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This note was prepared by Susan Chaplinsky, Associate Professor
of Business Administration, and Robert S. Harris, Professor of
Business Administration. It was written as a basis for class
discussion rather than to illustrate effective or ineffective
handling of an administrative situation. Copyright 1996 by the
University of Virginia Darden School Foundation, Charlottesville,
VA. All rights reserved. To order copies, send an e-mail to
[email protected]. No part of this publication may be
reproduced, stored in a retrieval system, used in a spreadsheet, or
transmitted in any form or by any meanselectronic, mechanical,
photocopying, recording, or otherwisewithout the permission of the
Darden School Foundation.
CAPITAL STRUCTURE THEORY: A CURRENT PERSPECTIVE A complex set of
decisions creates a firms capital structure. Capital structure
dictates the
funding sources tapped by the company and allocates risks and
control rights to various parties. Pursued wisely, capital
structure decisions should enhance value in financial markets. Key
decisions include the overall mix of debt and equity, the forms,
terms and maturity structure of debt, the allocation of voting
control among equity classes, the timing of security issuance, and
a host of issues about particular types of financial claims
(including hybrids such as convertibles and debt substitutes such
as leasing).
Finance scholars approach to capital structure issues reflects a
progression of thought over time. The result is an eclectic set of,
sometimes competing, theories dealing with many forces that shape
financial decisions. This note provides an overview of the current
state of capital structure theory. Classical Theory - Perfect
Capital Markets
Early theory focused on capital structure as a way to carve up a
fixed amount of operating cash flow. In this fixed pie view, the
key choice was the best split between debt and equity to allocate
these operating results. This view originated with the classic
contribution of Modigliani and Miller (1958). They showed that in
perfect capital markets a firms value is independent of capital
structure: that is, any number of different mixes of debt and
equity can result in the same firm value. While MMs policy
conclusion is not particularly appealing, their work laid an
important foundation. In particular, by spelling out the
assumptions of perfect capital markets MM pointed the way to
factors (relaxed assumptions) that help explain financial
structure. The critical properties of perfect capital markets
are:
1. No taxes, 2. No transactions or distress costs, 3. Common
objectives among decision makers (value maximization), and 4.
Perfect information available to all.
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The evolution of capital structure theory can be viewed as the
exploration of relaxing each of these four assumptions. The first
contributions noted that corporate tax benefits arise from the tax
deductibility of interest, providing a powerful incentive for using
debt. Coupled with this was the recognition that substantial
transactions costs could emerge if the firm failed to meet its debt
obligations resulting in costs of financial distress. A combination
of these two forces led to what can be called the modern
traditional theory of capital structure. The Modern Traditional
Theory - a Partial Synthesis
The modern traditional view builds on MM theory but concludes
that a firm can pick an optimal mix of debt and equity by focusing
on the tradeoffs between the tax benefits of debt and the potential
costs of financial distress. More debt exploits the tax
deductibility of interest and keeps more money in private (versus
public) hands, thereby increasing firm value.1 Eventually, however,
debt tax benefits begin to be eroded because 1) the firm runs out
of income to be shielded from taxes (perhaps due to other non-debt
tax shields such as depletion or depreciation), or 2) the increased
prospects and the potential costs of financial distress offset the
incremental tax benefits of more debt. In essence, this tradeoff
sees firms increasing their use of debt until either they run out
of income to shelter or they run up against the threat of financial
distress.2 The underlying assumption is that there is a fixed pie
of operating cash flows coming into the firm (independent of its
capital structure) and the capital structure choice is how to
divide this cash flow between debt and equity with as little going
to the government and to the costs of financial distress as
possible. The tradeoff at the margin between tax advantages and the
costs of financial distress still dominates most textbook
treatments of capital structure and was the primary focus of First
Year Finance.
This treatment of capital structure views debt and equity
generically. The primary concern centers on the overall amount of
debt and much less to said about other dimensions of capital
structure. No attention is paid to the source of equity (e.g.,
whether equity is internally generated versus raised externally) or
to the allocation of control rights. Further, transactions are
assumed to be straight forward, uncomplicated, observable exchanges
where there is little concern that one partys superior information
may disadvantage other parties. Perhaps most importantly,
individual decision makers act as price-takers who work to maximize
firm value, a common goal, rather than pursue their own agenda.
