What Managers Think of Capital Structure Theory: A Survey

Author(s): J. Michael Pinegar and Lisa Wilbricht

Source: Financial Management, Vol. 18, No. 4 (Winter, 1989), pp. 82-91
Published by: Wiley on behalf of the Financial Management Association International
Stable URL: http://www.jstor.org/stable/3665800
Accessed: 16-08-2015 06:48 UTC

Your use of the JSTOR archive indicates your acceptance of the Terms & Conditions of Use, available at http://www.jstor.org/page/
info/about/policies/terms.jsp
JSTOR is a not-for-profit service that helps scholars, researchers, and students discover, use, and build upon a wide range of content
in a trusted digital archive. We use information technology and tools to increase productivity and facilitate new forms of scholarship.
For more information about JSTOR, please contact support@jstor.org.

Wiley and Financial Management Association International are collaborating with JSTOR to digitize, preserve and extend
access to Financial Management.

http://www.jstor.org

This content downloaded from 132.181.2.66 on Sun, 16 Aug 2015 06:48:24 UTC
All use subject to JSTOR Terms and Conditions

Survey

What

Managers
Theory: A Survey

Think

of

Capital

Structure

J. MichaelPinegarand LisaWilbricht

J. Michael Pinegar is an Associate Professorof Finance, MarriottSchool

of Management,Brigham Young University,Provo, UT. Lisa Wilbrichtis
an honors graduatefrom the College of Business, Universityof Iowa, Iowa
City.

This survey examines the extent managers use the

assumptions and/or inputs of capital structure models
generated by academicians in making financing decisions. Modigliani and Miller [14] showed that capital
structure decisions do not affect firm value when capital markets are perfect, corporate and personal taxes
do not exist, and the firm's financing and investment
decisions are independent. However,when one or more
of the MM assumptions are relaxed, many authors
demonstrate how firm value may vary with changes in
the debt-equity mix. Most frequently, the optimal capital structure maximizes firm value by simultaneously
minimizing external claims to the cash flow stream
flowing from the firm's assets. Such claims include

taxes paid to the government by the firm and its security

holders; bankruptcycosts paid to accountants, lawyers,
and the firm's vendors; and/or agency costs incurred to
align managerial interests with the interests of capital
suppliers.
Until recently,the capitalstructuredebatewas mainly
a theoretical one, with the relevance or irrelevance of
financing decisions turning on the modeler's willingness to accept the existence of significant market imperfections. (See Miller [12], DeAngelo and Masulis
[2], Kim [9], Haugen and Senbet [6], Titman [25],
Jensen and Meckling [8], Fama [5], and Smith and
Warner [22] for different perspectives on the relevance
of the market imperfections in the preceding paragraph.)However,empiricalevidence,summarizednicely
by Smith [21], now strongly indicates that changes in a
firm's capital structure can affect firm value. Thus, the

We appreciate the many useful comments made by James Ang,

Barbara Yerkes, and the referees of this journal.
82

This content downloaded from 132.181.2.66 on Sun, 16 Aug 2015 06:48:24 UTC
All use subject to JSTOR Terms and Conditions

PINEGARANDWILBRICHT/CAPITAL
STRUCTURETHEORY:A SURVEY

focus of the debate has shifted from whether capital

structure decisions matter to why they matter.
One explanation of why security prices respond to
announcements of capital structurechange is that firms
are moving closer to (or farther from) their optimal or
target capital structures, as defined by the models alluded to above. A second explanation is that capital
structure decisions are irrelevant but that the information they conveyconcerningthe firm'sinvestmentopportunitiescausessecurityholdersto revisetheirexpectations
of the firm's prospects.
This study augments market studies of capital structure change that seek to disentangle the above two
interpretations by reporting results of a surveythat was
sent to chief financial officers of each of the Fortune
500 firms for 1986. Although this is not the first to
report surveyresultson capital structureissues, it makes
important extensions to its precursors. In contrast to
Donaldson's [4] classic study which analyzed the financing practices of 25 major firms, this study reports
results for 176 firms from the Fortune 500 list. Further,
this surveydeals more extensively with capital structure
theory than did the survey of Scott and Johnson [19].

I. CapitalStructureTheories
The capital structure models considered here can be
classified conveniently into three groups: models that
imply an optimal combination of long-term funds, models that imply an optimal hierarchyin raising funds, and
models that imply neither of these approaches. Myers
[16] labels models in the first and second categories as
"static tradeoff" and "pecking order" models, respectively. Those terms are adopted in the brief discussion
below.

