Chapter 1

An approach by geographic areas of the diffusion processes of managerial practices

Chapter 2

An approach by point of interest: technique, branch, sector, company

Chapter 3

Disseminators of doctrine, authors and tenets of management


The Optimal Capital Structure and Financing Behaviour: A Brief Historical Review and New Evidence

  • Youssef CASSIS

    University of Geneva
  • Edoardo ALTAMURA

    University of Geneva

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This paper will consider the relationships between capital raising and managerial practices. We will concentrate on the second half of the 20th century, paying particular attention to the issue of firms’ capital structure, one of the main themes of discussion in corporate finance. We intend to link the theoretical contributions of economics with empirical historical research on the topic –an approach which has been insufficiently explored in both disciplines.

Combining a theoretical and a historical approach, we hope to shed new light on the long standing historical debate on the provision of finance to businesses and the specific issues raised by the Professional Training Programme on the History of Managerial Thought and Practice in the 19th and 20th centuries.

This paper is primarily concerned with the role of finance in the shaping of managerial practices. It is written from a historical rather than a business and management perspective, even though it attempts to straddle the two academic fields. Economic historians have long been interested in the relationships between banks and industry and, in particular, the respective merits of a financial system dominated by universal banks and one organised around a set of more specialised financial institutions. From a business history perspective, the main historical debates have been concerned with the provision of finance to industry.[The impact of a specific financial system on economic growth has also been discussed from a macro economic perspective. See the pioneering works of Gerschenkron, Economic Backwardness in Historical Perspective, Cambridge, Mass., 1962, and Cameron, Banking in the early stages of industrialization, New York, 1967 ; and the recent contribution of financial economics to the topic (see for example Levine, “Bank-Based or Market-Based Financial Systems: Which is Better?”, Journal of Financial Intermediation, 11, 2002, pp. 398-428. While the recent literature considers that finance matters for economic growth, it plays down the differences between financial systems.] Research conducted since the 1980s has convincingly concluded that, since the emergence of the big banks in the mid-nineteenth century, financial institutions and markets have, within both systems, supplied businesses in general and manufacturing companies in particular, with adequate capital. Empirical research has also shed new light on both supply and demand of capital, lending criteria, and more broadly the relationships between banks and their customers[There is a vast literature on the topic, with the bulk of recent research focused on Anglo-German comparisons. See in particular Cassis, “British Finance: Success and Controversy”, in Van Helten and Cassis (eds.), Capitalism in a Mature Economy. Financial Institutions, Capital Exports and British Industry, 1870-1939, Aldershot, 1990 ; Capie and Collins, Have the Banks Failed British Industry?, London, 1992 ; Edwards and Fischer, Banks, Finance and Investment in Germany, Cambridge, 1994 ; Collins and Baker, Commercial banks and Industrial Finance in England and Wales, 1860-1913, Oxford, 2003 ; Fohlin, Finance Capitalism and Germany's Rise to Industrial Power : Corporate Finance, Governance, and Performance from the 1840s to the Present, Cambridge, 2007 ; Marguerat, Tissot and Froixdevau (eds.), Banques et entreprises industrielles en Europe de l’Ouest, XIXe-XXe siècles: aspects nationaux et régionaux, Geneva, 2000 ; Quennouëlle-Corre and Strauss (eds.), Financer les entreprises face aux mutations économiques du XXe siècle, Paris, 2009.].


However, the impact of the financial system on managerial practices, in particular within industrial companies, has not been systematically discussed in a long-term historical and comparative perspective. Attention was mainly paid to the presence of bank directors of industrial companies and their formal or informal influence on the decision making process.[See for example Wellhöner, Grossbanken und Grossindustrie im Kaiserreich, Göttingen, 1989 ; Tolliday,Business, Banking and Politics. The case of British Steel, 1918-1939, Cambridge, Mass., 1987.] While there remains much scope for historical research on this latter theme, this paper considers the relationship between finance and managerial practices from a different perspective. Rather than looking at the influence of banks and bankers on managerial behaviour, it considers the impact of finance, in other words the development of the field of financial economics, on this process. We have been particularly interested in the optimal capital structure and its effects on financing behaviour, from the 1950s –taking the Modigliani and Miller theorem as our starting point– to the present. The paper is divided in two main parts: the first provides a historical and theoretical background to the firm’s optimal capital structure, while the second discusses some empirical research on companies’ financial structure; some conclusions are presented in the third part.