1 As Miller (1977) points out, the true tax advantage of debt
must also account for any personal tax
disadvantage if bond income is taxed at a higher rate than share
income. 2 Recent work has provided a closer look at the costs of
financial distress. For instance, the degree to which
assets have alternative uses and well-developed secondary
markets exist for the assets can result in lower liquidation costs
(Shleifer and Vishny (1992). Greater liquidation values enhance
debt capacity and can affect both the amount and structure (e.g.,
collateralized versus debenture issues) of debt. The theories have
also broadened the scope of the effects* of financial distress to
include not only explicit costs (e.g., attorneys fees) but also
other more subtle costs that arise as a firm approaches financial
difficulty. Some of these more subtle costs are explored in the
following discussion.
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Recent Developments in Theory
Recent advances result from two strands of literature
reexamining the third and fourth properties of perfect capital
markets. The first set of contributions come from agency theory
which focuses on the particular incentives and behavior of
individuals (e.g., managers and investors) who make decisions
(Jensen and Meckling (1976)). The second strand of theory
recognizes that imperfect information is the norm. Different people
have different knowledge (Leland and Pyle (1977), Ross (1977),
Myers and Majhif (1984)) and costs arise from these imbalances in
information.
More recent thought has broadened the scope of inquiry. Now the
fundamental question is: How does capital structure affect other
decisions? That is, how big is the pie? Important decisions include
investment choices by managers, purchasing decisions by customers,
and investor reactions to corporate decisions. Newer theories
require consideration of how capital structure affects the total
cash flow generated by the firm; no longer is it sufficient to
simply allocate a fixed cash flow stream Brennan (1995)). In this
size of the pie approach, attention is paid to how capital
structure will affect decision makers incentives and actions. The
operative assumption is that individual decision makers act in
self-interested ways. Capital structure is therefore seen as a
complicated nexus of contracts where different parties contributing
capital have diverse and potentially conflicting interests.
Reducing the potential for conflict among capital providers
enhances the firms ability to operate efficiently. Additionally,
the allocation of control rights, distinctions between internal and
external financing, and interactions between financial policy and
business results all come to the foreground.
Imperfect information interacts with agency theory as
individuals act based on their own information. To appreciate how
imperfect information and agency costs interact, consider the
following everyday life situation described in Milgrom and Roberts
(1992) where a driver (decision maker) must delegate some task to
an agent (the mechanic) but the decision maker is not fully
informed.
Suppose that you are traveling along a highway when a dashboard
light comes on indicating that your car is overheating. There is a
service station nearby, so you drive your car there. The
traditional analysis of this market situation is simple: There is
some price to be paid to repair the problem; either you pay it and
the car is fixed, or you decide to take your chances and decline to
get the car serviced.
That account might reflect what would happen, but there are
other possibilities. After beginning to work on the car, the
mechanic might say, Your radiator is shot. A new one will cost
$500. If you are like most drivers, you have no idea whether the
mechanic is being truthful or not. After all, it may be in the
mechanics interest to sell you a radiator, especially at that
price. You face the same problem that decision makers in
organizations frequently face: When those with critical information
have interests different from those of the decision maker, they may
fail to report completely and accurately, the information needed to
make good decisions. If the mechanic is lying to you, then both
your interests and societys interest in efficiency are
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harmed. Your interests are harmed because the mechanic is
profiting at your expense, and societys interests are harmed
because productive resources have been wasted: A radiator that
could have been repaired has instead been discarded.
Suppose that you agree to buy the radiator, wait an hour while
it is installed, and then proceed down the highway another 100
miles toward your destination. You notice the overheating indicator
on your dashboard lighting up again. Pulling into another service
station, you learn that the new radiator was not installed
correctly and it will cost you another $35 and another hour of
waiting to have the job done right. When buyers cannot easily
monitor the quality of the goods or services that they receive,
there is a tendency for some suppliers to substitute poor quality
goods or to exercise too little effort, care, or diligence in
providing the services. Once again, both you and society are
harmed. You, because you paid and waited twice for the same
service, and society, because resources were wasted.
Notice that the above problems arise because the agent may
choose to pursue his or her private interests at others expense.