A. StaticTradeoffModels
In general, static tradeoff models predict that firms
maintain a target debt-equity ratio that maximizes firm
value by minimizing the costs of prevailing market
imperfections. The earliest of these models (e.g., Kraus
and Litzenberger [11], Scott [20], and Kim [9]) balance
the corporate tax advantages of debt against the cost
disadvantages of bankruptcy. Later refinements also
incorporate personal taxes and non-debt tax shields
(e.g., Miller [12] and DeAngelo and Masulis [2]).
Agency cost theories, though not categorized by
Myers, share many of the features of the tax-cumbankruptcy cost models. In Jensen and Meckling [8],
for example, the value of the firm is maximized when
total agency costs of debt and external equity are min-

83

imized. To minimize total agency costs, managers issue

both debt and equity and agree to restrictive covenants
written into bond indentures (as in Smith and Warner
[22]). Hence, firms' unique optimal capital structures
involve a balance of debt and equity, even though neither corporate nor personal taxes are assumed to exist.

B. PeckingOrderHypothesis
Myers and Majluf [17] extend Donaldson [4] by
assuming that the firm is undervalued because managers have, but cannot reveal, information that the
market lacks concerning new and existing investment
opportunities. Managers avoid issuing undervalued securities by financing first with internal equity and then
with external claims that are least likely to be mispriced. Internal equity is the most preferred source,
external equity is the least, and straight and convertible
debt are in the middle.1

C. OtherModels
Like Myers and Majluf, Miller and Rock [13] develop a model in which internal funding strictly dominates external sources. However, unlike Myers and
Majluf, Miller and Rock make no distinction between
the types of external funds raised because all such
sources signal to the market that internal sources have
fallen short of projections. Hence, the Miller-Rock
model representsthe capital structurecategoryin which
neither an optimal combination nor an optimal hierarchy of external sources is implied.
The predictions of the foregoing models follow directly from the assumptions used to develop them. The
Myers-Majluf and Miller-Rock models assume that
corporate taxes do not exist; static tradeoff models
assume that investors and managers have equal information about real growth opportunities.Although such
assumptions make the models tractable, they oversimplify the conditions under which managers make
'Hierarchies also could be derived using the Jensen [7] free cash flow
hypothesis or the Ross [18] signaling model. The hierarchies in the
Jensen and Ross models would run from debt (and preferred stock)
to common stock. The assumptions about investment opportunities
in Ross [18], Myers and Majluf [17] and Jensen [7] are not the same,
however. Ross assumes that the investment decision has already been
made but that the market does not understand the true value of the
firm; Myers and Majluf assume that because the firm is undervalued
managers may refuse to undertake even positive NPV projects; and
Jensen assumes the market knows that all positive NPV projects have
already been undertaken and that managers must be monitored to
keep them from wasting free cash flows.

This content downloaded from 132.181.2.66 on Sun, 16 Aug 2015 06:48:24 UTC
All use subject to JSTOR Terms and Conditions

FINANCIALMANAGEMENT/WINTER1989

84

financing decisions. Thus, the results reported below

are unlikely to support any of the models above to the
exclusion of the others. Nevertheless, the survey responses indicate that the pecking order hypothesis is
more descriptive of how financing decisions are made
in practice than are either of the other two alternatives.
More descriptive still, however, are conventional financial planning principles.

II.SamplingProcedures
A list of the Fortune 500 firms for 1986 was obtained
from the April 27, 1987 edition of Fortune magazine.
Standardand Poor's Registerof Directorsand Executives
was then used to find the names and addresses of the
chief financial officer of each firm. A cover letter was
enclosed with each questionnaire requesting that the
chief financial officer or the officer most familiar with
financing procedures answer the nine-question survey.No attempt was made to identify specific firms that
participated. Thus, cross-classifying financing preferences with firm size, industry,or ownership structure is
not possible. The reason for proceeding in this manner
was to protect the anonymity of the respondents. Conceivably, the decision improved the candor with which
the questions were answered and increased the number
of usable responses (176) received.3
Moreover, some generalizations are possible even if
specific firms that participated in the survey are not
identified. First, since the Fortune 500 list includes
only industrials, there are no utilities and no financial
corporations in the sample. Thus, firms that are most
heavily regulated and whose financing decisions are
least likely to convey new information to the market
are excluded. Second, most firms in the sample are
large. Only 15 of the entire Fortune 500 list for 1986
had market values of $100 million or lower. Therefore,
although financing preferences may differ by firm size,
A copy of the survey is given in the appendix. Respondents were not
specificallyasked to state their positions with the firms.Consequently,
actual decision makers may not have responded in some cases. To the
extent that is true, respondents may have answered according to what
they think financing policies should be rather than what they are.
However, given the inconclusiveness of capital structure theory, it is
not clear what the policy should be. Hence, how this potential bias
affects the results is unknown.
3In total, 203 responses were received. However, 17 firms explained
that they no longer respond to survey requests because of increased
demands on managerial time, and 10 firms were not publicly traded.

