 1 / 2 . In this case I’s expected payoff is 1/8.
E’s expected payoff is k2/4. It increases when k increases. Hence the opti-
mal k is the largest value of k that satisfies I’s budget constraint, i.e. 1/2.
Optimal e ′ = 1 / 4 and E’s expected payoff is 1/16.
Now consider debt financing. Two cases are possible. (1) e < D . In this
case the manager maximizes 1 / 3 * (2e − D ) − e2 . So optimal e = 1 / 3 . The
manager’s payoff is 1 / 9 − D / 3 . (2) e > D . In this case the manager maxi-
mizes 1 / 3 ( e − D ) + 1 / 3 * ( 2e − D ) − e2 . So optimal e = 1 / 2 . The manag-
er’s payoff is 1 / 4 − 2 D / 3 . By comparing the manager’s payoffs in each
case we find that if D < 5 / 12 the optimal e = 1 / 2 and otherwise e = 1 / 3
. Now to find D note that the investor’s payoff should be greater than b.
So in the second case D = 3 / 2b . This is possible only if b < 5 / 18 , which

Fig. 7.4  Optimal effort under equity financing

146  Capital Structure in the Modern World

is our case. So the firm can be financed with debt with a face value 3/16
and the manager’s profit is 1/8 in this case.
One can see that under debt financing the manager chooses optimal
e = 1 / 2 . Innes shows that debt can be optimal if the distribution func-
tion for the firm’s earnings follows the MLRP condition,12 the manager is
risk neutral, and the contracts are non-decreasing.
Among the more recent interesting ideas note the following.
Berkovitch, Israel, and Spiegel (2000) investigate the interaction between
financial structure and managerial compensation. A three-period model
is considered. In period 0, a manager is hired. In period 1, the manager
takes actions that determine the firm’s future earnings and make the firm
more dependent on his ability. For example, the manager selects workers,
organizes production, chooses the firm’s strategy in the product market,
etc. After observing signals about the firm’s future earnings, sharehold-
ers may replace the manager. When the firm is leveraged, replacing a
manager whose ability is known with a new manager whose ability is
unknown shifts value from the debtholders to the shareholders (similar
to the asset substitution effect from Chap. 4). Consequently, risky debt
credibly commits the shareholders to an overly aggressive replacement
policy, and this may motivate the manager to exert more effort ex ante in
order to promote his chances of keeping his job.
Fairchild (2005) examines the combined effects of managerial over-
confidence (overconfidence in their model is interpreted as a bias esti-
mation of a firm’s investment project success probability), asymmetric
information, and the moral hazard problem on the manager’s choice of
financing (debt or equity). It is shown that the effect of overconfidence
on managerial moral hazard is ambiguous. It has a positive effect by
inducing higher managerial effort. However, it may lead to excessive use
of debt and higher expected bankruptcy costs.
Some research points out that, in many cases, a manager’s contract
looks like an inside debt (pension plans for example) that may align the
interests of managers and outside debtholders (Sundaram and Yermack
2007; Anantharaman et al. 2014). Some of these contracts are unfunded
and unsecured, while others are funded and secured to some extent, and

 See Holmstrom (1979).

12
 7  Capital Structure and Corporate Governance  147

they may be invested in equity and withdrawn flexibly pre-retirement.

Special arrangements in executive debt-like compensation could hence
weaken, or even nullify, any incentive-alignment effect.
Dewatripont, Legros, and Matthews (2003) develop an agency model
with a risk-averse entrepreneur and observable but unverifiable effort, and
renegotiable contracts. Within this class of contracts/equilibria, regard-
less of who has the renegotiating bargaining power, debt and convertible
debt maximize the entrepreneur’s incentives to exert effort.

7.5 Earnings Manipulation

Corporate scandals over the last 10–20 years have raised heated debates
regarding earnings manipulation (EM) by firms’ insiders. Some issues
in this area are related to the links between capital structure and a firm’s
incentives to engage in EM.
It was documented in the literature that firms manage their earnings
prior to their IPOs (window-dressing). IPO firms manipulate earn-
ings using accrual earnings management and this manipulation leads
to lower post-IPO stock performances (Teoh et al. 1998a, b; Gramlich
and Sorensen 2004)). Similar observations were made for SEO (Rangan
1998; DuCharme et al. 2001).
Secondly, it was also found that managers manage earnings more
actively (empirical studies document a discontinuity in earnings manage-
ment estimations) when firms have to achieve a “zero-earnings” threshold
(Burgstahler and Dichev 1997; Degeorge et al. 1999). This is especially
important for levereged firms since failure to achieve this threshold can
lead to bankruptcy.
It was also found that managers of firms who provide large stock
options to their employees are more willing to engage in EM. Some evi-
dence is consistent with executives influencing the grant date stock price
through timing, i.e. by accelerating the release of negative information
before scheduled grant dates and delaying the release of positive infor-
mation after scheduled grant dates (Yermak 1997; Aboody and Kasznik
2000). Another way that managers can influence the grant date stock
price is by ex-post timing of the grant date itself, or backdating. Bebchuk,
148  Capital Structure in the Modern World

Grinstein and Peyer (2006) find evidence of opportunistic timing of

director grants largely related to backdating.
In the aftermath of the accounting scandals at Enron and Worldcom,
the Sarbanes-Oxley Act (2002) eliminated insiders’ discretion in several
standards and choices. Other regulations were also created including
those by the International Accounting Standard Board in Germany, the
Deutsche Standardisierungsrut, and others.
Earnings manipulation exists because earnings verification is costly.
Earlier theoretical literature related to problems of earnings verification
suggested that debt is an optimal contract and that under this contract
a truthful revelation of earnings will be delivered by the firm (Townsend
1979; Gale and Hellwig 1985). Consider a firm that is run by a manager/
entrepreneur (E) who owns the firm. The firm has to make an investment
20, which requires external financing from an outside investor (I). The
investment generates earnings R that are uniformly distributed between
0 and 100. Earnings are not observable by I so the manager can report
any amount. However, I can request an audit (the cost is 20 and it is paid
by the firm) of the firm. A financing contract between I and E deter-
mines the schedule of the investor’s payments P(R) as a function of R
(earnings declared by E). The question is: What is the optimal contract
P(R) that will maximize the firm’s expected earnings under the condition
that the investor is compensated for its investment? It was argued that
the revelation principle implies that the truth should be told in equilib-
rium and the contract should be incentive-compatible (see, for example,
Fudenberg and Tirole 1991).
Let X be the set of values for R when the investor makes an audit.
First note that P ( R ) = D for all R not in X. Otherwise, for any R that is
in X, the firm will choose to declare the value of R with a minimal pay-
ment to I. So this will not be an incentive-compatible contract. Also,
all R in X should be less than D. Otherwise for this value of R in X, the
firm will always have an incentive to declare R that is not in A. Gale and
Hellwig show that an optimal contract represents a standard debt con-
tract. To see the intuition suppose that another contract A is optimal (see
Fig. 7.5). Contract A pays 40 to the investor if R > 50 and 0 otherwise.
So the investor’s expected return is 40 ∗ 5 / 10 = 20 . The expected audit
cost is 20 ∗ 1 / 2 = 10 , where 1/2 is the probability of the audit (when
 7  Capital Structure and Corporate Governance  149

Fig. 7.5  Optimal contract under costly state verification

R < 50 ). The E ' s expected return is 50 − 20 − 10 = 20 . Consider con-

tract B.  It pays 25 if R > 25 and R otherwise. The investor’s expected
return is: 25 ∗ 7.5 / 10 + 12.5 ∗ 2.5 / 10 = 21.875 . The E’s expected return is
50 − 21.875 − 5 = 24.125 . So contract B is better than contract A for the
entrepreneur. It represents a standard debt contract (see Fig. 7.5). In fact
this contract can even be improved a little bit making sure that the inves-
tor’s payment is equal to 20.
If this can solve the problem of earnings reporting why do prob-
lems still exist? On the one hand, relying on debt financing is risky and
increases potential bankruptcy costs. Another interesting issue is the
difference between accounting misreporting and real earnings manipu-
lations.13 Graham et  al. (2005) show that accounting misreporting
declined after the Sarbanes-Oxley Act, while real earnings manipulations
increased. They also find that three-quarters of firms are involved in earn-
ings manipulations (in their opinion it is a lower bound). In their survey,
the authors asked financial managers the following question: “Imagine
a hypothetical scenario. Near the end of the quarter, it looks like your
company might come in below the desired earnings target. Which of the
following choices might your company make?” It was found that firms

13
 See, for example, Roychowdhury (2006).
150  Capital Structure in the Modern World

are more willing to be engaged in real actions (for example, “decrease

discretionary spending including R&D, advertising, etc.” or “delay start-
ing a new project even if this entails a small sacrifice in value”) than in
accounting actions (for example, “alter accounting assumptions” (e.g.,
allowances)).
In contrast to earnings being misreported, which in most cases repre-
sents accounting fraud, real earnings manipulation is often considered
in literature as a transfer of funds between periods. This transfer does
not create any social value (in contrast to productive effort) and is usu-
ally costly. Some typical examples include recognition of sales not yet
shipped, allowance of bad debt, delays in maintenance expenditures,
delayed approvals of important decisions, and inefficient discount poli-
cies. Certain methods are possibly optimal economic actions in certain
economic circumstances. However, if managers engage in these activities
more extensively than what is considered normal, given their economic
circumstances, with the objective of beating some thresholds that increase
the value of claims belonging to them and destroy the firm’s value, they
are engaging in EM.
Degeorge et al. (1999) present a theoretical model involving EM by a
manager with a bonus-type contract. The authors show that the manag-
er’s incentive to manipulate earnings depends on the values of the latent
(pre-managed) earnings, the manager’s bonus, and the magnitude of the
social loss from the EM. The manager’s decision also relies on whether
predictions of future profits are certain or risky.
Miglo (2010) develops a model where EM is a part of the equilibrium
relationships between firms’ insiders and outsiders. It is shown that values
of firms that manipulate earnings can be higher than those of firms that
do not manipulate earnings. Also, the model suggests that debt can pro-
vide a better incentive than equity.
To see the idea, consider a setup that is similar to those we considered
previously. This time the firm has to make an investment b > 0 . The
firm needs external financing from an outside investor (I). If the invest-
ment is made, the firm generates earnings R1 at period 1 and R2 at period
2. R1 depends on E’s effort e ∈[ 0,1] . R1 equals 1 with probability e and
0 otherwise. This implies that ER1 = e . The cost of effort is e2. E can be
involved in EM after observing intermediate earnings R10 and R20. So if
 7  Capital Structure and Corporate Governance  151

R10 = 0 and E uses EM, the final first period earnings R1 = R10 + s and
the second-period earnings R2 = R20 + s − c , where c is the cost of the
EM.
Under equity financing, E has no interest in EM since it does
not change E’s fraction of earnings nor does it change who controls
the company in period 2. As we saw in previous examples, optimal
e′ = k / 2 and it is below the socially optimal level of effort. Under debt
financing, E will use EM ( s = D ) if R10 = 0 . Otherwise, E loses control
of the firm and gets nothing at the second period. If R10 = 1 , earnings
will not be manipulated since any changes in second-period earnings
for E will just mirror the change in period 1 (opposite signs) minus the
cost of EM.

If R10 = 0 , E gets s − D + R20 − s − c . If R10 = 1 , E gets 1 − D + R20 .

E’s payoff is e (1 − D + R20 ) + (1 − e) ( R20 − D − c ) − e2 . Optimal e equals
e″ = (1 + c ) / 2.

If c is sufficiently small and b is sufficiently large (making k relatively

small), e ″ will be closer to the optimal level of effort ½ than e ′. This
means that the firm’s value will be higher in this case. Furthermore, if EM
is impossible, the outcome will be worse. If R10 = 0 , E gets 0. If R10 = 1 ,
E gets 1 − D + R20 . E’s payoff is e (1 − D + R20 ) − e2 . Optimal e equals
( )
e ′′′ = 1 − D + R20 / 2.

Figure 7.6 illustrates that if c < 1 , E’s level of effort is closer to the
socially optimal level and provides a better social surplus than the case
without EM.
This analysis also shows that Innes’s (1990) result can hold even if the
manager is subject to a double moral hazard problem: production effort
and earnings manipulation.
Among recent papers note the following. An, Li, and Yu (2013) exam-
ine the effect of earnings management on financial leverage and how this
relation is influenced by institutional environments by studying a large
panel of 25,798 firms across 37 countries spanning the years 1989 to
152  Capital Structure in the Modern World

Fig. 7.6  Optimal effort under debt financing

2009. It was found that firms with high earnings management activities
are associated with high corporate leverage.
Gunny (2010) examines real earnings manipulation in firms that meet
two earnings benchmarks (zero and last year’s earnings). The results indi-
cate that real activity manipulations of expenses on R&D, SG&A,14 and
production are positively associated with firms just meeting the earnings
benchmarks. Also, it was found that firm-years reflecting real earnings
manipulation to just meet earnings benchmarks had higher subsequent
firm performances compared to firm-years that do not engage in earnings
manipulation and miss or just meet the earnings benchmarks.
Cohen and Zarowin (2010) examine earnings management behavior
around SEOs, focusing on both real activities and accrual-based manipu-
lation. They document that firms use real, as well as accrual-based, earn-
ings management tools around SEOs.
Alhadab, Clacher, and Keasey (2013) find that IPO firms engage in
real and accrual earnings management during the IPO and that big audit
firms constrain discretionary expenses-based and accrual-based manipu-

 R&D: research and development, and SG&A: selling, general and administrative expenses.
14
 7  Capital Structure and Corporate Governance  153

lations. The restriction of these forms of earnings management leads IPO

firms to resort to a higher level of sales-based manipulation.

7.6 Other Works

Capital Structure and Employees/Bargaining Issues

Matsa (2010) analyzes the strategic use of debt financing to improve a
firm’s bargaining position with an important supplier—organized labor.
Because maintaining high levels of corporate liquidity can encourage
workers to raise their wage demands, a firm with external finance con-
straints has an incentive to use the cash flow demands of debt service to
improve its bargaining position with workers. It is shown that strategic
incentives from union bargaining appear to have a substantial impact on
corporate financing decisions.
Chang (1992) analyzes a model, where investors can force a value
enhancing restructuring that is costly for employees in bankruptcy.
Issuing more debt makes bankruptcy, and the associated restructuring,
more likely. Optimal leverage is determined by maximizing firm value
subject to this trade-off.
In a related paper, Chang (1993) focuses on the interaction between
payout policy, capital structure and compensation contracts. Managers
are induced to pay dividends through their compensation contracts;
bankruptcy serves as an opportunity for investors to get information on
the optimal payout level and hence to restructure the firm. When the
right amount of debt is issued ex ante, bankruptcy occurs in states where
new information about the optimal payout level is likely to be available.
Baldwin (1983) models a firm in which employees can appropriate the
return to capital after capital costs have been sunk. Issuing a sufficient
amount of debt may mitigate this hold-up problem, but bankruptcy is
assumed to be costly for workers.
Perotti and Spier (1993) emphasize debt’s similar role. In their model,
equityholders may issue junior debt, thereby creating an underinvest-
ment incentive. This can then be used to obtain wage concessions from
employees to restore incentives to invest.
154  Capital Structure in the Modern World

Subramanian (2002) also analyzes a firm where the employee makes

capital structure and investment decisions, taking his personal ­bankruptcy
costs and risk aversion into account. In each period, the employee’s
income is derived from a bargaining process with the equityholders.
Berk, Stenton, and Zechner (2010) derive a firm’s optimal capital
structure and managerial compensation contract when employees are
averse to bearing their own human capital risk, while equityholders can
diversify this risk away. An important new empirical prediction is that
firms with more leverage should pay higher wages.

Capital Structure and Corporate/National Culture

Kreps (1990) argues that corporate culture is the result of transaction/
communication costs inside the firm. Hermalin (2001) argues that cor-
porate culture is an important determinant of corporate governance
and corporate finance. One prediction of this theory is that the capital
structure policy of a firm with a parent company can be explained by
the capital structure policy of the parent company, because they usually
have similar corporate cultures. This prediction finds some support in
Cronqvist, Low and Nilsson (2009). Another prediction of this theory is
that corporate culture can be more important for capital structure policy
in mature firms and bigger firms.

Lemmon, Roberts, and Zender (2008) argue that a major determinant

of capital structure is debt policy and more specifically debt structure
prior to the IPO. Firms with low leverage prior to their IPOs tend to have
low leverage subsequently and vice versa.
Bruer, Quiten, and Salzman (2015) analyze the relationship between
corporate debt choice (either bank or bond financing) and cultural value
types—in particular autonomy (countries that value freedom, creativ-
ity, broadmindedness, and curiosity) and embeddedness (countries that
value respect for tradition, social order, national security, reciprocation
of favors, self-discipline, wisdom, moderation, honoring of parents
and elders, preserving public image, obedience, devotion, forgiveness
and cleanliness). Referring to the importance of specific human capital
investments and individuals’ future orientation, the authors show that
 7  Capital Structure and Corporate Governance  155

firms in autonomy cultures tend to prefer bank finance, whereas firms in

embeddedness cultures show a preference for financing by issuing bonds.
Empirical evidence from 71 countries confirms the results.
Griffin and Li (2009) investigate the role of the managers’ countries of
origin in leverage decisions using data on foreign joint ventures in China.
It was found that national culture has significant explanatory power in the
financial leverage decisions of foreign joint ventures in China. Country-­
level variation is evident in capital structure and appears to work through
choices of firm characteristics, industry affiliation, ownership structure,
and region of investment.
Cao and Mauer (2010) investigate the effect of corporate culture on
capital structure policy. They find that cultural changes brought by new
CEOs have significant impacts on the continuation of firms’ existing
debt policies. Firms with a recent CEO replacement tend to switch their
debt policy. Firms that never change their debt policy over their history
have significantly fewer CEO turnovers than firms with policy changes,
which is consistent with the idea that new CEOs induce capital structure
changes.
Hilgen (2014) examines the impact of cultural clusters on the capital
structure decisions made by European retailers. The paper finds a sig-
nificant difference between the mean capital structures of the different
cultural clusters.
Overall links between capital structure and corporate/national culture
look like promising research areas.

Questions and Exercises

1. Consider a situation where a firm issues debt (with face value D) and
equity to raise B = 2 to invest. After funds are received the manager
should choose among two projects. Project j generates non-negative
earnings R j , j = 1, 2 . Rj is uniformly distributed. The support for R1 is
[0,5] and for R2 is [0,3]. If project 2 is chosen, the manager’s non-cash
or private benefit equals 0.5 and if project 1 is chosen it equals 0.2.
Official manager’s benefits equal zero for either project. If the firm is
bankrupt the manager’s total benefit is zero. For example, the manager
loses job and reputation, etc.
156  Capital Structure in the Modern World

(a) Show that under equity financing, the manager will choose inef-
ficient project.
(b) Find the condition under which debt financing can improve man-
agerial incentives. What is the minimal face value of debt that
satisfies this condition?
(c) What is the real value of debt found in part (b)?
(d) What fraction of investment will be financed by equity and what
by debt?

2. Consider a firm totally financed by equity. The firm’s founder/manager/

entrepreneur (E) is risk-neutral. Also the firm has an investment project
with cost b = 1 / 4 . The project’s expected first-period earnings r depend
on E’s effort e ∈[ 0,1] . The cost of effort is 2e2. Suppose that earnings
can have three values (all with equal probabilities): 0, 2e, and 4e.

(a) Find the first-best level of manager’s effort.

(b) Find the manager’s effort and optimal contract for the manager
under equity financing.
(c) Consider debt financing. Same question.
(d) What is the optimal financing strategy?

