Emerald Group Publishing Limited
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Introduction to Managerial Finances special issue on capital structure
Article Type: Guest editorial From: Managerial Finance, Volume 37, Issue 8
About the Guest Editor
Robert M. HullClarence W. King Endowed Chair in Finance at Washburn University, Topeka, Kansas, USA. Professor Hull has taught for the past 20 years at Washburn University.
With lingering doubts and unsure of what I was getting into, I set out (over a year ago) as Guest Editor to put together a special issue on “Capital Structure.” The official call for paper asked for theoretical, empirical, practical, and pedagogical papers covering a wide range of topics related to the general subject of capital structure. Topics sought included trade-off theory, pecking order theory, agency-based theories, signaling theories, event period research related to seasoned offerings and initial public offerings, corporate governance issues, cost of capital, debt-equivalent liabilities, and generally anything related to the capital structure decision-making process. In addition, I sent out over 100 e-mails to scholars throughout the world who I identified as having done recent research in the field of capital structure. Before our deadline for submission expired, the call for papers generated nearly 30 submissions of which most were sent out to referees after passing the “eye test.”
From those submissions sent out, the review process was able to accept six papers for inclusion and my congratulations to these authors of accepted paper and for also incorporating the quality feedback given by our referees. These six accepted papers represented research covering my goal of having a special issue that included theoretical, empirical, practical, and pedagogical research. The average paper submitted to this special issue was examined by over two referees helping to guarantee that the finished work could be of high quality with minimum errors. For a few papers, it took up to 15 solicitations to find enough available referees who felt competent enough to agree to referee the paper within our time requirement. When referees disagreed on a paper’s quality, I sought further opinions. Since I am author of one of the six papers, I am required to report that this paper was handled separately outside of my jurisdiction under the same blind-review process.
2. The six accepted papers
With the above preliminaries out of the way, I will now introduce our six papers and, in the process, hopefully motivate researchers to read the papers and examine their merit. They will be introduced in the order that they were received for publication.
2.1 Distortion in corporate valuation: implications of capital structure changes
The paper “Distortion in corporate valuation: implications of capital structure changes” shows how the valuation process should be modified for firms that are expected to rebalance their debt. The authors of this paper, Professors Jacob Oded, Michel Allen, and Steven P. Feinstein (OAF), call into question the sole reliance on a traditional DCF valuation procedure that must assume firms maintain a policy of fixed debt. OAF note that this assumption is not consistent with empirical evidence that suggests many firms rebalance their debt. Thus, they contend that research is needed to explore the implication of this evidence when it comes to valuing firms that undergo a capital structure change. OAF attempts this task by reviewing and comparing the valuation procedure of firms that change their capital structure under the policies of fixed debt and rebalanced debt. Their analysis argues that the standard valuation procedure is only correct for firms that are expected to maintain a fixed level of debt following the capital structure change. OAF assert that another procedure must be used for firms that are expected to rebalance their debt after the capital structure change. They illustrate that failing to choose the appropriate valuation procedure can result in significant distortion in corporate valuation. As a practical point, the last part of their paper considers the difference in value for a sample of the largest leveraged buyouts of the current decade under the policies of fixed and rebalanced debt. This application reveals that the distortion in valuation can be substantial when a rebalanced policy is ignored.
As I look at this paper, one thought of importance surfaced for me: the discount rate of the tax shield (or any cash flows that result from debt) is an important determinant of a levered firm’s value. OAF argue that this rate increases for the rebalance situation. The general notion that cash flows resulting from leverage should not be assumed to be risk-free is consistent with my research. I would further argue that a firm’s growth rate can be a factor that also influences how we discount cash flows that result from a firm’s capital structure decision. I have attempted to address this growth rate influence in some recent publications including the pedagogical publication in this special issue.
2.2 Testing trade-off and pecking order models of capital structure: does legal system matter?
The paper “Testing trade-off and pecking order models of capital structure: does legal system matter?” provides a cross-country test for the trade-off and pecking order models of capital structure focusing on whether the country’s legal tradition (common law versus civil law) affects the model adopted and their recapitalization policy. The authors of this paper, Professors Carmen Cotei, Joseph Farhat, and Benjamin A. Abugri (CFA), conjecture that differences in legal traditions across countries lead to different levels of information asymmetry and recapitalization costs. CFA show that firms in civil law countries exhibit a significantly higher degree of information asymmetry, use more short-term debt in their capital structure, have higher cost of equity, rely more on internally generated funds to finance their investments and use more short-term debt as external source of funds relative to those in common law countries.
There are four areas that the reader might note when reading CFA’s paper that make it valuable reading for researchers. First, the significant differences in information asymmetry across countries with different legal systems provide a unique setting to test the validity and predictions of the pecking order and trade-off theories. This is the setting for CFA’s research. Second, CFA build on previous research by including 37 developed and developing countries. Third, the paper distinguishes the total speed of adjustment toward an optimal capital structure for both short- and long-term debt. My opinion is that short-term debt should not be ignored and CFA do not ignore this aspect. Fourth, regardless of the country’s legal tradition, firms seem to adjust toward an optimal capital structure albeit the rate of adjustment (and the contribution of long-term debt to such a rate) is higher in common law than in civil law countries.
2.3 Syndicated bank loans and capital structure
The paper “Syndicated bank loans and capital structure” examines the impact of interest rates on the size and the maturity choice of a syndicated bank loan, and the long-run impact of a syndicated loan on the borrower’s capital structure. The author of this paper, Professor Halil D. Kaya, evaluates a group of firms that borrow when market conditions are less favorable compared to six months ago and a group that borrow when market conditions are more favorable compared to six months ago. He finds no significant difference between the two groups of firms in terms of size, market-to-book ratio, profitability, tangibility, degree of leverage, and the amount borrowed. Thus, unlike those that find evidence of market timing for public debt offerings, Kaya finds no evidence of market timing for syndicated bank loans. In regards to loan maturities, Kaya confirms prior research by finding that firms choose longer maturities when the interest rates are low compared to the rates two or three years ago.