the sample essentially eliminates the variation attributable to the smallest market value firms.
The bias toward large, successful firms in the sample
does limit the inferences that can be drawn. Sampling
from a single point in time may impose further restrictions. However, the bias that exists may make the permissible inferences more interesting.For example,large
successfulfirmsshould have more flexibilitythan smaller
firms to alter their financing mix in response to the
enactment of the Tax Reform Act of 1986. Hence, if tax
laws are dominant determinants of a firm's capital
structure, successful firms will alter their financing mix
to increase after-taxcash flows. Similarly,because ownership of the sample firms is likely to be disperse,
managers should have incentives to limit the agency
costs they bear. Thus, both the tax and the agency cost
biases favor a target capital structure over a financing
hierarchy.4

IV.Sample Results
A. Static Tradeoff vs. Pecking Order and Other
Models
Despite the aforementionedbiases, 68.8% (121/176)
of our survey respondents indicated a preference for
the financing hierarchy.5 Rankings of six sources of
long-term funds by respondents who expressed this
preferenceare summarizedin Exhibit 1.For each source,
the percentage of responses within each rank, the percentage of respondents who did not rank the source,
and the mean of the rankings are given. Higher means
imply higher preferences.
As indicated, 84.3% of the respondents ranked internal equity as their first choice, while 39.7% ranked
external equity as their last choice. The respectivemean
4Although agency cost arguments can support either a target capital
structure (Jensen and Meckling [8]) or a financing hierarchy(Jensen
[7]), the success of the Fortune 500 firms suggests that positive NPV
opportunities still exist. Therefore, the costs of free cash flow discussed by Jensen should be less important than the costs discussed in
Jensen and Meckling.
?Some of the answers were inferred from the responses to question
2. Respondents who expressed a preference for maintaining a target
debt-equity ratio were instructednot to answerquestion 2. Therefore,
when question 2 was answered but question I was not, an 'intended'
response to question 1 was assumed. When only direct answers to
question 1 are used, 66.7% (80/120) of the respondents indicated that
they follow a financing hierarchy. Because the results for this and
other questions are insensitive to these inferences, both direct and
inferred answers are reported.

This content downloaded from 132.181.2.66 on Sun, 16 Aug 2015 06:48:24 UTC
All use subject to JSTOR Terms and Conditions

PINEGARANDWILBRICHT/CAPITAL
STRUCTURETHEORY:A SURVEY

85

Exhibit 1. Preference Rankings of Long-Term Sources of Funds Among U.S. Industrial Firms that Follow a
Financing Hierarchya
Sources by Order of
Preference

First

Second

Percentage of Responses Within Each Rank

Third
Fourth
Fifth
Sixth

1. Internal Equity
(Retained Earnings)
2. Straight Debt
3. Convertible Debt

84.3

7.4

14.9

71.9

5.0

0.0

2.5

43.0

4. External Common
Equity
5. Straight Preferred
Stock
6. Convertible Preferred
Stock

0.0

9.9

23.1

0.0

4.1

0.0

2.5

Meanb

1.7

5.61

2.5

0.8

5.0

1.7

0.8

0.8

4.88

31.4

9.9

3.3

9.9

3.02

19.0

1.7

39.7

6.6

2.42

16.5

15.7

37.2

14.0

12.4

2.22

3.3

15.7

33.1

33.1

12.4

1.72

2.5

0.8

Not Ranked

"Intotal, 121 firms indicated they follow a financing hierarchy,while 47 indicated they seek to maintain a target capital structure. These estimates
include both direct and inferred answers. When only direct answers are used, the numbers following the financing hierarchy and target capital
structure are 80 and 40, respectively. The percentages given in the table are immateriallydifferent from the percentages that obtain for the 80
firms.
hMeansare calculated by assigning scores of 6 through 1 for rankingsfrom 1 through 6, respectively, and by multiplyingeach score by the fraction
of responses within each rank. A score of 0 is assigned when a source is not ranked.

rankings for the common equity alternatives are 5.61

and 2.42. Similarly,straight debt dominates convertible
debt. The mean ranks are 4.88 and 3.02. For debt and
common equity, therefore, the pattern depicted in Exhibit 1 conforms to the Myers-Majluf[17] predictions-managerswho follow a financinghierarchypreferinternal
equity, then straight debt, then convertible debt, and
finally new common stock.6
On the other hand, the rankings of straight and
convertible preferred stock are more difficult to interpret. Straight preferred is more popular than convertible preferred, as the respective mean ranks of 2.22 and
1.72 indicate. But, judging from those means, preferred
stock financing of any sort is less appealing than financing with external common stock. This finding is inconsistent with the pecking order hypothesis as it currently
stands.7

B. Specific CapitalStructureModelsand
PlanningPrinciples
A better understanding of the relative significance
of specific capital structure theories can be gained by
examining managers' rankings of 11 inputs and/or assumptions often found in theoretical models. Exhibit 2
summarizes those rankings. The format is the same as
the format for Exhibit 1; the percentages here, however, are based on the full sample.