1. Historical and Theoretical Background


The starting point of our analysis is the seminal work of Modigliani and Miller.[Modigliani and Miller, “The Cost of Capital, Corporation Finance and the Theory of Finance”, American Economic Review, June 1958 261-297 ; Modigliani and Miller, “Corporate Income taxes and the Cost of Capital”, American Economic Review, June 1963, 433-443.] Their work made a strong assumption on capital structure –the famous “First Proposition”. Under some circumstances, notably perfect capital markets: “The average cost of capital of a firm is completely independent of its capital structure (…)”. In other words, the value of the firm is completely independent of its debt to equity ratio. Because of the imperfections, that cannot be denied, within the markets, subsequent literature has focused on relaxing the assumptions of Modigliani and Miller and has sought to verify whether their results were confirmed when taking into consideration market frictions. In this work we consider, in particular, agency costs, bankruptcy costs and transaction costs.

As we know, Agency costs derive from the clash of interests between the owner of the company (the principal) and the manager (the agent). In this context, a great menace to the welfare of the company is represented by the presence of free cash flows, i.e. the cash flow in excess of what would be required to fund all projects that have a positive net present value (NPV) when discounted at the relevant cost of capital. The major problem is to motivate the agent to allocate the free cash flow to positive NPV investments and/or to give it back to shareholders. Debt, diverting cash flows from non productive investments and bonding managers to the repayments, carries out a fundamental controlling role.

Bankruptcy costs were simply not considered by the original Modigliani and Miller work. If bankruptcy costs are relevant, it may be argued that at some point their expected value outweighs the tax benefit of debt and the firm will have reached its optimal capital structure. Many empirical works have attempted to verify the scope of these bankruptcy costs. One of the first works to appear was the one from Warner[Warner, “Bankruptcy costs: some evidence”, Journal of Finance, Vol. XXXII, No. 2, May 1977.]. He analyzed 11 railroad companies and investigated the “direct costs” of bankruptcy, i.e. the explicit costs paid by the debtor in the reorganization or liquidation process. Warner found out that these costs represented about 1 percent of market value seven years prior to the bankruptcy and 5.3 percent of market value just prior to the petition date. From that he inferred that bankruptcy costs were relatively small and not meaningful in assessing optimum capital structure decisions.

The major weakness of this work resided in the lack of specification and measurement of indirect bankruptcy costs. Altman was one of the first researchers who included both direct and indirect costs of bankruptcy in his work.[Altman, “A further empirical investigation of the bankruptcy cost question”, Journal of Finance, Vol. XXXIX, No. 4, Sept. 1984, p. 1067-1089.] Indirect costs were measured taking into consideration foregone sales and profits. The interesting finding was, first, that 8 of the 14 firms studied were over-leveraged at one statement prior to a bankruptcy petition and, secondly, that bankruptcy costs (direct and indirect) exceeded 20 percent of the value of the firm measured just before bankruptcy, ranging from 11percent to 27 percent of the firm’s value up to three years prior to bankruptcy. Apparently, bankruptcy costs are not that trivial and they should be included when reasoning about optimal capital structure against the idea of irrelevance of debt and equity even though the literature on this subject too is quite contradictory.

Turning to transaction costs, debt and equity are best regarded, according to Oliver Williamson, as different governing structures.[Williamson, “Corporate finance and corporate governance”, Journal of Finance, Vol. XLIII, No. 3, Jul. 1988, p. 567-592.] Specifically, debt allows debt-holders to step in and exercise their claims to push the company into bankruptcy only when a firm defaults on its repayment schedule and does not meet its contractual obligations. Debt-holders, therefore, have little control over managerial actions and they are unable to influence the firm’s operations as long as the contractual stipulations are satisfied. Equity-holders bear a residual claimant status vis-à-vis the firm in both earnings and asset liquidation. Their contract is for the duration of the firm and they are able to play an active role in the corporate decisions (audit, choice of management, etc.).  Another factor which influences the financial structure is the specificity of the assets in place and their degree of redeployability.  Equity capital will be more suited to projects where the assets are relatively less redeployable or more specific while debt financing will be more efficient for general or non idiosyncratic assets.