In his capital structure tests, Kaya find that the leverage ratios of all borrowers go up for two years after the offering. However, by the third year, the impact of the interest rates on leverage is statistically insignificant. Kaya’s study offers some weak support for the trade-off theory in that syndicated loan borrowers tend to move towards their pre-issue leverage levels over time. However, five years after the issue, they still have significantly higher debt ratios compared to their original levels. In terms of the paper’s practical ramifications, the reader might note that while the level of interest rates can be important for firms in their choices of maturity, it is not important in their choice of loan size. If financial managers can successfully predict the market activity in the coming months, they may be able to implement better strategies for their own financing needs.
2.4 Hard debt, soft CEOs, and union rents
The paper “Hard debt, soft CEOs, and union rents” offers insights on optimal managerial compensation and firm capital structure in unionized firms. Those who study capital structure should pay heed to these insights. The author of this paper, Professor Linus Wilson, uses applied game theory to address problems of CEO motivation in companies with unionized workforces. This paper is unique in its use of applied game theory to examine how CEO pay and capital structure influence the productivity of a unionized workforce.
Wilson finds that managers can use greater levels of debt and costly bankruptcy to win earnings concessions from workers, while workers can hinder management in the detection of low-quality work. CEO compensation that promotes rent sharing may reduce union hostility and concomitant dead weight losses. Shareholder value may be maximized by CEO incentive contracts with limited upsides, lower levels of pay, and some entrenchment protections. Thus, from a practical perspective, Wilson’s study offers a unique justification for top management contracts with limited upside potential and some degree of entrenchment protection. His findings lend some support for stakeholder theories of corporate governance. It is worth pondering that Wilson rejects the notion that causing the CEO to be the perfect agent of shareholders is always consistent with maximizing shareholder value. He argues that when shareholders are stuck with an incumbent union, they can make the best of a bad situation by appointing a CEO whose compensation makes him or her responsive to the demands of both shareholders and union members.
2.5 Debt-equity decision-making with and without growth
The paper “Debt-equity decision-making with and without growth” is written by me (Professor Robert M. Hull). I attempt to offer a pedagogical class exercise of the debt-equity decision-making process with and without growth. By incorporating growth, I extend the nongrowth capital structure teaching application published in the Journal of Financial Education in 2008. This paper’s extension by nature is much more complicated. The exercise applies both standard textbook gain to leverage (GL) equations and more recent GL equation including one that ties together the plowback-payout choice with the debt-equity choice. The latter GL equation is given by my recently published capital structure model with growth. Given estimates for tax rates, discount rates (costs of borrowing), and growth rates, this equation offers potential to guide managers of growth firms on how to choose an optimal debt level. This paper’s class exercise is unique in teaching students the interconnections of the plowback-payout and debt-equity decisions when maximizing firm value.
How a manager actually applies the knowledge given practical constraints (lack of formal financial theory, statistical modeling, proficiency in analytical software, time demands, and a myriad of other factors that affect firm value in reality) is not solved, but that is not the purpose of the paper. The paper seeks to provide a deeper understanding of theory through the presented exercise. Warning: readers may need a glossary to keep up with all the terminology such as given in Table 1.
2.6 Capital structure: professional management guidance
The paper “Capital structure: professional management guidance” offer a very useful way to introduce undergraduate and graduate students to capital structure materials. The authors of this paper, Professors Robert Stretcher and Steve Johnson (SJ), take a classic approach of capital structure theories that will appeal to contemporary managers and future managers who someday will be confronted with actual capital structure decision making. SJ provide students with an understanding of the how the financing choice impacts firm value, while also embodying a practical application giving mangers insight into the debt-to-equity choice.
The paper bridges the gap between the classic approach to capital structure and its use in the modern corporate environment in a very simplistic manner. Readers are not required to do the math but rather just understand the theory and applicability of the concepts in today’s working environment. SJ provide a basic understanding of capital structure and the influences on capital structure often missing from the mainstream textbooks in this area. The discussion of degrees of leverage and other considerations should prove to be relevant and useful for the reader. SJ not only identify the limitations of the capital structure theories that are discussed but also show how even limited theories have implications that are large in scope.
There are some social implications in SJ’s work. For example, proper managerial techniques and considerations for capital structure decision making can benefit society through more prudent use of debt, based on the variety of measures presented in the paper. The authors close by suggesting that the use of indicators such as leverage multiples, debt servicing multiples and the Z-score are obtainable data sources for practitioners. While indicators may not reveal an exact optimal capital structure, managers can find them useful in determining their leverage choice. If these assertions could be adopted by educators, SJ contend that our students could exhibit a greater preparation for the professional management arena.
In conclusion, I would like to thank all of the referees who names will not be given to preserve anonymity. Without your time and effort, knowledge cannot be properly advanced. To those who submitted and did not make this special issue, I would like to thank you for your submission. Many of these papers had qualities that will lead to eventual publication. Several papers with revisions (and that were not received in a timely fashion to make this special issue) will hopefully appear in another Managerial Finance (MF) issue. Hopefully, the remarks by our referees will help guide these papers.
Finally, I would like to thank all of those associated with MF who have support my efforts as Guest Editor including Andrea Watson-Lee, Support Manager for Emerald Group Publishing Limited. A special “thank you” goes to Don Johnson, MF’s Head Editor, who answered my many questions in a timely fashion and guided me throughout the process.
Robert M. HullGuest Editor