InformationConveyance Models Of all the inputs in Exhibit 2, the projected cash flow of the assets
to be financed (4.41), avoiding dilution of common
shareholders' claims (3.94), and the risk of the new
asset (3.91) have the highest mean ranks. Since two of
these factors relate to the new project, the findings
strongly suggest that corporate managers evaluate investment andfinancingdecisionssimultaneously.Hence,
these decisions are not independent and security price
reactions to capital structure changes may reflect a

61f managers move to the target capital structure by following a

hierarchy, these two concepts need not be mutually exclusive. However, the process envisioned by Myers [16] and the responses above
seem to imply that most managers do not even seek the target capital
structure because the process is dynamic, not static.

7This finding may indicate that industrial managers resort to preferred stock mainly for specialized needs, such as acquisition or
reorganization. (See Dewing [3, pp. 131-134].)

This content downloaded from 132.181.2.66 on Sun, 16 Aug 2015 06:48:24 UTC
All use subject to JSTOR Terms and Conditions

86

FINANCIAL
1989
MANAGEMENT/WINTER

Exhibit 2. Relative Importance of Capital Structure Model Inputs and/or Assumptions in Governing Financing
Decisions of Major U.S. Industrial Firms
Inputs/Assumptions by Order of
Importance
1. Projected cash flow from asset
to be financed
2. Avoiding dilution of common
shareholders' claims
3. Risk of asset to be financed
4. Restrictive covenants on senior
securities
5. Avoiding mispricings of
securities to be issued
6. Corporate tax rate
7. Voting control
8. Depreciation and other nondebt tax shields
9. Correcting mispricings of outstanding securities
10. Personal tax rates of debt and
equity holders
11. Bankruptcycosts

Percentage of Responses Within Each Ranka

3
4
Important Not Ranked

Unimportant

1.7

1.1

9.7

29.5

58.0

0.0

4.41

2.8

6.3

18.2

39.8

33.0

0.0

3.94

Meanb

2.8

6.3

20.5

36.9

33.0

0.6

3.91

9.1

9.7

18.7

35.2

27.3

0.0

3.62

3.4

10.8

27.3

39.8

18.7

0.0

3.60

4.0
17.6

9.7

29.5

10.8

42.6
31.2

8.5

17.6

21.0
40.9

14.8

27.8

31.2
69.3

13.1

1.1
0.0

3.52
3.24

24.4

19.3
7.4

1.1

3.05

36.4

14.2

5.1

1.7

2.66

34.1

25.6

8.0

1.1

0.0

2.14

13.1

6.8

4.0

4.5

2.3

1.58

"These estimates are based on 176 responses.

bMeans are calculated by assigning scores of 1 through 5 for rankingsfrom "unimportant"to "important,"respectively, and by multiplyingeach
score by the fraction of responses within each rank.A score of 0 is assigned when a source is not ranked.

revision in market expectations of the firm's operating

performance.8
Moreover, a series of questions that asked managers
to indicate to what extent they felt their securities were
correctly priced also produced results suggestive of a
signaling scenario. Although almost half of the managers (47.2%) indicated their securities were correctly
priced more than 80% of the time, another 40.3%
indicated fair pricing between 50 and 80% of the time,
and 11.9% said their securities were correctly priced
less than 50% of the time. Thus, many managers disagree with the notion of efficient markets at least part
of the time.
Despite theses perceptions, however, managers may
not deliberatelyattempt to signal their firms'true value.
SThisfinding also points to the "residualequity method" in evaluating
asset choices. See Solomon [23] and Taggart [24] for a discussion of
this approach.

The low mean rank in Exhibit 2 on correcting mispricings of outstanding securities (2.66) is inconsistent with
an overt signal. Therefore, the relation between the
perceptions of market efficiency and managers' rankings of the factors in Exhibit 2 were cross-classified to
determine whether financing choices are affected by
managers perceptions of fair market prices.
Marketefficiencyresponseswere grouped bywhether
managers believe their securities are correctly priced
more than 80% of the time or 80% or less. Exhibit 2
responses were also categorized into 'low' (ranks 1 and
2), 'medium' (rank 3), and 'high' (ranks 4 and 5) ranges.
Then, two Pearson chi-squarestatisticswere computed,
based first on the high, medium, and low ranges and
then on the high and the low.
The p-values for these statistics represent the probability of incorrectly inferring an association between
managers' perceptions of market efficiency and the
importance assigned to the factors in Exhibit 2. Ideally,
such probabilities should be low. However, only two of

This content downloaded from 132.181.2.66 on Sun, 16 Aug 2015 06:48:24 UTC
All use subject to JSTOR Terms and Conditions