The reason is simple: if the assets are firm-specific, they are not likely to be as valuable when put to another use. The value obtained from liquidation would be extremely low and lenders would recover only a fraction of their initial investment. The loss in investment will be greater the greater the degree of specificity of the assets involved in the liquidation process. For the majority of the researchers on transaction costs, the choice of financial structure is likely to depend on the trade-off between the benefits and governance ability and the specificity of the assets in the transaction.

 As Williamson pointed out clearly: “Debt is a governance structure that works out of rules and is well suited to projects where the assets are highly redeployable. Equity is a governance structure that allows discretion and is used for projects where assets are less redeployable”.[Ibid.] Transaction costs thus seem to play a considerable role in the choice of the optimal capital structure as well as the asset specificity and governance structures.

Given the importance of market imperfections in the definition of the optimal capital structure and financing behaviour, two major theories have emerged: the Trade-off Theory and the Pecking Order Theory. The former allows bankruptcy costs to exist while the latter tries to capture the costs of asymmetric information. The Trade-off Theory views the firm’s optimal debt ratio as being determined by a trade-off between the costs, for example the possibility of bankruptcy, and the benefits of borrowing, also the tax shield of debt. According to this theory, the firm is supposed to substitute debt for equity until the value of the firm is maximized. However, as Myers and other authors have pointed out there are many well established and well rated companies which have operated for many years at low debt ratios. A good number of studies have further demonstrated that the most profitable companies in a given industry tend to borrow the least and this is in clear contrast with the Trade-off Theory. The Pecking Order Theory was developed by Myers and Majluf and Myers.[Myers and Majluf, “Corporate financing and investment decisions when firms have information that investors do not have”, Journal of Financial Economics, Vol. 13, No. 2, June 1984, p. 187-221 ; Myers, “The capital structure puzzle”, Journal of Finance, Vol. XXXIX, n°3, Papers and Proceedings, Forty-Second Annual Meeting, American Finance Association, San Francisco, CA, Dec. 28-30, 1983, p. 575-592.] Starting from a condition of information asymmetry, the theory could be summarized as follows. Firms prefer internal to external finance; dividends are “sticky”, so that dividend cuts are not used to finance capital expenditures and changes in cash requirements are not soaked up in short-run dividend changes; if external funds are required for capital investments, firms will issue the safest security first, in other words, debt before equity. As the requirements for external financing increase, the firm will work down the pecking order, from safe to riskier debt; each firm’s debt ratio therefore reflects its cumulative requirement for external financing.

The above mentioned assumptions seem consistent with the fact that most of the aggregate gross investments by U.S. non-financial corporations have been financed from internal cash flow. External financing has covered less than 20 percent of real investment. Net stock issues have often been negative, which means that more shares have been extinguished than created. As Myers noted: “The Pecking Order Theory explains why the bulk of external finance comes from debt. It also explains why more profitable firms borrow less: not because their target debt ratio is low –in the Pecking Order they don’t have a target –but because profitable firms have more internal financing available”.[Myers, “Capital structure”, Journal of Economic Perspectives, Vol. 15, No. 2, Spring 2001, p. 81-102.]

Despite some important contributions, the existing literature has not been able to reach an agreement on which theory better explains firms’ financing behaviour. It appears clear to us that quantitative analyses are not enough and a broader research with a strong qualitative aspect (i.e. empirical researches, analysis of the corporate history, interviews to CFOs) is needed to help the further develop research. That is properly what we have tried to do by analyzing existing empirical evidence and searching for new ones.


2. Empirical Research


One of the most important empirical researches done in the current decade is the fundamental work of Graham and Harvey.[Graham and Harvey, “The theory and practice of corporate finance: evidence from the field”, Journal of Financial Economics, Vol. 69, May 2001, p. 187-243.] The authors interviewed 392 Chief Financial Officers (CFOs) of large, medium and small American companies asking them several questions about the financial structure of their company. Their survey contained more than 100 questions, concerning: capital budgeting, cost of capital and capital structure and sent it to approximately 4,400 firms. In total, 392 CFOs responded to the survey, for a response rate of 9 percent. The questions about capital structure focused primarily on debt, equity, debt maturity, convertible debt, foreign debt, target debt ratios, credit ratings and actual debt ratios. First, the authors investigated whether the Trade-Off Theory was verified, in other words whether firms had target debt ratios.