3. Consider a firm that has to make an investment that costs 19/32. The
firm’s owner/entrepreneur (E) needs external financing from an out-
side investor (I). E and I are risk-neutral. If the investment is made,
the firm generates earnings R1 in period 1 and R2 in period 2. R1 equals
1 with probability e and 0 otherwise. The cost of effort is e2. I cannot
observe e. E can be involved in EM after observing intermediate earn-
ings R10 and R20. So if R10 = 0 and E uses EM, the final first-period
earnings are R1 = R10 + s and the second-period earnings are
R2 = R20 + s − c , where c = 1 / 8 is the cost of EM. Show that financing
with short-term debt and some degree of earnings manipulation can
be better than financing with equity.
 7  Capital Structure and Corporate Governance  157

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 8
Capital Structure of Start-Up Firms
and Small Firms

8.1 Life Cycle Theory of Capital Structure

An interesting idea is to look at the importance of different factors affect-
ing the capital structure choice at different stages of a firm’s development
(so called “life cycle theory” of capital structure).1 For example, start-up
firms usually do not have much profit, so the tax advantage of debt is not
as important as it is for a mature firm. Likewise, start-up firms do not
usually need to provide strong incentives for managers since there is no
large separation between ownership and management as there is in big
public corporations. This leads to the idea that mature firms value debt
more than start-up firms do.
Factors affecting the capital structure choice in the early stages of a
firm’s development are flexibility (firms can lose flexibility if they have
too much debt (debt overhang)—Chap. 5), asymmetric information
(Chap. 3), costly managerial effort (Chap. 7), asset substitution (Chap. 5)
and some others. The extent of asymmetric information is large for start-
up firms especially for start-up innovative firms, implying difficulties in

 See, for example, Damodaran (2003).

1

© The Editor(s) (if applicable) and The Author(s) 2016 163

A. Miglo, Capital Structure in the Modern World,
DOI 10.1007/978-3-319-30713-8_8
164  Capital Structure in the Modern World

Capital
Structure Flexibility Flexibility Tax shield
Factors
Credit Bankruptcy Free cash Free cash
rationing Costs theory theory
More
important

Less Tax shield Tax shield Flexibility

important
Free cash
theory

Firm life cycle’s stages

Development/ Growth Maturity Decline

Start–up

Fig. 8.1  Capital structure ideas across a firm’s life cycle

r­aising bank financing and in issuing shares publicly. Since these firms
have a lot of choice, the asset substitution problem is important but only
if the firm has a lot of debt. The credit rationing phenomenon is also very
important for these firms. Although this was explained using the asset
substitution effect it can also be explained with asymmetric information
between lenders and borrowers.2
Most factors point to the preference of equity over debt for start-up
firms. For many years this was used as an explanation for why start-up
firms often use the capital of their firms’ founders and managers, or
“sweet” equity from friends and relatives, and why they have difficulties
using bank financing. Closer analyses of start-up entrepreneurial firms,
however, reveal that many firms use convertible securities for financing.
Jacob Demitt, in a December 2015 article, described an $8 million financ-
ing for Textio via series A funding.3 It was led by Emergence Capital, one of
the top software-as-a-service investors, known for backing companies like
 See, for example, Stiglitz and Weiss (1981) and Freixas and Rochet (1999).
2

 Demitt (December 16, 2015).

3
 8  Capital Structure of Start-Up Firms and Small Firms  165

Salesforce, Box, and Yammer. Textio was founded in 2014, after one of their
founders Snyder conducted research on gender bias in performance reviews
in the tech industry. Snyder is a linguistics expert who previously worked at
Amazon and Microsoft’s Bing unit. Co-founder and CTO Jensen Harris,
meanwhile, spent 16 years at Microsoft including stints running the user
experience teams for Outlook, Office, and Windows. The key to Textio’s
offering is the use of artificial intelligence to sift through job postings and
make recommendations for edits based on what kind of language is going
to appeal—or scare away—certain demographics. For instance, if you use
words like “manage a team” or “proven track record,” Texio says you’re going
to get more male applicants. Phrases like “passion for learning” and “develop
a team,” meanwhile, will attract more women. Wikipedia describes Series A
Preferred Stock as the first round of stock offered during the seed or early
stage round.4 Preferred stock is often convertible into common stock in cer-
tain cases such as an IPO or the sale of the company. Further in this chapter
we will consider a model that illustrates why a start-up firm may be interested
in using convertible securities.
Another issue in the financing of start-up and small firms is the revival
of debt financing. Emma Vins describes loan programs for start-ups.5
Debt financing for start-up and small companies is subject to credit
rationing, as we discussed in Chap. 4. Until recently, experts thought that
debt was not a major source of financing for start-up firms and instead
payed more attention to entrepreneurs own funds, venture funds, and
angel financing. In recent years the situation seems to have been chang-
ing. We will consider later why debt financing is important for start-up
firms and what the usage of debt signals about the firm’s quality.

8.2 Capital Structure of Venture Firms

Venture capital (VC) differs from other forms of finance because the
venture capitalist often provides management and commercial exper-
tise along with funds. The founder of a small firm has many functions

 http://www.investopedia.com/terms/s/seriesa.asp
4

 Vins (December 7, 2015).

5
166  Capital Structure in the Modern World

in managing the enterprise. In the growth enterprise, assistance may be

needed in management.
VC is usually provided to high risk ventures that provide potentially
higher returns than other investments. The company receives manage-
ment assistance through its development and often further injections of
funds until maturity, which is when the investor anticipates a capital gain
from the sale of the firm. This may take several years depending on where
the venture capitalist enters the firm’s growth cycle.
Below we develop a model that is able to generate predictions regard-
ing the optimal financing structure for venture firms, in particular the
usage of convertible securities.
Consider a firm that has to make an investment b = 5/16. The firm’s
owner/entrepreneur (E) needs external financing from an outside inves-
tor (I). In exchange for the investment I expects to receive 1/8 in period
1 and 3/16 (net of effort cost) in period 2. E and I are risk-neutral. If
the investment is made, the firm generates earnings R1 in period 1 and
R2 in period 2. R1 depends on E’s effort e ∈[ 0,1] . Similar to the case
from Chap. 7, R1 can have three values (all with equal probabilities): 0,
e and 2e. This implies ER1 = e . The cost of effort is e2. R2 depends on
E’s effort e1 ∈[ 0,1] and I’s effort e2 ∈[ 0,1] . R2 can also have three val-
ues (all with equal probabilities): 0, e1 + e2 and 2 (e1 + e2 ) . This implies
ER2 = e1 + e2 . The cost of efforts are ei2 , i = 1, 2 . The interpretation of this
condition is that in period 1 (start-up stage) the firm’s success mostly
depends on the entrepreneur’s effort while in the second stage both
the entrepreneur and the investor can contribute to the firm’s success.
The investor’s contribution may consist of management expertise, as we
discussed previously, or fundraisng help. It will be shown that financing
with convertible debt or convertible preferred equity can be better than
financing with equity or debt.
The sequence of events is as shown in Fig. 8.2.

Period 1
The first-best effort maximizes the firm’s value: e − e2 . Socially optimal
e* = 1 / 2. In the case of equity financing E will maximize ke − e2 , where
k is the fraction of equity that belongs to E. Optimal e ′ = k / 2 . For any
k < 1, e ′ < e* .
 8  Capital Structure of Start-Up Firms and Small Firms  167

Entrepreneur
Entrepreneur
and Investor
chooses the
choose their
level of effort in
A irm raises level of effort in
period 1. Period
inancing for an period 2. Period
1 earnings
investment 2 earnings
become known
project become known
and are
and are
distributed to
distributed to
claimholders
claimholders

Fig. 8.2  Sequence of events

E’s profit is then k2/4. To find the optimal contract, we have to find k that
will maximize E’s profit under the condition that the investor’s expected
profit is not less than b. This condition is e (1 − k ) = k (1 − k ) / 2 ≥ 1 / 8 . The
left side of the inequality reaches its maximum when k = 1 / 2 . In this
case, I’s expected payoff is 1/8. E’s expected payoff is k2/4. It is increasing
on k. Hence the optimal k is the largest value of k that satisfies I’s budget
constraint, i.e. 1/2. The optimal e = 1 / 4 and E’s expected payoff is 1/16.
Now consider debt financing. Two cases are possible. First, e < D
. In this case the manager maximizes 1 / 3 ( 2e − D ) − e2 . So the optimal
e = 1 / 3 . E’s expected payoff is 1 / 9 − 1 / 3D . Second, e > D . In this case
the manager maximizes 1 / 3 (e − D ) + 1 / 3 (2e − D ) − e2 . So the optimal
e = 1 / 2 . E’s expected payoff is 1 / 4 − 2 / 3D . By comparing the man-
ager’s payoffs in each case we find that if D < 5 / 12 the optimal e = 1 / 2
and otherwise e = 1 / 3 . Now to find D, note that the investor’s payoff
should be greater than b. So in the second case D = 3 / 2b . It is possible
only if b < 5 / 18 , which is our case. So the firm can be financed with debt
with face value 3/16. The manager’s profit, in this case, is 1/8.

Period 2
The first-best effort maximizes the firm’s value: e1 + e2 − e12 − e22 . Hence,
socially optimal e1* = e2* = 1 / 2. Under equity financing, E has a fraction k
of the firm’s equity. So E will maximize k (e1 + e2 ) − e12 . Optimal e1 ′ = k / 2 .
Similarly we find e2 ′ = (1 − k ) / 2.
168  Capital Structure in the Modern World

1 − k (1 − k )
2

I’s payoff equals (1 − k ) (e1 + e2 ) − e = 2

2 − . If k = 1 / 2 , it
2 4
equals 3/16. E’s payoff also equals 3/16.
Now consider debt financing. Two cases are possible. First,
e1 + e2 < D . In this case E maximizes 1 / 3 ( 2(e1 + e2 ) − D) − e12 . So
the optimal e1 = 1 / 3 . Second, e1 + e2 > D . In this case E maximizes
1 / 3 ( e1 + e2 − D ) + 1 / 3 ( 2(e1 + e2 ) − D) − e12 . So the optimal e1 = 1 / 2 . In
this case I’s payoff is 2/3D. So D equals 9/32. e2 = 0 so e1 + e2 > D .
Similarly to the way we did it in period 1, we can show that case 2 is bet-
ter for E. So the firm can be financed with debt with a face value of 9/32.
E’s profit is e1 + e2 − e12 − 3 / 16 = 1 / 16 in this case.

We can see that in period 2, equity is a better financing structure.

The optimal capital structure in this case is debt financing in period 1
and equity financing in period 2. It can also be interpreted as a convert-
ible debt or convertible preferred equity that is converted into common
equity in period 2.
Empirical literature in this field generally confirms that the entrepre-
neur has more control when the business is performing relatively well
while the degree of control is significantly reduced in favor of venture
capitalists when the opposite occurs. This literature also stresses that,
while in real financial contracts the allocation of cash flow rights plays
an important role, the parties involved usually make separate determina-
tions for the allocations of various kinds of property rights. These rights
include residual cash flow rights, liquidation rights, board rights, etc.
Moreover, there are significant quantitative differences between the per-
centages of different rights allotted to the parties.6
Recent literature also explained why, in many cases, investors hold
convertible securities and not simply debt. Examples include Berglof
(1994), Kalay and Zender (1997), Gompers (1998), Schmidt (2003),
Cornelli and Yoscha (2003), and Hellmann (2006).

6
 See, for instance, Kaplan and Stromberg (2003) and Elfenbein and Lerner (2003) with regard to
venture capital contracts and Gilson (1990) for corporate contracts.
 8  Capital Structure of Start-Up Firms and Small Firms  169

As was found in Kaplan and Stromberg (2003), convertible preferred

shares were used in 170 rounds and convertible preferred participating
shares were used in 82 rounds.7 These two are the most popular types
of securities used in combination with VC. In the early stages of a firm,
when risk is high, preferred shares (as opposite to common shares) can
mitigate risk for investors by promising a fixed dividend that does not
depend on the amount of profit. It may also be a flexible option for the
firm since in the event of insufficient profits the dividend can be cumula-
tive, i.e paid in later years. It also reduces the risk for investors because
preferred shares have priority over common shares in cases of liquidation.
Convertible preferred shares on the other hand allow investors to convert
shares into common shares if the business is developing successfully.
Cumming (2005) analyzes VC in the US and finds that the results are
consistent with the proposition that convertible preferred equity is the
optimal form of VC finance. The study also presents new evidence from
208 US VC financings of Canadian entrepreneurial firms. In contrast
to VC investments in US entrepreneurial firms, US venture capitalists
finance Canadian entrepreneurial firms with a variety of forms of finance.
The differences are attributable to the importance of institutional deter-
minants of venture capitalist capital structures within the US and abroad.
Among other things, the data indicates that US venture capitalists often
do not choose convertible preferred shares in the absence of tax consider-
ations in favor of that financing vehicle.
Among recent articles about venture capital, consider Tian’s (2011),
which shows that VC investors located farther away from an entrepreneur-
ial firm tend to finance the firm using a larger number of financing rounds,
shorter durations between successive rounds, and investing a smaller
amount in each round. However, VC investors’ propensity to stage is inde-
pendent of whether the firm is located in a close community. It also finds
that VC staging positively affects the entrepreneurial firm’s operating per-

7
 Convertible preferred stock: Preferred stock that can be converted at the shareholder’s discretion
into common stock. Participating convertible preferred stock: A type of preferred stock that gives
the holder the right to receive dividends equal to the normally specified rate that preferred divi-
dends receive as well as an additional dividend based on some predetermined condition.
http://www.investopedia.com/terms/c/convertiblepreferredstock.asp, http://www.investopedia.
com/terms/p/participating-convertible-preferred-share.asp
170  Capital Structure in the Modern World

formance in the initial public offering (IPO) year, and post-­IPO survival
rate, but only if the firm is located far away from the VC investor.
Talmor and Cuny (2005) analyze the choice between milestone financ-
ing and round financing when VC commits to future rounds upfront.
When the role of a venture capitalist’s effort is small, the incentivization
of the entrepreneur dominates the contractual relationship and round
financing is preferred to milestone financing. When it is the role of entre-
preneurial effort that is small, however, the need for contract flexibility
dominates, and milestone financing is preferred to round financing.
Häussler et al. (2012) develop a model where certification serves as a
signal about the quality of entrepreneurial firms. They derive and empiri-
cally test several hypotheses using a sample of British and German com-
panies that seek VC. They find that patent applications—as signals from
ventures—are positively related to VC financing. Moreover, applications
trigger institutionalized processes at the patent office, which can generate
valuable technological and commercial information via search reports,
citations and opposition procedures, and thus affect VC financing. The
results highlight the role of signaling, but additional information about
venture quality is generated via an institutionalized certification process.
Another recent trend in the financing of start-up firms is crowdfund-
ing. Crowdfunding is the practice of funding a start-up company or a
project by raising funds from a large number of people (“crowd”). It is
usually performed online.8 The concept can also be executed through
mail-order subscriptions, benefit events, and other methods. Moritz and
Block (2014) provide a review of the recent literature in this field.

8.3 Debt Financing for Small Businesses

Capital structure is one of the most important topics of corporate finance.
The vast majority of research has been focused on large public companies.
In recent years, however, the capital structure of small companies, espe-
cially start-ups, has been a quickly growing area of research.9

8
 See, for example, Schwienbacher and Larralde (2012).
9
 For a detailed discussion of reasons for that and the role of the Kauffmann Foundation see, for
example, Robb and Robinson (2012) and Cole and Sokolyk (2014).
 8  Capital Structure of Start-Up Firms and Small Firms  171

One of the issues that has been receiving a lot of attention is the usage
of debt by small companies (Robb and Robinson 2012; Cole and Sokolyk
2014). Some authors argue that recent findings about the importance of
outside (formal) debt for small companies are contradictory to common
opinion that small businesses, especially start-ups, rely heavily on internal
finance including the owner’s equity and funds from relatives and friends
(Robb and Robinson, 2012). Robb and Robinson (2012) also find that
the usage of outside debt by a start-up firm is indicative of its success a
few years after its creation. In particular, they find that firms that use
outside debt have better growth and have better chances of survival com-
pared to firms that do not use outside debt. Below we present a model
where entrepreneurs have a choice between outside debt, inside debt, and
the owner’s equity to finance their start-up firms.
Consider a set of entrepreneurs, indexed with j, with investment proj-
ects available. The projects require the same amount of external financing
equal to 1. In the case of success, a project generates a cash flow Fj and
a cash flow of zero otherwise. The probability of success is pj. There are
three types of financing available for the project. Full financing for the
project can be obtained via outside debt (OD). It is assumed that each
entrepreneur has collateral valued 1. Alternatively, the entrepreneur can
use inside debt (ID). Here, an entrepreneur borrows an amount β , β ≤ 1
from a friend or relative. If the project succeeds, the earnings are βFj.
Finally, the entrepreneur can use inside equity (IE).10 An entrepreneur
has an amount α available to finance the firm, α < β . If the project
­succeeds, the earnings are αFj. Fj and pj are private information for each
entrepreneur. Entrepreneurs and investors are risk-neutral.
In this model the entrepreneurs’ choices of financing for their start-up
firms are based on the following trade-off. Entrepreneurs who do not use
OD are facing greater financial constraints during the first years of their
businesses. On the other hand the providers of OD have more experience
in enforcing debt payments compared to the providers of ID. Asymmetric
information between the entrepreneurs and the capital providers plays a
very important role in start-up firms, which affects the details of negotia-
tions including interest rates on loans and collateral. Robb and Robinson
10
 Outside equity is ruled out. It does constitute a relatively small fraction of small firms’ capital
structure. Seven times as many firms report outside debt as report outside equity (Robb and
Robinson 2012).
172  Capital Structure in the Modern World

(2012) mentioned that outside debt providers, like banks, are more expe-
rienced in terms of controlling collaterals and enforcing debt contracts
(both for firms with unlimited liability and firms with limited liability)
compared to friends and relatives. Even if the firm is formally created as a
firm with limited liability, financing for start-ups often circumvents lim-
ited liability and requires personal guarantees from entrepreneurs. Often
entrepreneurs own levered equity in their firms. They borrow on their
own behalf and then invest in their start-up firms. If the firm fails, the
entrepreneur can lose a large part of the wealth that he or she pledged as
collateral.
We argue that in equilibrium entrepreneurs with business credit have
higher success rates and greater revenues than other firms. This is consis-
tent with empirical evidence.

