590
C H A PT E R 1 8 Capital Structure and The Cost of Capital
may account for this decline in credit quality, including
more risk-tolerant investors, more
risk-taking corporate managers, and perceptions of lower bankruptcy costs. In 2016, only two
U.S. corporations were AAA rated: Johnson & Johnson, and Microsoft.
17
Agency Costs
From Chapter 13, we know that agency costs are restrictions placed on corporate managers to
limit their discretion. They measure the cost of distrust between investors and management.
To protect bondholders, covenants may require the fi rm to maintain a minimum liquidity level
or they may restrict future debt issues, future dividend payments, or certain forms of fi nancial
restructuring. Agency costs may take the form of explicit expenses, such as a requirement that
the fi rm’s fi nances be periodically audited.
The cost to the fi rm’s shareholders of excessive covenants and interference with manage-
ment discretion will likely cause fi rms to avoid excessive debt in the United States. In other
words, the relationship between the level of agency costs and fi rm debt
will look similar to that
of bankruptcy costs and fi rm debt in Figure 18.8. The joint eff ect of bankruptcy and agency
costs will reduce the optimal debt fi nancing level for a fi rm below the level that would be
appropriate if agency costs were zero.
GLOBAL
The situation may be diff erent for non-U.S. companies. Agency costs may diff er
across national borders as a result of diff erent accounting principles, banking structures, and
securities laws and regulations. U.S. and UK fi rms use more equity fi nancing than fi rms in
France, Germany,
and Japan, which use relatively more debt fi nancing. Some argue these appar-
ent diff erences can be explained by diff erences in equity and debt agency costs across the coun-
tries.
18
For example, agency costs of equity seem to be lower in the United States and the United
Kingdom. These countries have more accurate systems of accounting than the other countries,
with higher auditing standards. Dividends and fi nancial statements are distributed to sharehold-
ers more frequently, as well, which allows shareholders to monitor management more easily.
Germany, France, and Japan, on the other hand, all have systems of debt fi nance that may
reduce the agency costs of lending. In these countries, a bank can hold an equity stake in a
corporation, meet the bulk of the corporation’s borrowing needs, and have representation on
the corporate board of directors. Corporations can own stock in other companies and have
representatives on other companies’ boards. Companies frequently get fi nancial advice from
groups of banks and other large corporations with which they have interlocking directorates.
These institutional arrangements reduce the monitoring and agency costs of debt; thus, debt
ratios are higher in France, Germany, and Japan.
19
A Firm’s Assets and Its Financing Policy
Firms’ asset structures and capital structures are related because
of agency and bankruptcy
costs. Evidence shows that fi rms with fungible, tangible assets (i.e., assets in place that can
be easily sold and used by another fi rm, such as railroad cars or automobiles) use more
17
In April 2016, due to declining oil prices and steady capital spending plans, S&P downgraded ExxonMobil from
AAA to AA+. See Ciara Linnane, “ExxonMobil’s downgrade leaves just two AAA-rated companies in the U.S.,”
accessed July 14, 2016, http://www.marketwatch.com/story/exxon-mobils-downgrade-leaves-just-two-aaa-rated-
companies-in-the-us-2016-04-26. In April 2014, ADP (Automatic Data Processing) was downgraded from AAA fol-
lowing the spin-off of a subsidiary, with plans to use the proceeds to repurchase stock. See Matt Kranz, “Downgrade!
Only 3 U.S. Companies now rated AAA,” accessed March 9, 2016, http://americasmarkets.usatoday.com/2014/04/11/
downgrade-only-3-u-s-companies-now-rated-aaa/. A fi fth fi rm, Pfi zer, downgraded to AA due to the debt and cash
fl ow aspects of its 2009 acquisition of Wyeth Labs.
See Ben Steverman, “Pfi zer Loses Its Triple-A Credit Rating,”
accessed July 14, 2016, http://www.bloomberg.com/news/articles/2009-10-15/pfi zer-loses-its-triple-a-credit-rating.
Eric, Dash, “AAA Rating Is a Rarity in Business,”
New York Times
, (August 2, 2011), p. B1; Charles Mead, Victoria
Stilwell, & Sarika Gangar, “Apple’s $145 Billion in Cash Fails to Win AAA Debt Rating,” accessed June 17, 2013,
http://www.bloomberg.com/news/2013-04-24/apple-s-145-billion-in-cash-fails-to-win-aaa-debt-rating.html.
18
See J. Rutherford, “An International Perspective on the Capital Structure Puzzle,”
Midland Corporate Finance
Journal
,
Fall 1985, pp. 60–72. For a perspective on several countries in the Asia Pacifi c region, see Rataporn Dee-
somsak,
Krishna Paudyal, and Gioia Pescetto, “The Determinants of Capital Structure: Evidence from the Asia
Pacifi c Region,”
Journal of Multinational Financial Management
, vol. 14, issue 4-5, 2004, pp. 387–405.
19
Higher debt ratios exist in these countries, after allowing for diff erences in accounting principles.
18.8 Insights From Theory and Practice
591
debt fi nancing than fi rms with many intangible assets. Examples of intangible assets include
growth opportunities, the value of the fi rm’s R&D eff orts, and customer loyalty built and
maintained through large advertising expenditures.
Agency costs and bankruptcy costs impose lighter burdens on fi nancing for investments
in tangible assets. A lender can more easily monitor the use of tangible assets, such as physical
plant and equipment. Well-developed accounting rules govern methods
for tracking such asset
values. Also, tangible assets can be sold and reused, and they will not lose all of their value
following a period of fi nancial distress. Such may not be the case for intangible assets whose
value mainly resides within the fi rm.
The Pecking Order Hypothesis
One perspective on fi rms’ capital structure decisions is based on repeated observations of how
corporations seem to raise funds over time. The theory behind this perspective is based on the
belief that management knows more about the fi rm and its opportunities than does the fi nan-
cial marketplace, and it is based on the belief that management does not want to be forced to
issue equity when stock prices are depressed.
Evidence shows that corporations rely mainly on additions to retained earnings to fi nance
growth and capital budgeting projects. If they need outside fi nancing, fi rms typically issue
debt fi rst, as it imposes lower risk on the investor than equity and it costs less to the corpor-
ation. Should a fi rm approach its debt capacity, it may
well favor hybrid securities, such as
convertible bonds, over common stock. As a last resort, the fi rm will issue common equity.
Thus, the fi rm has a fi nancing “pecking order” rather than a goal to maintain a specifi c target
debt/equity ratio over time.
Under this
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