Table 1 – Debt Policy factors

Debt Policy Factors

% Important or Very Important





Financial Flexibility



Credit Ratings



Earnings and Cash Flow Volatility



Interest Tax Savings



Transaction Costs and Fees



Comparable Firms Debt Levels



Bankruptcy/Distress Costs



Customer/Supplier Comfort




Source: J. Graham & C. Harvey, “The theory and practice of corporate finance: evidence from the field”, Journal of Financial Economics, Vol. 69, May 2001, p. 187-243.


As can be seen from Table 1, financial flexibility, credit rating and earnings, and cash flow volatility are the three most important factors that the CFOs who were interviewed took into consideration. The tax advantage of debt is moderately important globally but significantly important for large, regulated and dividend-paying firms with, most likely, high corporate tax rates and large tax incentives to use debt. By contrast, bankruptcy costs do not appear to be significant in the decision to issue debt. This could be due to misjudgement of the real size of these costs, especially since credit ratings are a very important factor of choice. When asked whether firms had an optimal or target debt-equity ratio, 19 percent answered they did not have a target debt ratio or target range, 37 percent had a flexible target and 34 percent had a somewhat tight target or range. Fifty-five percent of large firms had at least strict target ratios compared to 36 percent of small firms. This evidence provides “mixed support for the notion that companies trade off costs and benefits to derive an optimal debt ratio”.

To test whether the Pecking Order Theory was verified empirically, the authors asked several questions: if firms issued securities when internal funds were not sufficient to fund their activities; and separately if equity was used when debt, convertibles or other sources of financing were not available. Equity under-evaluation as a determining factor when deciding which security to use was also investigated. Results show several interesting factors. First, the most important item affecting corporate debt decisions is management’s desire for financial flexibility. Insufficient internal funds have a moderately important influence on the decision to issue debt. Both these results are fairly consistent with the Pecking Order Theory, even though further enquiries are needed. Concerning equity under-evaluation, firms appear reluctant to issue equity when they perceive their shares to be undervalued. When this occurs, rather than issuing equity many firms issue convertible debt instead; even if this behaviour could be consistent with the Pecking Order Theory, the authors point out that it was not originated by asymmetric information, as the theory would imply. The importance of the debt levels of competing firms appears in aggregate as moderately significant, though it mattered more to CFOs of public, regulated companies and the majority of Fortune 500 firms than to those of less regulated, private firms. Some of the most intriguing findings show how some “profane” factors, not taken into consideration by the academic models on capital structure, influence the financing decisions. For example, many companies issue long-term debt so that they do not have to refinance in “bad times”. This is especially true for leveraged companies and manufacturing firms. The size of the firm also plays an important role in the determination of the capital structure, with different behaviours between small and large firms. Finally, the reasons for issuing equity can be seen from Table 2. Earnings per Share (EPS) dilution clearly appears as the most important concern; the result is stronger for regulated, large and dividend-paying firms. Equity under-evaluation was mentioned earlier.


Table 2 – Common Stock Policy Factors

Common Stock Policy Factors

% Important or Very Important





EPS Dilution



Equity Over/Under Valuation



Stock Price Increase



Providing Shares to Employee Bonus/Option Plans



Maintaining Target Debt/Equity Ratio



Diluiting Holdings of Certain Shareholders



Stock is Our “Least Risky”Source of Funds



Sufficiency of Recent Profits to Fund Activities



Similar Amount of Equity as Same-Industry Firms



Favorable Investor Impression vs Issuing Debt




Source: J. Graham & C. Harvey, “The theory and practice of corporate finance: evidence from the field”, Journal of Financial Economics, Vol. 69, May 2001, p. 187-243.


In conclusion, according to the survey Graham and Harvey drew, the most important factors affecting capital structure decisions are: credit ratings, EPS dilution, financial flexibility, recent changes in stock price, maturity matching, hedging foreign operations and practical cash management. These results show how some “practical” factors are important in the management of the capital structure of the firm and how all the major theoretical models have omitted and continue to omit in their formulation all the major factors related to the daily routine of a CFO.