Choice of Financing
We have the following set of equations that determine an equilibrium.
The choice between ID (the face value is D) and IE is given by:

p j ( β Fj − D ) = α p j Fj − α (8.1)

The left side of (8.1) shows the entrepreneur’s expected earnings for
ID. The probability of success is multiplied by the net earnings in the case
of success. The right side shows the entrepreneur’s expected earnings for
IE. The firm’s expected revenues are reduced by the amount of the initial
investment. Equation (8.1) can be rewritten as:

−α
pj = (8.2)
β Fj − D − α Fj

For marginal entrepreneurs (marginal entrepreneurs’ proj-

∂p j α (β − α )
ects satisfy (8.2) we have: = >0. Also:
∂Fj (β F − D − α Fj )
2
j
2α ( β − α )
2
∂2 p j
= > 0.
(β F − D − α Fj )
3
∂Fj 2
j
 8  Capital Structure of Start-Up Firms and Small Firms  173

If an entrepreneur’s project satisfies (8.1) he is indifferent between ID

and IE.
The choice between ID and OD (the face value is D') is given by:

p j ( β Fj − D ) = p j ( Fj − D′ ) − (1 − p j )

This equation can be rewritten as:

−1 (8.3)
pj =
β Fj − D + D′ − 1 − Fj

∂p j − (1 − β )
We have = >0 and
∂Fj (β F − D + D′ − 1 − Fj )
2
j

2 (1 − β )
2
∂2 p j
= > 0.
∂Fj 2 (β F − D + D′ − 1 − Fj )
3
j

Finally, the choice between OD and IE is given by:

p j ( Fj − D′ ) − (1 − p j ) = α p j Fj − α

This equation can be rewritten as:

1−α
pj = (8.4)
Fj − D′ + 1 − α Fj

− (1 − α )
2
∂p j
We have: = >0. Also:
(F − D′ + 1 − α Fj )
2
∂Fj
j

2 (1 − α )
2
∂2 p j
= >0.
(F − D′ + 1 − α Fj )
3
∂Fj 2
j
174  Capital Structure in the Modern World

The analysis of (8.2), (8.3), and (8.4) reveals that the marginal entre-
preneur with Fj = F * and p j = p* is indifferent between every type of
financing where

− D + α D − α D′ + α
F* = (8.5)
− β + αβ

and

− β + αβ
p* = (8.6)
− D + α D + β D′ − α D′ − β + α

We can also check that the slope of (8.4) is larger than that of (8.3).
Figure 8.3 illustrates the equilibrium decision-making for the entrepre-
neurs. The thick lines represent equations (8.2), (8.3), and (8.4). Letters
IE, OD, and ID denote the areas where the entrepreneurs choose the
internal equity, the outside debt, or the inside debt respectively.
From Fig. 8.3, entrepreneurs with OD have a higher probability of suc-
cess for any value of Fj compared to entrepreneurs with IE and ID. Also,

Fig. 8.3  The choice of financing

 8  Capital Structure of Start-Up Firms and Small Firms  175

entrepreneurs with OD have a higher Fj for any value of pj compared to

entrepreneurs with IE and ID.11
From recent literature we know that 75 % of firms use some type of
credit at the firm’s start-up.12 We also know, from empirical literature in
the field, that the role of outside debt for start-up firms is underestimated
in the theory. Our model suggests that, in equilibrium, entrepreneurs
with business credit have higher success rates and greater revenues than
other firms. This is consistent with the empirical evidence. Our model
also shows that the decision to use debt at the firm’s start-up matters for
the critical subsequent firm outcomes of survival and growth.
A start-up’s first three years in operation are critical to its survival and
performance. A better understanding of what types of firms use credit
can help policymakers take action to increase the availability of credit to
start-up firms, which will potentially lead to the creation of more jobs
and faster economic growth. According to our model, firms that use
outside debt have a better survival potential and more growth oppor-
tunities. Also, firms that use internal debt overinvest. So creating more
organizations interested in providing loans for start-up firms will reduce
the extent of asymmetric information between entrepreneurs and lenders
and potentially reduce distortions in the market for start-up financing
(we discussed an example at the beginning of the chapter). Secondly,
the government can increase taxes on firms using internal debt. This will
reduce overinvestment in this group. This can be a part of a tax reform
proposal.
In our model, good quality firms prefer debt to internal funds. This
is opposite to public companies. The pecking-order theory predicts that
firms will prefer internal funds to avoid any asymmetric information
problems. This order is different for small firms where collateral, includ-
ing entrepreneurs’ own wealth, plays an important role. These firms are

 The fact that equations (2), (3) and (4) have discontinuities does not affect this result. For example,
11

the line corresponding to equation (2) has a discontinuity in Fj = D / ( β − α ) . But the continua-
tion of this line after the disconnection lies below p j = 0 . So in the area above this line
­entrepreneurs prefer ID to IE.
12
 Cole and Sokolyk (2014).
176  Capital Structure in the Modern World

often created with unlimited liability. Using outside debt sends a strong
message about a firm’s quality.
Several strands of the existing literature discuss related problems. First
is the literature on debt financing of privately held firms (see, e.g. Ang
(1992), Berger and Udell (1998), Cole (2013), Brav (2009), Ang et al.
(2010), Robb and Robinson (2012), Cole (2013)). Secondly, the growing
literature that analyzes start-up firms using data from the Kauffman Firm
Surveys (see, e.g., Coleman and Robb (2009), Fairlie and Robb (2009),
Cole (2011), Coleman and Robb (2012), Robb and Watson (2012), and
Robb and Robinson (2012)). Thirdly, capital structure choice literature
that is based on asymmetric information (see, e.g., mentioned in Chap. 3
Myers and Majluf (1984); also DeMeza and Webb (1987), and Boadway
and Keen (2005)). Finally, the literature that analyzes the role of unlim-
ited liability in entrepreneurs’ decision-making (see, e.g., Becker and
Fuest (2007), Miglo (2007)).
Stiglitz and Weiss (1981) and de Meza and Webb (1987) focus on debt
financing under asymmetric information. They predict that when inter-
mediaries are unable to distinguish between high and low quality new
investment projects, they make an inefficient volume of loans. This may
create the possibility of welfare-improving interventions even by a gov-
ernment that is no better informed than the intermediaries themselves.
Boadway and Keen (2005) argue that the assumptions are too restrictive
in both of those papers (in terms of revenue distributions) which, on the
one hand leads to opposite predictions (too many loans vs. too few loans)
and on the other hand does not help understand the capital structure
choice. Internal funds are not a part of their models. They also lack the
other features of financing relating to small business.
There is also literature on the difference between firms with limited
liability and unlimited liability. To the best of our knowledge, there is no
paper that predicts that either type has a natural advantage in terms of
signaling the firm’s quality or survival opportunities. Some papers address
the issues close to ours. For example, Becker and Fuest (2007) and Miglo
(2007) use the asymmetric information framework to explain the link
between the limited liability/unlimited liability choice and corporate
taxation in situations when entrepreneurs can offset potential losses and
when asymmetric information exists regarding projects’ qualities.
 8  Capital Structure of Start-Up Firms and Small Firms  177

Cole (2010) looks at data from the 1993, 1998, and 2003 SSBFs to
provide evidence about the types of firms that use the different types of
credit: trade credit, bank credit, both, or no credit. Only about one in
five firms use no credit and finance assets with 100 % equity. Robb and
Robinson (2012) use data from the Kauffman Firm Surveys to docu-
ment that newly founded firms rely heavily on formal debt financing
rather than on informal funding from friends and family. They document
that, contrary to the widely held view about entrepreneurial finance, the
largest part of total financial capital comes from outsiders’ debt. Cole
and Sokolyk (2014) confirm the importance of outside (formal) debt for
small companies. Robb and Robinson (2012) also find that firms that
use outside debt have better growth and chances of survival compared to
firms that do not.

Questions and Exercises

1. Consider a firm that has to make an investment b = 1 / 4 . The firm’s
owner/entrepreneur (E) needs external financing from an outside
investor (I). In exchange for the investment I expects to receive 1/4 in
period 1 and 3/8 (net of effort cost) in period 2. E and I are risk-­
neutral. If the investment is made, the firm generates earnings R1 in
period 1 and R2 in period 2. R1 depend on E’s effort e ∈[ 0,1] . R1 can
have three values (all with equal probabilities): 0, 2e and 4e. The cost
of effort is 2e2. R2 depends on E’s effort e1 ∈[ 0,1] and I’s effort e2 ∈[ 0,1] .
R2 can also have three values (all with equal probabilities): 0, e1 + e2
and 2 (e1 + e2 ) . It implies ER2 = e1 + e2 . The cost of efforts is ei2 , i = 1, 2 .
Suppose that the investor’s claim in each period can have either a form
of debt or equity. Show that the outcome exists when the investor
holds debt in period 1 and equity in period 2.

(a) Find the first-best in period 1.

(b) Find the optimal contract in the case of equity financing in
period 1.
(c) Now consider debt financing. Same question.
(d) Compare debt and equity financing.
(e-h) Repeat questions a-d for period 2.
(j) Provide an interpretation of your results.
178  Capital Structure in the Modern World

2. Consider a set of entrepreneurs, indexed by j, with investment proj-

ects available. Projects require the same amount of external financing
equal to 1. In the case of success a project generates a cash flow Fj and
a cash flow of zero otherwise. The probability of success is pj. There are
three types of financing available for the project. A full financing for
the project can be obtained with an outside debt (OD). It is assumed
that each entrepreneur has collateral, equal to 0.3. Alternatively, the
entrepreneur can use an inside debt (ID). Here, an entrepreneur bor-
rows an amount 0.5 from a friend or relative. If the project succeeds,
the earnings are 0.5Fj. Finally, the entrepreneur can use inside equity
(IE). An entrepreneur has an amount 0.3 available for financing the
firm. If the project succeeds, the earnings are 0.3Fj. Fj and pj are each
entrepreneur’s private information. Entrepreneurs and investors are
risk-neutral.

(a) Find equations describing equilibrium. Show them graphically.

(b) On the graph, show the areas of underinvestment and overinvest-
ment. How can tax policy help to mitigate these problems?

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Ang, J., Cole, R., & Lawson, J. (2010). The role of owner in capital structure
decisions: An analysis of single-owner corporations. Journal of Entrepreneurial
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Becker, J., & Fuest, C. (2007). Why is there corporate taxation? The role of
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 9
Corporate Capital Structure vs. Project
Financing

9.1 Introduction
This chapter discusses project finance. From my experience, when speak-
ing about project finance people think about different things. Often they
are confused because they do not understand why project finance should
be discussed as a separate topic since it is, seemingly, a part of almost
every other topic including general topics like investments, net present
value, etc. We will learn in this chapter that project financing has a very
special meaning in finance and is often related to terms like non-recourse
debt, limited recourse debt, asset-backed securities, and many others. To
begin, let us note that project financing has been used in many important
projects around the globe including many historical projects. Below we
will review some of them.
Lyonett du Moutier (2010) describes the famous Eiffel Tower construc-
tion, which was the world’s tallest structure at its completion in 1889.
Apparently, a project finance model was used. Public authorities awarded
a concession to the project’s private sponsor. The sponsor was financing it
with equity and limited-recourse debt. Lyonett (2010) a­ nalyzes how spe-

© The Editor(s) (if applicable) and The Author(s) 2016 183

A. Miglo, Capital Structure in the Modern World,
DOI 10.1007/978-3-319-30713-8_9
184  Capital Structure in the Modern World

cific provisions in the Eiffel Tower project contracts helped reduce agency
costs, which are often very substantial in large projects.
The World Bank’s project finance and guarantees group describes on
its website (2005) the development of the Nam Theun 2 hydropower
project.1 Since 1995, it has been a top priority for the Government of
Laos. Electricité de France of France, Italian-Thai Development Public
Company Limited of Thailand, and Electricity Generating Public
Company Limited of Thailand sponsored the project. It is the largest ever
foreign investment in Laos, the world’s largest private sector cross-border
power project financing, the largest private sector hydroelectric project
financing, and one of the largest internationally financed projects in Asia.
The project has been structured as a limited recourse financing which,
the article argues, allows for an efficient allocation of multiple risks that
are usually involved in large construction projects including completion
risk, commercial and political risks, geological risk, and risk of timely and
within budget completion.
In a December 2015 article by Matthew Amlôt we find that the
National Central Cooling Company PJSC (Tabreed) announced its
completion of the signing of an AED 192.5 million long-term limited
recourse project finance facility with Emirates NBD for the district cool-
ing plant it is developing for Dubai Parks and Resorts.2 Jasim Husain
Thabet, Tabreed’s Chief Executive Officer, said, “Tabreed’s approach to
financing new projects is to utilize long-term project financing wherever
possible which we believe is the best way of financing our assets and max-
imizing value for all stakeholders. This loan facility with Emirates NBD
is a landmark deal as it is amongst the first district cooling transactions
completed in the UAE under a limited recourse project finance structure
for a Greenfield development.”
In 2004, project financing in the United States made up 10–15 % of
total capital investment.3 In 2007 the total volume of project financ-

1
 http://siteresources.worldbank.org/INTGUARANTEES/Resources/Lao_NamTheun2_Note.pdf
2
 Amlôt (December 16, 2015).
3
 Esty (2004).
 9  Corporate Capital Structure vs. Project Financing  185

ing reached 44,476.30 billion (Gardner and Wright 2012). According

to Corielli, Gatti, and Steffanoni (2010), the compound annual growth
rates across all global markets from 1994 to 2006 were 23 % for project
finance bank loans and 15 % for project finance bond issuances. Such
outstanding growth trends are also found by other authors (Kleimeier
and Versteeg 2010). With its rapid growth, project finance became one
of the most important sources of finance in the financial market. Even
the global financial crisis of 2008 has had a less harmful effect on project
finance transactions than on syndicated loans as a whole. To be precise,
the global lending volume of syndicated loans decreased by 44 % com-
pared to 2007. At the same time, the amount of project finance transac-
tions declined by only 10 % and is still signaling promising growth trends
(Bonetti et al. 2010).
While project financing has had a long history dating back to Roman
times, the 1980s saw the emergence of project financing as a popular
capital structure choice. More recently, it has become a global phenom-
enon spreading not only to developed countries but to less developed
countries as well. In 1985, project financing was used in approximately
80 countries. In 2003, this number increased by 75 % to 140 coun-
tries.4 According to Standard & Poor’s predictions, presented at the
20th Annual Project Finance Hot Topics Conference (November 1,
2011), the following 20 years should present a tremendous change in
the composition of project finance deals. Among the main reasons for
those changes are increasing privatization processes and the urge for
enormous investments into infrastructure development in low income
countries.
Generally speaking, project financing is the financing of a project by
a sponsoring firm, where the cash flows of the specific project are desig-
nated as the source of funds to repay the loan. The project is incorporated
as a separate legal entity, and the assets and cash flows are segregated
from those of the sponsoring firm. The firm repays this new entity’s debt
obligations solely from the cash flow generated by the operation of the
project.

 Hainz and Kleimeier (2012).

4
186  Capital Structure in the Modern World

In this sense, the debt of a project-financed venture is known as

“non-­recourse” debt because the creditors have no recourse to the
assets of the parent company. If, on the other hand, a firm jointly
incorporates the new project and issues standard corporate debt to
raise the initial investment cost, the lenders will usually have first
recourse to any assets generated by the entire company. These are not
necessarily attributable to the returns on the new project itself. Non-
recourse debt allows the firm’s managers to “protect” the remaining
assets of the firm because the lender is only entitled to the assets of the
project-financed company.
The theories discussed in this chapter differ in their explanation of
the use of project financing. They look to agency costs, asymmetric
information, or corporate control considerations as the primary rea-
sons to use project financing. The models that focus on agency costs
look primarily at how separating the debt claims of old and new credi-
tors leave shareholders’ payoffs unaltered and thus reduce the agency
costs of underinvestment or overinvestment. The models that look
at asymmetric information look primarily at the lack of information
for investors and how project financing may signal information to
investors and mitigate the mis-evaluation of securities issued by the
firm.
Existing empirical literature has discovered the following stylized
facts (Esty 2003; Kleimeier and Megginson 2001): (i) project compa-
nies are characterized by high capital expenditures, long loan periods,
and uncertain revenue streams; (ii) project companies use very high
leverage compared to corporate financed companies; (iii) project com-
panies have very concentrated debt and equity ownership with debt
being non-recourse to the sponsoring companies; (iv) project finance
requires finance executives to disclose more propriety information than
they would have to disclose under corporate finance; (v) structuring a
project finance company legally, rather than financing the project as
part of the corporate balance sheet, is more expensive and takes much
more time.
 9  Corporate Capital Structure vs. Project Financing  187

9.2 Moral Hazard Models

The central concept around which most discussions on the optimality of
project financing have been developed is the underinvestment problem.
As Myers (1977) argues, the latter can arise because of, for instance, a
debt overhang (see Chap. 5). Theoretical papers that will be discussed in
this section show that project financing can both solve underinvestment
problems and prevent them from arising.
Berkovitch and Kim (1990) look at moral hazard problems and exam-
ine how project financing works to effectively overcome the underinvest-
ment incentives of entrepreneurs. They develop a theoretical model with
the primary goal of investigating the effects of seniority rules and restric-
tive covenants on the incentives associated with risky debt.
Berkovitch and Kim’s model is set up as a two-period model. An invest-
ment project is undertaken in the first period by issuing debt. A firm’s
managers will decide whether to accept or reject the new project in the
second period. Berkovitch and Kim show the presence of underinvest-
ment incentives by examining the effect that the new project will have
on the market value of the old debt. When cash flows from a new project
accrue to existing creditors, as opposed to shareholders, the market value
of the old debt increases. This causes the shareholders to reject the project.
By using project financing, the firm separates the new investment from
its current assets, as well as the current debt obligations, and removes the
underinvestment problem because old creditors do not accrue any ben-
efits and there are no wealth transfers.
The following illustrates Berkovitch and Kim’s main insights into proj-
ect financing. There are two dates ( t = 0,1 ). The interest rate is equal to 0.
Suppose a firm owns the following project (project-in-place). At t = 1 , cash
flow from the project depends on the state of nature. In the good state G
(that occurs with probability p1) it equals R1 > 0 . In state B (bad state) it
equals R2 , R1 > R2. At t = 0, the firm is given the opportunity to make an
investment K, which generates C1 > 0 in state G and C2 in state B, C1 > C2
. This investment has a positive NPV, i.e.

p1C1 + (1 − p1 ) C2 − K > 0 (9.1)

188  Capital Structure in the Modern World

A irm with
debt and
Shareholders
assets-in-place
decide whether
receives
to accept or
information
reject the
about a new
project
investment
opportunity

If the project is
accepted, the Earnings are
irm issues realized and
new debt to distributed to
inance the claimholders
project

Fig. 9.1  Sequence of events

The firm issued senior debt with total amount D such that

R1 + C1 > D > R2 + C2
(9.2)

This means that in the good state the project’s payoff exceeds the
amount of debt but not in the bad state. The sequence of events is as in
Fig. 9.1.

Proposition 9.1  The usage of project financing (non-recourse debt) can

solve a debt overhang problem.

Without the new project the shareholders’ expected profit is

p1 ( R1 − D )
(9.3)

If the firm invests in the new project, the shareholders’ expected profit
is: p1 ( R1 + C1 − D ) − K . This is equal to the firm’s expected cash flow (the
total earnings in state G reduced by the payment to the senior creditors
 9  Corporate Capital Structure vs. Project Financing  189

multiplied by the probability of success) minus the payment to the new

outside investors. Whether the financing of the new project is done using
junior debt or equity, the expected payment to the investors should be
equal to the cost of the investment. Comparing the shareholders’ payoff
without the investment and with the investment we find that the firm
will invest if p1C1 − K > 0 .
If p1C1 − K < 0 the new project (even though it has a positive NPV) will
not be undertaken. This is similar to the debt overhang problem because
the presence of existing risky claims reduces the incentive for existing
shareholders to invest in that project because it increases the value of the
existing debt and not the value of shares, which is the essence of the debt
overhang problem.
Now suppose that the firm uses project financing (non-recourse debt).
In this case, the debtholders’ payoffs depend only on the returns from the
new project and not on the returns from the assets already in place. The
face value d can be found from:

K = d p1 + (1 − p1 ) C2 (9.4)

If B is realized, the debtholders get the cash flow from the new proj-
ect (C2). The shareholders’ expected payoff (note that the shareholders
get nothing if B is realized) is: p1 ( C1 − d + R1 − D ). This is greater than
(9.3) because it follows from (9.1) and (9.4) that d < C1. Hence, the
­shareholders’ payoff with the new project is higher than it is without
it. So the project will be undertaken and it will be financed with non-
recourse debt.
The second situation is based on overinvestment: the shareholder’s
incentive to invest in negative NPV projects (similar to the asset substitu-
tion effect from Chap. 4). Consider the same firm with assets in place,
as described previously. This time, assume that the firm has a senior debt
with a face value

D > R1 (9.5)

The new project reduces the probability of G occurring by Δp. Also

assume that C2 = 0 and
190  Capital Structure in the Modern World

∆pR2 − ∆pR1 + ( p1 − ∆p ) C1 < K (9.6)

This implies that the change in the firm’s expected earnings (left side of
this inequality) is less than the amount of the investment, which means
that the new project has a negative NPV.