THEORY:A SURVEY
STRUCTURE
PINEGARANDWILBRICHT/CAPITAL

the factors hadp-values of 0.100 or lower.9 Specifically,

perceptions of market efficiency appear to influence
the importance assigned to risk (p-values = 0.065 and
0.021) and to the restrictive covenants on senior securities (p-values = 0.194 and 0.071). Almost all of the
managers (95%) who said the market is inefficient also
said that asset risk is highly important. In comparison,
82% of the managers who believe the market is efficient categorize risk as highly important. The corresponding fractions for the restrictive covenants are 0.83
and 0.70.
Although the above fractions are statistically higher
when managers believe the market is inefficient, they
are not low even when managers perceive their securities to be correctly priced. Thus, perceptions of market efficiency appear to have little impact on financing
decisions, and deliberate signals of firm value through
the debt-equity choice seem unlikely.10

CostandOtherStaticTradeTax-Cum-Bankruptcy

off Models Of the three capital structure categories

discussed above, the static tradeoff models seem least
well supported by the data in Exhibit 2. From these
models, restrictive covenants on senior securities, the
corporate tax rate, voting control, and depreciation and
other non-debt tax shields are the most important inputs. Nevertheless, the respective mean ranks of 3.62,
3.52, 3.24, and 3.05 indicate only moderate concern for
these factors. (Boquist and Moore [1] also find little
support for the hypothesis that non-debt tax shields
help determine the debt-equity choice at the individual
firm level.) The mean ranks for the personal tax rates
of debt and equity holders (2.14) and for bankruptcy
costs (1.58) are even less supportive of the static tradeoff theories.
Although the low ranking of bankruptcycosts is not
surprisinggiven the size and success of the firms in our
sample, the extensive treatment of tax arguments in the
finance literaturecoupled with the recent majorchanges
in the tax law suggest that taxes should be more important to managers in making financing decisions. Nevertheless, responses to a separate series of questions
9The probability of observing at least two significant factors at the
0.100 level by random chance alone is 0.910. Therefore, the association between managers' perception of market efficiency and capital
structure inputs is dubious.
1'A chi-squarestatisticwas also computed to determinewhether managers' perceptions of market efficiency influence their preference for
a target capital structureor a financing hierarchy.Thep-value for that
test (0.453) indicates that perceived mispricingsare not critical determinants of that choice.

87

relating to the Tax Reform Act of 1986 indicate that

the relative rankings above are accurate.
The first question of that series asked what effect the
Tax Reform Act would have on after-tax cash flows.
Half of the managers indicated their cash flows would
increase, 26.7% indicated a decrease, and 22.7% indicated the Act would have no effect. Asked next how
their capital structure was likely to change as a result
of the Tax Reform Act, 82.4% of the managers indicated no revision in their capital structure would be
made. Of the managers indicating no change, 83.4%
said other factors are more important than tax laws in
determining their financing mix. Additionally, 4.8%
said that no change would be made because tax laws
could change again soon; 0.7% indicated that changes
had already been made in anticipation of the new tax
law; 3.4% indicated that the precise implications of the
tax law were not clear; and 7.6% listed a combination
of the above reasons or did not respond to the question.
Hence, tax factors do not appear to be the fundamental
determinants of the debt-equity choice even for the
large, successful firms in our sample.

Financial Planning Principles Managers'relative

disinclination toward capital structure theory, in general, is further reflected in their rankings of seven
financial planning principles summarized in Exhibit 3.
Five of the seven principles there have mean ranks of
3.90 or higher. In contrast, only 3 of the 11 inputs in
Exhibit 2 had mean ranks that high. Financial planning
principles, therefore, dominate specific capital structure models in governing financing decisions for the
firms in the sample. This finding is underscored by the
observation from Exhibit 3 that maximizing security
prices also has a lower mean rank (3.99) than three of
the other financial planning principles. Given these
findings and the absence of a strong relation between
managers' perceptions of market efficiency and the
importance attached to information factors in Exhibit
2, the evidence suggests that the projected cash flow,
risk of the assets to be financed, and avoiding dilution
of common shareholders' claims are more closely associated with financial planning principles than with
information-related capital structure theories.

