Financial Strategy, Second Edition

6

The Capital Structure Puzzle

Another Look at the Evidence

Michael J. Barclay and Clifford W. Smith, Jr.

A perennial debate in corporate finance concerns the question of optimal capital structure: Given a level of total capital necessary to support a company's activities, is there a way of dividing up that capital into debt and equity that maximizes current firm value? And, if so, what are the critical factors in setting the leverage ratio for a given company?

Although corporate finance has been taught in business schools for almost a century, the academic finance profession has found it remarkably difficult to provide definitive answers to these questions – answers that can guide practicing corporate executives in making their financing decisions. Part of the difficulty stems from how the discipline of finance has evolved. For much of this century, both the teaching of finance and the supporting research were dominated by the case-study method. In effect, finance education was a glorified apprenticeship system designed to convey to students the accepted wisdom – often codified in the form of rules of thumb – of successful practitioners. Such rules of thumb may have been quite effective in a given set of circumstances, but as those circumstances change over time such rules tend to degenerate into dogma. An example was Eastman Kodak's long-standing decision to shun debt financing – a policy stemming from George Eastman's brush with insolvency at the turn of the century that was ...