Proposition 9.2  The usage of project financing can solve overinvestment

problems.
Suppose that to finance the new project the firm issues a standard
subordinated debt. Assuming risk neutrality and a risk-free interest rate
of zero, the face value, d’, of this debt can be found from the following
equation: K = d ′ ( p1 − ∆p ) + (1 − p1 + ∆p ) ( 0 ). This means that if G is real-
ized, the new debtholders will receive the face value of the debt; if, how-
ever, B is realized, the firm’s cash flow will be R2 + C2 , which (as follows
from 9.4)) is less than the face value of the senior debt D, leaving the new
creditors with nothing.
The shareholders’ expected payoff without the new investment is 0.
They get nothing even in state G as follows from 9.5). With the new
project, it will be ( p1 − ∆p ) ( R1 + C1 − D − d ′ ) . In some cases it is positive
(see an example below) so, the project can be undertaken even when its
NPV is negative.
Now suppose that the firm uses project financing. In this case, the
debtholders’ payoffs depend only on the returns from the new project
and not on the returns from the assets already in place. Since the NPV is
negative, the firm will not be able to finance the project.
To summarize our analysis of these two cases. Without the ability to
issue non-recourse debt the firm is not able to solve the debt overhang
problem. Secondly, by issuing subordinated debt the firm will be able to
invest in projects with negative NPVs to the expense of the firm’s overall
value. Setting a new project as a new independent project and issuing
non-recourse debt will eliminate the incentive to invest in projects with
negative NPVs. Project financing, or financing with non-recourse debt,
can also help other agency problems related to debt financing. It will also
help to solve free cash flow or empire-building problems (Chap. 7). This
is especially important for large projects with potentially large amounts
 9  Corporate Capital Structure vs. Project Financing  191

of cash. Finally, it can also help increase managerial incentives (Chap. 7)

compared to only equity financing.

Example 9.1
Consider a firm with assets in place, an investment opportunity avail-
able, and outstanding senior debt with a face value of D = 5000. Existing
assets can produce: 8000  in state G (good state) with probability 1/2
and 3000 in state B with probability 1/2. The new project requires an
initial investment of 1500, and the firm will finance this investment by
issuing new debt. A new project’s cost is 1500. The new project generates
2200 in state G and 1000 in state B.
First note that the new project has a positive net present value (NPV)
because 1 / 2 ∗ 1000 + 1 / 2 ∗ 2200 > 1500 . Now suppose that to finance the
new project the firm issues a standard subordinated debt. The face value,
d’, of this debt can be found from the following equation:

1500 = d′ * 1 / 2 + 1 / 2 * 0

Therefore d′ = 3000. The shareholders’ expected payoff without the

new investment is 1 / 2 ∗ ( 8000 − D) = 1500. With the new project, it
will be 1 / 2 ∗ ( 8000 + 2200 − D − d′ ) = 1100. Since the expected payoff
­without the new project is more than that with the project, it will not
be undertaken.
Now suppose that the firm uses project financing (non-recourse debt).
The face value d can be found from:

1500 = d ∗ 1 / 2 + 1 / 2 ∗ 1000

Here d = 2000 . The shareholders’ expected payoff (note that the share-
holders get nothing if B is realized) is: 1 / 2 * ( 8000 − D + 2200 − d ) = 1600.
This is greater than 1500 (the shareholders’ expected payoff without the
new investment), and thus the project will be undertaken and it will be
financed with non-recourse debt.
Now assume that the firm (with the same initial project) has a senior debt
with a face value of D = 10, 000. The new project requires an initial invest-
192  Capital Structure in the Modern World

ment of 100. The new project generates 4000 in state G and 0 in state B but
reduces the probability of G occurring by 30 %. Note that the new proj-
ect has a negative NPV because 0.3 ∗ 3000 − 0.3 ∗ 8000 + 0.2 ∗ 4000 < 100
(see condition 9.6)).
Suppose that to finance the new project the firm issues a standard
subordinated debt. The face value, d’, of this debt can be found from the
following equation:

100 = d ′ * 0.2 + 0.8 * 0 (9.7)

This means that if G is realized, the new debtholders will receive the
face value of the debt; if, however, B is realized, the firm’s cash flow is
3000 + 1000 = 4000 , which is less than the face value of the senior debt,
leaving the new creditors with nothing. From 9.7), d ′ = 500 .
The shareholders’ expected payoff without the new investment is 0.
With the new project, it will be 0.2 ∗ (12, 000 − 10, 000 − 500 ) = 300 . Since
the expected payoff with the new project is more than that without the
project, it will be undertaken.
Now suppose that the firm uses project financing (non-recourse debt).
In this case, the debtholders’ payoffs depend only on the returns from the
new project and not on the returns from the assets already in place. Since
the NPV is negative, the firm will not able to finance the project.
John and John (1991) analyze project financing in the context of the
underinvestment problem in the spirit of Myers (1977). They also take
taxes into consideration. It is shown that a project financing arrange-
ment, where the debt is optimally allocated to the sponsor firm and the
new venture, increases the project’s value by reducing agency costs and
increasing the value of the tax shields (compared to the case of straight
debt financing).
There are several empirical papers that look for the existence of proj-
ect financing in capital structure and how it has worked to mitigate the
moral hazard problem.
For instance, Kensinger and Martin (1988) noted that because of
the number of large capital expenditures businesses are making, moral
 9  Corporate Capital Structure vs. Project Financing  193

hazard dilemmas are of paramount concern. Project financing helps

reduce agency costs, particularly by reducing underinvestment incentives.
Kensinger and Martin (1988) also noted that project finance could play
a role in a company’s restructuring because it pushes companies toward
greater specialization and decentralization. Similarly, project finance has
the power to act as a catalyst for a change in the governance of business
activities because it allows companies to segregate cash flows from newly
adopted projects; this protects both the sponsoring firm and the manag-
ers from defaulting on it.
Esty (2003) observes that in the United States, the majority of proj-
ect financed ventures can be seen in the natural resource and infrastruc-
tural development sectors. Project financing is being used to fund power
plants, toll roads, mines, pipelines, telecommunications systems and
developments in the oil and gas sectors. These large investment projects
with tangible assets are very susceptible to agency conflicts because of
the number of people who are involved. Project companies help deter
opportunistic behavior.
Brealey, Cooper, and Habib (1996) also credit the growing impor-
tance of project financing in infrastructure to its ability to mitigate some
agency problems. Contractual and financing arrangements that project
financing can offer are very important; their importance is magnified in
infrastructure projects because of their scope, duration, and implications
for so many people.
Hainz and Kleimeier (2006) develop a double moral hazard (an effort
by a bank and an effort by a firm) model in which the bank’s incentive
to mitigate risk is highest with a non-recourse project finance loan, while
full-recourse loans are best for the firm. It is suggested that the use of
project finance increases with both the political risk of the country in
which the project is located and the lender’s influence over this political
risk exposure. Furthermore, the use of project finance should decrease
as the economic health and corporate governance provisions of the bor-
rower’s home country improve.
194  Capital Structure in the Modern World

9.3 Asymmetric Information Models

This section demonstrates that project financing can help solve asym-
metric information problems in finance. As Chap. 3 argued, asymmet-
ric information between a firm’s insiders and outsiders can create several
problems for the firm. Good quality firms may not be able to efficiently
signal the quality of their projects and thus their stocks may become
undervalued. Also, asymmetric information problems are perhaps the
reason that firms refuse to invest in projects with positive NPVs.
We first demonstrate that project financing can help high quality firms
signal their quality. Brennan and Kraus (1987) show that an efficient
separating equilibrium in a financing game, where firms have private
information about their future cash flows, is impossible if cash flows are
ordered by the first-order dominance condition. Therefore under every
type of equilibria, issuing securities will be costly.
To illustrate the Brennan and Kraus (1987) idea, consider a company
that is raising funds for an investment project. The investment cost is
B. There are two types of firms. A type j firm’s earnings are denoted Rj,
j = 1, 2 . R1 is distributed according to the distribution function F and
the density function f and R2 is distributed according to the distribution
function G and the density function g. A firm’s type is not known to the
public.
The timing of events in this situation is as shown in Fig. 9.2.
Suppose type 1’s earnings first-order dominate type 2’s earnings.
Suppose type j issues a security that can be described as sj(R), i.e. when
the firm’s earnings are R, the security holder will get s(R). An efficient
signaling equilibrium is when every type of firm receives their first-best
value in equilibrium and no firm has any incentive to deviate from its
equilibrium strategy or mimic another type.

Proposition 9.3  If Project 1’s cash flow distribution first-order dominates

Project 2’s cash flows and sj(R) is non-decreasing, an efficient signaling equi-
librium does not exist.

The shareholders’ payoff is R − s ( R ) when a firm’s earnings equal R.

Suppose that an efficient signaling equilibrium exists. In this case each
 9  Corporate Capital Structure vs. Project Financing  195

A irm's type
Earnings are
is detrmined. Securities
realized and
The irm are sold to
distributed
chooses its outside
to
capital investors
claimholders
structure

Fig. 9.2  Sequence of events

type gets their first-best value (expected earnings from the project minus
the investment cost). So for type 1 it is ER1 − B and for type 2 it is ER2 − B .
Consider a type 2 firm mimicking a type 1. The difference between the
shareholders’ expected payoff in this case and their equilibrium payoff is

∞ ∞ ∞
∆T = ∫ ( R − s ( R ) ) g ( R ) dR − ∫ ( R − s ( R ) ) g ( R ) dR = ∫ ( s ( R ) − s ( R ) )
−∞
1
−∞
2
−∞
2 1

g ( R ) dP

∞ ∞
We also know that
∫ s1 ( R ) f ( R ) dR = B and
−∞
∫ s ( R ) g ( R ) dR = B.
−∞
2

∞ ∞
We will show that ∆T > 0 or that ∫ s1 ( R ) g ( R ) dR < ∫ s ( R ) f ( R ) dR = B.
1
−∞ −∞
∞

Consider ∫ s ( R ) ( f ( R ) − g ( R ) ) dR.
−∞
1

Let v = s1 ( R ) and du = ( f ( R ) − g ( R ) ) dR . Then

∞
∆T = s1 ( R ) ( G ( R ) − F ( R ) ) |∞−∞ − ∫ s1′ ( R ) ( F ( R ) − G ( R ) ) dR
−∞
∞

= ∫ s1 ( R ) ( G ( R ) − F ( R ) ) dR
′

−∞

This is positive since s1′ ( R ) ≥ 0 and G ( R ) ≥ F ( R ) for any R.

Brennan and Kraus (1987: 1227) assume that a firm’s cash flow is indi-
visible. Below we show that when cash flow is divided into two parts (two
196  Capital Structure in the Modern World

projects) and firms are allowed to issue securities with the projects’ con-
tingent payoffs rather than only with total cash flows contingent payoffs,
a separation may exist even if the firm’s total cash flows are ordered by
the first-order dominance condition. Possible interpretations are project
financing or financing with non-recourse debt, issuing asset-backed secu-
rities, and firms’ spin-offs. In all of these cases the firm creates securities
that represent claims on specific projects (assets).
To illustrate the idea, consider the following example. A firm has two
projects available, k = 1, 2. The return of project k is Rk. The project’s suc-
cess depends on the firm’s type j, j = h, l. Rk equals 1 with probability θkj
and equals 0 otherwise.
As in Brennan and Kraus, Rh first-order dominates Rl, which means
that the probability that Rh = 0 is less than the probability of Rl = 0 and
that the probability that Rh equals 0 or 1 is less than that of Rl. It implies:

θ h1θ h 2 > θl1θl 2 (9.8)

( h1 ) ( − θh2 ) < (1 − θl1 ) (1 − θl 2 )

1 − θ 1 (9.9)

The contracts are as follows: the creditors of Project k get dk if Project

k is successful and 0 otherwise.
The investor budget constraint for type j and Project k is: d jk kj = bk .
Hence,

d jk = bk / θ kj (9.10)

The non-deviation condition for l (i.e. the condition for which type l
will choose not to mimic type h) can be written as

(1 − dh1 )θl1 + (1 − dh2 )θl 2 ≤ (1 − dl1 )θl1 + (1 − dl 2 )θl 2

Taking into account (9.10) it becomes:

(1 − b1 / θ1h )θl1 + (1 − b2 / θ2h )θl 2 ≤ (1 − b1 / θ1l )θl1 + (1 − b2 / θ2l )θl 2

 9  Corporate Capital Structure vs. Project Financing  197

After simplifactions we get:

 θ   θ 
b1  1 − l1  ≤ b2  1 − l 2  (9.11)
 θ h1   θ h 2 

If this condition is satisfied, a separating equilibrium may exist where

the high profit type signals its quality by using project financing.
Obviously if θh1 > θl1 and θl 2 < θh 2, condition (9.11) fails. However, if
θ h1 > θl1 and θl 2 > θ h 2 or θ h1 < θl1 and θl 2 < θ h 2, it may work. Note that the
latter does not necessarily contradict (9.8) and (9.9).

Example 9.2
Suppose that θh1 = 0.7, θh2 = 0.3, θl1 = 0.2, θl 2 = 0.6 and b=
1 b=1 0.2. We
can check that Rh first-order dominates Rl because conditions (9.8) and
(9.9) hold. From (9.10): dh1 = 2 / 7, dh2 = 2 / 3, dl1 = 1 and dl 2 = 1 / 3. The
non-deviation condition for l (i.e., the condition for which type l will
choose not to mimic type h) can be written as

(1 − 2 / 7) * 0.2 + (1 − 2 / 3) * 0.6 ≤ (1 − 1) * 0.2 + (1 − 1 / 3) * 0.6

After simplifications we get 5 / 35 ≤ 6 / 30 which holds.
In fact, condition (9.11) suggests a large variety of possible strategies
for type h to signal its type when it performs better than l in only one
project. See Miglo (2010) for more analysis.
Many consider Myers and Majluf (1984) to have pioneered asymmet-
ric information models. According to Myers and Majluf (1984), under-
investment occurs because of asymmetric information about the value of
assets-in-place and the consideration of the investment project. When
insiders know more about the true value of a firm than outside investors,
potential creditors must rely on market signals to assess a firm’s value.
Therefore, if investors know less than insiders about the true value of the
firm’s assets in place, equity may be mispriced.
In their model, Myers and Majluf (1984) show how outside investors
will value a firm’s shares as the average of two (or more) possible values.
198  Capital Structure in the Modern World

There is a return distribution for these shares that is common knowl-

edge to all potential investors. Because of this averaging, “bad” firms will
have overpriced shares and “good” firms will have underpriced shares.
Therefore, in equilibrium, only bad firms will choose to issue equity.
Creditors are assumed to be rational players and realize this. Asymmetric
information, in this instance, has a negative implication for the good type
of firm because it will prefer not to invest in positive net present value
projects rather than be subject to underpricing their shares.
We now proceed with a quick example of their model (see Chap. 3 for
more details). Suppose there are two firms with an investment opportu-
nity available. The project costs $60 and will bring earnings of $70. The
value of their assets in place is initially either $150 or $40. Management
will know the true state of the firm, but the outside market will not. They
will only know that there is a 50  % chance of either. We can show (anal-
ogously to Chap. 3) that an equilibrium where both firms issue shares
and undertake the new project does not exist. Only the low value firm
will invest because the payoff from investing is higher than from not
investing. For this firm, the shares are overpriced and management will
obviously choose to invest in the growth opportunity. The high value
firm, on the other hand, will choose to not invest.
Indeed suppose that an equilibrium exists where both firms issue
equity to finance the new project. Let α be the fraction of equity sold
to the new investor. The new investor’s expected earnings should cover
the investment cost: α * ( 70 + 0.5 * ( 40 + 150 ) ) = 60 . This implies that
α = 12 / 31. The earnings of the high value firm shareholders then equal:
26
(1 − α ) * ( 70 + 150 ) = 134 . Since this is smaller than 150, the sharehold-
31
ers will not be interested in issuing shares for the new project.
This exemplifies the adverse selection problem. Because of asymmetric
information, firms with higher values will pass on positive return proj-
ects. The result holds if, instead of issuing equity, firms were allowed to
issue standard corporate debt.
The underinvestment problem could be avoided if the firm were to
have the ability to issue riskless debt (this assumption is often unrealistic).
While Myers and Majluf (1984) do not actually study the implications
 9  Corporate Capital Structure vs. Project Financing  199

of project financing, they do “hint” that the underinvestment problem

can be resolved by a spin-off of its assets-in-place into a separately incor-
porated company.5 In the example above, both types of firms may issue
non-recourse debt with face value 60, which would solve the underinvest-
ment problem. The new investor will finance the new project with non-­
recourse debt. The face value of debt will be 60. Earnings from the new
project (which equal 70) will cover the amount of debt. Furthermore, we
can show that in some cases the same insight holds if we consider asym-
metric information about the amount of earnings from the new invest-
ment and not about the value of assets-in-place as in the above example.
An interesting question is why projects that are financed with non-­
recourse debt often have a high degree of risk and why the amount of
investment is usually very large. Miglo (2010) considers different sce-
narios where firms choose between non-recourse debt and conventional
debt. To illustrate the idea, consider a model similar to the one described
above (where θkj is the probability of success of project j for a type k firm)
but now assume that the firm will use corporate financing (regular debt
with recourse with face value D) for the first project and non-recourse
debt for the second project (face value d). If the first project is successful,
the investors are paid in full. If it fails and the second project succeeds,
two situations are possible. If 1 − D ≥ d the investors of project 1 are paid
in full, otherwise they get 1 − d . For the second project, investors are paid
in full if the second project is successful and get nothing otherwise.
The promised payment for project 2 is d = b2 / θh 2 . Let Pk(x) be the
probability that the total cash flow of firm k equals x. For example, we
have Ph ( 0 ) = (1 − θh1 ) (1 − θh 2 ).
b1 b b1
If 1 ≥ + 2 then D = . In this case the investors (firm
1 − Ph ( 0 ) θ h 2 1 − Ph ( 0 )
h) of both projects are paid in full if the firm’s earnings equal either 1 or 2
(but not 0). If l mimics h, its payoff is: Pl (2 ) (2 − D − d ) + Pl (1) (1 − D − d ) .
This should not be greater than it’s equilibrium value θl1 + θl1 − b1 − b2 .
The non-deviation constraint for l is then:

 Myers and Majluf (1984: 22).