C. Factors Governing Preferences for Specific

Financing Sources
Spearmanrank correlationsbetween the preferences
listed in Exhibit 1 and the relative rankings listed in
Exhibits 2 and 3 were calculated to determine which of
the planning principles and/or capital structure inputs

This content downloaded from 132.181.2.66 on Sun, 16 Aug 2015 06:48:24 UTC
All use subject to JSTOR Terms and Conditions

FINANCIALMANAGEMENT/WINTER1989

88

Exhibit 3. Relative Importance of Various Financial Planning Principles in Governing Financing Decisions of
Major U.S. Industrial Firms
Percentage of Responses Within Each Ranka
4
3
Important Not Ranked

Planning Principle by Order of

Importance

Unimportant

1. Maintainingfinancial flexibility
2. Ensuring long-term survivability

0.6

0.0

4.5

33.0

1.7

6.8

10.8

61.4
76.7

0.6
0.0

4.55

4.0
1.7

2.8

20.5

39.2

35.8

0.0

4.05

4. Maximizingsecurity prices

3.4

4.5

19.3

33.5

37.5

1.7

3.99

5. Maintaining financial independence

6. Maintaining a high debt rating
7. Maintaining comparabilitywith
other firms in the industry

3.4

4.5

22.2

27.3

40.9

1.7

3.99

2.3
15.9

9.1

32.4

36.9

33.0

43.2
10.8

13.1
2.8

0.0
0.6

3.56
2.47

3. Maintaining a predictable
source of funds

Meanh

4.55

aThese estimates are based on 176 responses.

bMeans are calculated by assigning scores of 1 through 5 for rankings from "unimportant"to "important,"respectively, and by multiplyingeach
score by the fraction of responses within each rank. A score of 0 is assigned when a source is not ranked.

guide the selection of each funding source. Significant

correlations are reported in Exhibit 4.11 The funding
source, the factor that is significant, and the direction
of the relation are listed in the first through third
columns, respectively.
For internal equity and convertible preferred stock,
no significant correlations exist. The lack of variation
in the preferences reported in Exhibit 1 for these sources may explain this finding.12In contrast, the negative
relation between managerial preferences for external
equity and avoiding dilution of common shareholders'
claims suggests that dilution deters new equity issues.
Straight debt is used to maximize security prices; none
of the theoretical factors, however, has a significant
correlation.Preferencesfor convertibledebt relate negatively to the importance attached to expected cash
flows from new assets and positively to maintaining the
long-term survivability of the firm. These relations
'The significance level is 0.05. Obviously, more correlations are
significant at the 0.10 level; however, interpreting those correlations
is more difficultbecause highersignificancelevels induce more "noise."
12The same argument explainswhy maintainingfinancial flexibilityin

Exhibit 3 is uncorrelated with any of the financing sources in Exhibit

1. Over 94% of the respondents ranked maintaining financial flexibility as being very important (i.e., as a 4 or a 5). The lack of variability
in the responses concerning internal equity and financial flexibility
suggests something akin to an identity: internal equity is the most
preferred source because it provides the greatest flexibility.

suggest that managers concerned about 'hanging' the

convertible because of cash flow shortages in early
stages of an asset's life nonetheless issue the debt if the
investment is crucial to the firm's long-run survivability. Finally, the negative correlation between the
preference for straight preferred stock and the importance assigned to maintaining comparabilitywith other
firms is consistent with the explanation (given in footnote 7) that preferred stock is used mainly for specialized needs.
Although the above explanations are plausible, they
are also almost certainly oversimplified. By definition,
the judgment required to make sound financing decisions implies that managers balance the need to avoid
dilution against (for example) the need to grow and to
maintain financial flexibility. Hence, multiple factors
bear on the financing choice, and several financing
alternatives may be considered simultaneously. Perhaps such complexitiesexplainwhy managersare guided
more by planning principles than by the implied precision of our theoretical models.13
13It is possible that planning principles frequently cause managers to
finance their firms in ways predicted by capital structure models even
though the principles-not the models-provide the motivation. For
example, Kim and Sorensen [10] present evidence that supports
Myers [15] and many of the tax-cum-bankruptcycost models. However, the irresponsiveness of most managers in this sample to changes
induced by the Tax Reform Act illustrates why knowing the motivation for financing decisions is important.

This content downloaded from 132.181.2.66 on Sun, 16 Aug 2015 06:48:24 UTC
All use subject to JSTOR Terms and Conditions

PINEGAR AND WILBRICHT/CAPITALSTRUCTURE THEORY: A SURVEY

Exhibit 4. Significant Correlations Between Managerial Preferences for Funding Sources and
the Perceived Importance of Capital Structure Model Inputs and/or Financial Planning Principlesa
Funding Source

Capital Structure Input

or Planning Principle

Direction of
Relationship

Internal Equity

None

NA

External Common
Equity

Avoiding Dilution

Negative

Straight Debt

MaximizingSecurity
Prices

Positive

Convertible Debt

Cash Flow
Survivability

Negative
Positive

Straight Preferred

Comparability

Negative

Convertible
Preferred

None

NA

89

IV.Conclusion
Corporate managers in this sample are more likely
to follow a financing hierarchy than to maintain a
target debt-equity ratio. Further, models based on corporate and/or personal taxes and bankruptcyand other
leverage-related costs are not as useful in determining
the financing mix as are models that suggest that new
financing reveals aspects of the firm's marginal asset
performance. However, the importance managers attach to specific capital structure theories is not related
to managerial perceptions of market efficiency. Thus,
most managers do not overtly signal firm value through
capital structureadjustments.In general, financialplanning principles are more important in governing the
financing decisions of the firm than are specific capital
structuretheories. Moreover, the capital structuredecision, per se, is less binding than either the investment
or the dividend decision of the firm.