From this empirical work we found contrasting evidence in support of the existence of a pecking order and a clear proof in favour of the importance of informal factors in shaping corporate financial decisions. To further verify the Pecking Order Theory we analysed the history of some major multinational firms (British Petroleum, Royal Dutch Shell and Unilever). Despite some difficulties in finding the necessary material on this topic, we found a confirmation of the existence of a sort of pecking order, at least in the past decades. These companies were chosen because of their scope and the available literature about them.

From the recent history of the British Petroleum Company (BP), written by James Bamberg,[Bamberg, British Petroleum and Global Oil, 1950-1975: The Challenge of Nationalism, Cambridge, 2000.] we can infer that a sort of pecking order existed. In 1950, following an important change in the basis on which oil companies made their payments to oil-producing countries, BP experienced a drop in profits and a great increase in capital expenditure. The Company was unable to cover such expenditure with funds generated from its operations (auto-financing) and turned to the capital markets by raising new long-term debt with the issue of £20 million 5 percent bonds in January 1953. Interestingly, Bamberg specifies that this was the first time since 1932 that BP had been obliged to turn to the capital markets to fund itself “ending a remarkable unbroken run of more than 20 years in which the finance for expansion was entirely self-generated”. Even after the debt issuance, the capital position of BP was very strong with £90 million in liquid resources and a debt to debt-plus-equity ratio of just less than 12 percent

During the 1960s and 1970s BP had to increase production in order to meet the demand of the oil-producing countries and therefore the Company started to plan its operations on the basis of meeting volume rather than profit targets. Sales expanded from less than 1 million barrels per day in 1955 to almost 4 million in 1970 but the increase in production did not imply an increase in profitability.[Bamberg, British Petroleum and Global Oil, p. 301.] The deceiving performance of BP broadly reflected the macro conditions in the oil industry in that period, characterized by an abundant supply of oil and competition from recent entrants. All the major oil companies suffered from the downturn, but BP was among the worst hit because it lacked a presence in the sheltered market in the US, where import quotas were applied since the late 1950s. If BP was the most profitable oil company in 1955 with a return on capital of 15 percent, it became the least profitable in 1970 with a less-than-5 percent return. The poor performance of the company influenced its financing behaviour. In 1955 BP had the lowest reliance on long-term debt of all the major oil companies apart from Socal, but in the following years BP became more reliant on borrowing than any other major company apart from Gulf.[Ibid., p. 305.] 

If the debt ratio at the end of 1963 was comfortably at 13 percent, in the subsequent years BP’s financial position deteriorated rapidly, as expenditure, especially in marketing and refining, continued to increase. BP’s debt ratio climbed to 16 percent in 1964 and to 20 percent in 1965. A series of measures were put in motion, capital expenditures were cut back and new capital was raised from BP’s shareholders through a rights issue. In 1966, £60 million was raised; this was the first issue of ordinary shares for new capital since 1923. A different approach towards financing was taken in the acquisition of Distillers’ interests in chemical and plastics. The acquisition was financed by the issue of new BP’s shares with a value of £61 million. But this use of new shares could be explained primarily by the ambition of BP to dilute the British Government’s BP shareholding to below 50 percent. By contrast, the purchase of the ARCO/Sinclair refining and marketing assets on the eastern seaboard of the USA in 1969 was financed by £400 million of debt, which raised BP’s debt ratio to 33 percent. In 1972 the debt ration reached 38 percent

From this short extract of BP’s financial history we can gather some significant remarks on the financing behaviour of a major company. First, until 1953, BP used almost exclusively internal financing to finance its operations, even though at that time, and especially in the UK, financial markets were well developed and efficient. This behaviour is consistent with the Pecking Order Theory of Myers: internal financing is the preferred choice of financing for companies. Second, the biggest debt issue took place in 1953, twenty-one years after the previous one. For many years, debt was the preferred instrument of financing rather than equity. This behaviour is also consistent with the pecking order, whereby internal financing debt is the preferred financing instrument after internal financing. And third, the first equity issue after 1923 happened in 1966, thirteen years after the bond issue of 1953. This also seems to confirm Pecking Order Theory: the company will issue equity only when it has ceased to rely on internal financing and debt.

