Our guest blogger this week is Dr. Harry DeAngelo, the Kenneth King Stonier Chair in Business Administration at the Marshall School of Business at USC. Dr. DeAngelo is a noted
expert on payout policy, capital structure, and corporate governance. Here,
Dr. DeAngelo discusses how transitory debt can affect the capital
structure decision. For a more detailed analysis, you can read the
entire paper "Capital Structure Dynamics and Capital Structure" here.
According to the
tradeoff theory of capital structure, firms select an optimal leverage ratio by
balancing the tax advantages of debt against the potential costs of financial
distress.
For simplicity,
consider a version of the tradeoff theory in which firms face a corporate tax
rate of 35%. Interest payments are tax
deductible, but dividend payments are not. Suppose also that any debt-to-assets ratio over 0.45 is almost certain
to result in costly financial distress while those less than or equal to 0.45
imply no chance of distress. The latter
knife-edge structure is, of course, unrealistic. But let’s stick with the assumption in order
to illustrate an economically important feature of corporate capital structure
decisions that is omitted from the traditional tradeoff arguments about optimal
capital structure.
What is the
optimal capital structure for our hypothetical firm? According to the traditional tradeoff logic,
the optimal leverage ratio is 0.45. The
firm gets maximum tax benefits by levering up to 0.45, and it runs no risk of incurring
financial distress costs. So, by the
usual tradeoff logic, the optimal strategy is to fully exhaust debt capacity (take
leverage up 0.45) to capture the tax benefits of debt.
That logic is
fine in a simple static setting in
which a firm is only concerned with balancing tax benefits and distress costs
while holding investment policy fixed.
But things
change fundamentally when we look at the problem dynamically and recognize that debt policy is about more than
finding the right mix of interest and dividend payouts. Importantly, firms issue debt because it is a
low (transaction and asymmetric information) cost vehicle for raising funds for
investment.
It is no longer
attractive for the firm to lever all the way up to 0.45. Why not? The reason is that the firm would like to have unused borrowing capacity
that it can tap in the future if a really attractive investment opportunity
arrives. The rational policy is to keep
some “dry powder” – untapped debt capacity – available. The one exception would be if the firm
currently had an outstanding investment opportunity and probable future
investment opportunities that are much less attractive. In that case, it would be rational to exhaust
debt capacity today instead of saving “dry powder” for future use.
What should a
firm with untapped debt capacity do when an attractive investment opportunity
arrives and it doesn’t have sufficient resources to fund it? In most cases, the right response is to
borrow to fund that investment and then use future earnings to pay down debt
and restore the option to borrow to meet future funding needs.
The firm’s ideal
“target” leverage ratio is less than 0.45 once one takes into account the value
of the option to borrow to meet
future funding needs.
Traditional
tradeoff theories view corporate capital structures as having only “permanent”
debt and equity components. The dynamic
theory that we have sketched here recognizes that capital structures also have
a “transitory” debt component that involves the exercise of the option to
borrow and then the restoration of that option by subsequently paying down debt.
You can think of
this view of capital structure as the corporate analog of the manner in which a
rational individual will manage his or her credit card: Use the borrowing
capacity to meet unanticipated funding needs and then repay the debt to free up
debt capacity for future use.
The logic here is
based on “Capital Structure Dynamics and Transitory Debt” by Harry DeAngelo, Linda
DeAngelo, and Toni Whited in the Journal of Financial Economics (2011, pp.
235-261).