5
200  Capital Structure in the Modern World

 1 − Pl ( 0 )   θ 
b1  1 − ≤ b 1 − l2 (9.12)
 1 − P ( 0 )  2  θ 
 h   h 2 

If we consider the case when θh1 < θl1 and θl 2 < θh 2 then condition (9.12)
can be interpreted as follows. The likelihood that this condition is satis-
fied (and successful utilization of project finance by firm h) increases with
an increase in the amount of investment in project 2 (b2) maintaining that
b1 is sufficiently small. Secondly, if θl2 is sufficiently smaller than θh2 and/
or if 1 − Pl (0 ) is sufficiently close to 1 − Ph (0 ) . This means that a separat-
ing equilibrium exists when the asymmetry regarding the firm’s overall
quality (probability of default in both projects) is sufficiently small while
the asymmetry regarding the project, for which the firm issues project-­
contingent securities, is large. A similar condition can be obtained for the
b1 b
case 1 < + 2.
1 − Ph ( 0 ) θ h 2

Example 9.3
Suppose that θh1 = 0.3, θh2 = 0.6, θl1 = 0.6, θl 2 = 0.2, b1 = 0.1 and b2 = 0.4 .
We can check that Rh first-order dominates Rl because conditions (9.8)
and (9.9) above hold.
As follows from our previous analysis: d = b2 / θh 2 . So d = 2 / 3 . Also
b1 b1
D= = = 5 / 36. The non-deviation condition
1 − Ph ( 0 ) 1 − (1 − θ h1 ) (1 − θ h 2 )
for l (i.e. the condition for which type l will choose not to mimic type h)
can be written as (1 − 2 / 3 − 5 / 36 ) ∗ 0.6 + (1 − 2 / 3) ∗ 0.2 ≤ 0.2 . After sim-
plifications we get 11 / 60 ≤ 0.2 which holds.
We can also see that h cannot do it the other way around, i.e. use
project financing for project 1. We have: d = b1 / θh1. So d = 1 / 3 and
b2
D= = 5 / 9. The non-deviation condition for l (i.e. the condi-
1 − Ph ( 0 )
tion for which type l will choose not to mimic type h) can be written as

(1 − 1 / 3 − 5 / 9) ∗ 0.2 + (1 − 2 / 3) ∗ 0.6 ≤ 0.2 . After simplifications we get

2 / 9 ≤ 0.2 , which does not hold.
 9  Corporate Capital Structure vs. Project Financing  201

One interpretation of these results is project financing or financing by

non-recourse debt. Project financing differs from corporate financing in
two ways: (1) the creditors do not have a claim to the profit from other
projects if the project fails while corporate financing gives this right to
the investors and; (2) it typically has priority on the cash flows from the
project over any corporate claims. The case described in the beginning
of Sect. 9.3 can thus be interpreted as financing both projects with non-­
recourse debt. The second case can be seen as financing project 2 with
non-recourse debt and financing project 1 with standard corporate debt
when the creditors’ payoffs depend on the firm’s total earnings (after the
project 2 creditors are paid) and are not attached uniquely to the earnings
from project 1).
From (9.12), the existence of a separating equilibrium is probable
when the amount of investment financed by non-recourse debt is suf-
ficiently large with regard to the corporate investment and the uncer-
tainty regarding the performance of projects financed by non-recourse
debt is greater than that of projects financed by corporate debt. Also,
as follows from (9.12), the uncertainty regarding the performance of
projects financed by non-recourse debt is greater than that of projects
financed by corporate debt. There exists some evidence consistent with
the spirit of the above predictions. Brealey, Cooper, and Habib (1996);
Esty (2003, 2004); McGuinty (1981), and Nevitt (1979) argue that
non-recourse debt is typically used for financing large, capital-inten-
sive, projects and that the leverage ratio of project companies is typi-
cally larger than that of parent companies. Also, this is consistent with
the evidence that project financing is usually used for financing risky
projects (see for instance: Esty (2004); Flybjerg et al. (2002); McGuinty
(1981); Merrow et  al. (1988); Miller and Lezard (2000), and Nevitt
(1979)).
Shah and Thakor (1987) analyze optimal financing in the presence
of corporate taxation. In their model, projects have the same mean of
return, the owners have private information about risk, and investors may
acquire (costly) information about the parameters of a firm’s risks. If the
benefits from information production are relatively big, project financing
is optimal because the cost of screening a separately incorporated project
202  Capital Structure in the Modern World

is low. Alternatively, project financing can result in higher leverage and

provide greater tax benefits. This is because, under corporate financing,
leverage is below the optimal level. In the absence of bankruptcy costs,
the first-best financing method is “pure” debt. However, firms reduce
leverage in order to provide a credible signal about risk.
Similarly, the results of this section can be applied to asset-backed
securities (ABS). Suppose that the firm issues ABS to finance the first
project. If the project fails then the creditors (or the holders of ABS)
do not have any legal rights of recourse to the assets of the firm. In
addition, there exists a bankruptcy remoteness condition. If the parent
company fails it cannot use the assets of the project company. Therefore,
formally, this debt is analogous to the case of non-recourse debt issued
for both projects in the model. ABS are now used by many corporations
as a financing method. The standard explanation in existing literature is
that these securities exist primarily for regulatory reasons (for instance,
banks trying to avoid minimal capital requirements). However, recent
empirical literature (Calomaris and Mason 2004) argues that secu-
ritization seems to be motivated more by reasons related to efficient
contracting.
Finally, note that Schipper and Smith (1983) found that 72 out of
93 firms in their sample of spin-offs involved parent companies and
subsidiaries with different industry memberships (cross-industry spin-
offs). The financing strategies discussed here can be interpreted as a
spin-off because they contain financing by non-recourse debt and the
creation of an independent company respectively. The likelihood that
firms in separate industries have divergent performance (see comments
for condition 9.9)) is higher than it is for firms in the same industry.
Thus, Schipper and Smith’s (1983) results are consistent with the spirit
of this chapter.

9.4 Other Models

The paper written by Chemmanur and John (1996) looks at managerial
considerations and the threat of a takeover as incentives for the use of
 9  Corporate Capital Structure vs. Project Financing  203

project financing. They assume that retaining control of a firm provides

the greatest benefit to entrepreneurs and that they will make their capital
structure decisions keeping this in mind. For instance, if a firm’s cur-
rent manager were to issue equity to raise funds, there is a possibility
that the majority of it will be purchased by another market participant;
which jeopardizes the manager’s position as the controller. However, by
issuing only corporate debt, the firm accrues the bankruptcy costs associ-
ated with high debt levels. Therefore, entrepreneurs will always aim to
maximize the present value of their control benefits and the security ben-
efits from lower debt levels. Non-recourse debt will allow the manager
to minimize overall debt levels and reduce bankruptcy costs. Whether
project financing will be preferred to normal debt depends on the value
of the control benefits and their degrees of risk.
In the previous two sections, the models reviewed either discussed
project financing as a solution to agency costs or as a solution to asym-
metric information. Habib and Johnsen (1999), however, combine these
two and look at how non-recourse secured debt, when combined with
ex-ante debt contracts, can solve agency costs in spite of information
asymmetries. More specifically, they examine the role that non-recourse
secured debt plays in ensuring the optimal allocation of ownership over
secured physical assets across various possible states of the world. In this
case, with non-recourse secured debt, if the borrower defaults, the lender/
issuer can seize the collateral, but the lender’s recovery is limited only to
this collateral.
Habib and Johnsen (1999) apply the results of their model to aircraft
financing in order to demonstrate the benefits of non-recourse debt over
those of ex-post bargaining. They choose to look at the aircraft financing
industry because it is made up of a large variety of financing contracts
and, more importantly, the industry is subject to exogenous shocks such
as wars or industry deregulation and these affect the state of the world.
This makes the need for a redeployer plausible because the optimal use of
assets may change frequently. Similarly, it creates an investment environ-
ment subject to risk.
The implication of Habib and Johnsen’s (1999) model is that the rede-
ployment value of a firm’s assets should have an important influence on
204  Capital Structure in the Modern World

its optimal capital structure. This helps explain why some firms have vir-
tually no debt while others have quite a lot. While there are many other
considerations behind a firm’s capital structure choice, this model helps
shed more light on the subject. It shows how the structure of project
financing contracts can help reduce agency costs and moral hazard dilem-
mas that plague firms even when there are informational asymmetries
between entrepreneurs and creditors.
As mentioned, project financing uses a complex series of contracts to
“distribute the different risks presented by a project among the various
parties involved in the project.”6 They are created to dictate the manage-
ment’s response to any number of issues. The large number of contracts
clearly reduces agency costs because there is less worry that the manag-
ers will not be acting in the best interests of the firm as a whole. With
corporate debt, there are a number of problems with creating contracts
to specify actions of shareholders and managers in response to market
stimuli. As Brealey, Cooper, and Habib (1996) note, there are simply too
many circumstances to consider.
It is very important that these contracts anticipate what may happen
and provide a solution. Some of the risks that a project finance company
may be subjected to include technological risk, construction risk, com-
pletion risks, inflation risk, environmental risk, regulatory risk, and polit-
ical and country risk. For example, the telecom sector showed a decline
in 2006 likely due to the technological acceleration and development in
the sector.7 The contracts are necessary to properly allocate the risks to
the counterparty best able to control and manage them. This is another
one of the primary reasons why firm managers will choose to separately
incorporate a new investment with project financing.
Marty and Voisins (2007) noted that since the shareholders may be
likely to sell off their stake well before the expiry date of the concession,
a professional evaluation of the project financed companies at different
stages of the project’s life seems increasingly important.
Kleimeier and Versteeg (2010) argue that project finance is designed
to reduce transaction costs arising from a lack of information on possible

 Brealey, Cooper and Habib (1996: 28).

6

 Gatti (2008).
7
 9  Corporate Capital Structure vs. Project Financing  205

investments and capital allocation, insufficient monitoring and enforce-

ment of corporate governance, risk management, and the inability to
mobilize and pool savings. Their empirical analysis of 90 countries, from
1991 to 2005, confirms that project finance is a strong driver of eco-
nomic growth in low income countries with high transaction costs.
Gatti et  al. (2013) study negotiations of financial packages between
sponsors and lenders and their costs. It was found that lenders indeed rely
on the network of contracts as a mechanism to control agency costs and
project risks. This network of nonfinancial contracts limits the manage-
rial discretion of project sponsors, to make cash flows better verifiable
for lenders, and to reduce the negative impact of unexpected events on
project cash flows. It was also found that lenders are reluctant to reduce
the price of the credit if sponsors are involved as project counterparties in
the relevant contracts.
In Lyonett du Moutier (2010), a positive agency theory model is built
through a detailed analysis of property rights exchanged in the trans-
actions needed to build the Eiffel Tower. The analysis of the original
financial documents and contracts for the Tower reveals how specific
provisions in the contracts combined to reduce agency costs all around.
Thus a model derived from positive agency theory may help us better
understand modern project finance.
Hainz and Kleimeier (2012) analyze the design of loan contracts for
financing projects in countries with high political risk. They argue that
non-recourse project finance loans and the participation of development
banks in the loan syndicate help mitigate political risk. Their results also
show that if political risk is higher, then project finance loans are more
likely to be used, and development banks are more likely to participate
in the syndicate.

Questions and Exercises

1. Non-recourse debt can be used to solve a debt overhang problem.
2. The main difference between non-recourse debt and secured debt is
that the riskiness of secured debt is firm-specific while the riskiness of
non-recourse debt is project-specific.
206  Capital Structure in the Modern World

3. Consider a firm with assets in place, an investment opportunity avail-

able, and outstanding senior debt with a face value D = 8000 . Existing
assets can produce: 20,000  in state G (good state) with probability
1/2, 2000 in state B with probability 1/2. The new project requires an
investment of 3000, and the firm will finance this investment by issu-
ing new debt. The new project generates 5000 in state G and 2000 in
state B.

(a) Find the NPV of new project.

(b) Suppose that to finance the new project the firm issues a standard
subordinated debt. Will the new project be undertaken?
(c) Now suppose that the firm uses project financing (non-recourse
debt). Same question.
(d) Now assume that the firm has a senior debt with a face value
D = 15, 000 . The new project requires an initial investment of
1000. The new project generates 4000 in state G and 0 in state B
and it also reduces the probability of G occurring by 10 %.
Find the NPV of the new project.
(e) Suppose that to finance the new project the firm issues a standard
subordinated debt. Will the new project be undertaken?
(f ) Now suppose that the firm uses project financing (non-recourse
debt). Same question.

4. The economy consists of two different types of firms. Each firm has
two projects: they produce 1 if they are successful and 0 otherwise.
The probability of success for firm j, j = 1, 2 and project k, k = 1, 2 is
given by θjk. We have θ11 = 0.75, θ12 = 0.25, θ22 = 0.6, θ 21 = 0.25. Both
projects require an investment 0.2. Outside investors don’t know the
type of the firm (there is 50 % of each type of firms in this economy)
but they can observe the interest rate for each contract signed by each
firm.

(a) Discuss if a separating equilibrium is possible where type 1 uses

corporate debt (one contract).
(b) Analyze the situation where both firms use project financing for
each project.
 9  Corporate Capital Structure vs. Project Financing  207

References
Amlôt, M. (2015, December 16). Tabreed finalises AED 192.5m loan facility
for district cooling plant for Dubai Parks and Resorts. CPI financials. http://
www.cpifinancial.net/news/post/34011/tabreed-finalises-aed-192-5m-loan-
facility-for-district-cooling-plant-for-dubai-parks-and-Resorts
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Bonetti, V., Caselli, S., & Gatti, S. (2010). Offtaking agreements and how they
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Brennan, M., & Kraus, A. (1987). Efficient financing under information asym-
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Corielli, F., Gatti, S., & Steffanoni, A. (2010). Risk shifting through nonfinan-
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Flyvbjerg, B., Holm, M., & Buhl, S. (2002). Underestimating costs in pub-
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Habib, M. A., & Johnsen, D. B. (1999). The financing and redeployment of
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John, K., & John, T. (1991). Optimality of project financing: Theory and
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 10
Capital Structure Analysis: Some
Examples

In this chapter we analyze the financing decisions and capital structures

of Facebook and United Continental Holdings.1 Facebook has low debt
and United has relatively high debt. We argue that none of the existing
capital structure theories can individually explain a firm’s capital struc-
ture. However, they can be used together to describe patterns of observed
behavior.

10.1 Social Media and Airline Industries

A social network’s mission is to connect people who share common
interests. Most networks are web-based. Among the most popular are
American-based companies Facebook, Google+, LinkedIn, Instagram,
Shialand, Reddit, Pinterest, Vine, Tumblr, and Twitter. Among other
companies of note are Nexopia, Badoo Bebo, Vkontakte, Delphi,
Skyrock, StudiVZ, Tagged, Myspace, Cyworld, Mixi, NetEase, Renren,

1
For capital structure analysis of internet companies as of 2011 see Lee, Liang, and Miglo (2014).
For capital structure analysis of some companies in the fertiliser industry see Khatik and Singh
(2006).

© The Editor(s) (if applicable) and The Author(s) 2016 211

A. Miglo, Capital Structure in the Modern World,
DOI 10.1007/978-3-319-30713-8_10
212 Capital Structure in the Modern World

Friendster, Sina Weibo and Wretch. Surveys reveal that 73 % of US adults

use social networking websites and that international markets are becom-
ing increasingly important.2
Early social networks focused on bringing people together to interact
with each other via the internet. In the late 1990s, user profiles became
a central feature of social networking websites, allowing users to find
“friends” with similar interests. One of the first large social network-
ing websites was Cyworld (South Korea). It also became one of the first
companies to profit from the sale of virtual goods. Facebook, launched
in 2004, became the largest social networking site in the world in early
2009.3
Usually social networks do not charge money for membership.
Companies such as Myspace and Facebook sell online advertisements on
their websites. Their business model is based on a large membership count
so charging for membership would be counterproductive. Some research-
ers believe that most of the information that the networks accumulate,
due to the nature of these networks, provides advantages regarding adver-
tising strategies compared to regular businesses.4 Social networks operate
under an autonomous business model where networks’ members serve
dual roles as both suppliers and consumers of content. This is different
from the traditional business model where the suppliers and consumers
are distinct agents.
There has been a rapid growth in the number of US patent applica-
tions that cover new technology related to social networking. The num-
ber of published applications has been growing rapidly since 2003. There
are now over 3500 published applications and as many as 7000 applica-
tions may be currently on file including those that have not yet been
published.5
The airline industry is the business of transporting paying passengers
and freight by air, typically by airplane or helicopter. The largest income
in the airline industry comes from passenger services; hence the airlines
2
http://news.biharprabha.com/2014/07/india-records-highest-social-networking-growth-study/
and Lunden (2013).
3
Kazeniac (February 9, 2009).
4
Tynan (July 30, 2007).
5
Nowotarski (January 23, 2011).
 10 Capital Structure Analysis: Some Examples 213

are dependent on consumer and business confidence.6 Flying, which is

often included in a vacation, could be seen as a luxury good for private
travelers.
An important aspect of passenger service is the business traveler, who
most likely flies more frequently than, for example, the vacation (lei-
sure) passenger. Airlines try to obtain the loyalty of business passengers
by using, for example, frequent flyer programs. By earning more points,
the benefits become larger and give the customer more incentive to fly.
Business travelers are also more likely to purchase the upgraded services,
which gives the airline a higher profit margin on their services. They are
also often not very price sensitive: they make a lot of last minute orders
and often do not have as much flexibility as private travelers. This results
in a lower price elasticity of demand, so their demand would not fall that
much in the event of an economic downturn in this sector.7
A significant factor in the development of the airline industry was the
large scale deregulation that started in the United States at the end of
the 1970s, and later spread into Europe and Asia. It affected the com-
petitive environment in the industry by lowering entry barriers which led
to accelerated competition in the deregulated regions. This introduced
the need for cost efficiency and operating profitability management, and
could be seen as the beginning of low cost carriers that began to success-
fully compete with incumbent well-established companies.
The airline industry is very procyclical and hence its success is strongly
correlated with economic conditions. The deregulation has increased
competition and affected growth and profitability. Profitability, even in
the good years, is generally low: in the range of 2–3 % net profit after
interest and tax.8 Net profit has been very volatile since the 1990s. One
of the results of the financial crisis of 2007–2008 was record losses for
the airline industry. The September 11, 2001 terrorist attack also had a
negative impact on its profitability.9
6
Avjobs. http://www.avjobs.com/history/airline-economics.asp
7
https://www.iata.org/whatwedo/Documents/economics/Intervistas_Elasticity_Study_2007.pdf
8
International Air Transport Association (IATA), Fact Sheet: World Industry Statistics, https://
www.iata.org/pressroom/facts_figures/fact_sheets/Documents/fact-sheet-industry-facts.pdf
9
MIT Global Airline Industry Program.
http://web.mit.edu/airlines/analysis/analysis_airline_industry.html
214 Capital Structure in the Modern World

The increasing competition forced airlines to seek lower costs and

higher productivity. This caused a high number of mergers, acquisitions
and internal growth to take advantage of economies of scale. The eco-
nomic downturn and higher operating costs led to massive layoffs and
cutbacks in the industry. These challenges led many large airlines (US
Airways, United, Delta, and Northwest among others) into Chapter 11
bankruptcy between 2001 and 2005. Under bankruptcy protection these
airlines started cost reducing restructurings.

