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DESIGNING CAPITAL STRUCTURE TO CREATE SHAREHOLDER VALUE
Author(s) -
Opler Tim C.,
Saron Michael,
Titman Sheridan
Publication year - 1997
Publication title -
journal of applied corporate finance
Language(s) - English
Resource type - Journals
eISSN - 1745-6622
pISSN - 1078-1196
DOI - 10.1111/j.1745-6622.1997.tb00122.x
Subject(s) - capital structure , equity value , tax shield , cost of capital , debt , business , weighted average cost of capital , debt ratio , shareholder value , shareholder , economics , monetary economics , finance , debt to equity ratio , incentive , financial capital , internal debt , microeconomics , profit (economics) , debt levels and flows , public economics , individual capital , corporate governance , population , sociology , gross income , state income tax , nonprobability sampling , demography , tax reform
In the past decade, many U.S. companies have launched aggressive share repurchase programs with the expectation that value can be created by returning excess capital to shareholders and moving the firm closer to its optimal capital structure. But how much capital does a company really need to support its business activities? This article presents an economic framework or “model” that can be used to simulate the effect of various capital structure choices on shareholder value. The fundamental insight underlying the model is that judicious use of debt can add value by reducing corporate taxes and strengthening management incentives to increase efficiency, but that too much debt can result in a loss of business and perhaps a costly reorganization. Indeed, one of the key findings of the authors' recent research is that companies with highly leveraged balance sheets suffer disproportionately large losses in market share and value during industry downturns. As illustrated in a case study of a hypothetical general merchandiser, the model makes it possible to identify an optimal debt‐equity ratio (and percentage of fixed‐ versus floating‐rate debt)—one that balances the value of the tax shield from debt against the increased risk of financial distress.