References

aThe correlations are calculated with the nonparametric Spearman

rank statistic, and the significance level is 0.05.

D. FinancingDecisions and OtherSources and

Uses of Funds
The importance of capital structure decisions (in
general) relative to other decisions managers make can
be assessed by examining responses relating to firms'
sources and uses of funds. When presented with an
attractive new growth opportunity that could not be
undertaken without departing from the target capital
structure or financing hierarchy, cutting the dividend,
or selling off other assets, 82.4% of the managers indicated they would deviate from their target capital structure or financing hierarchy.In contrast, 1.7% said they
would cut the dividend, and 3.4% said they would forgo
the investment opportunity. The remainder said they
would sell off other assets or pursue some combination
of all the alternatives. Thus, the financing decision is
the most flexible of all the sources and uses of funds
constraints. That is, it is least binding. To the extent this
is true and to the extent motivations for capital structure changes are complex and imprecise, interpreting
common stock price responses to unanticipated capital
structure changes will continue to pose difficult challenges to finance researchers.

1. J.A. Boquist and W.T. Moore, "Interindustry Leverage Differences and the DeAngelo-Masulis Tax Shield Hypothesis,"
Financial Management(Spring 1984), pp. 5-9.
2. H. DeAngelo and R.W. Masulis, "Optimal Capital Structure
Under Corporate and Personal Taxation,"Journal of Financial
Economics (June 1980), pp. 3-29.
3. A. Dewing, Financial Policies of Corporations,5th ed., New York,
Ronald Press, 1953.
4. G. Donaldson, CorporateDebt Capacity:A Study of Corporate
Debt Policy and the Determinationof CorporateDebt Capacity,
Boston, Division of Research, HarvardSchool of Business, 1961.
5. E. Fama, "Agency Problems and the Theory of the Firm,"Journal of Political Economy (April 1980), pp. 288-307.
6. R.A. Haugen and L.W. Senbet, "The Insignificance of Bankruptcy Costs to the Theory of Optimal Capital Structure,"Journalof Finance (May 1978), pp. 383-393.
7. M.C. Jensen, "Agency Costs of Free Cash Flow, Corporate
Finance,and Takeovers,"AmericanEconomic Review(May 1986),
pp. 323-329.
8. M.C. Jensen and W.H. Meckling, "Theory of the Firm: Managerial Behavior, Agency Costs and Ownership Structure,"Journal of Financial Economics (October 1976), pp. 305--360.
9. E.H. Kim, "A Mean Variance Theory of Optimal Capital Structure and Corporate Debt Capacity,"Journal of Finance (March
1978), pp. 45-64.
10. W.S. Kim and E.H. Sorensen, "Evidence on the Impact of the
Agency Costs of Debt on Corporate Debt Policy," Journal of
Financial and QuantitativeAnalysis (June 1986), pp. 131-144.
11. A. Kraus and R.H. Litzenberger, "A State Preference Model of
Optimal Financial Leverage," Journal of Finance (September
1973), pp. 911-922.
12. M.H. Miller, "Debt and Taxes,"Joumal of Finance (May 1977),
pp. 261-276.
13. M.H. Miller and K. Rock, "Dividend Policy Under Asymmetric
Information,"Journal of Finance (September 1985), pp. 10311051.

This content downloaded from 132.181.2.66 on Sun, 16 Aug 2015 06:48:24 UTC
All use subject to JSTOR Terms and Conditions