10.2 Methodology
A company’s capital structure is analyzed with the help of a spreadsheet
analysis, which is based on the trade-off between the tax advantages of
debt and the increased risk from debt financing.10 I mostly use data from
Yahoo! Finance and openly available data from companies’ own websites.
In addition to a traditional spreadsheet analysis I also add an estimation of
the value of financial flexibility.11 And I also add share price underpricing
estimation in case the firm issues new shares. In general, I believe capital
structure needs more analyses similar to the ones in this chapter (so called
case studies). This is an effective way to do research in areas that include
several layers of analysis and different approaches and theories. This book
suggests that capital structure management represents such an area. There
are a lot of competing theories of capital structure. Furthermore one of
our main objectives is to find firms’ optimal capital structure policies
and contrast them with existing policies. Some of the theories are better
formalized and are simpler to use in real life situations (such as trade-off
theory) while others are very complex (such as asymmetric information).
A case study is a good research strategy because the area of our research
is multilayered (Singleton et al. 1993; Mertens 1998). Campbell (1989)
advocates a case study design for investigating real-life events, including
organizational and managerial processes.
10
See Damodaran (2003); Fernandez (2015); and Lee, Liang and Miglo (2014) for examples of
spreadsheet analysis regarding optimal capital structure.
11
See, for example, A. Damodaran’s note: http://people.stern.nyu.edu/adamodar/pdfiles/country/
option.pdf
 10 Capital Structure Analysis: Some Examples 215

10.3 Capital Structure Analysis

10.3.1 Facebook

Mark Zuckerberg and his Harvard roommates launched Facebook in

2004. Users can create a user profile, add other users as “friends,” exchange
messages, post status updates and photos, share videos and receive notifi-
cations when others update their profiles. Facebook had over 1.44 billion
monthly active users in March 2015.12 Facebook, Inc. held its initial pub-
lic offering in February 2012 and began selling stock to the public three
months later, reaching an original peak market capitalization of $104
billion. On July 13, 2015, Facebook became the fastest company on the
Standard & Poor’s 500 Index to reach a market cap of $250 billion.13
In June 2004, Facebook moved its headquarters to California. It
received its first investment later that month from PayPal co-founder
Peter Thiel.14 In 2005, the company dropped “the” from its name after
purchasing the domain name facebook.com for US$200,000. In May
2005, Accel partners invested $12.7 million in Facebook, and Jim Breyer
added $1 million of his own money.15 On October 24, 2007, Microsoft
announced that it had purchased a 1.6 % share of Facebook for $240
million, giving Facebook a total implied value of around $15 billion.16
Microsoft’s purchase included rights to place international advertisements
on the social networking site. In October 2008, Facebook announced
that it would set up its international headquarters in Dublin, Ireland.17

12
“Facebook Reports First Quarter 2015 Results” (April 22, 2015). http://investor.fb.com/
releasedetail.cfm?ReleaseID=908022. Retrieved January 23, 2016.
13
Davis (July 13, 2015).
14
“Why you should beware of Facebook”. The Age (Melbourne). January 20, 2008. Retrieved
January 23, 2016.
15
Williams (October 1, 2007) and “Jim Breyer (via Accel Partners).” CNBC. May 22, 2012. http://
www.cnbc.com/id/47387334. Retrieved January 23, 2016.
16
“Facebook and Microsoft Expand Strategic Alliance” (Press release). Microsoft. October 24,
2007.
17
“Facebook to Establish International Headquarters in Dublin, Ireland” (Press release). Facebook.
October 2, 2008.
216 Capital Structure in the Modern World

Almost a year later, on September 2009, Facebook said that it had turned
cash-flow positive for the first time.18
Facebook filed their IPO documents with the Securities and Exchange
Commission on February 1, 2012. The company applied for a $5 bil-
lion IPO, one of the biggest offerings in the history of technology. The
IPO raised $16 billion, making it the third-largest in US history.19 On
May 22, 2012, the Yahoo! Finance website reported that Facebook’s
lead underwriters, Morgan Stanley, JP Morgan, and Goldman Sachs,
cut their earnings forecasts for the company in the middle of the IPO
process.20
On November 15, 2010, Facebook announced it had acquired the
domain name fb.com from the American Farm Bureau Federation for
an undisclosed amount. On January 11, 2011, the Farm Bureau dis-
closed $8.5 million in “domain sales income”, making the acquisition
of FB.com one of the 10 highest domain sales in history.21 Facebook has
acquired more than 50 companies, including Instagram and WhatsApp.
The acquisition of WhatsApp cost $19 billion: more than $40 per
WhatsApp user. It also purchased the defunct company ConnectU in
a court settlement and acquired intellectual property formerly held by
rival Friendster. The majority of the companies acquired by Facebook
are based in the United States; a large percentage of these companies are
based in or around the San Francisco Bay Area. Facebook has also made
investments in LuckyCal and Wildfire Interactive. Most of Facebook’s
acquisitions have been ‘talent acquisitions’ and acquired products are
often shut down. Mr. Zuckerberg has stated: “we have not once bought a
company for the company. We buy companies to get excellent people…
In order to have a really entrepreneurial culture one of the key things
is to make sure we’re recruiting the best people. One of the ways to do
this is to focus on acquiring great companies with great founders.”22 The

18
“Facebook ‘cash flow positive,’ signs 300M users.” CBC News (Toronto). September 16, 2009.
19
“Facebook Officially Files for $5 Billion IPO.” KeyNoodle. February 1, 2012. Archived from the
original on October 18, 2013. Retrieved February 1, 2012; and Rusli and Eavis (May 17, 2012).
20
Blodget (May 22, 2012).
21
“FB.com acquired by Facebook.” NameMon News. January 11, 2011.
22
“Why Facebook buys startups.” Youtube https://www.youtube.com/watch?v=OlBDyItD0Ak
 10 Capital Structure Analysis: Some Examples 217

Table 10.1 Results from Facebook analysis 2011

Current capital Optimal capital
structure structure Change
D/(D + E) Ratio 9.88 % 30.00 % 20.12 %
Beta for the stock 1.7 2.07 0.37
Cost of equity 18.08 % 21.45 % 3.37 %
Cost of debt 2.30 % 3.20 % 0.90 %
WACC 16.52 % 15.98 % −0.55 %
Firm value (m) 31,565 32,643 1077
Value/share 26.34 27.34 1.00
See Damodaran (2003), Fernandez (2015), and Lee, Liang and Miglo (2014) for
more details in methodology. Debt/equity ratios are measured in market
values, WACC stands for weighted average cost of capital

Table 10.2 Results from Facebook analysis 2015

Current capital Optimal capital
structure structure Change
D/(D + E) Ratio 1.77 % 15.00 % 13.23 %
Beta for the stock 0.93 1.038 0.11
Cost of equity 11.09 % 12.12 % 1.03 %
Cost of debt 1.91 % 2.80 % 0.89 %
WACC 10.92 % 10.72 % −0.20 %
Firm value (m) 247,856 252,530 4673
Value/share 107.26 109.32 2.06

Instagram acquisition, announced on April 9, 2012 appears to be the first

exception to this pattern.

Capital Structure

Facebook uses more equity financing than debt financing. Facebook

changed its debt/assets ratio from 9.88 to 1.77 % between 2011 and
2015 (see Tables 10.1 and 10.2). Facebook’s cash flows and profits are
so strong that they can finance the business with their retained earnings.
Trade-off theory states that capital structure is the result of a trade-off
between the tax advantage of debt and the higher risk and bankruptcy
costs resulting from debt financing. The spreadsheet analysis suggests that
218 Capital Structure in the Modern World

Facebook’s optimal debt ratio was 30.0 % in 2011 and 15 % in 2015,

which is higher that their actual debt/equity ratios those years.
From the trade-off theory point of view, the low debt ratio is hurting
the company’s profitability because it is underusing its debt tax shield.
This situation is similar to other internet companies (Lee et al. 2014). In
recent years some companies have begun to realize that using tax shields
can be beneficial. However, they usually use other ideas aside from the
debt tax shield.23
The pecking order theory implies that companies should use internal
funds before using debt and equity and should use external debt before
external equity. Facebook uses internal funds and equity but not much
debt, which means that Facebook considered going for an IPO before
debt, which contradicts the pecking-order theory. Second, this theory
implies a negative correlation between debt and profitability, which is
supported by Facebook’s profitability and lack of debt. At the time of its
IPO, Facebook had enough profits to keep its operation running but,
rather than taking on more debt, it still decided to gather funds through
equity. The latter will help create a market for firm shares including shares
belonging to employees.
On one hand, the agency cost theory favors low debt, which implies
a low bankruptcy cost and a high level of confidence for investors. This
is consistent with Facebook’s policies. On the other hand, the agency
cost theory states that higher debt is good for a company because it can
stimulate the manager to perform better. This part is not consistent with
Facebook’s case. In Facebook’s case, the conflict between the sharehold-
ers and the managers is of little importance because the company is very
profitable. In the long term, things may change. An important indicator
of potential conflict between shareholders and managers is the fraction of
shares owned by the managers. According to SEC filings, Mr. Zuckerberg,
his co-founders, and his early investors control about 74 % of the voting
power through ownership of Class B stock, which give them 10 votes per
share. Shareholders who bought stock in the IPO were issued Class A
stock, with just one vote per share. Zuckerberg personally controls about

23
Darby III (May 15, 2007).
 10 Capital Structure Analysis: Some Examples 219

55 % of the voting power through his ownership of 422 million class B

shares and voting agreements with other shareholders.24
At the same time the total number of shareholders is quite large. It
appears that Facebook uses partial ownership in terms of involvement
of employees in shareholdings as a tool to motivate personnel to per-
form efficiently instead of using external pressure by creditors. Although
by issuing shares, Facebook might be sharing ownership with different
groups of people, it is avoiding the risk of letting the company be con-
trolled by too few people. Womack (2012) mentioned that a part of the
IPO proceeds would be used to cover taxes including a $3 billion bridge
loan to fund taxes for employees who exercise restricted stock units.25 The
units cannot be sold until about five months after the IPO.
A conflict between the creditors and shareholders is not likely to hap-
pen because Facebook has less debt. According to Facebook’s policy, the
board of directors has an obligation to monitor and manage potential
conflicts of interest. The board also ensures that there is no abuse of cor-
porate assets or unlawful related party transactions. One of the reasons
why Facebook wanted to go public rather than use debt could have been
to avoid conflicts between the company and outsiders.
An equity issue can also be consistent with the spirit of its business
model where members serve dual roles as both the suppliers and the con-
sumers of content. This is similar to the crowdfunding idea that customer
involvement provides incentives for them as suppliers. This can also be
related to Facebook’s overall corporate culture. The link between capital
structure decisions and corporate culture looks like a promising area for
future research, as mentioned in Chap. 7.
As the flexibility theory and life cycle theory propose, it is not ben-
eficial for new firms to use debt financing; they rely more on equity to
make their operations smooth at early stages of their existence; hence
they are considered more flexible. Facebook’s expansion and growth busi-
ness approach requires a lot of funds. Their business model with a no-cost
membership is based on a large number of customers, which creates a

24
Taylor (June 11, 2015).
25
Womack (2012, October 24).
220 Capital Structure in the Modern World

good environment for advertisement. Acquisitions are a big part of this

strategy. The initial public offering on April of 2012 helped the company
grow. Our calculations show that the value of flexibility is 0.86 % of the
asset’s value, which is greater than the potential reduction in the cost of
capital from moving to an optimal debt/equity ratio. This may explain
why management does not want to increase the debt/equity ratio.
According to the life cycle theory of growing and mature firms, firms
are more likely to have a higher leverage ratio, which results in low flex-
ibility. It is the opposite in Facebook’s case, as it does not use a lot of
debt. The Debt/equity ratio for Facebook in 2012 was higher than it was
in 2015.
The signaling theory states that from the investor’s perspective, the
market reaction of an issuance of debt is neutral and is negative of equity.
In Facebook’s case, the evidence is ambiguous. Negative reactions to
equity issues were observed in April and May 2012 although the reasons
for each might be different.
Market timing. The market timing hypothesis provides a good expla-
nation for the timing of firms’ IPOs. For example, nearly all companies
issue equity through public offerings at opportune times, most notably
during the “tech craze” or “dot-com bubble” of the late 1990s. One can
see that firms underwent public offerings when the market recovered
from the tech crash of 2000 or at other times when the management
felt their stock was overvalued. Companies make stock repurchases at
windows of opportunities when they believe their stock is undervalued.
However, from a broader point of view, the market timing theory does
not explain a firm’s capital structure well despite the IPO decision.

10.3.2 United Continental Holdings

United Continental Holdings, Inc. (UCH) is a publicly traded airline

holding company headquartered in Chicago. UCH owns and operates
United Airlines, Inc. The company is the successor of UAL Corporation,
which agreed to change its name to United Continental Holdings in May
2010, when a merger agreement was reached between United Airlines
and Continental Airlines. As a result of the merger, Continental share-
 10 Capital Structure Analysis: Some Examples 221

holders received 1.05 shares of UAL stock for each Continental share,
effectively meaning Continental was acquired by the UAL Corporation;
at the time of closing, it was estimated that United shareholders owned
55 % of the merged entity and Continental shareholders owned 45 %.26
Once completely combined, United became the world’s largest airline, as
measured by revenue passenger miles.27
UCH has major operations at Chicago–O’Hare, Denver, Guam,
Houston–Intercontinental, Los Angeles, Newark (New Jersey), San
Francisco, Tokyo–Narita, and Washington–Dulles. UCH’s United Air
Lines, Inc. controls several key air rights, including being one of only two
American carriers authorized to serve Asia from Tokyo-Narita (the other
being Delta Air Lines). Additionally, UCH’s United is the largest US
carrier to the People’s Republic of China and maintains a large operation
throughout Asia.
Both airlines took losses in the recession and expected the merger to
generate savings of more than $1 billion a year.28 Combined revenues
were projected to be about $29 billion.29 Unlike Facebook, revenues have
not been significantly growing in UCH for the last four years. Employer-
worker relationships are of significant importance.
Susan Carey (2012) describes the pilot strike at UCH in 2012.30 Pilots
at United Continental Holdings Inc., frustrated that nearly two years
of negotiations at the merged airline had failed to yield a joint contract,
concluded a strike vote in July 2012 with 99 % of the voters approving
a plan to withdraw their services, if allowed by federal mediators. Pilots
wanted raises and other improved terms, and insisted that the merger

26
“United Continental Holdings, Inc.—Investor Relations – News.” Ir.unitedcontinentalholdings.
com.
27
“United, Continental create world’s biggest airline.” The Sydney Morning Herald. May 4, 2010.
http://www.smh.com.au/business/world-business/united-and-continental-create-worlds-biggest-
airline-20100503-u426.html. Retrieved January 23, 2016.
28
“United and Continental Airlines to merge.”. BBC News. May 3, 2010. http://www.bbc.com/
news/10095080. Retrieved January 23, 2016.
29
“United, Continental create world’s biggest airline.” The Sydney Morning Herald. May 4, 2010.
http://www.smh.com.au/business/world-business/united-and-continental-create-worlds-biggest-
airline-20100503-u426.html. Retrieved January 23, 2016.
30
Carey (July 17, 2012).
222 Capital Structure in the Modern World

Table 10.3 Results from United analysis 2015

Current capital Optimal capital
structure structure Change
D/(D + E) Ratio 51.66 % 45.00 % −6.66 %
Beta for the stock 0.79 0.707 −0.08
Cost of equity 9.76 % 8.97 % −0.78 %
Cost of debt 2.21 % 1.91 % −0.30 %
WACC 5.86 % 5.79 % −0.07 %
Firm value (m) 45,329 45,810 481
Value/share 58.78 60.07 1.29

synergies United Continental sought could not be fully obtained without

a joint pilot contract.
In 2014–2015 the situation improved significantly because of the low
fuel oil/fuel prices. It is interesting that the company decided to use its
good situation and excess cash on improving its financial situation rather
than on aggressive expansion plans.31 As a part of it, UHC seems content
to spend most of its free cash flow on share buybacks. Given that it has
the lowest market cap of the three big legacy carriers, this focus on buy-
backs may be wise. United plans to complete a $1 billion buyback pro-
gram announced last year, and it recently announced a new $3 billion
share repurchase authorization.

Capital Structure

United uses a much higher debt ratio than Facebook. In 2015 it was
about 51 % (see Table 10.3).
Trade-off theory based spreadsheet analysis suggests that United’s opti-
mal debt ratio was 45.0 % in 2015, which is lower than what its actual
debt ratio was that year. Unlike Facebook, UCH assets are mostly tan-
gible, which helps explain why its debt ratio is higher.
The pecking-order theory implies that the company should use inter-
nal funds before using debt and equity and should use external debt
before external equity. It seems that this is consistent with United’s strat-
egy since it does not issue new shares publicly and when the cash situa-
31
Levine-Weinberg (October 13, 2015).
 10 Capital Structure Analysis: Some Examples 223

tion improves (for example, as happened in 2015) UHC plans to buy its
shares back. It is not clear, however, why shares were not purchased back
using borrowing during the times when the cash flow was not as high as
in 2015! The answer can be provided by spreadsheet analysis or trade-off
theory since raising debt in bad times can be quite expensive.
On the one hand, the agency cost of debt theory (asset substitution,
debt overhang) favors keeping low debt. This is not consistent with
United’s policies. On the other hand, the agency cost theory states that
higher debt is good for a company because it can stimulate the manager
to perform better. This part is consistent with the United case. Compared
to Facebook, the conflict between the shareholders and managers has
greater importance as the company is struggling financially and the insid-
ers do not own as much equity as in Facebook’s case (see Table 10.4). At
the same time the total number of shareholders is quite large. A conflict
between the creditors and shareholders is likely to happen because United
is more concerned with the creditors as it has more debt.
As the flexibility theory and life cycle theory propose it is more natural
for UHC to use debt financing than it is for Facebook. UHC can be con-
sidered a mature business with a well established reputation, principles,
and traditions. Also, its expansion and growth plans are not comparable
with those of Facebook. Our calculations show that the value of flex-
ibility is 0.043 % of the assets value, which is smaller than in the case of
Facebook.
The signaling theory states that from the investors’ perspective, the
market reaction is neutral on the issuance of debt and negative on equity.
It may also explain why UCH does not issue shares publicly.

Table 10.4 Information UHC ownership

(Source: yahoofinance)
Equity United
No. of institution 549
owners
% owned by institutions 86 %
and funds
% owned by Insiders 6%
and 5 % owners
224 Capital Structure in the Modern World

The 2010 strike suggests that labour relationships are important. As we

mentioned in Chap. 7, a higher debt level can improve a firm’s bargain-
ing position. It can also help negotiate for government support. A higher
debt level can also signal a higher output in an oligopolistic market as was
discussed in Chap. 4.
UCH’s production strategy can also play a part in explaining their
capital structure decisions. Some young firms with a low cost-low
quality approach may use low debt as mentioned in Chap. 7. For estab-
lished firms, however, a high debt may signal a commitment to a larger
output.
The following is a summary of our analysis. Facebook uses a low debt/
equity ratio. It is a profitable company and uses internal earnings and
funds for most of its projects. It is only partly consistent with the POT
since the company issued a large IPO and did not make a large loan or
bond issue. Also, the company does not use the debt tax shield prescribed
by trade-off theory and spreadsheet analysis. Factors that may explain
these patterns are: need for flexibility, a unique business model and cor-
porate culture, and a low degree of separation between ownership and
management (debt is not needed as a discipline device).
UCH’s capital structure seems to be more consistent with the major
theories. The difference between the current debt/equity ratio and the
optimal one prescribed by the spreadsheet analysis is relatively small. The
company seems to benefit from the debt tax shield but does not extend
debt unwisely. It follows the POT in that it primarily uses internal cash
when available for capital spending and debt secondarily; public issues of
shares are not common. Other ideas can help explain capital structure.
Separation between ownership and management is greater than in the
case of Facebook so the role of debt, as a discipline device, is more impor-
tant. There is a new idea that having debt as a commitment in bargaining
with unions and the government is a reason for high debt. Some agency
costs of debt, such as debt overhang and asset substitution, may be under-
estimated by management.
An additional idea is for both companies (especially UCH) to use inter-
national financing more efficiently. Corporations can raise international
debt in different currencies. The currency differential does not just diver-
sify risk, it helps lower interest rates because the international market is
 10 Capital Structure Analysis: Some Examples 225

limitless. If a corporation conducts business in a foreign country and gets

revenues in foreign currencies, then debt nominated in foreign curren-
cies creates new opportunities. If earnings are hedged against the foreign
currency’s depreciation, then the company can profit when the foreign
currency depreciates, as it reduces the real value of the debt.