We consider, now, the case of Royal Dutch Shell[Sluyterman, Keeping Competitive in Turbulent Markets, 1973-2007. A History of Royal Dutch Shell, volume 3, Oxford, 2007.]. In the second half of the 20th century, Royal Dutch Shell implemented a policy of mergers and acquisitions in order to increase its capacity to create revenues for its shareholders. In the 1990s a great deal of companies were bought, merged and divested again; as The Economist pointed out in 1997: “European chemical companies are splitting and recombining faster than molecules in a catalytic cracker”. The reason for restructuring was twofold. The first one was to respond to an increasing pressure from shareholders to achieve a return on average capital employed of 12 percent or more. In 1979 it was calculated that the average return on capital in Shell’s chemical sector between 1959 and 1979 had been 6.4 percent. To double this result, underperforming activities were constantly candidates for divestiture. Research was under constant pressure to become more focused and reduce expenses; in-house technology only occurred where this provided a clear advantage over out-sourcing. The second reason was globalization. Companies started to focus on products in which they could create a global position. This strategy implied cutting down the portfolio. In the 1990s, Shell divested its agrochemicals business, including CelaMark, recently acquired, by selling it to American Cyanamid. The next businesses sold were fine chemicals, which were sold in 1996 to Inspec plc. From these data, we can infer that for Royal Dutch Shell the preferred way to finance itself and cut costs was the cash flow generated by large divestments. Again, these findings seem consistent with the pecking order literature.

The history of Royal Dutch Shell with its large investments and divestments is typical of another cash rich Anglo-Dutch company: Unilever[Jones, Renewing Unilever, Oxford, 2005.]. Unilever embarked, especially in the second half of the 1980s, in a long series of takeovers (Brooke Bond and  Chesebrough-Pond’s in the US, Les Nutons in Belgium, Costablanca Group in Spain, San Giorgio in Italy, Anderson Clayton, Conasupo and Visa in Mexico and other acquisitions in Africa) but these takeovers did not affect the financial position of the Company. Between 1983 and 1987 Unilever sold over seventy companies with sales of £3.4billion and recouped £2.1billion from these sales. Over the same period, the Company acquired some seventy companies with total sales of £4.5 billion at a cost of £4 billion. In the process of reshaping the business, low-margin businesses were sold and high margin businesses were acquired while ongoing businesses were attentively scrutinized and subjected to vigorous restructuring and cost-cutting.

Unilever remained a cash rich business thanks to its position in mature product markets and a “proactive” treasury policy which included vigorous trimming of Unilever’s assets by selling off some of its vast amount of property, including real estate properties and office buildings. Despite this trend of large and costly operations, it was only with the acquisition of Fabergé/Elizabeth Arden in 1989 that Unilever’s debt rose from £300 million to £3 billion. It is fundamental for the purpose of our study to point out the fact that in 1990 the Company had still not issued any equity since 1950. Unilever took great care in guarding its traditional image with the financial community as a conservative company with a triple A credit rating and low borrowings and an ability “to fund organic growth without any increase in borrowings”.

We can draw some conclusions from this brief survey of Unilever’s recent history. First, it appears clear that even in this case the favorite funding instrument was internal financing. Second, debt was kept at low levels until the end of the 1980s. Nevertheless, in 1989 the total amount of debt was £3billion. Apparently in case of need (in this case the acquisition of Fabergé/Elizabeth Arden) and after internal financing, debt was the second financial instrument of choice. Third, for more 40 years, from the 1950s to the 1990s, Unilever did not issue any equity capital. It is indicative that, despite all the challenges that the Company encountered in this long period of time, the management decided not to issue further equity. A deeper analysis of the reasons for these choices is required to gain a scientific value, but for our paper it is very meaningful that a sort of pecking order can be established within Unilever’s financing strategies and, more broadly, within the strategies of the other companies we considered. It is still to be verified whether information asymmetry played a role in these decisions, as expressed by Myers and Myers and Majluf.

