We explore equilibrium corporate capital structure under the tradeoff that additional debt generates the familiar corporate tax benefit, while additional equity generates more information about growth opportunities, allowing a more precise estimate of the return on real investment. This precision creates value by leading to better real investment decisions. Unlike agency costs of debt, whose magnitude can be expected to be small at low leverage levels, this information benefit of equity need not necessarily be small at low leverage levels. Therefore, an all-equity corner solution for optimal capital structure may arise. Such an outcome is most likely to occur for firms that are profitable, have many growth opportunities, and are relatively unique. The model may provide valuable insight in the most important cases for which capital structure tradeoff theories have failed to predict corporate practice.
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This paper shows how to value debt or a debt equivalent, particularly emphasizing leases, when the borrowing firm has an optimal capital structure. The results contrast with those of the current leasing literature. The methodology for valuing a lease depends upon the determinants of the optimal capital structure. For example, when capital structure is determined by the tradeoff between the corporate tax benefit and agency costs of debt, using the after-tax borrowing rate to value a lease is generally incorrect. Instead, lease valuation uses the pretax borrowing rate, but requires an additional term to reflect marginal agency costs. In contrast, when capital structure is determined by the tradeoff between the corporate tax benefit of debt and the personal tax benefit of equity, lease valuation uses the after-tax borrowing rate, using the effective corporate tax rate. The calculations required in each valuation methodology presented is straightforward to implement, with the exception of the standard leasing result, which generally requires the effective corporate tax rate to be calculated.
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Venture capital funding is commonly provided to startup firms on a piecemeal basis over numerous stages. One way in which this can be implemented is through milestone financing, where a venture capitalist commits upfront to providing additional future funding contingent upon the firm meeting certain conditions, or milestones. Alternately, the firm can operate without a firm commitment in place, still reasonably expecting to be able to receive additional rounds of funding after goals are met (round financing). We identify four dimensions which can affect the optimal contract and choice of financing method: entrepreneurial effort, venture capitalist effort, venture capitalist preference for liquid investments, and heterogeneous expectations about the feasibility of the underlying real technology. The effects of these on the optimal milestone and round financing contracts are examined. Firms that prefer milestone financing to round financing (and conversely) are characterized.
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We examine stock price movements around the announcement and implementation of changes in the S&P MidCap 400 and S&P SmallCap 600 indices. For both promotions to and demotions from the indices, we find significant movements in the price of stocks facing a status change on both on the trading day following the announcement and the trading day leading up to the implementation. The stock price change is positive for promotions and negative for demotions. Although part of this price movement is retraced in the trading days after the implementation of the change, about half to three-quarters of the movement is permanent.
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We examine the optimal structure of corporate debt maturity in a multiperiod context. Three debt issuance strategies are examined: simultaneously issuing short-term and long-term debt, sequentially issuing short-term debt followed by long-term debt, and sequentially issuing long-term debt followed by short-term debt. In a model with stylized benefits and costs of debt with symmetric information, the optimal debt maturity mix for each strategy is derived, as are implications for the optimal order of debt negotiation. The effects of asymmetric information between management and investors are discussed.
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