References
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facebook-revenue-estimates-middle-133648905.html
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Robert K. Yin, ed., Newbury Park, CA: Sage Publications.
Carey, S. (2012, July 17). Pilots at United Continental Approve a strike. The
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Answers/Solutions to Selected Questions/
Exercises

The first part of this book was focused on the major theories of capi-
tal structure: trade-off theory, pecking-order theory, asset substitu-
tion, credit rationing, and debt overhang. According to most empirical
research, none of these theories are able to fully explain real life decisions
made by companies. However, in most research related to capital struc-
ture, these basic ideas are used either as reference points or intermedi-
ate tools that help develop further ideas. The future of capital structure
theory is still uncertain, in my opinion. Will any theory(ies) emerge as a
clear “winner” (in terms of its ability to explain the reality) or will they
all combine into one “big” theory? Will any of these basic ideas be com-
pletely forgotten because the market imperfections used as a basis will no
longer be relevant in practice, or because empirical research consistently
rejects the results of a theory? In my opinion all of these possibilities are
still on the table. It seems that unlike other areas of finance, research-
ers of capital structure are still far from bridging the gap between its
theory and practical reality. Grahan and Harvey (2001) is a good refer-
ence point.
Part II discussed different topics of capital structure. As was men-
tioned earlier, the objective of the book was not to cover as many topics

© The Editor(s) (if applicable) and The Author(s) 2016 227

A. Miglo, Capital Structure in the Modern World,
DOI 10.1007/978-3-319-30713-8
228  Answers/Solutions to Selected Questions/Exercises

of capital structure as possible but rather to review the major theoretical

concepts and provide basic tools to understand the complicated area of
capital structure. Many advanced theories of capital structure discussed
in this book are still growing areas of research. I think that some areas
are very promising including the links between capital structure and
corporate/national culture, dynamic versions of trade-off theory and
pecking-­order or signaling theories, interactions between capital struc-
ture choices and bargaining strategies (with unions, suppliers or govern-
ments), capital structure of small and start-up companies, links between
capital structure choices and market timing, theoretical foundations of
flexibility and life cycle ideas of capital structure, and capital structure
management of financial institutions and its role in preventing financial
crises.
Educators should spend more time teaching capital structure given
that the topic has seen tremendous growth in recent years. Students are
very excited when they hear the words entrepreneurial finance (young
talent plus money combination!) and are very excited about such profes-
sions as investment banker and corporate treasurer. All of this is directly
related to capital structure knowledge. I have noticed in recent years that
students have stopped being afraid of capital structure topics and courses
and have begun to speak professionally, and with interest, about capital
structure related topics! So I think that new courses specifically dedicated
to capital structure theory and management and new programs preparing
specialists in the area of capital structure analysis and management could
be created at universities. Another reason for the existence of the large
gap between the theory and practice of capital structure is that educators
focus mostly on the positive aspects of the theory and its applications and
not on its normative aspects. As a result, students may be aware of exist-
ing models but are not able to apply them in real life when they become
managers. I feel that this is especially true for asymmetric information
and agency cost theories, which are without a doubt the most technically
complicated. Educators need to find a way to explain the practical appli-
cations of these theories.
   Answers/Solutions to Selected Questions/Exercises  229

Finally, I am a big fan of further integration of universities and

the financial sector. Practitioners should be given the opportunity to
teach more courses and professors should allocate more time to practi-
cal work. Nobel Prize winner Josef Stiglitz is a good example. Theories
have become more and more complicated so if the gap between the
theory and practice is not being constantly reduced, severe conse-
quences will follow. The challenges of this approach are to find prac-
titioners who have deep theoretical knowledge and professors who are
able to work in ­managerial positions. Both combinations are pretty
rare from my experience. Where we stand now, it is hard to imagine
that in the near future a large volume of (constantly growing expo-
nentially) complicated mathematical research will be able to seri-
ously penetrate into the practical sector with satisfactory speed and
intensity.
My book is aimed primarily at those who feel very excited about the
financial sector both theoretically and practically. I tried to make most
of my points in a theoretically rigourous fashion and bridge the deep
theoretical concepts with the practical examples and cases. If you, my
dear reader, feel this way I will be very satisfied. And good luck with your
exciting journey in the world of finance and capital structure!

Part I

Chapter 1

1. False
2. b
3. c
4. False
5. True
230  Answers/Solutions to Selected Questions/Exercises

6. We have V = 20000, D = 50000 and W = 100000. Since D > V , the

firm is in financial distress and the firm’s owner is personally liable for
the firm’s debt because it’s a sole proprietorship. Since W > D − V,
the firm’s owner will likely sell a part of his assets to pay the firm’s
debt.
7. False
8. c
10. True
11. False

Chapter 2

1. True
2. False
3. False.
4. False.
5. True.
6. True
7. True
8. True
9. False
12. Consider an investor holding 10 % of firm U′ s shares. Consider the
following two strategies for this investor:
Strategy 1: To keep 10 % of firm U′s shares
Strategy 2: Sell the shares for 0.1 ∗ 100, 000 = 10, 000 , buy 12.5 % of
company L′S shares (the value is 0.125 ∗ 40, 000 = 5, 000 ) and buy
12.5 % of company L′S bonds (the value is 0.125 ∗ 40, 000 = 5, 000 ).

Strategy 2 provides higher earnings in each scenario and thus is defi-

nitely better than strategy 1.
 Strategy 1 Strategy 2
Investment 0 10, 000 − 5, 000 − 5, 000 = 0
Earnings if economy is weak 400 = 0.1 * 4, 000 500 = 0.125 * ( 4000 − 0.1 * 40000 ) + 0.1 * 5, 000
Earnings if economy is strong 15, 000 = 0.1 * 150, 000 18, 750 = 0.125 * (150000 − 0.1 * 40000 ) + 0.1 * 5, 000
  Answers/Solutions to Selected Questions/Exercises 
231
232  Answers/Solutions to Selected Questions/Exercises

13. The value of the unlevered firm can be found as follows:

1000
VU = (1 − 0.2 ) = 400
2

Tax shield:

 1000 − D D D 
TS = 0.2 *  ×D+ × 
 1000 1000 2 

Bankruptcy costs:

D D * 0.2
BC = ×
1000 2

The firm’s value V equals

 1000 − D D D 
V = VU + TS − BC = 400 + 0.2 *  ×D+ × 
 1000 1000 2 
D D * 0.2
− ×
1000 2

The firm’s choice of leverage is determined by maximizing V. The first-­

order condition with respect to D is D = 500.

Chapter 3

1. False
2. True
3. True
4. b
5.
   Answers/Solutions to Selected Questions/Exercises  233

(a) Outside investors know the value of the existing assets (100).
When they buy equity, if they get a fraction α of the firm, their
wealth in period 2 is α190, and of course in a competitive market
(remember no discounting) this will equal the cost, 70. Thus:
α = 70 / 190 = 7 / 19 .
Thus, the new shareholders will ask for 7000000 additional
shares and the share price will be 70 / 7 = 10 per share. The original
equity is worth (1 − α )190 = 120.
(b) Since 120 > 100, the new equity will clearly be issued and the new
project will be undertaken.
(c) The expected intrinsic value of the assets-in-place is
EX = p160 + (1 − p ) 40 = 100. If the project is not undertaken, the
entrepreneur’s wealth WNI is 40 or 160 depending on the firm’s
type.
Suppose now that equity is issued under any value of the asset.
A competitive capital market implies 70 = α (100 + 90 ) where
investors now break even only in expectation. The necessary
equity fraction required by outsiders is then

70 7
α= =
190 19

The wealth of the entrepreneur when he invests is now given (for

a high-value type) by:

12
(160 + 90 ) ≈ 157
19

For a low-value type, it is:

12
( 40 + 90 ) ≈ 82.1
19

So, a low-value type firm will invest because 82 > 40 while the
high-value type will not because 157 < 160.
234  Answers/Solutions to Selected Questions/Exercises

(d) When observing a new issue of shares, investors rationally realize

that the firm which issues shares is of a low-value type. A
­competitive capital market implies 70 = α ( 40 + 90 ). The necessary
equity fraction required by outsiders is then

70 7
α= =
130 13

The wealth of the entrepreneur when he invests is now given by

(for a low-value type)

6
( 40 + 90 ) = 60
13

(e) In
the beginning, the share price is (based on average value of
assets-in-place)

100 1
=8
12 3

After the market knows that the firm has an opportunity to invest
in the new project the share price becomes the average between
the future share values for each type of firm: high-value type is
160/12 and low-­value type is 5. So the price will be 9 and 1/6. The
price of shares sold during the issue is 70 / 14 = 5.
(f ) Lemon problem

6. If the information about the expected profits were public then Firm 1
would be sold for 20 and Firm 2 would be sold for 100.
Consider the case with asymmetric information. Suppose that the
entrepreneurs sell their firms. The price in this case will be 60. The
investors will be ready to buy the firm for an average expected return.
Consider the entrepreneurs’ expected utilities. The entrepreneur of
   Answers/Solutions to Selected Questions/Exercises  235

Firm 1 will obviously benefit from selling the firm for 60. His expected
utility will be 60. If he keeps the firm, his expected utility is less than
20. What about the entrepreneur of Firm 2?
If he does not sell the firm, his expected utility is

1
100 − ρ 50 = 100 − 25ρ
2

If he sells, then it is 60. The entrepreneur is only interested in selling

the firm if ρ > 8 / 5. Otherwise, he will keep his shares.

Partial sale of shares. Firm 1 sells all shares: P1 = 20 . Firm 2 sells

partially. To find α, we need to solve the following equation:

α2 2 (100 – 20 )
=
1−α ρ 50

Suppose that ρ = 1. The condition becomes:

α2 16
=
1−α 5

Solving for α, given that 0 < α < 1, gives: α = 0.8. Therefore, the entre-
preneur of Firm 2 should keep approximately 80 % of the shares and
sell 20 %.
236  Answers/Solutions to Selected Questions/Exercises

Chapter 4

1. (a) 40 and 35 (expected earnings minus cost)

Earnings
b g Expected
(Pr=0.5) (Pr=0.5) earnings
Project F 60 60 60
Project S 20 90 55

(b) Project S
Payoff to shareholders
b g Expected
(Pr=0.5) (Pr=0.5) value
Project F 10 10 10
Project S 0 40 20

Payoff to creditors
b g Expected
(Pr=0.5) (Pr=0.5) value
Project F 50 50 $50
Project S 20 50 $35

In this case, the shareholders will make the firm choose project S
because it has a higher NPV of 20; it, however, leaves the creditors
with a payoff worth 35.
(c) Still S.
Shareholder payoff
b g Expected
(Pr=0.5) Pr=0.5) value
Project F 0 0 0
Project S 0 10 5
   Answers/Solutions to Selected Questions/Exercises  237

Payoff to creditors
b (Pr=0.5) g (Pr=0.5) EV
Project F 60 60 60
Project S 20 80 50

Earnings
b g Expected
2. (Pr=1/2) (Pr=1/2) earnings
Project 1 10 10 10
Project 2 3 15 9

(a) It depends on D.

1. D$15. Both projects give 0 to shareholders.

2. 10 # D < 15. Then only Project 2 may provide some payment to
shareholders (only in the good state). So Project 2 is chosen.
3. 3 < D < 10.

The shareholders’ payoff:

b g Expected
(Pr=1/2) (Pr=1/2) payoff
Project 1 10-D 10-D 10-D
Project 2 0 15-D ½(15-D)

Comparing the payoffs we find that if D > 5 project 2 will be cho-

sen and Project 1 otherwise.

3. (a) D < 3. Project 1 will be chosen since it has higher expected earn-
ings and debt is risk-free.

(b) Project 2 is riskier. So when D is large enough there will be an

asset substitution.
(c) Asset substitution. Higher debt is worse for the asset substitution
problem.
(d) There is no FOD so asset substitution may take place. There is no
IR so sometimes there will be no substitution.
238  Answers/Solutions to Selected Questions/Exercises

(e) D > 6 . In this case Project 2 will be chosen. For creditors, the fol-
lowing should hold: ½ * D + 1 / 2 * 3 = 6. Since D = 9.
(f ) 1 / 2 * (15 − 9 ) + 1 / 2 * 0 = 3
(g) The shareholders’ expected payoff with the additional project is 3.
With the new project (assuming a new senior debt with face value
2 is issued): 1 / 2 * (15 + 3 − 2 − 9 ) + 1 / 2 * 0 = 3.5. The shareholders
will take the new project, which has a negative NPV:
3 * 1 / 2 − 2 = −0.5. The problem illustrated here is overinvestment.

4. D

7. In this question, we have to compare the payoff to the shareholders.

In both scenarios, whichever is greater will be the option they will
choose.
Liquidation:
Year 1
CF 1100
Senior debt payments –1100
Shareholders’ profit 0

Continuation (bank will accept a promise to pay 330 next year because
it will get 165 on average which will give the bank an average rate of
return of 10 %):
Year 1 Year 2
Good state Bad state
CF 0 1500 500
Senior debt payments –150 –1000 –500
Bank 150 –330 0
Shareholders’ profit 0 170 0

The shareholders would prefer to continue operations. The senior

debtholders are made worse off.
8. First let us compare the projects’ NPVs.
   Answers/Solutions to Selected Questions/Exercises  239

NPV ( F ) = 0.5* 60 + 0.5 * 60 − 20 = 40.

NPV ( S ) = 0.5 * 20 + 0.5 * 90 − 20 = 35.

Since F has a higher NPV than S, the shareholders will choose F. For
example, the firm can issue a risk-free debt with face value 20.
Now suppose that the cost of the project is 50. Now the projects’
NPVs are: NPV ( F ) = 10; NPV ( S ) = 5. Project F still has a higher NPV
than S. Which project will be chosen by the shareholders?
Suppose the firm can raise the 50 by issuing a bond with a
face value of 50. The shareholders earnings from taking proj-
ect F are: 1 / 2 ( 60 − 50 ) + 1 / 2 ( 60 − 50 ) = 10. And those from S are:
1 / 2 ( 90 − 50 ) + 1 / 2 ( 0 ) = 20. Shareholders will prefer project S which leads
to an asset substitution problem. Note also that the lender’s expected cash
flow from project S is 1 / 2 ( 20 ) + 1 / 2 ( 50 ) = 35 which is less than 50 if the
shareholders choose project S.
What should the face value of debt D be in order for creditors to have
an incentive to invest in the project?
Suppose that D > 50. If F is chosen, the shareholders’ payoff is
1 / 2 ( 60 − D ) + 1 / 2 ( 60 − D ) = 60 − D if D < 60 . Otherwise, it is 0. If S is
chosen, the shareholders’ payoff is 1 / 2 ( 90 − D ) + 1 / 2 * 0 = 45 − 1 / 2 D.
Comparing F and S we find that, since D > 30, S will be chosen.
How do we find the minimal acceptable value of D for credi-
tors? Their expected cash flow should cover the initial investment 50:
1 / 2 * D + 1 / 2 * 20 = 50. This gives D = 80. So the equilibrium scenario in
this seemingly very simple problem is that the firm will borrow an amount
50 by promising to return 80 and the shareholders will undertake project
S which has a smaller value compared to project F. If the creditors miscal-
culate the shareholders’ incentives it may lead to their loss in equilibrium.

9. (a) Project A’s NPV is 40 (expected earnings minus cost) and Project
B’s is 15.

(b) Considering a debt with face value 40, the shareholders’ payoffs
are:
240  Answers/Solutions to Selected Questions/Exercises

If A: 1 / 2 * 40 + 1 / 2 * 40 = 40.
If B: 1 / 2 (110 − 40 ) + 1 / 2 * 0 = 35.

Therefore, project A will be chosen. The creditors will be inter-

ested in providing the firm with the needed funds because debt is
essentially risk-free when the firm takes project A.
(c) In order to be able to raise debt, the firm needs to convince the
potential creditors that they can earn at least 50 % (on average).
Otherwise the creditors would prefer to invest in risk-free govern-
ment bonds. If the debt face value is 60 (= 40 * (1 + 0.5 )), the
shareholders’ expected payoffs will be as follows. If A:
0.5 ( 20 ) + 0.5 ( 20 ) = 20. If B: 0.5 ( 0 ) + 0.5 ( 50 ) = 25. Therefore, proj-
ect B will be chosen. In this case, the creditors’ expected payoff is
0.5 * 60 + 0.5 * 0 = 30, which is less than the cost of the investment.
As a result, they will not be willing to lend the money.
(d) The maximal possible face value of the debt is 110 (otherwise the
shareholders do not receive any profit). Therefore the maximal
expected payoff to the creditors is 0.5 * 110 = 55 < 60 . So there is
no equilibrium where creditors can count on earning at least at a
minimal acceptable interest rate of 50 %.

Chapter 5

1. (a) The firm’s expected earnings increase by 100, 000 * 0.4 = 40, 000
which is greater than the 30000 investment cost. So the NPV of
the project for the firm equals 100, 000 * 0.4 − 30, 000 = 10, 000.

(b) Without the new project, the shareholders’ earnings are:
(100, 000 − D ) * 0.4. If D = 20, 000, the shareholders’ expected earn-
ings are (10, 000 − 20, 000 ) * 0.4 = 32, 000 . If the firm undertakes
the new project the shareholders’ expected payoff will be
(100, 000 − 20, 000 ) * 0.8 − 30, 000 = 34, 000 > 32, 000 so the project
will be undertaken.
(c) Consider D = 60, 000. Without the new project the shareholders’
expected earnings are (100, 000 − 60, 000 ) * 0.4 = 16, 000. If the firm
undertakes the new project the shareholders’ expected payoff will
   Answers/Solutions to Selected Questions/Exercises  241

be (100, 000 − 60, 000 ) * 0.8 − 30, 000 = 2, 000 < 16, 000 so the proj-
ect will not be undertaken.
(d) Debt overhang; higher debt increases the likelihood of debt

overhang.

2. (a) The NPV = 3000 − 2000 = 1000 > 0.

(b) Without the new project, the shareholders’ expected payoff is:
1 / 2 (10000 − 6000 ) = 2000. Now consider the new investment
opportunity. Let F be the face value of the new debt. The expected
payoff to the new debtholders: 1 / 2 * F = 2000 , thus F = 4000. The
1
shareholders’ payoff is * (13000 − 6000 − 4000 ) = 1500. This is less
2
than the shareholders’ payoff without the new project. Thus, the
project will not be undertaken.
(c) Now suppose the initial debt is junior and the firm can issue a
senior debt to finance the new project. The face value of the new
senior debt is 2000 (since the total earnings are at least 2000 in
both states). So the shareholders’ expected payoff, if the new proj-
1
ect is undertaken, is: * (13000 − 6000 − 2000 ) = 2500. This is
2
greater than 2000. So the new project will be undertaken.
(d) Suppose the incumbent debtholders agree to finance the new proj-
ect with a new (junior) debt with a face value (including principal
and interests) of 2200. Suppose the shareholders accept financing
from the incumbent creditors. The shareholders’ payoffs with the
new project will be 0.5 * (13, 000 − 6, 000 − 2, 200 ) = 2400.
This is greater than 2, 000 and hence the shareholders will be inter-
ested in having a deal with the incumbent creditors. Now consider
the incentive for the creditors. Without the new project their
expected payoff is 0.5 * 6, 000 + 0.5 * 4, 000 = 5, 000 . With the proj-
ect it is: 0.5 * ( 6, 000 + 2, 200 ) + 0.5 * ( 7,000 ) − 2, 000 = 5, 600 .
So the deal is beneficial for both the shareholders and the creditors.
(e) Minimal for creditors: 1000. Maximal for shareholders: 3000.
Use the proof of Propositions 5.3 and 5.4.
(f ) Free rider-problem.
242  Answers/Solutions to Selected Questions/Exercises

3. Debtholders will sell the debt for 5000. To see this, note that in the
current situation debtholders will receive: 1 / 2 * 10000 + 1 / 2 * 0 = 5000 .
Will shareholders repurchase the debt? Currently, the shareholders’
expected payoff (given that corporate tax is 40  %) is:
1 / 2 (18000 − 10000 ) * (1 − 0.4 ) + 1 / 2 ( 0 ) = 2400. The new shareholders
will be able to pay 5000 for the newly issued shares if they get 25/27
of the firm’s equity. To see this note that the firm’s net income after the
debt repurchase in the bad state will still be 0 and that in the good
state it will be 18000 * 0.6 = 10800. Since this occurs with a 50 % prob-
ability, new shareholders will need 10000 in that state. So their frac-
tion should be equal to 25/27. The initial shareholders’ fraction of
equity is then 2/27 and their expected payoff is 2 / 27 * 10800 = 800,
which is less than 2400.

