COURSE TITLE: SEMINOR IN FINANCE COURSE CODE: MPH 622

Presentation on

Synopsis on: What Managers Think Of Capital Structure Theory: A Survey

Conducted by:

J. Michael Pinegar and Lisa WilbrichtAssociate Professor, Brigham Young University

AndAn Honors Graduate, University of Iowa

Published in: Financial Management; 18, 4; pg. 82-91. (1989)

27th April, 2011

Presentation Outline

Purpose and motivation

Research Methodology

Major Findings

Critical appraisal

Purpose & motivation

To examine the extent managers use the assumptions and/or inputs of capital structure models generated by academicians in making financial decisions.

The inspiration of the study is based on the opposing views of the academicians regarding capital structure theory and research gap in practice.

Purpose & motivation…..

Research Gap(Practitioners’ point of view):

Motivation of the study

MM (1958): capital structure

decisions do not affect

firm value

Other authors, summarized by Smith (1986):

capital structure can

affect firm value.

Finance Literature

With the literature on capital structure, authors stated that, the focus of the debate shifted from whether capital structure decisions matter to why they matter?

Explanation 1:

Change in cap. structure = Change in security prices, because firms are moving closer to their optimal or target capital structure.

Explanation 2:

Capital structure decisions are irrelevant but that the information they convey concerning the firm’s investment opportunities causes security holders to revise their expectations of the firm’s prospects.

Purpose &motivation…..

Population: US firms

Sample: Fortune 500 firms

Response rate: 35.2%

Respondents: CFOs or the officials more close to

financing procedures

Study period: base1986, data retrieved from edition of

fortune magazine on 27th April 1987.

Methodology

Method…

Capital Structure Theories

First, Static tradeoff models: predict that firms maintain a target debt-equity ratio.

Second, Pecking order hypothesis: internal funding strictly dominates external sources.

Finally, Other models: neither an optimal combination nor an optimal hierarchy of external sources is implied.

Major findings

121 indicated a preference for the financing hierarchy,

while 47 preferred to maintain a target capital structure.

It is concluded that that managers who follow a

financing hierarchy prefer internal equity, then straight

debt, then convertible debt, and finally new common

stock.

Sources of funds First . . . . SixthNot

Ranked Mean

1. Internal Equity (RE) 84.3 0.8 1.7 5.61

2. Straight Debt 14.9 0.8 0.8 4.88

3. Convertible Debt 0 3.3 9.9 3.02

4. External Common Equity 0 39.7 6.6 2.42

5. Straight Pref. Stock 0 14 12.4 2.22

6. Convertible Pref. Stock 0 33.1 12.4 1.72

Corporate managers evaluate investment and financing decisions simultaneously. Justified that two

of the factors in the top ranking is related to the new

project and one regarding financing.

Major findings…..

Inputs/Assumptions Unimportant . . . Important Not Ranked Mean

1. Projected CF from asset to be financed 1.7 58 0 4.41

2. Avoiding dilution of common shareholders' claims 2.8 33 0 3.94

3. Risk of asset to be financed 2.8 33 0.6 3.91

4. Restrictive covenants on senior securities 9.1 27.3 0 3.62

5. Avoiding mispricings of securities to be issued 3.4 18.7 0 3.6

6. Corporate tax rate 4 13.1 1.1 3.52

7. Voting control 17.6 19.3 0 3.24

8. Depreciation and other non-debt tax shields 8.5 7.4 1.1 3.05

9. Correcting mispricings of outstanding securities 14.8 5.1 1.7 2.66

10. Personal tax rates of debt and equity holders 31.2 1.1 0 2.14

11. Bankruptcy costs 69.3 4.5 2.3 1.58

Major findings…..

Managers disagree with the notion of efficient markets at least part of the time.

Nature % of respondents Time

Correctly price 47.2 More than 80%

Fair pricing 40.3 50 to 80%

Correctly price 11.9 Less than 50%

This conclusion is also supported by the chi-square test

that market is not efficient.

Thus, market efficiency appear to have little impact on

financing decisions, and deliberate signals of the firm

value through the debt-equity choice seem unlikely.

Major findings…..

The static tradeoff models seem least well supported by the survey results. Its key characteristics ranked low.

Inputs/Assumptions Mean

1. Projected CF from asset to be financed 4.41

2. Avoiding dilution of common shareholders' claims 3.94

3. Risk of asset to be financed 3.91

4. Restrictive covenants on senior securities 3.62

5. Avoiding mispricing of securities to be issued 3.6

6. Corporate tax rate 3.52

7. Voting control 3.24

8. Depreciation and other non-debt tax shields 3.05

Tax factors do not appeared the fundamental determinants of the debt-equity choice even for the large, successful firms.

Major findings…..

Description Response

No revision in capital structure when tax reform 82.40%

Other factors are more important tan tax 83.40%

Financing planning principles dominate specific capital structure models in governing financing decisions for the firms. (planning principle vs inputs)

Major findings…..

Planning principle Unimportant . . . ImportantNot

Ranked Mean

1. Maintaining financial flexibility 0.6 61.4 0.6 4.55

2. Ensuring long-term survivability 4 76.7 0 4.55

3. Maintaining a predictable source of funds 1.7 35.8 0 4.05

4. Maximizing security prices 3.4 37.5 1.7 3.99

5. Maintaining financial independence 3.4 40.9 1.7 3.99

6. Maintaining a high debt rating 2.3 13.1 0 3.56

7. Maintainging comparability with other firms in the industry 15.9 2.8 0.6 2.47

Inputs/Assumptions Unimportant . . . Important Not Ranked Mean

1. Projected CF from asset to be financed 1.7 58 0 4.41

2. Avoiding dilution of common shareholders' claims 2.8 33 0 3.943. Risk of asset to be financed 2.8 33 0.6 3.91

5 of 7>3.90

3 of 11>3.90

Preferred stock is used mainly for specialized needs

Major findings…..

The financing decision is the most flexible of all the

sources and uses of funds constraints i.e. it is least

binding.

When new attractive investment opportunity is

available, most of the managers (82.4%) indicated that

they would deviate from their target capital structure or

financing hierarchy.

Strength:

The study is useful for the initial learners; basic statistics were used for the analysis, thus, it is easy to understand and to get the ideas of the study.

Weaknesses:

The study is based on the survey, thus the generalization of the results might not be possible and it is biased toward large firms.

Critical appraisal

Thank you.