VANDERBILT UNIVERSITY ROUNDTABLE ON THE CAPITAL STRUCTURE PUZZLE

• DOI: http://doi.org/10.1111/j.1745-6622.1998.tb00073.x
• Date: 01 March 1998
• Published date: 01 March 1998

JOURNAL OF APPLIED CORPORATE FINANCE

88

BANK OF AMERICA JOURNAL OF APPLIED CORPORATE FINANCE

JOEL STERN: Good afternoon. I’m

Joel Stern, managing partner of Stern

Stewart & Co., and, on behalf of our

hosts here at Vanderbilt’s Owen Gradu-

ate School of Management, I want to

welcome you all to this discussion of

corporate capital structure. Before

getting into our subject matter, let me

take a moment to thank Hans Stoll for

organizing this conference on “Finan-

cial Markets and the Corporation.” I

also want to take this opportunity to

salute Professor Martin Weingartner—

in whose honor this conference is

being held—at the conclusion of a

long and productive career. Marty’s

contributions to the field of corporate

finance are many and considerable;

and, though he may be stepping

down from his formal position, we

expect to continue to hear from him

for many more years.

The subject of today’s meeting is

corporate capital structure: Does capi-

tal structure matter? And, if so, how and

why does it matter? Although these

questions have been seriously debated

in the academic finance profession for

almost 40 years, we seem to be no

closer to a definitive answer than we

were in 1958, when Merton Miller and

Franco Modigliani published their ar-

ticle presenting the first of their two

famous “irrelevance” propositions.

Following the M&M propositions,

academic researchers in the 1960s

and ’70s turned their attention to

various market “imperfections” that

might make firm value depend on

capital structure and dividend policy.

The main suspects were (1) a tax code

that encourages debt by making inter-

est payments, but not dividends, tax-

deductible and (2) expected costs of

financial distress, including corporate

underinvestment, that can become

important as you increase the amount

of debt in the capital structure. To-

ward the end of the ’70s, there was

also discussion of “signalling” effects—

for example, the tendency for the

stock market to respond negatively to

announcements of new stock issues.

Such effects seemed to confirm the

existence of large “information costs”

that might also influence corporate

financing choices in predictable ways.

VANDERBILT UNIVERSITY ROUNDTABLE ON

THE CAPITAL STRUCTURE PUZZLE

April 2, 1998 Nashville, Tennessee

PHOTOGRAPHS BY PEYTON HOGE

9

VOLUME 11 NUMBER 1 SPRING 1998

A defining moment in the aca-

demic capital structure debate came

in 1984, when Professor Stewart

Myers devoted his Presidential ad-

dress to the American Finance Asso-

ciation to something he called “The

Capital Structure Puzzle.” The puzzle

was this: Most academic discussions

of capital structure were based on

the assumption that companies make

financing decisions that are guided

by a target capital structure—a pro-

portion of debt to equity that man-

agement aims to achieve, if not at all

times, then at least as a long-run

average. But the empirical evidence

suggested otherwise. Rather than ad-

hering to targets, Professor Myers

observed, most large U.S. public com-

panies behaved as if they were fol-

lowing a financial “pecking order.”

They were funding investment with

retained earnings rather than exter-

nal financing if possible; and if exter-

nal funding was necessary, they is-

sued debt first and equity only as a

last resort.

Since then, the capital structure

debate has raged on. Harvard profes-

sor Michael Jensen entered it in the

mid-1980s, pointing to the success of

LBOs and citing the beneficial effect

of debt financing on management’s

tendency to overinvest in industries

with excess capital and capacity. And,

as if to oblige Professor Jensen, the

market continued to supply large

numbers of LBOs and other highly

leveraged transactions throughout the

rest of the decade. Then, in the early

’90s, we saw an almost complete halt

to leveraged deals. But today, of

course, leverage is back. A new wave

of LBOs has shattered most of the old

records, and junk-bond issuance is at

all-time highs.

So, if capital structure is irrelevant,

then what’s going on here? And do the

successes of the LBO movement have

anything to say to the managements

of our largest public companies?

With us here to discuss these is-

sues, and to help us shed some light

on this capital structure puzzle, is a

small, but distinguished group of aca-

demics and practitioners. And let me

introduce them briefly:

STEWART MYERS, whose name I

have already mentioned several times,

is the Billard Professor of Corporate

Finance at one of my favorite schools,

the MIT Sloan School of Management.

Stew has done research over the years

in issues dealing with capital struc-

ture, valuation, and regulation. He

has also been an adviser to a large

number of corporations and financial

institutions. And let me mention that,

for us at Stern Stewart, the name

Stewart Myers has a special signifi-

cance. As most people here are well

aware, Stew is the co-author, with

Dick Brealey of the London Business

School, of Principles of Corporate Fi-

nance, the leading textbook in corpo-

rate finance. Every person who gets

hired at Stern Stewart is required to

have read that volume by the time he

or she walks in the door.

ALICE PETERSON is Vice Presi-

dent and Treasurer of Sears, Roe-

buck and Co. As we all know, Sears

has made dramatic improvements in

operating performance and achieved

large increases in shareholder value

over the past few years. Alice joined

Sears in 1989 as Director of Corpo-

rate Finance, four years before being

made Vice President and Treasurer

in 1993. Prior to coming to Sears, she

held corporate finance and treasury

positions at Kraft and at Pepsico. She

earned her MBA here at Vanderbilt

in 1981, and she serves on the boards

of two New York Stock Exchange

companies.

JOHN McCONNELL is the

Emanuel T. Weiler Professor of Fi-

nance at Purdue University. John has

made extensive contributions to the

field of corporate finance, especially

in the analysis of innovative securi-

ties. I still remember an article on

income bonds that John contributed

to our old Chase Financial Quar-

terly, the original predecessor of our

Journal of Applied Corporate Finance.

And, in an issue of the JACF about

five or six years ago, John co-

authored (with Eduardo Schwartz) a

fascinating account of the origins of

LYONS, the very successful puttable,

convertible securities pioneered by

Merrill Lynch. Given John’s ability to

tell stories, none of us is surprised

that he manages to win teaching

awards at Purdue year after year.

Last is DENNIS SOTER, my col-

league and fellow partner at Stern

Stewart. After graduating from the

University of Rochester’s Simon

School of Business in 1972, Dennis

joined me at the Chase Manhattan

Bank. Then, in 1979, we parted ways.

Dennis became Vice President in

charge of corporate development at

Brown Foreman, where he helped

transform the firm from the maker of

Jack Daniels (and other mild intoxi-

cants) into a diversified consumer

goods firm. Then he went to Ernst &

Whinney, where he was the national

practice director of M & A. Next he

joined Citizens Utilities and helped

them to become something of an

unregulated company as well as a

regulated company.

Several years ago, we were very

fortunate in persuading each other

that we should be together again.

And Dennis now runs our corporate

finance advisory activity and also

oversees implementations of EVA in

middle market-sized companies. In

the past two years, as I’m sure Den-

nis will tell us, he served as financial

adviser in three highly successful le-

veraged recapitalizations. Each of

these three deals involved borrow-

ing substantial amounts of new debt

to buy back shares—and two in-

volved major changes in dividend

policy as well.