Chapter 6

CAPITAL STRUCTURE
Behavioral Corporate Finance
by Hersh Shefrin

McGraw-Hill/Irwin

Copyright 2007 by The McGraw-Hill Companies, Inc. All rights

Choosing Capital Structure

In Practice
Survey evidence indicates that dilution and
market timing are the top factors that influence
managers decisions about issuing new equity.
The top factor influencing financial executives
decisions about new debt is financial flexibility.
As a group, managers report that they attempt
to target values for their firms debt-to-equity
ratios.

However, this factor is rated fifth in importance.

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Long Lasting Effect?

Empirical evidence indicates that firms issue
new equity when stock prices have recently
risen and market-to-book ratios are high.
This suggests that managers issue equity when
that equity is most likely to be overpriced.

Some have concluded that this is no short-run

phenomenon, that fluctuations in market value can
have very long-run impacts on capital structure.

Traditional Explanation
Some empirical studies conclude that
executives do establish target debt-to-equity
ratios.

Managers attempt to close half the gap between

current ratios and target ratios in less than two
years.

These studies suggest that market timing is a

minor consideration.

However, other empirical studies conclude that

market timing is a major consideration, so the issue
is not settled.

Convertible Debt
More than 55% of CFOs who issue
convertible debt view it as an inexpensive
way to issue delayed common stock.
50% claim to issue convertible debt
because their stock is currently
undervalued.
Behavioral issues: convertible debt framed
as both cheap debt and cheap equity.
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Debt Puzzle
Firms with low expected costs of financial
distress use debt conservatively.
Large liquid firms in non-cyclical industries use
debt conservatively.
During the early 1990s, the unexploited tax
shield by U.S. firms was about the same as the
actual tax shields.

The tax benefit of debt has been estimated to be

about 7% of firm value, after taking into account the
effect of personal taxes.
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Traditional Pecking Order

Empirical Evidence
When large firms engage in substantial
investments, they tend to rely on debt
financing.
However, they do not appear to exhaust their
cash reserves before undertaking debt.
Therefore, managers do not behave in strict
accordance with pecking order theory.

FEI survey finds little evidence to suggest that

executives believe that the source of the
undervaluation is perceived information asymmetry.
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Behavioral APV
Behavioral APV reflects errors and biases
by managers, the market, or both.
Behavioral APV calculation indicates
whether managers of financially
constrained firms with positive NPV
projects, but whose equity is
undervalued, should invest or
repurchase.
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Project Hurdle Rate

Three key variables determine the
appropriate adjustment to project
hurdle rate.
1. the firms financing constraints
2. degree of mispricing
3. the impact of the firms repurchase
activity on the price of its shares
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Repurchasing
Average market response to announcement of
an open market repurchase is 3.5%.
Investors appear to underreact to repurchases,
in that stock prices drift upwards when firms
repurchase shares.
Stocks of firms who repurchase shares earn
four-year abnormal returns of 12.1%.

45.3% for firms with high book-to-market equity.

Example: AutoNation.
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Sensitivity of Investment to
Cash Flow
Firms acquisition activity increases when they are
the recipients of large cash windfalls coming from
legal settlements unrelated to their ongoing lines of
business.
Reinsurance companies reduce the supply of
earthquake insurance after their capital positions
have been impaired by large hurricanes.
When cash flow increases or leverage decreases in
one division of a firm, investments in other divisions
of the firm increase significantly.
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Behavioral Explanation
Excessively optimistic, overconfident managers
of cash poor firms reject positive NPV projects
because they overvalue the equity of their firms,
and won't issue new shares to fund the project.
Excessively optimistic, overconfident managers
of cash rich firms adopt negative NPV projects
because they overvalue the cash flows from
those projects and adopt them.

Example: Adaptec.
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Excessively Optimistic,
Overconfident CEOs
The press often describes some CEOs as
optimistic and confident.
Longholders hold stock options too long.

Example: Scott McNealy of Sun Microsystems.

Empirical evidence that firms with longholder

CEOs have investment policies that are
excessively sensitive to cash flows.

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Conflict Between Short-term

and Long-term Horizons
Consider a firm whose book-to-market equity
ratio is low, and whose stock price has
increased rapidly.
Such a firm might earn low returns long-term
because its stock is overpriced.
Managers who adopt projects for short-term
gain effectively act as if they use low discount
rates in their capital budgeting analysis.
Challenge is balancing interests of short-term
and long-term investors.
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