THE JOURNAL OF FINANCE • VOL. LIII, NO. 4 • AUGUST 1998
Agency Costs, Risk Management,
and Capital Structure
HAYNE E. LELAND*
The joint determination of capital structure and investment risk is examined. Optimal capital structure ref lects both the tax advantages of debt less default costs ~Modigliani and Miller ~1958, 1963!!, and the agency costs resulting from asset substitution ~Jensen and Meckling ~1976!!. Agency costs restrict leverage and debt maturity and increase yield spreads, but their importance is small for the range of environments considered.
Risk management is also examined. Hedging permits greater leverage. Even when a firm cannot precommit to hedging, it will still do so. Surprisingly, hedging benefits often are greater when agency costs are low.
THE CHOICE OF INVESTMENT F INANCING, and its link with optimal risk exposure, is central to the economic performance of corporations. Financial economics has a rich literature analyzing the capital structure decision in qualitative terms. But it has provided relatively little specific guidance. In contrast with the precision offered by the Black and Scholes ~1973! option pricing model and its extensions, the theory addressing capital structure remains distressingly imprecise. This has limited its application to corporate decision making.
Two insights have profoundly shaped the development of capital structure theory. The arbitrage argument of Modigliani and Miller ~M-M ! ~1958, 1963! shows that, with fixed investment decisions, nonfirm claimants must be present for capital structure to affect firm value. The optimal amount of debt balances the tax deductions provided by interest payments against the external costs of potential default.
Jensen and Meckling ~J-M ! ~1976! challenge the M-M assumption that investment decisions are independent of capital structure. Equityholders of a levered firm, for example, can potentially extract value from debtholders by increasing investment risk after debt is in place: the “asset substitution” problem. Such predatory behavior creates agency costs that the choice of capital structure must recognize and control.
* Haas School of Business, University of California, Berkeley. This article is a revised version of my Presidential Address to the American Finance Association meeting in Chicago, Illinois in January 1998. I thank Samir Dutt, Nengjiu Ju, Michael Ross, and Klaus Toft both for computer assistance and for economic insights. My intellectual debts to professional colleagues are too numerous to list, but are clear from the references cited. Any errors remain my sole responsibility.
The Journal of Finance
A large volume of theoretical and empirical work has built upon these insights.1 But to practitioners and academics alike, past research falls short in two critical dimensions.
First, the two approaches have not been fully integrated. Although higher risk may transfer value from bondholders, it may also limit the ability of the firm to reduce taxes through leverage. A general theory must explain how both J-M and M-M concerns interact to determine the joint choice of optimal capital structure and risk.
Second, the theories fail to offer quantitative advice as to the amount ~and maturity! of debt a firm should issue in different environments. A principal obstacle to developing quantitative models has been the valuation of corporate debt with credit risk. The pricing of risky debt is a precondition for determining the optimal amount and maturity of debt. But risky debt is a complex instrument. Its value will depend on the amount issued, maturity, call provisions, the determinants of default, default costs, taxes, dividend payouts, and the structure of risk-free rates. It will also depend on the risk strategy chosen by the firm—which in turn will depend on the amount and maturity of debt in the firm’s capital structure.
Despite promising work two decades ago by Merton ~1974! and...
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