The possibility of this sort of behavior is ruled out by the
perfect market assumptions of MM. Of course, if one could
costlessly write and enforce contracts that anticipate and prevent
all aspects of self interested behavior (by costlessly monitoring
an agents actions), agency costs could be eliminated. Since this
prospect is in reality unachievable, agency costs are a pervasive
influence on corporate decision making.
In Corporate Financings, we encounter agency costs most
frequently in the context of the firms capital raising efforts.
Agency theory here refers to the incentives of various parties to
pursue their own interests ahead of the shareholders or
organizations interests. Agency theory attempts to reduce the
potential for conflicts among the firms capital providers by
recognizing (and avoiding) the circumstances in which managers,
shareholders, and debtholders interests are most likely to diverge.
Special attention is paid to the design of specific securities.
What is the role of covenants? of convertible features? of
security? The motivation behind security design is to lower
monitoring costs, curtail opportunistic behavior by agents, and
hence reduce agency costs.
There are several agency problems that are frequently
encountered by firms in establishing an optimal financing policy.
These are the: (1) the agency costs of equity, and (2) the agency
costs of debt (see Jensen and Meckling (1976), Harris and Raviv
(1991), and Milgrom and Roberts (1992)). We discuss each in turn.
Agency Costs of Equity
One primary task of capital structure is the allocation of
voting and control rights. Agency costs of using equity may arise
if such usage creates a wedge between the decisions made by
managers and the interests of shareholders. It is often claimed
that managers interests (e.g. for security and personal reward) may
not coincide with those of shareholders. Suppose an
entrepreneur/manager owns 100% of the equity of a firm. Suppose
further that he or she is
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considering the purchase of an oriental carpet for the office or
by analogy any other perquisite such as corporate jets, empire
building or overpaying subordinates. If the carpet is purchased,
lets assume firm value would drop by $10,000, the full cost of
which is absorbed by the entrepreneur. Now suppose instead that
managements ownership stake had been 50%. If management refrains
from consuming perquisites, firm value will be $10,000 higher than
if the carpet is purchased. But notice that a managers gain from
behaving him or herself is only $5,000. Alternatively stated,
management can gain a resource it values at $10,000 (managements
private valuation of the carpet) for only $5,000. Accordingly, as
managements share of the equity falls, there is less and less
incentive for managers to refrain from these value destroying
investments.
The wedge between managers and shareholders interests gives
managers incentives to over invest in perquisites beyond the level
that would maximize firm value. Several courses of action have been
proposed to reduce the agency costs of equity, or the costs that
stem from the separation of ownership and control. First, one
solution is to increase the fraction of the firms equity owned by
the manager. This aligns a managers interests more directly with
shareholders interests. Alternatively, the board of directors and
other outside investors (including corporate raiders) may monitor
managers to reduce their incentives to pursue their own interests
ahead of the shareholders. Finally, Jensen (1986) suggests that
high levels of debt impose a strict discipline on managers.3 Since
debt commits the firm to pay out cash, it reduces the amount of
free cash flow available to managers to engage in self interested
behavior. In addition, holding constant the dollar size of a
managers equity holdings, greater use of leverage increases the
managers percentage control rights,4 thereby mitigating the
potential conflict between managers and shareholders. Agency Costs
of Debt
The above suggests that firms may benefit from additional debt
because it reduces the
agency costs of equity. However, before one concludes that the
firm should rely more on debt, we must recognize that greater debt
usage creates the potential for additional conflicts of interest
that do not arise in an all-equity financed firm. Debt usage can
give rise to conflicts between the interests of shareholders
(perhaps including management) and those of creditors. Conflicts
between debtholders and equityholders arise because the debt
contract gives equityholders an incentive to invest suboptimally.
There are two ways in particular that debt contracts can result in
suboptimal investment. In the literature these are described as the
asset substitution problem and the debt-overhang problem.
3 High leverage may be more appropriate in situations in which
the firm has substantial free cash flow over which management has
discretion and few promising investment opportunities.
4 Consider an example where an entrepreneur holds $100 of equity
and all other outside claims ($50) are in outside equity and there
is no debt. In this case, managerial control rights are 67%
(1001150). If leverage is increased to 33% (501150) by the
substitution of debt for all outside equity, managerial control
rights increase to 100%.
