The Capital Structure Puzzle: The Evidence Revisited

Michael J. Barclay · Clifford W. Smith

221 citations0/0 files storedJournal of applied corporate finance

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Corporate Finance and Governance Financial Analysis and Corporate Governance Financial Reporting and Valuation Research

Abstract

Since the formulation of the M&M propositions almost 50 years ago, financial economists have been debating whether there is such a thing as an optimal capital structure—a proportion of debt to equity that maximizes shareholder value. Some finance scholars have followed M&M in arguing that both capital structure and dividend policy are largely “irrelevant” in the sense that they have no significant, predictable effects on corporate market values. Another school of thought holds that corporate financing choices reflect an attempt by corporate managers to balance the tax shields and disciplinary benefits of greater debt against the costs of financial distress. Yet another theory says that companies do not have capital structure targets, but simply follow a financial “pecking order” in which retained earnings are preferred to outside financing, and debt is preferred to equity when outside funding is required. In reviewing the evidence that has accumulated since M&M, the authors argue that taxes, bankruptcy (and other “contracting”) costs, and information costs all appear to play an important role in corporate financing decisions. While much of the evidence is consistent with the argument that companies set target leverage ratios, there is also considerable support for the pecking order theory's contention that firms are willing to deviate widely from their targets for long periods of time. According to the authors, the key to reconciling the different theories—and thus to solving the capital structure puzzle—lies in achieving a better understanding of the relation between corporate financing stocks (the levels of debt and equity in relation to the target) and flows(or which security to issue at a particular time).

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References

1986Agency Costs of Free Cash Flow, Corporate Finance, and Takeovers 1977Determinants of corporate borrowing 1984The Capital Structure Puzzle 1995What Do We Know about Capital Structure? Some Evidence from International Data 1977The Determination of Financial Structure: The Incentive-Signalling Approach 1992The investment opportunity set and corporate financing, dividend, and compensation policies 1980Optimal capital structure under corporate and personal taxation 1984On the Existence of an Optimal Capital Structure: Theory and Evidence

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