1 NEW YORK UNIVERSITY FINECII Franklin Allen and Douglas Gale January 31, 2003 Capital Structure The Modigliani and Miller capital structure and payout policy theorems were the result of the practical questions ?How should a firm choose its capital structure?. The theory that we covered last time clarified the nature of the Modigliani and Miller result. This had taken some time to do. Along the way people expended a large amount of effort trying to understand what was going on. For example, the Stiglitz and Hellwig papers are interesting because they show how difficult people found it to understand the nature of the result. In terms of what we end up with the fact that capital structure can matter with incomplete markets is not a particularly useful result in answering the basic question. Nobody has really pursued this at any length as a way of explaining what we observe with regard to firm?s capital structures. At this stage you should read the following paper (available from www.jstor.org). Rajan, R. and L. Zingales (1995). ?What do we know about Capital Structure? Evidence from International Data,? Journal of Finance 50, 1421-1460. As the title suggests this outlines differences in capital structure across countries. It shows that institutional factors such as taxes and bankruptcy codes may well be important. 2 Payout Policy In the lecture last time the interpretation of the financing was that it was referring to different securities. One obvious interpretation of this is that it is debt, equity or preferred stock. However, another important interpretation is that it is differences in payout policies. In addition to capital structure firms must make the decision of ?How should earnings be paid out to shareholders?? One way is dividends. Another is share repurchases. The ?Dividend Puzzle? has been why firms use dividends since in most countries dividends are taxed more heavily than repurchases. Another related issue, which has not been considered as much in the literature, is why firms don?t repurchase the shares of other companies, which potentially have a lower tax basis. In other words why don?t they undertake cash M&A?s? A paper that surveys the dividends literature and provides empirical evidence about payout policy is the following. Allen, F. and R. Michaely (2001). ?Payout Policy? to appear in Constantinides, Harris and Stulz (eds) Handbook of Finance, North-Holland. Wharton Financial Institutions Center, Working Paper 1-21 (http://fic.wharton.upenn.edu/fic/papers/01/0121.pdf). Concluding Remarks In the coming weeks we will be developing theories to try and explain some of the basic things that we observe about the financial policies of firms. The underlying premise of these theories is that it is not just institutional factors that matter. There are economic theories that can help us understand what is going on. In developing these 3 theories it is important to keep in mind the ultimate objective of the exercise, which is how a firm should choose its financial structure.