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Asset Substitution and Incentives for Over-Investment
A well known feature of debt contracts is that they have limited
upside potential. If the firms investments pay off more than what
is promised to the debtholders, equityholders capture most of the
gain. On the other hand, if the investment fails, debtholders bear
the consequences. Thus debtholders and equityholders have different
incentives to bear risk which affect their preferences for the type
of investments firms should make. The potential for conflict is
greatest when the firm is near or in financial distress. In this
circumstance equityholders may favor investing in very risky
projects that are value-decreasing (i.e., negative net present
value.) Consider a firm that has to pay $50 to debtholders in two
years and has resources consisting of $50 cash and a investment
project requiring $50 in capital today. For simplicity assume that
the firm has no other assets or interim cash flows. If no
investment is made, equityholders claims are worthless. However, if
there exists a risky project with even a remote chance of realizing
a good outcome (i.e., a payoff well above $50 in two years),
shareholders will favor this project.
Shareholders can favor this project even if the expected net
present value based on an expected value of all possible outcomes
[e.g., good, average, bad] is negative. If the project achieves a
good outcome, equityholders receive all of the benefits but debt
holders are paid only what they are promised (no more than they
would have received in the absence of the project). If the project
results in anything other than a good outcome (average or bad),
equity claims are likely to remain worthless but debtholders lose
the capital ($50) invested in the project. For a given expected net
present value, the parties interests are in direct conflict.
Debtholders instincts are to preserve capital at all costs, whereas
equityholders are to spend it on high risk projects (the equivalent
of lottery tickets.) The adoption of these bad projects causes the
firms (and debts) value to erode. However, if managers are assumed
to work in shareholders interests, bad investments are still made
because the loss in equity value from the bad investment is
outweighed by the gain in equity value captured at the expense of
debtholders. That is to say, equityholders can gain more from the
potential wealth transfer from debtholders than they lose from the
negative NPV of the project.5 Thus, this agency conflict results in
an incentive to over-invest in excessively risky projects.
Of course, one might think that these problems could be
anticipated. To the extent that they are foreseeable, the amount
creditors will lend will be less or the return they demand will be
higher. For example, if debtholders perceive these problems to be a
concern, equityholders will realize less for the sale of debt
securities than they otherwise would. Higher interest expense paid
to debtholders reduces cash flow to equity and, in turn, the value
of equity. In these ways, equityholders bear the anticipated costs
of their incentives to pursue suboptimal investment which is
created by the use of debt. Consequently, equity holders have
incentives to find ways to credibly limit their undertaking of
risky investments. An example of this are covenants placed in the
debt contract to limit capital expenditures. While these actions
may prove helpful in lowering an issuers cost, the larger point
remains: the capital markets exact a toll for these potential
conflicts and these costs must be factored into the firms decision
to seek external capital.
5 The legal term for these wealth transfers is appropriation of
capital.
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Debt Overhang and Incentives for Under-Investment
A second problem arises when the firm has excessive levels of
debt relative to its assets but also has profitable investment
opportunities (Myers (1977)) (as opposed to the above case of
unprofitable projects.) Consider the following situation where a
firm has assets worth $140 and outstanding debt of $160 million.
Currently the firm has a project which it could undertake that
costs $10 million and would produce a certain net present value of
$15 million. If the firm could find financing for the project,
asset value would rise to $165. But who would be willing to supply
the necessary funds? Suppose a new lender agrees to provide the $10
million. If the firm decides to liquidate and existing debtholders
must be paid first, then $20 of the $25 projects gross value and
all of the NPV will accrue to the old debtholders. The project is
not profitable to a new lender who receives only $5 million on a
$10 million investment. In this example, new debtholders provide
the full cost of the investment, but the returns are captured
mainly by the old debtholders. Thus, new lenders have no incentive
to supply needed funds to the firm and the profitable investment is
foregone with a resulting loss in value.6
Notice that if new lenders have little incentive to supply
additional capital to the firm, equityliolders have even less.
