This document summarizes a survey of US Fortune 500 company managers conducted in 1987 regarding their views on capital structure theory. The survey found that managers generally follow a financing hierarchy preferring internal equity, straight debt, convertible debt, and then external equity. Managers evaluated investment and financing decisions simultaneously and felt the most important inputs were projected cash flows from assets and avoiding dilution of shareholders. Static tradeoff models were found to be the least supported by managers. Tax factors were also not the primary determinants of capital structure decisions. Financial flexibility and long-term survivability were the most important planning principles for managers.

1. COURSE TITLE: SEMINOR IN FINANCE COURSE CODE: MPH 622
Presentation on
Synopsis on: What Managers Think Of
Capital Structure Theory: A Survey
Conducted by:
J. Michael Pinegar and Lisa Wilbricht
Associate Professor, Brigham Young University
And
An Honors Graduate, University of Iowa
Published in: Financial Management; 18, 4; pg. 82-91. (1989)
27th April, 2011

2. Presentation Outline
Purpose and motivation
Research Methodology
Major Findings
Critical appraisal

3. Purpose & motivation
To examine the extent managers use the
assumptions and/or inputs of capital
structure models generated by academicians
in making financial decisions.
The inspiration of the study is based on the
opposing views of the academicians regarding
capital structure theory and research gap in
practice.

4. Purpose & motivation…..
Research Gap
(Practitioners’ point of view):
Motivation of the study
MM (1958):
capital structure
decisions do not affect
firm value
Other authors,
summarized by
Smith (1986):
capital structure can
affect firm value.
Finance Literature

5. With the literature on capital structure, authors stated
that, the focus of the debate shifted from whether
capital structure decisions matter to why they matter?
 Explanation 1:
Change in cap. structure = Change in security prices,
because firms are moving closer to their optimal or target
capital structure.
 Explanation 2:
Capital structure decisions are irrelevant but that the
information they convey concerning the firm’s investment
opportunities causes security holders to revise their
expectations of the firm’s prospects.
Purpose &motivation…..

6.  Population: US firms
 Sample: Fortune 500 firms
 Response rate: 35.2%
 Respondents: CFOs or the officials more close to
financing procedures
 Study period: base1986, data retrieved from edition of
fortune magazine on 27th April 1987.
Methodology

7. Method…
Capital Structure Theories
 First, Static tradeoff models: predict that firms
maintain a target debt-equity ratio.
 Second, Pecking order hypothesis: internal funding
strictly dominates external sources.
 Finally, Other models: neither an optimal combination
nor an optimal hierarchy of external sources is
implied.

8. Major findings
121 indicated a preference for the financing hierarchy,
while 47 preferred to maintain a target capital structure.
It is concluded that that managers who follow a
financing hierarchy prefer internal equity, then straight
debt, then convertible debt, and finally new common
stock.
Sources of funds First . . . . Sixth
Not
Ranked Mean
1. Internal Equity (RE) 84.3 0.8 1.7 5.61
2. Straight Debt 14.9 0.8 0.8 4.88
3. Convertible Debt 0 3.3 9.9 3.02
4. External Common Equity 0 39.7 6.6 2.42
5. Straight Pref. Stock 0 14 12.4 2.22
6. Convertible Pref. Stock 0 33.1 12.4 1.72

9. Corporate managers evaluate investment and
financing decisions simultaneously. Justified that two
of the factors in the top ranking is related to the new
project and one regarding financing.
Major findings…..
Inputs/Assumptions Unimportant . . . Important Not Ranked Mean
1. Projected CF from asset to be financed 1.7 58 0 4.41
2. Avoiding dilution of common shareholders' claims 2.8 33 0 3.94
3. Risk of asset to be financed 2.8 33 0.6 3.91
4. Restrictive covenants on senior securities 9.1 27.3 0 3.62
5. Avoiding mispricings of securities to be issued 3.4 18.7 0 3.6
6. Corporate tax rate 4 13.1 1.1 3.52
7. Voting control 17.6 19.3 0 3.24
8. Depreciation and other non-debt tax shields 8.5 7.4 1.1 3.05
9. Correcting mispricings of outstanding securities 14.8 5.1 1.7 2.66
10. Personal tax rates of debt and equity holders 31.2 1.1 0 2.14
11. Bankruptcy costs 69.3 4.5 2.3 1.58

10. Major findings…..
Managers disagree with the notion of efficient
markets at least part of the time.
Nature % of respondents Time
Correctly price 47.2 More than 80%
Fair pricing 40.3 50 to 80%
Correctly price 11.9 Less than 50%
This conclusion is also supported by the chi-square test
that market is not efficient.
Thus, market efficiency appear to have little impact on
financing decisions, and deliberate signals of the firm
value through the debt-equity choice seem unlikely.

11. Major findings…..
The static tradeoff models seem least well supported
by the survey results. Its key characteristics ranked
low.
Inputs/Assumptions Mean
1. Projected CF from asset to be financed 4.41
2. Avoiding dilution of common shareholders' claims 3.94
3. Risk of asset to be financed 3.91
4. Restrictive covenants on senior securities 3.62
5. Avoiding mispricing of securities to be issued 3.6
6. Corporate tax rate 3.52
7. Voting control 3.24
8. Depreciation and other non-debt tax shields 3.05

12. Tax factors do not appeared the fundamental
determinants of the debt-equity choice even for the
large, successful firms.
Major findings…..
Description Response
No revision in capital structure when tax reform 82.40%
Other factors are more important tan tax 83.40%

13. Financing planning principles dominate specific
capital structure models in governing financing
decisions for the firms. (planning principle vs inputs)
Major findings…..
Planning principle Unimportant . . . Important
Not
Ranked Mean
1. Maintaining financial flexibility 0.6 61.4 0.6 4.55
2. Ensuring long-term survivability 4 76.7 0 4.55
3. Maintaining a predictable source of funds 1.7 35.8 0 4.05
4. Maximizing security prices 3.4 37.5 1.7 3.99
5. Maintaining financial independence 3.4 40.9 1.7 3.99
6. Maintaining a high debt rating 2.3 13.1 0 3.56
7. Maintainging comparability with other
firms in the industry 15.9 2.8 0.6 2.47
Inputs/Assumptions Unimportant . . . Important Not Ranked Mean
1. Projected CF from asset to be financed 1.7 58 0 4.41
2. Avoiding dilution of common
shareholders' claims 2.8 33 0 3.94
3. Risk of asset to be financed 2.8 33 0.6 3.91
5 of 7>3.90
3 of 11>3.90

14. Preferred stock is used mainly for specialized needs
Major findings…..
The financing decision is the most flexible of all the
sources and uses of funds constraints i.e. it is least
binding.
When new attractive investment opportunity is
available, most of the managers (82.4%) indicated that
they would deviate from their target capital structure or
financing hierarchy.

15. Strength:
The study is useful for the initial learners; basic
statistics were used for the analysis, thus, it is easy
to understand and to get the ideas of the study.
Weaknesses:
The study is based on the survey, thus the
generalization of the results might not be possible
and it is biased toward large firms.
Critical appraisal

16. Thank you.