This paper integrates elements from the theory of agency, the theory of property rights and the theory of finance to develop a theory of the ownership structure of the firm. We define the concept of agency costs, show its relationship to the ‘separation and control’ issue, investigate the nature of the agency costs generated by the existence of debt and outside equity, demonstrate who bears costs and why, and investigate the Pareto optimality of their existence. We also provide a new definition of the firm, and show how our analysis of the factors influencing the creation and issuance of debt and equity claims is a special case of the supply side of the completeness of markets problem.

We survey 392 CFOs about the cost of capital, capital budgeting, and capital structure. Large firms rely heavily on present value techniques and the capital asset pricing model, while small firms are relatively likely to use the payback criterion. We find that a surprising number of firms use their firm risk rather than project risk in evaluating new investments. Firms are concerned about maintaining financial flexibility and a good credit rating when issuing debt, and earnings per share dilution and recent stock price appreciation when issuing equity. We find some support for the pecking-order and trade-off capital structure hypotheses but little evidence that executives are concerned about asset substitution, asymmetric information, transactions costs, free cash flows, or personal taxes. Key words: capital structure, cost of capital, cost of equity, capital budgeting, discount rates, project valuation, survey. 1 We thank Franklin Allen for his detailed comments on the survey instrument and the overall project. We

It is well known that firms are more likely to issue equity when their market values are high, relative to book and past market values, and to repurchase equity when their market values are low. We document that the resulting effects on capital structure are very persistent. As a consequence, current capital structure is strongly related to historical market values. The results suggest the theory that capital structure is the cumulative outcome of past attempts to time the equity market.

The joint determination of capital structure and investment risk is examined. Optimal capital structure reflects both the tax advantages of debt less default costs (Modigliani-Miller), and the agency costs resulting from asset substitution (Jensen-Meckling). Agency costs restrict leverage and debt maturity and increase yield spreads, but their importance is relatively small for the range of environments considered. Risk management

Abstract not found

This paper provides a competitive equilibrium model of capital structure and industry dynamics. In the model, firms make financing, investment, entry, and exit decisions subject to idiosyncratic technology shocks. The capital structure choice reflects the tradeoff between the tax benefits of debt and the associated bankruptcy and agency costs. The interaction between financing and production decisions influences the stationary distribution of firms and their survival probabilities. The analysis demonstrates that the equilibrium output price has an important feedback effect. This effect has a number of testable implications. For example, high growth industries have relatively lower leverage and turnover rates. THE INTERACTION BETWEEN CAPITAL STRUCTURE and product market decisions has recently received considerable attention in both economics and finance. Beginning

I would like to thank seminar participants at Baruch College and SUNY Binghamton for helpful comments. Are Observed Capital Structures Determined by Equity Market Timing? Contrary to Baker and Wurgler (2002), we find that the importance of historical average market-to-book in leverage regressions is not due to past equity market timing. We find that though equity transactions may be timed to equity market conditions, they do not have significant long-lasting effects on capital structure. Debt transactions exhibit timing patterns that are unlikely to induce a negative relation between market-to-book and leverage. We also find that historical average market-to-book has a significant effect on current financing and investment decisions, implying that it contains information about Traditional theories of corporate financing explain firms ’ financing choices as either the result of the fundamental trade-offs between various costs and benefits of debt and equity

Routledge have been very helpful to us. We would also like to thank seminar participants at GSIA, Rochester and We compute the value of a firm that pays its cash flows each period through share repurchases in a dynamic environment where personal taxes are paid on realized capital gains and dividends. These results provide a measure of the personal tax advantages of equity financing relative to debt financing, which are often cited as increasing the cost of debt. The initial price of the firm depends on the present value of the taxes paid, which, in turn, depends on the initial price. We solve this valuation problem in closed form in a deterministic setting and numerically in a stochastic setting. We find significant valuation effects from the tax protection afforded by the equity basis. The tax savings are on the order of 40-50 % of the taxes paid by the shareholders of firm that distributes cash through dividends, and the cost of capital is reduced by approximately.8 to 1.2 The Modigliani and Miller (1963) model of capital structure choice under taxation still forms the theoretical basis for most pedagogy and practice in modern Finance, despite its obvious empirical and theoretical limitations. This theory predicts a corner solution of all debt financing for all firms, due to the deductibility of interest payments at the corporate level. Such an outcome, however, appears grossly at variance with

Most of the existing evidence on the effectiveness of large shareholders in corporate governance has been restricted to a handful of developed countries, notably the UK, US, Germany and Japan. This paper provides evidence on the role of large shareholders in monitoring company value from a developing and emerging economy, India, whose corporate governance system is a hybrid of the outsider-dominated market-based systems of the UK and the US, and the insider-dominated bankbased systems of Germany and Japan. The picture of large-shareholder monitoring that emerges from our case study of Indian corporates is a mixed one. Like many of the existing studies, while we find blockholdings by directors to increase company value after a certain level of holdings, we find no evidence that institutional investors, typically mutual funds, are active in governance. We find support for the efficiency of the German/Japanese bank-based model of governance; our results suggest that lending institutions start monitoring the company effectively once they have substantial equity holdings in the company and that this monitoring is reinforced by the extent of debt holdings by these institutions. Our analysis also highlights that foreign equity ownership has a beneficial effect on company value. In general, our analysis supports the view emerging from developed country

This paper uses U.S. Statistics of Income (SOI) Corporate Income TaxReturns balance sheet data on all corporations, to estimate the effects of changes in corporate tax rates on the debt policies of firms of different sizes. Small firms face very different tax rates than larger firms, and relative tax rates have also changed frequently over time, providing substantial information to identify tax effects. The results suggest that taxes have had a strong and statistically significant effect on debt levels. For example, cutting the corporate tax rate by ten percentage points (e.g. from 46 % to 36%), holding personal tax rates fixed, is forecast to reduce the fraction of assets financed with debt by around 3.5%. Since small firms normally rely much more heavily on debt finance yet face much lower tax incentives to use debt, the estimated effect of taxes would be strongly biased downwards without controls for firm size.