Infusions of equity at this point work only to insure the claims of
debtholders without necessarily supplying any return to the
equityliolder (the coinsurance problem.) That is, the projects
success will simply reduce bondholder losses rather than accrue as
shareholder gains. As in the case of excessive risk taking, the
under-investment problem can be more severe when more of a firms
value is based on future growth opportunities (linked to future
decisions) rather than to assets already currently in place.
Because the interests of old debtholders and new capital providers
are potentially so divergent, distressed firms virtually impossible
to raise additional capital through private market channels.
When firms forego profitable opportunities it also implies that
there might be other arrangements that would make everyone better
off if it were possible to renegotiate the contracts at this point.
If the project is foregone, old debtholders lose $20 million.
Suppose we can convince them to forgive $10 million of their
claims. Since new lenders will now receive $15 million back on
their $10 million investment, they will be willing to lend on the
project. By taking the project old debtholders cut their losses to
$10 million. The reality is that even though every one is better
off, it is difficult to renegotiate the terms of the debt contracts
at this point. Thus, perhaps the best course of action is to set
limits on the amount of debt in relation to assets to reduce the
probability of the firm finding itself in this situation. Other
Agency Costs
A third source of agency costs concerns the relationships not
only within the firm (among managers and investors) but between
different firms and with customers. For instance, suppose a
6 The situation described provides a rationale for
debtor-in-possession financing. To aid distressed firms in raising
much needed capital, bankruptcy courts sometimes approve DIP
financing which affords new creditors claims a higher priority than
existing creditors claims.
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firms products involved an extensive need for maintenance and/or
repair services. Current purchases of the product may depend on
customers confidence that the firm will provide these services in
the future. If such confidence is reduced by higher debt loads and
the attendant possibility of financial distress, more debt may
actually hurt the firms sales and operational performance (Titman
(1984)). In this case, there is a direct link between the size of
the pie to be divided and the choice of how to allocate returns.
Such a linkage is in direct contrast to MMs underlying assumptions.
The implication of this reasoning is that product characteristics
and links to other firms will affect debt usage.
In sum, one can view each of the agency costs of debt
articulated here as adding extra costs to the use of debt,
increasing the true costs that may result from anticipated
financial distress. Such costs include not only out-of-pocket costs
of a bankruptcy proceeding but also costs due to suboptimal
decision making and compromised business relationships. Connection
with Imperfect Information
As noted earlier, agency problems are often exacerbated in the
presence of imperfect information. Imperfect information increases
the difficulty of the parties to verify and monitor their position
vis-a-vis other capital holders, thereby increasing the costs of
raising capital. The term asymmetric information refers to one
party having superior information to another. Often, it is assumed
that managers, who possess inside information, likely know more
about the firm than investors, who possess only public information.
In such a setting, capital structure and capital structure changes
(e.g., security issues, repurchases, dividends) can reveal private
information to financial markets and hence affect value (Ross
(1997)).
In Myers and Majluf (1984), the firms announcement of a debt or
equity security issue indirectly reveals (signals) managers view of
the future outlook for the firm. If a firm announces an equity
issue, investors must evaluate whether the firms need for capital
is due to an abundance of profitable investment activities (good
news) or is due to management acting opportunistically and issuing
shares when they are over-valued (bad news). Unless shareholders
can readily distinguish good from bad firms or management can
credibly signal they are a good firm (bonding), investors must
factor in some probability that the firm is issuing
opportunistically and that stock price will fall following the
offer. Thus, investors rationally discount the firms stock price
when they learn of an equity offer. This explanation provides some
rationale for why equity issues are typically accompanied by stock
price declines. Debt issuance, on the other hand, does not elicit
stock price decreases. Hence, relative to equity issues, debt
issues convey more positive news (Smith (1986)). One explanation
for the more neutral response of debt issues is that even if the
firms stock price falls following the issue (likely because
operating performance weakens), the value of debt could be largely
unaffected by these events-especially if the debt is highly rated.
