The Capital Structure Puzzle: What are We Missing?

The Holy Grail of corporate finance is a theory that explains the capital structure behavior of real-world firms. It’s been 63 years since Modigliani and Miller’s (1958, MM) landmark paper and we still do not have a model that explains even the broad-brush features of observed capital structures.

In this paper, I identify the conceptual sources of the empirical failures of the leading models of capital structure, and delineate model features that would repair those failures. In the process, I explain why we should largely ignore Miller’s (1977) “horse-and-rabbit-stew” view of the tax incentive to lever up and Jensen’s (1986) view of the disciplinary role of debt. The analysis yields a compact set of foundational principles for building an empirically credible theory of capital structure.

I argue that our failure to solve the capital structure puzzle reflects a major Catch-22: The formal analytical (optimization) approach that is used in our leading models inherently ignores—and therefore implicitly rules out—the key to explaining real-world capital structure behavior. By insisting that our models be framed in a way that implicitly precludes a key element of the solution, we have inadvertently ensured that the literature has stagnated far short of a solution to the capital structure puzzle.

What we have mistakenly ruled out is the role of imperfect managerial knowledge: Managers do not have sufficient knowledge to optimize capital structure with any real precision.

The imperfect-knowledge view departs radically from the prevailing paradigm in which all of the leading capital structure models are framed with full-knowledge optimization: Managers are endowed with perfect knowledge of how to optimize financial policy without any cost or effort on their part. Managers know the “correct” model and the exact parameter values for the stochastic investment opportunity set, contracting costs, all other relevant frictions, and capital-market-pricing conditions. That information enables them to calculate the state- and date-contingent path of optimal capital structure decisions.

The full-knowledge-optimization paradigm has had a long trial period and its ability to explain observed capital structures has been quite disappointing. Despite 60-plus years of research using state-of-the-art empirical methods and highly sophisticated theoretical analysis, financial economists remain clueless about how to identify whether any given firm has a uniquely optimal capital structure, much less how to isolate with precision what that unique optimum might be. Our inability to come close to solving the capital structure puzzle makes a compelling case for treating imperfect managerial knowledge as a factor of first-order importance when analyzing financial policy.

Imperfect managerial knowledge is a central component of my answer to the question: What sort of economically sensible model features would repair the empirical failures that plague the leading models and thus provide a framework that explains the main capital structure regularities?

I arrived at the answer detailed in the paper inductively. I knew the main facts about capital structure, including the failures of the leading models, and I understood the conceptual structures of those models. I then “backed out” my answer by thinking about economically sensible features of frameworks that wouldn’t suffer from those failures.

Stripped to the foundation, the picture that emerges from this analysis is: Firms focus on reliable access to funding rather than on optimizing the debt-equity mix because (1) managers do not have knowledge of even a rough approximation of the “correct” (empirically relevant) model of optimal capital structure, yet (2) there is no doubt that funding is needed to produce value.

Viewed in more detail, the analysis yields the following compact set of principles for analyzing capital structure in an empirically supported way:

1. The foundational problem of corporate finance is arranging reliable access to funding.
2. There is no single clearly best way to arrange reliable funding access. The reason is that managers, like financial economists, cannot identify optimal financial policies with any real precision.
3. There are numerous combinations of debt, cash, and payout policies that appear (roughly) equally attractive, with optimality requiring that they fit together in a way that provides reliable funding access.
4. Optimizing leverage per se is too narrow a way to think about capital structure. It ignores the funding role of the asset side of the balance sheet and interdependencies among debt, cash, and payout policies.
5. Reliable access to funding is a valuable asset, with banks (and shadow banks) creating social and private value by producing it, e.g., by supplying credit lines and issuing deposit debt.
6. Financial distress: Avoiding it is important, since funding access is especially difficult in distress.
7. Transitory debt: Firms use debt the way individuals use credit cards. They borrow (lever up) to address funding needs and then deleverage (as earnings permit) so they can borrow to meet new funding needs.
8. Dry powder and the option to borrow: That option is valuable and comes from untapped debt capacity and includes the unused portion of a corporate line of credit.
9. Permanent debt: Debt in the capital structure generates tax savings, but uses dry powder, per #8. So, having permanent debt is more attractive when funding needs can more likely be covered from earnings.
10. Cash balances: Cash holdings are a valuable source of dry powder to meet funding needs, but firms limit them due to taxes and a liquidity discount on returns earned on cash.
11. Payouts: They are funding needs, just as investment/operating outlays are. Payouts per se matter because they—not free cash flows that might not ever reach shareholders—determine equity value.
12. Leverage targets: They include the option to borrow and move temporarily away from being optimally positioned to address funding needs. Firms do not move inexorably toward a leverage target (see #7).
13. Credit-rating targets: They are more relevant than leverage targets because they are more indicative of the extent to which a firm has reliable access to funding (see #4).
14. Market timing: Managers believe they can time the markets for their firm’s securities and often act on that belief. It is unclear that they often actually capture gains from attempts to time the market.
15. Debt overhang: It is important at troubled firms, but pervasive attempts to capture overhang-related wealth transfers (leverage-ratchet effects) are not important.
16. Disciplinary role of debt: It is not generally important, even in LBOs. It is plausibly important near the corporate endgame to help ensure efficient liquidation.

The complete paper is available for download here.