Even though we are discussing seminal results and further evidence must be collected to verify our material, we found a recurring path, consisting of relying on internal financing, then on debt and finally on equity capital. The assumption of the original Pecking Order Theory could not be verified though. The existence of an ideal pecking order and the importance of practical factors in financial decisions were given further strength by the interview we had with Mr Maurizio Francescatti, Executive Vice President and Head of Treasury of Fiat Group S.p.A since 1997.[Interview of Mr Francescatti, Turin, May 2009.] First of all, as Mr Francescatti pointed out, financial decisions are never free. There are many diverging interests (explicit or implicit) in the cabin crew of a firm; financial decisions suffer from this situation and often the final decision is a compromise solution. Second, the financing decisions are “dynamic” and are influenced by the economic cycle and the life cycle of the firm. This means that they are heavily influenced by macro-economic conditions. For example when interest rates are low and/or the economic system is stable, the system requires lower spread on the risk and issuing debt becomes more convenient, i.e. less expensive, than issuing equity. When interest rates are low there is an incentive to increase the leverage in the balance sheets, betting on strong future results. By contrast, when interest rates are under pressure and/or the economic outlook is grim, firms tend to rely more on equity, given the relatively high cost of issuing debt and the positive effect of equity in reducing debt, as can be seen from Figure 1. This phenomenon explains why, in difficult times, companies tend to rely more on equity rather than debt. Third, a pecking order does exist: when possible, a company would first use internal sources of financing first, then debt capital, judging the reaction of the market participants and the cost of the issue, and would eventually issue equity capital to repurchase some debt. It is important to note that, when issuing equity capital, the value of the stock is crucial –this is consistent with the results of Graham and Harvey.

Refinancing sources in the economic cycle

Source: Credit Suisse, Institutional Research Flash, White Paper No. 7, “Cash is king-the need and ability of refinancing”, 14 April 2009, Zurich.



Another factor that appears important in determining the capital structure of a company is the ownership structure of the firm. Firms in continental Europe are characterised by a more concentrated ownership structure, with the presence of a major shareholder and several minor shareholders, in many cases a family is the owner of a company, even amongst multinational companies. In this context, equity is less favoured by the management because it will dilute the ownership structure and limit the power to influence the firm’s decisions. By contrast, in the Anglo-Saxon world companies have many different shareholders and therefore there is a greater use of financial instruments that could dilute the ownership structure. One last piece of evidence retained from the Mr Francescatti’s interview is that the life cycle of the company plays a crucial role in capital structure decisions. When a company is growing and in good financial shape, cash flows are strong and the firm is able to proceed with equity repurchasing, with plans for acquisitions, investments, etc., but when a company is facing a crisis, the options for refinancing decrease. Debt becomes impracticable because of the spread required and the sole viable possibilities are to issue equity or dispose of assets (see Figure 2).

The dynamic square of refinancing

Source: Credit Suisse, Institutional Research Flash, White Paper No. 7, “Cash is king-the need and ability of refinancing”, 14 April 2009, Zurich.


Several of these statements were confirmed by Mr Alain Minc, former CFO of Saint-Gobain, from the end of the 1970s until 1986.[Interview of Mr Alain Minc, Paris, May 2009.] From our interview it appears clear that corporate finance practices made a giant leap forward in just twenty years. Throughout the post-war period until the end of the eighties, the “multiples” and indicators (EPS; P/E; etc.) so omnipresent in every modern financial publication or newspaper article, were often unknown and not considered. Everything changed in the 1990s under the pressure of credit rating agencies, financial analysts, new accounting principles and regulations (e.g. Basel II Agreements).  In particular, the role of financial analysts and rating agencies has been completely overlooked by all major theories about capital structure in spite of the fact that these “actors” play a crucial role in the financial markets. Following new accounting rules, two of the main indicators considered by financial analysts to assess the financial quality (i.e. its ability to generate profits of a company) are the EPS (Earning per Share), an indicator of the capability to return the initial investments, and the Price/Earning Ratio (P/E), the price paid for the share relative to its earnings. A higher P/E is supposed to indicate higher future profits. Founding their analysis on such indicators, analysts have put a lot of pressure in the past years on CEOs and CFOs to boost their multiples by implementing important share buyback programs without much considering the effect of these operations. In fact, by buying stocks using internal funds managers were destroying cash to accumulate debt. The importance of these multiples is highlighted by the results gathered by Graham and Harvey where EPS dilution is the major factor taken into consideration by CFOs when issuing new equities. The exponential growth in share repurchase programs in the last twenty years is one of the clearest indicators of the importance of financial analysts in capital structure decisions.