FINANCIALMANAGEMENT/WINTER1989

90

14. F. Modigliani and M.H. Miller, "The Cost of Capital, Corporation Finance, and the Theory of Investment," American Economic Review (June 1958), pp. 261-297.
15. S.C. Myers,"Determinants of Corporate Borrowing,"Journalof
Financial Economics (November 1977), pp. 147-176.
16. , "The Capital Structure Puzzle," Journal of Finance
(July 1984), pp. 575-592.
17. S.C. Myers and N.S. Majluf, "Corporate Financing and Investment Decisions When Firms Have Information That Investors
Do Not Have,"Journal of Financial Economics (June 1984), pp.
187-221.
18. S.A. Ross, "The Determination of Financial Structure:The Incentive SignallingApproach,"Bell Journal of Economics (Spring
1977), pp. 23-40.
19. D.F. Scott, Jr. and D.J. Johnson, "Financing Policies and Practices in Large Corporations," Financial Management(Summer
1982), pp. 51-59.
20. J.H. Scott, "A Theory of Optimal Capital Structure,"BellJournal
of Economics (Spring 1976), pp. 33-54.
21. C.W. Smith, "Investment Banking and the Capital Acquisition
Process," Journal of Financial Economics (January/February
1986), pp. 23-25.
22. C.W. Smith and J.B. Warner, "On Financial Contracting: An
Analysis of Bond Covenants," Journal of Financial Economics
(June 1979), pp.117-161.
23. E. Solomon, The Theoryof Financial Management, New York,
Columbia University Press, 1963.
24. R.A. Taggart, Jr., "Capital Budgeting and the Financing Decision: An Exposition," Financial Management (Summer 1977),
pp. 59--64.
25. S. Titman, "The Effect of Capital Structure on a Firm's Liquidation Decision,"Journalof FinancialEconomics (March 1984), pp.
137-151.

Appendix
The following is a reproduction of the surveysent to
chief financial officers.

2.Rank the following sources of long-term funds in

order of preference for financing new investments
(1 = first choice, 6 = last choice).

Rank
a.

Internal equity (retained earnings)

b.

External common equity

c.

Straight debt
Convertible debt

d.
e.

- Straight preferred stock

Convertible preferred stock

3.Please indicate the relative importance of the followingconsiderationsin governingyourfirm'sfinancing

decisions.On a scaleof 1 to 5, where 1 = Unimportant
and 5 = Important.)
a.
Maximizing prices of publicly traded securities
b.

Maintaining financial flexibility

c.

Ensuring long-term survivabilityof the firm

d.

Maintaining financial independence

Maintaining comparability with firms in the
industry
Maintaining a high debt rating

g.

Maintaining a predictable source of funds

e.

4.Approximately what percent of the time would you

estimate that your firm's outstanding securities are
priced fairly by the market?
a. More than 80 percent of the time
b. Between 50 and 80 percent of the time

Instructions Please answerthe following questions

as they relate to decisions you make in raising new
long-term funds.
1.In raising new funds, your firm
a. Seeks to maintaina targetcapitalstructureby using
approximatelyconstantproportionsof severaltypes
of long-termcapitalsimultaneously.(Answerquestions 3 through 9.)
b. Follows a hierarchy in which the most advantageous sources of funds are exhausted before
other sourcesareused.(Answerquestions2 through
9.)

c. Less than 50 percent of the time

5.Given an attractive new growth opportunity that
could not be taken without departing from your
target capital structure or financing hierarchy,cutting the dividend, or selling off other assets, what
action is your firm most likely to take?
a. Forgo the growth opportunity.
b. Deviate from the target capital structure or financing hierarchy.
c. Cut the dividend.
d. Sell off other assets.

This content downloaded from 132.181.2.66 on Sun, 16 Aug 2015 06:48:24 UTC
All use subject to JSTOR Terms and Conditions

THEORY:A SURVEY
STRUCTURE
PINEGARANDWILBRICHT/CAPITAL

6.Indicate the relative importance of the following

factors in governing your firm's financing decisions.
(On a scale of 1 to 5, where 1 = Unimportant and
5 = Important.)
The corporate tax rate
a.
b.

Personal tax rates of your debt and equity

holders

c.

The level of depreciation and other non-debt

tax shields

d. _
e.

Costs of bankruptcy

f
g.

Voting control
-Restrictive covenants of senior securities
Projected cash flow or earnings from the
assets to be financed

h.

Riskiness of the assets to be financed

i.

Avoiding dilution of common shareholders'

claims

j.

Avoiding mispricings of securities to be issued

k.

Correcting mispricings of outstanding securities

7. Other things held constant, the Tax Reform Act of

1986 will have the effect of

91

8.As a result of the Tax Reform Act of 1986, your firm

is likely to
a. Increase the proportion of debt used in the capital structure.
b. Decrease the proportion of debt used in the capital structure.
c. Leave the proportion of debt used in the capital
structure unchanged.
9.If your firm does not plan to alter the proportion of
debt currently used in its capital structure as a result
of the Tax Reform Act of 1986, which of the following explanations most closely corresponds to your
reasons?
a. Tax laws could be changed again soon.
b. Changes have already been made in the capital
structure in anticipation of the Tax Reform Act
of 1986.
c. The precise implications of the Tax Reform Act
of 1986 are not clear.
d. Other factors are more important than tax laws
in determining your capital structure.

a. Increasing your firm's after-tax cash flows.

b. Decreasing your firm's after-tax cash flows.
c. Leavingyourfirm'safter-taxcashflows unchanged.

This content downloaded from 132.181.2.66 on Sun, 16 Aug 2015 06:48:24 UTC
All use subject to JSTOR Terms and Conditions