This article is an updated version of “The Capital Structure Puzzle: Another Look at the Evidence,” which was published in this journal in the spring of 1999 (Vol. 12, No. 1).
The Capital Structure Puzzle: The Evidence Revisited
Article first published online: 8 APR 2005
Journal of Applied Corporate Finance
Volume 17, Issue 1, pages 8–17, Winter 2005
How to Cite
Barclay, M. J. and Smith, C. W. (2005), The Capital Structure Puzzle: The Evidence Revisited. Journal of Applied Corporate Finance, 17: 8–17. doi: 10.1111/j.1745-6622.2005.012_2.x
- Issue published online: 8 APR 2005
- Article first published online: 8 APR 2005
Since the formulation of the M&M propositions almost 50 years ago, financial economists have been debating whether there is such a thing as an optimal capital structure—a proportion of debt to equity that maximizes shareholder value. Some finance scholars have followed M&M in arguing that both capital structure and dividend policy are largely “irrelevant” in the sense that they have no significant, predictable effects on corporate market values. Another school of thought holds that corporate financing choices reflect an attempt by corporate managers to balance the tax shields and disciplinary benefits of greater debt against the costs of financial distress. Yet another theory says that companies do not have capital structure targets, but simply follow a financial “pecking order” in which retained earnings are preferred to outside financing, and debt is preferred to equity when outside funding is required.
In reviewing the evidence that has accumulated since M&M, the authors argue that taxes, bankruptcy (and other “contracting”) costs, and information costs all appear to play an important role in corporate financing decisions. While much of the evidence is consistent with the argument that companies set target leverage ratios, there is also considerable support for the pecking order theory's contention that firms are willing to deviate widely from their targets for long periods of time. According to the authors, the key to reconciling the different theories—and thus to solving the capital structure puzzle—lies in achieving a better understanding of the relation between corporate financing stocks (the levels of debt and equity in relation to the target) and flows(or which security to issue at a particular time).