What Managers Think of Capital Structure Theory: A Survey

Abstract

N This survey examines the extent managers use the assumptions and/or inputs of capital structure models generated by academicians in making financing decisions. Modigliani and Miller [14] showed that capital structure decisions do not affect firm value when capital markets are perfect, corporate and personal taxes do not exist, and the firm's financing and investment decisions are independent. However, when one or more of the MM assumptions are relaxed, many authors demonstrate how firm value may vary with changes in the debt-equity mix. Most frequently, the optimal capital structure maximizes firm value by simultaneously minimizing external claims to the cash flow stream flowing from the firm's assets. Such claims include taxes paid to the government by the firm and its security holders; bankruptcy costs paid to accountants, lawyers, and the firm's vendors; and/or agency costs incurred to align managerial interests with the interests of capital suppliers. Until recently, the capital structure debate was mainly a theoretical one, with the relevance or irrelevance of financing decisions turning on the modeler's willingness to accept the existence of significant market imperfections. (See Miller [12], DeAngelo and Masulis [2], Kim [9], Haugen and Senbet [6], Titman [25], Jensen and Meckling [8], Fama [5], and Smith and Warner [22] for different perspectives on the relevance of the market imperfections in the preceding paragraph.) However, empirical evidence, summarized nicely by Smith [21], now strongly indicates that changes in a firm's capital structure can affect firm value. Thus, the We appreciate the many useful comments made by James Ang, Barbara Yerkes, and the referees of this journal.