Chapter 7 – Capital Structure
Chapter Seven
Capital Structure
OVERVIEW
Chapter 7 discusses the behavioral issues associated with capital structure. In
practice, decisions about capital structure reflect a mix of traditional and behavioral
considerations. Although many managers do at times target their firms’ debt–to-equity
The behavioral approach to capital structure emphasizes that managers might be
subject to behavioral biases, investors might be subject to behavioral biases, or both
might be subject to behavioral biases. When a firm is financially constrained, but its
When managers exhibit excessive optimism and overconfidence, but the market
is efficient, then managers of cash rich firms typically adopt negative net present value
Chapter 7 – Capital Structure
a press coverage indicator, and the second is a longholder property that pertains to the
late exercise of executive stock options.
LEARNING OBJECTIVES
The main objective of this chapter is for students to demonstrate that they can identify the
manner in which biases impact the decisions that managers make about capital structure,
amount of financing, and capital budgeting. After completing this chapter students will be
able to:
1. Describe the evidence that the primary factors that drive managers’ decisions
2. Compute behavioral adjusted present value (BPV) to analyze how corporate
3. Explain why concerns about dilution and market timing lead to
interdependencies between financing and investment policy, with the latter being
Chapter 7 – Capital Structure
optimistic, overconfident managers of cash poor firms to reject some positive net
present value projects.
4. Identify excessive optimism and overconfidence in the psychological profile of
5. Explain why in some circumstances, framing effects can inhibit some firms
the primary vehicles for testing whether students have met the learning objectives.
CHAPTER OUTLINE
Traditional Approach to Capital Structure
The traditional approach to capital structure focuses on two approaches, tradeoff
theory and pecking order theory. Tradeoff theory centers on the choice of a debt–to-equity
How Do Managers Choose Capital Structure in Practice?
Chief financial officers indicate that the top two considerations that drive their
decisions about issuing new equity are dilution and market timing. The top consideration
Chapter 7 – Capital Structure
driving their decision about how much debt to issue is financial flexibility. Some aspects
BPV: Behavioral APV
Behavioral adjusted present value augments traditional adjusted present value to
include terms associated with managers’ perceptions of project NPV and financing side
Financial Flexibility and Project Hurdle Rates
Cash poor firms with limited debt capacity might choose to reject some positive
Sensitivity of Investment to Cash Flow
In practice, the investment policies of many firms are sensitive to their cash flows,
in that firms are more apt to engage in investment activity when they are cash rich than
Chapter 7 – Capital Structure
Excessive Optimism, Overconfidence, and Cash
Excessively optimistic, overconfident managers of cash poor firms reject some
positive NPV projects. Excessively optimistic, overconfident managers of cash rich firms
adopt some negative NPV projects. Two indications of excessive optimism and
BPV and the Conflict Between Short-Term and Long-Term Horizons
Mispricing can create a conflict for managers, in that they might be forced to
TEACHING TIPS FOR POWERPOINT SLIDES
Before showing the first PowerPoint slide, instructors might want to remind
students briefly what the traditional theories of capital structure indicate are the important
considerations for managers: tax shields, costs of financial distress, flotation costs, and
Chapter 7 – Capital Structure
Slide 10
Slide 10 summarizes the main considerations that financial executives report as
driving their decisions about capital structure. Dilution, market timing, and financial
flexibility top the list. Traditional considerations are mentioned as important but are
ranked below the top three.
Instructors might ask students at this stage whether they believe that any of the
Slides 17-19
Slides 17-19 continues the discussion about market timing. The slide makes the
point that stocks with low book-to-market equity are more likely to be overpriced than
the stocks of firms with high book-to-market equity. A similar remark applies to stocks
that have recently gone up in price relative to stocks that have not. One behavioral study
Chapter 7 – Capital Structure
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7
timing rather than target debt-to-equity ratios drive capital structure. Instructors might
point out that the issue remains unsettled.
Slides 14-15
Slide 4 deals with convertible debt, debt that can convert to equity at a future time
if the equity rises sufficiently in value. Convertible debt is popular among financial
executives. The slide points out that there are framing issues associated with convertible
debt in that it can be framed both as cheap debt (lower interest rate than conventional
Slide 20
Slide 20 raises the issue of the debt puzzle. The debt puzzle is one of the main
challenges to tradeoff theory. Empirical evidence suggests that firms do not fully exploit
tax shields associated with debt, relative to expected costs of financial distress. The
Chapter 7 – Capital Structure
Slide 23
Slide 23 pertains to traditional pecking order theory. Some studies conclude that
firms do seem to prioritize their sources of funding in line with the predictions of pecking
order theory. However, firms do not exhaust their sources of internal equity before
Slides 6-7
Slides 6-7 introduce the concept of BPV, behavioral APV. There are two points to
be made. First, behavioral APV is an extension of traditional APV, with perceived project
These slides pertain to the conflict between long-term and short-term that
managers face when they perceive the securities of their firms to be mispriced. A firm
that exploits what it regards as short-term mispricing might set in place long-term
Chapter 7 – Capital Structure
Slides 29-33
Slides 29-33 describe issues faced by firms having managers who are excessively
optimistic and overconfident. The overarching issue is cash flow sensitivity. For example,
a conflict faced by financially constrained firms with cash who have to choose between
using their cash to fund positive NPV projects or to repurchase undervalued equity.
excessively optimistic, overconfident managers perceive that the market is inefficient.
Instructors might ask students how such managers are likely to view the prices of their
firms’ securities and the NPV of their firms’ projects? Excessively optimistic,
overconfident managers are likely to judge that the NPV of their firms’ projects are too
high and the securities issued by their firms as undervalued. Taking that as a premise,
instructors might explain why excessively optimistic, overconfident managers of cash
Chapter 7 – Capital Structure
Instructors might ask students to comment on the Behavioral Pitfalls box on page
164 describing the experience of Adaptec. Students should be able to identify comments
pertaining to cash flow sensitivity, but linked to perceived mispricing. Instructors might
also use the Adaptec example to draw students out on the implied pecking order
Slide 26
Slide 26 deals with repurchases. The market reacts favorably to repurchase
announcements. In addition, repurchases are associated with stock price drift, suggesting
that investors underreact to the event. Instructors might ask students to comment on the
AutoNation example provided in the Behavioral Pitfalls box on page 97. In this respect,
instructors might ask students if they see any connection between the remarks made by
Chapter 7 – Capital Structure
Slides 36-41
Slides 36-41 discuss two indicators of excessive optimism and overconfidence
among corporate CEOs. The indicators are press coverage and longholding behavior in