Part II
Chapter 6

1. True
2. True
3. True
4. Consider first financing for stage 2. We have 0.25 * D = 0.1. Hence
D = 2 / 5. In stage 1 investors require a fraction of equity s1 such that:
s1 * 0.7 + s1 * 0.25 * (1 − 2 / 5 ) = 0.1. Therefore s1 = 2 / 17. Now consider
the payoff of shareholders of b in case b decides to mimic g. This
equals 15 * 0.1 + 15 * 0.8 *  1 − 2  = 29 . If a signaling equilibrium
17 17  5 50
exists, the shareholders’ payoff for type b is pb1 + pb 2 − C1 − C2 = 0.7
(the present value of b). Thus, a separating equilibrium exists because
29 / 50 < 0.7.
5. Consider pooling equilibrium where both firms issue equity. We have
0.1 0.1
αe = =
0.3 * 0.3 + 0.7 * 0.1 + m + 0.12 0.28 + m
   Answers/Solutions to Selected Questions/Exercises  243

Consider the incentives for type 2. It’s optimal choice depends on

0.1( 0.42 + m ) . It holds if
0.12 > m > 0.42.
0.28 + m

Chapter 7

1. The expected earnings of project 1 equal 2.5 and they are greater than
that of project 2. So from the firm’s point of view, the manager should
choose project 1. The manager’s expected payoff if project 1 is chosen
equals 0.2 and 0.5 for project 2. If D = 0 the probability of bankruptcy
equals zero and the manager chooses project 2 since 0.5 > 0.2.
If D > 0, the manager’s expected payoff under project 1 is
0.2 * ( 5 − D ) / 5 and for project 2 it is 0.5 * ( 3 − D ) / 3. The manager will
choose project 1 if D > 45 / 19.
If D = 45 / 19, the real value of debt equals
45 / 19 * ( 5 − D ) / 5 + 45 / 38 * ( D / 5 ) = 6525 / 3610. This amount can be
provided by debtholders and in this case the rest should be raised by
selling equity.
2. (a) The first-best effort maximizes the firm’s value: 2e − 2e2. Socially
optimal e* = 1 / 2.

(b) E will maximize 2ke − 2e2 , where k is the fraction of equity that
belongs to E. Optimal e′ = k / 2 . For any k < 1, e′ < e*. If the man-
ager owns less than 100 % of the equity, the level of effort is below
the first-best level. The manager’s profit is then k2/2. To find the
optimal contract, we have to find the value of k that will maximize
the entrepreneur’s profit under the condition that the investor’s
expected profit is not less than b. This condition is
2e (1 − k ) = k (1 − k ) ≥ 1 / 8. The left side of this inequality reaches
its maximum when k = 1 / 2. In this case I′s expected payoff is 1/4.
E′s expected payoff is k2/2. It is increasing in k. Hence the optimal
k is the largest value of k that satisfies I’s budget constraint, i.e.
1/2. Optimal e = 1 / 4 and E′s expected payoff is 1/8.
(c) Two cases are possible. (1) 2e < D. In this case the manager maxi-
mizes 1 / 3 ( 4e − D ) − 2e2 . So optimal e = 1 / 3. The manager’s pay-
244  Answers/Solutions to Selected Questions/Exercises

off is 2 / 9 − D / 3. (2) 2e > D . In this case the manager maximizes

1 / 3 ( 2e − D ) + 1 / 3 ( 4e − D ) − 2e2. So optimal e = 1 / 2 . The manag-
er’s payoff is 1 / 2 − 2 D / 3. By comparing the manager’s payoffs in
each case we find that if D < 5 / 6 the optimal e = 1 / 2 and other-
wise e = 1 / 3. Now to find D note that the investor’s payoff should
be greater than b. So in the second case D = 3 / 2b . It is possible
only if b < 15 / 18. That is our case. So the firm can be financed
with debt with face value 3/8 and the manager’s profit is 1/4 in
this case.
(d) The manager’s payoff is higher under debt financing.

3. Equity financing. As was shown, earnings will not be manipulated in

this case. E will maximize ke + 2k − e2 , where k is the fraction of equity
that belongs to E. Optimal e′ = k / 2 . To find the optimal contract, we
have to find k that will maximize the entrepreneur’s profit under the
condition that the investor’s expected profit is not less than 19/32.
This condition is

(1 − k ) ( e + 2 ) = (1 − k )  
k
+ 2  ≥ 19 / 32
2 

The left side of this inequality is decreasing in k and equals 19/32

when k = 3 / 4 . In this case I′s expected payoff is 19/32. E′s expected
k 
payoff is k  + 2  . It’s increasing in k. Hence the optimal k is the larg-
 2 
est value of k that satisfies I′s budget constraint. E′s expected net pay-
off when k = 3 / 4 is 57 / 32 − 9 / 64 = 105 / 64.
Debt financing
E will use EM if R10 = 0. Otherwise, E loses control of the firm and
gets nothing in the second period. Optimal e equals e′ = (1 + c ) / 2 = 9 / 16.
Since R = 1 regardless the value of r, I′s payoff is D. Optimal D= b= 19 / 32.
E′s payoff is then 245/128. This is better than E′s payoff in the case of
equity financing without EM.
   Answers/Solutions to Selected Questions/Exercises  245

Chapter 8

1. (a) Period 1. The first-best effort maximizes the firm’s value: 2e − 2e2.
Socially optimal e* = 1 / 2.

(b) In the case of equity financing E will maximize 2ke − 2e2 , where k
is the fraction of equity that belongs to E. Optimal e′ = k / 2 . For
any k < 1, e′ < e* .
E′s profit is then k2/2. To find the optimal contract, we have to
find k that will maximize E′s profit under the condition that the
investor’s expected profit is not less than b. This condition is
2e (1 − k ) = 2 k (1 − k ) / 2 ≥ 1 / 8. The left side of the inequality
reaches its maximum when k = 1 / 2. In this case, I′s expected pay-
off is 1/4. E′s expected payoff is k2/2. It is increasing on k. Hence
the optimal k is the largest value of k that satisfies I′s budget con-
straint, i.e. 1/2. Optimal e = 1 / 4 and E′s expected payoff is 1/8.
(c) Now consider debt financing. Two cases are possible. (1) e < D. In
this case the manager maximizes 1 / 3 ( 4e − D ) − 2e2 . So optimal
e = 1 / 3. E′s payoff is 2 / 9 − 1 / 3D. (2) e > D. In this case the man-
ager maximizes 1 / 3 ( 2e − D ) + 1 / 3 ( 4e − D ) − 2e2. So optimal
e = 1 / 2 . E′s payoff is 1 / 2 − 2 / 3 D. By comparing the manager’s
payoffs in each case we find that if D < 5 / 6 optimal e = 1 / 2 and
otherwise e = 1 / 3. Now to find D, note that the investor’s payoff
should be greater than b. So in the second case D = 3 / 2b . It is pos-
sible only if b < 3 / 8, which is our case. So the firm can be financed
with debt with face value 3/8 and the manager’s profit is 1/4 in
this case.
(d) Debt is better because E′s payoff is higher in this case.
(e) Period 2. The first-best effort maximizes the firm’s value:
2e1 + 2e2 − 2e12 − 2e2 2 . Hence e= 1 e=
2 1 / 2.
(f ) Under equity financing, E has a fraction k of the firm’s equity. So
E will maximize k ( 2e1 + 2e2 ) − 2e12 . Optimal e1′ = k / 2 . Similarly
we find e ′2 = (1 − k ) / 2. I′s payoff equals
246  Answers/Solutions to Selected Questions/Exercises

(1 − k ) . If
2

(1 − k ) ( 2e1 + 2e2 ) − 2e22 = 1 − k − k = 1 / 2, it equals

2
3/8. E′s payoff also equals 3/8.
(g) Now consider debt financing. Two cases are possible. (1)
2 ( e1 + e2 ) < D. In this case E maximizes 1 / 3 ( 4 ( e1 + e2 ) − D ) − 2e12 .
So the optimal e1 = 1 / 3. (2) 2 ( e1 + e2 ) > D . In this case E maxi-
mizes 1 / 3 ( 2e1 + 2e2 − D ) + 1 / 3 ( 4 ( e1 + e2 ) − D ) − 2e12. So optimal
e1 = 1 / 2 . In this case I′s payoff is 2/3D. So D equals 9/16. e2 = 0
so 2 ( e1 + e2 ) > D . Similarly to the way we did it in period 1 one
can show that the second case is better for E and it works for I. So
the firm can be financed with debt with a face value of 9/16. E’s
profit is 2e1 + 2e2 − 2e12 − 3 / 8 = 1 / 8.
(h) So one can see that in period 2, equity is a better financing
structure.
(j) An optimal capital structure in this case is debt financing in period
1 and equity financing in period 2. It can also be interpreted as a
convertible debt or convertible preferred equity that are converted
into common equity in period 2.

2. The choice between the ID and IE is given by:

−0.3
pj =
0.2 Fj − D

It can be rewritten as:

−0.3
pj = .
0.2 Fj − D

The choice between the ID and the OD is given by:

p j ( 0.5Fj − D ) = p j ( Fj − D′ ) − 0.3 (1 − p j )
   Answers/Solutions to Selected Questions/Exercises  247

This equation can be rewritten as:

−0.3
pj =
− D + D′ − 0.3 − 0.5Fj

Finally, the choice between the OD and IE is given by:

p j ( Fj − D′ ) − 0.3 (1 − p j ) = 0.3 p j Fj − 0.3

This equation can be rewritten as:

D′ − 0.3
Fj =
0.7

The marginal entrepreneur with Fj = F * and p j = p* is indifferent

between all types of financing where

D′ − 0.3
F* =
0.7

and

0.21
p* =
0.7 D + 0.2 D′ − 0.06

Chapter 9

1. True.
2. True
3. (a) The new project has a positive net present value (NPV) because
1 / 2 * 2, 000 + 1 / 2 * 5000 > 3500.
248  Answers/Solutions to Selected Questions/Exercises

(b) The face value, d′, of this debt can be found from the following
equation: 3000 = d ′ * 1 / 2 + 1 / 2 * 0. Therefore d ′ = 6000.
The shareholders’ expected payoff without the new investment
is 1 / 2 * ( 20000 − D ) = 6000. With the new project, it will be
1 / 2 ( 20000 + 5000 − D − d ′ ) = 5500. Since the expected payoff
without the new project is more than that with the project, it will
not be undertaken.
(c) The face value d can be found from: 3000 = d * 1 / 2 + 1 / 2 * 2, 000 .
Here d = 4000 .
The shareholders’ expected payoff is (note that the shareholders
get nothing if B is realized): 1 / 2 * ( 20000 − D + 5000 − d ) = 6500 .
This is greater than 6000 (the shareholders’ expected payoff with-
out new investment), and thus the project will be undertaken and
it will be financed with non-recourse debt.
(d) The new project has a negative net present value (NPV) because
0.4 * 4, 000 − 0.1 * 20000 + 0.1 * 2000 < 0.
(e) The face value, d ′, of this debt can be found from the following
equation: 1000 = d ’* 0.4 + 0.6 * 0. This means that if G is realized,
the new debtholders will receive the face value of the debt; if,
however, B is realized, the firm’s cash flow is 2000, which is less
than the face value of the senior debt, leaving the new creditors
with nothing. Therefore, d' = 2500. The shareholders’ expected
payoff without the new investment is 0.5 * ( 20000 − 15000 ) = 2500.
With the new project, it will be 0.4 * ( 24000 − 15000 − 2500 ) = 2600.
Since the expected payoff with the new project is more than it is
without the project, it will be undertaken.
(f ) In this case, the debtholders’ payoffs depend only on the returns
from the new project and not on the returns from the assets
already in place. Since the NPV is negative, the firm will not able
to finance the project.

4. (a) It is impossible because the face value of debt will be lower for
type 1 than it is for type 2 if the latter were to use it. It’s because
   Answers/Solutions to Selected Questions/Exercises  249

the profit equals 2 with probability 0.75 * 0.25 and it equals 1

with probability 0.75 * 0.75 + 0.25 * 0.25. Both numbers are lower
for type 2. Therefore type 2 will mimic type 1.

(b) Suppose that both firms use project financing. We have:

0.2 0.2 0.2 0.2

=d11 = , d12 = , d21 = , d22
0.75 0.25 0.25 0.6
The shareholders’ expected payoff for type 2 is:

EE = 0.6 * 0.25 * (1 + 1 − 0.2 / 0.6 − 0.2 / 0.25 ) + 0.6 * (1 − 0.25 ) *

 0.2   0.2 
1 −  + 0.4 * 0.25 *  1 −  + 0.4 * 0.75 * 0 = 0.45
 0.6   0.25 

Type 1 firms will not mimic type 2. Indeed, if they do, their pay-
off will be
E = 0.6 * 0.25 * (1 + 1 − 0.2 / 0.75 − 0.2 / 0.25 )
+ 0.6 * (1 − 0.25 ) * (1 − 0.2 / 0.25 ) + 0.4 * 0.25 * (1 − 0.2 / 0.75 )
+ 0.4 * 0.75 * 0 ≈ 0.31

Calculations are similar for type 1.

 Index

A Berglöf, E., 139, 143

Abhyankar, A., 93 Berkovitch, E., 146, 187
Antweiler, W., 61 Brealey, R., 193, 201, 204
asset substitution, viii, 69–94, 97, Brennan, M., 122, 194, 196
139, 146, 163, 164, 223, 224,
237–9
C
Chang, C., 153
B Chemmanur, T., 202
Baker, M., viii, 125, 126, 128 control, 15–16, 69, 72, 83, 86, 135,
bank, ix, 4, 29, 34, 61–3, 70, 78–80, 140, 144, 151, 168, 186,
82–5, 89, 90, 106, 108–10, 203–5, 218–19, 244
164, 172, 177, 185, 193, 202, Cooper, I., 193, 201, 204
205, 238 corporate governance, viii, 135–56,
bankruptcy 193
direct bankruptcy costs, 29, 34, correlation, 37–9, 54, 55, 60, 61, 79,
40, 139 115, 124, 130, 218
indirect bankruptcy costs, 29, 30, coupon, 17, 89
34, 40 credit rationing, viii, 69–94, 164, 165

© The Editor(s) (if applicable) and The Author(s) 2016 251

A. Miglo, Capital Structure in the Modern World,
DOI 10.1007/978-3-319-30713-8
252 Index

D H
debtor-in-possession, 106 Habib, M.A., 193, 201, 203, 204
debt overhang, 97–111, 139, Hart, O., 137, 140
187, 189, 190, 205, 223, Harvey, C., 5, 79, 107
224 Hennessy, C., 6, 39, 118
Degeorge, F., 147, 150 Ho, K., 93
Dewatripont, M., 140, 143, 147 Horvath, M., 14
dividend policy, 105, 106
“double taxation”, 31
I
incumbent debtholders, 241
E Innes, R., 144, 146, 151
Eckbo, B.E., 61 insiders, 46–7, 64, 119, 131, 147,
“empire-building”, 136, 138, 148, 150, 194, 197
139 investment, vii, 4, 6, 10, 12, 23–6,
Esty, B., 184, 186, 193, 201 47–52, 61, 64, 69, 71–7, 80,
Ewert, R., 14 84, 86–8, 97–102, 105, 107,
exchange, 27, 49, 56, 104, 118, 166, 110, 111, 115, 116, 118, 119,
177, 215 122, 126, 127, 130–1, 135,
137, 145, 146, 148, 150,
154–6, 166, 171, 172, 176–8,
F 183, 184, 187, 189–94,
Fama, E., 37 197–200, 203–6, 215, 216,
Fisher, I., 6 228, 239, 240
Frank, M., 5, 32, 36, 37, 54, 55,
61
Franks, J.R., 139 J
“free cash-flow”, 116, 135, 137–40, Jaramillo, F., 9
190, 222 Jensen, M., 71, 137, 139, 144
French, K., 37 John, K., 192, 202
Johnsen, D.B., 203

G
Gatti, S., 185, 204, 205 K
Goyal, V., 5, 32, 36, 37, 54, 55 Kaplan, S., 141, 169
Graham, J., 5, 32, 34, 37–9, 79, Kaufman, M., 82
107 Kensinger, J., 193
Green, R., 73, 75, 78 Kim, E., 187
Grossman, S., 137, 140 Kleimeier, S., 185, 186, 193, 205
 Index 253

Korteweg, A., 30 O
Kraus, A., 32, 122, 194, 196 Oberg, A., 14
outsiders, 46–7, 53, 64, 150, 177,
194, 219, 233, 234
L overinvestment, 77–9, 140, 175,
Leary, M.T., 5, 32, 39, 55 186, 190, 238
Lee, Z., 211, 214, 217, 218
Leland, H.E., 56, 61, 118
“lemon” problem, 53 P
Levi, H., 93 Patel, F., 147, 150
limited liability, 13–14, 16, 30–1, pecking-order theory, viii, 5, 47–56,
71, 172, 176 64, 107, 115, 117, 130, 175,
Lindhe, T., 14 218, 222, 227
Litzenberger, R., 32 preferred stock
Low, A., 154 convertible preferred stock,
169
participating convertible preferred
M stock, 169
Majluf, N., 117, 176, 197, 198, 199 present value, 32, 52, 120, 123, 203,
Martin, G., viii, 193 242
Meckling, W., 71, 144 project, 3, 47, 69, 97, 117, 137, 170,
Megginson, W.L., 186 183, 224
Miglo, A., 3, 5, 14, 31, 32, 55, 61, project financing, 183–206
117, 119, 121, 126, 143, 150, Pyle, D., 56, 61, 118
176, 197, 199, 211, 214, 217
Miller, M., vii, 6, 22, 40
Modigliani, F., vii, viii, 6, 22 R
Myers, S.C., 5, 32, 47, 51, 55, 97, Rajan, R., 37, 106
117, 176, 187, 192, 197, 198, Rajgopal, S., 149
199 risk, 8, 36, 47, 55, 57, 60, 61, 64,
71–4, 77, 79, 88, 93, 99, 106,
116, 139, 140, 146, 154, 166,
N 169, 184, 190, 193, 199,
Nachman, D., 51, 61 201–5, 214, 217, 219, 224
Niemann, R., 14 “risk-bearing” signaling, 56
Noe, T., 51, 61, 122 Roberts, M., 55, 154
non-recourse debt, 183, 186, Rosenthal, H., 139
189–93, 196, 199, 201–3, Ross, S.A., 56
205, 206, 248 Roychowdhury, S., 149
254 Index

S U
Schiantarelli, F., 9 underinvestment problem, 100–2,
Shah, K., 118 105, 106, 186, 187, 192–3, 199
Shah, S., 201 underpricing, 46, 56, 115, 198, 214
Shyam-Sunders, L., 5, 55 unlimited liability, 13–16, 172, 176
Sodersten, J., 14
Stiglitz, J., vii, 45–6, 70, 80, 164,
176, 229 V
stochastic dominance von Thadden, E.-L., 143
first-order stochastic dominance,
91
increasing risk, 93 W
second-order stochastic Weiss, A., 45, 70, 80, 164, 176
dominance, 88, 92 Wessels, R., 37
Strebulaev, I., 37, 39 Whited, T., 37–9
Sussman, O., 139 Woywode, M., 14
Wright, J., 185
Wright, S., 37
T
Thakor, A., 201
Tirole, J., vii, 140, 141, 143, Z
148 Zeckhauser, R., 147, 150
Titman, S., 37, 47, 84, 86, 99, Zender, J., 5, 143, 154, 168
106 Zhao, H., 93
Zingales, L., 37