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DESIGNING CAPITAL STRUCTURE TO CREATE SHAREHOLDER VALUE

DESIGNING CAPITAL STRUCTURE TO CREATE SHAREHOLDER VALUE In the past decade, many U.S. companies have launched aggressive share repurchase programs with the expectation that value can be created by returning excess capital to shareholders and moving the firm closer to its optimal capital structure. But how much capital does a company really need to support its business activities? This article presents an economic framework or “model” that can be used to simulate the effect of various capital structure choices on shareholder value. The fundamental insight underlying the model is that judicious use of debt can add value by reducing corporate taxes and strengthening management incentives to increase efficiency, but that too much debt can result in a loss of business and perhaps a costly reorganization. Indeed, one of the key findings of the authors' recent research is that companies with highly leveraged balance sheets suffer disproportionately large losses in market share and value during industry downturns. As illustrated in a case study of a hypothetical general merchandiser, the model makes it possible to identify an optimal debt‐equity ratio (and percentage of fixed‐ versus floating‐rate debt)—one that balances the value of the tax shield from debt against the increased risk of financial distress. http://www.deepdyve.com/assets/images/DeepDyve-Logo-lg.png Journal of Applied Corporate Finance Wiley

DESIGNING CAPITAL STRUCTURE TO CREATE SHAREHOLDER VALUE

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References (15)

Publisher
Wiley
Copyright
Copyright © 1997 Wiley Subscription Services, Inc., A Wiley Company
ISSN
1078-1196
eISSN
1745-6622
DOI
10.1111/j.1745-6622.1997.tb00122.x
Publisher site
See Article on Publisher Site

Abstract

In the past decade, many U.S. companies have launched aggressive share repurchase programs with the expectation that value can be created by returning excess capital to shareholders and moving the firm closer to its optimal capital structure. But how much capital does a company really need to support its business activities? This article presents an economic framework or “model” that can be used to simulate the effect of various capital structure choices on shareholder value. The fundamental insight underlying the model is that judicious use of debt can add value by reducing corporate taxes and strengthening management incentives to increase efficiency, but that too much debt can result in a loss of business and perhaps a costly reorganization. Indeed, one of the key findings of the authors' recent research is that companies with highly leveraged balance sheets suffer disproportionately large losses in market share and value during industry downturns. As illustrated in a case study of a hypothetical general merchandiser, the model makes it possible to identify an optimal debt‐equity ratio (and percentage of fixed‐ versus floating‐rate debt)—one that balances the value of the tax shield from debt against the increased risk of financial distress.

Journal

Journal of Applied Corporate Finance – Wiley

Published: Mar 1, 1997

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