The existence of asymmetric information and investors concerns that
they will be adversely affected by what management knows and they
dont raises the cost of obtaining outside capital. One can view the
loss in stock value on the day that an equity issue is announced as
an indirect cost of equity financing. A clear message is that
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management should spend time informing the market about company
value and management plans to avoid unnecessary guessing games that
may cause share price fluctuation. A key challenge is to develop a
reputation so that management communication is credible. Because
asymmetric information increases the transaction costs of raising
outside capital, particularly equity capital, Myers (1984) posits a
pecking order theory of capital structure. This theory predicts
that firms rely, to the extent possible, on internally generated
funds to finance new investment. After exhausting internal funds,
the theory states that firms have a strong preference to issue safe
debt first and only when absolutely necessary resort to riskier
claims such as equity. Theoretically the pecking order results from
the high transactions costs and important information asymmetries
between managers and investors that make security issuance costly.
By following this view firms avoid some of the distortions in
investment incentives that arise in the presence of agency costs
and imperfection information. Myers offers this view as broadly
consistent with the observed financing patterns of U.S. firms.7 An
implication of the pecking order is that firms not may have a
long-term target mix of debt and equity but rather adjust
episodically to the balance of funds generated and investment
needs. Moreover, in contrast to the MM view, internal equity via
returned earnings is a very different source of financing than new
share issues. It also implies that building up financial slack (in
the form of safe liquid assets) can be value enhancing.8 Pulling
the Elements Together
One perspective on capital structure choice is to view it as
posing tradeoffs among five elements:
1. the tax benefits of financing, 2. the explicit costs of
financial distress, 3. the agency costs of debt (including an array
of indirect costs linked to financial distress), 4. the agency
costs of equity, and 5. the signaling effect of security
issuance.
The first two elements lead to the modem traditional tradeoff
discussed earlier. The third and fourth build on agency theory and
imperfect information and emphasize the individual incentives of
decision makers. The fifth recognizes that the very act of issuing
a security can convey new information to investors when there is
imperfect information. These general strands of
7 Consider the well-known examples of highly profitable firms
(American Home Products, Lilly, US Tobacco)
which use little debt. Given their strong cash flows, these
firms would seem to have little probability of distress and great
need for tax shields.
8 in some respects a pecking order story appears to run counter
to some arguments based on control and agency costs of equity. For
instance, in Myers story building up financial slack is desirable
because it reduces the need to raise external capital. According to
Jensens (1986) free cash flow view, more financial slack can be
detrimental results of its managers interests supplanting those of
shareholders. The key distinction is that Jensens view applies
mainly to firms without strong investment opportunities.
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theoretical inquiry often overlap and each provides important
new insights that supplement the traditional tax/financial distress
tradeoff. These newer theories also provide a much richer array of
insights into more detailed dimensions of financial policy, down to
the structure of individual claims such as debt contracts, leases,
and convertibles. The downside is that at present, there is no
overarching synthesis of these theories. As a result, practical
application requires careful identification of how any of these
particular theories are relevant to the business, markets, and the
situation at hand. Where Does This Leave Us?
Bringing together these strands yields a new synthesis in which
optimal capital structure is viewed again as a trade off between
leverage related benefits and costs. Now, however, these effects
include agency costs and information effects supplementing the
traditional view of tax features and explicit costs of financial
distress. These new factors add the important implication that the
firms business results may actually depend on capital structure.
The size of the pie to be divided depends on how it is to be
sliced. Furthermore, slices come in many sizes and shapes that are
not covered by the simple distinction between debt and equity.
Table 1 recaps some of the important features of this new
synthesis. Table 2 lists some additional issues.
What are key implications of the new theories of capital
structure? Firms and managers must recognize that the world is
filled with potential conflicts of interest as different decision
makers interact. The field of actors is wide (managers, employees,
customers, investors, boards of directors), information is
imperfect and financial policy decisions can affect decision makers
incentives and information. Such effects feed into financing costs
as well as into the underlying business results for the firm. Firms
should take prudent steps to lower costs that arise from such
conflicts through appropriate channels such as agreeing to
covenants, purchasing productive assets that can be redeployed,
understanding customer and supplier views about its risk, keeping a
margin of reserve borrowing power, keeping markets informed of the
firms performance, structuring incentive based employee contracts,
and considering the structure of its board of directors. Newer
theories of financial policy emphasize that capital structure is
not a narrow decision about the level of debt but a broad look at
the firm, its products, its markets and its governance.
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Table 1: A Summary of Key Factors to Consider in Capital
Structure Policy
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Table 2: Other Dimensions of Capital Structure Policy
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