What In This Issue—A Message From The Editor

• DOI: http://doi.org/10.1111/j.1745-6622.1999.tb00654.x
• Published date: 01 March 1999
• Date: 01 March 1999

JOURNAL OF APPLIED CORPORATE FINANCE

2

What’s In This Issue—A Message From The Editor

Does capital structure matter? And,

if so, how and why does it matter?

Ever since Miller and Modigliani pub-

lished the first of their two famous

“irrelevance” propositions in 1958,

corporate finance scholars have found

it difficult to come up with definitive

answers to these questions.

Following the M & M propositions,

academic researchers in the 1960s

and ’70s turned their attention to

market “imperfections” that might

make firm value depend on capital

structure. The main suspects were

(1) a tax code that encourages debt

by making interest payments but not

dividends tax-deductible and (2) ex-

pected costs of financial distress that

rise with increasing amounts of debt.

Toward the end of the ’70s, there was

also discussion of “signaling” effects,

such as the tendency for stock prices

to fall significantly on the announce-

ment of new equity issues and to rise

on the news of stock buybacks. These

effects appeared to confirm the exist-

ence of large “information costs” that

could also influence financing choices

in predictable ways.

Such information costs took center

stage in the ongoing debate when, in

1984, MIT’s Stewart Myers devoted

his President’s address to the Ameri-

can Finance Association to what he

called “The Capital Structure Puzzle.”

The puzzle was this: Most academic

discussions of capital structure began

with the assumption that companies

making financing decisions are guided

by a target capital structure—a pro-

portion of debt to equity that manage-

ment aims to maintain, if not at all

times, then at least as a long-run

average. But the empirical evidence

suggested otherwise. Rather than ad-

hering to leverage targets, Myers ob-

served, most large U.S. public compa-

nies appear to follow a financing

“pecking order.” They use retained

earnings rather than external financ-

ing when possible; and if outside

capital is necessary, they issue debt

first and equity only as a last resort.

Based on the Darwinian principle

that efficient practices prevail, Myers

suggested that the pecking order

maximized firm value by minimizing

expected information costs—mainly,

it seems, by reducing to near zero the

probability that the firm would ever

have to issue equity.

The vulnerable point in the peck-

ing order is its apparent blanket en-

dorsement of financial “slack”; that is,

because internal funds are always

preferred to outside financing, the

model appears to imply that manag-

ers should hoard capital and so re-

duce their dependence on capital

markets. Then, in 1986, Harvard’s

Michael Jensen entered the capital

structure debate with a very different

message. Pointing to the success of

LBOs and leveraged acquisitions,

Jensen argued that, in the case of

mature companies, heavy debt fi-

nancing could add value by eliminat-

ing financial slack and thus curbing a

managerial tendency to overinvest in

industries with excess capacity. And,

as if to confirm that Jensen was on the

right track, the capital markets contin-

ued to supply large numbers of LBOs

and other leveraged deals during the

rest of the ’80s—a trend that, except

for a brief halt in the early ’90s, has

continued throughout this decade.

In the article that opens this issue,

Michael Barclay and Clifford Smith

argue that managerial incentives,

taxes, bankruptcy costs, and informa-

tion costs all appear to play important

roles in corporate financing decisions.

The key to reconciling the different

theories—and thus to solving the capi-

tal structure puzzle—lies in achieving

a better understanding of the relation

between corporate financing stocks

(leverage ratios) and flows (specific

choices between debt and equity).

According to the authors, the bulk of

the evidence on leverage ratios is

consistent with the idea that compa-

nies do have leverage targets, and

that such targets depend primarily on

one key variable: the company’s in-

vestment opportunities. As a general

rule, the larger the percentage of a

firm’s value that consists of intangible

“growth options,” the lower the lever-

age ratio. The authors explain this

pattern as follows: For high-growth

firms, the “underinvestment problem”

associated with heavy debt financing

can end up destroying significant

value. For mature companies, how-

ever, high leverage is likely to add

value by sheltering operating income

from taxes and controlling the mana-

gerial tendency to overinvest.

But if much of the evidence sug-

gests that companies do set leverage

targets, other research indicates that

firms often deviate widely from their

targets, particularly when experienc-

ing significant changes in profitabil-

ity. Although such findings are gener-

ally viewed as evidence that corpo-

rate managers do not have target

leverage ratios—or do not try very

hard to achieve them—Barclay and

Smith provide another interpretation:

Precisely because the information (and

other) costs of issuing riskier securi-

ties can be large, “even if companies

have target leverage ratios, there will

be an optimal deviation from those

targets—one that depends on the