Macroeconomic conditions play a role too. The high inflation in the 1980s discouraged the issue of new stocks, for example. With high inflation, companies experience an apparent increase in earnings and revenues but these numbers are "inflated" by inflation, in reality they are paying more for less. Another factor apparently ignored by mainstream literature about financial structure is the financial innovations of the last decade. If until the 1980s the financial instruments used by CFOs were principally equity, debt and loans provided by banks, since the 1990s and throughout the 2000s we have witnessed an endless race towards new and more sophisticated products (hybrid, structured, etc.) that have made all the previous literature quite old-fashioned and, despite some insightful contributions from the Pecking Order Theory, unlikely to help us in our research on current capital structure decisions. In our discussion with Mr Minc, we found a confirmation of the importance of governance structures in shaping and influencing the firm's financial structure. In particular, family-owned companies will be much more reticent about the issue of new equity fearing of loosing their share of power on the company's decisions. The high number of family-owned multinational companies in Europe makes this finding quite relevant for future research.




Although the evidential data taken into consideration in this paper may appear sometimes conflicting, a strong consistency may be found within the empirical results of Graham and Harvey, the findings from company histories and the interviews of CFOs –it has mainly to do with the importance of “informal” factors, the economic and financial cycles, and the ownership structure of the firm. The Modigliani-Miller Theorem gives us a purely theoretical model, unable to explain the reality of the facts since it is based on a perfect economic world without market frictions. Nevertheless, neither the Trade Off Theory nor the Pecking Order Theory (even though the latter, in particular, has helped to shed some light on the capital structure dynamics) is able to provide us with a comprehensive model of capital structure and financing behaviour. The empirical evidence in the literature supports in a certain way the existence of a pecking order in capital structure but there is little sign that the assumptions of the Pecking Order Theory are capable of explaining this fact.

The biggest flaw of all these theoretical models (M-M, Trade-Off Model, Pecking Order Theory) is the deep gap between them and the day-to-day routine of financial executives. Because of this, none of the classical models represents a valid instrument to understand past and present capital structures and financing behaviour. From the empirical researches available, and notably from Graham and Harvey and the interviews of Mr Francescatti and Mr Minc, it appears clear that none of the existing models is capable of describing, in a realistic way, the increasingly complex decisions that must be faced by CFOs. Another important factor to point out is the abysmal discrepancy between the financing behaviour during the post-war period until the end of the 1980s and financial practices since the1990s. New needs and new products make any possible comparison between these periods quite difficult and any subsequent historical work on this subject should take into consideration this fact. In order to understand past behaviour there is little that can be done at this point but, with regard to the future, new, dynamic and maybe behavioural theories should be developed –theories that should contemplate the increasingly complex and interconnected mechanisms of the global financial markets. 


Cost of Capital

The Cost of capital is the cost the firm must incur to finance itself on the market(s), issuing bonds, equities or hybrid instruments. From an investor’s point of view, it is the minimum return expected to lend to a firm. Once the cost of debt and the cost of equity obtained, the company is able to calculate its cost of funding. The most popular formula is the Weighted Average Cost of Capital (WACC).

Le coût du capital est le coût que l’entreprise doit supporter pour se financer sur le(s) marché(s), par l’émission d’obligations, d’actions ou d’instruments hybrides. Du point de vue de l’investisseur, cela constitue le rendement minimum attendu pour s’engager à prêter de l’argent à une entreprise. Après avoir établi le coût de la dette et de l'émission d’actions obtenu, la société peut calculer son coût de financement. La formule la plus connue, est le Weighted Average Cost of Capital (WACC)  ou Coût Moyen Pondéré du Capital (CMPC).


Net Present Value (NPV)

NPV is an indicator of how much value an investment or project will add to the firm measured by the sum of all the cash flows generated by a project discounted by an appropriate discount rate corresponding, generally, to an alternative investment of similar risk on the financial markets. A positive NPV theoretically means a project is valuable for the company, and vice versa.

La Valeur Actuelle Nette (VAN) est un indicateur pour évaluer la pertinence d’un investissement ou d’un projet pour une entreprise, mesuré par la somme de tous les flux d’argent générés par un projet et corrigé par un taux approprié correspondant à un investissement alternatif avec un risque similaire sur les marchés financiers. Une VAN positive signifie, en théorie, que le projet créera de la valeur pour la compagnie, et vice versa.


Earning per Share (EPS)

Earnings returned on the initial investment amount. The basic formula is: Profit/Weighted average common shares.

Rendements obtenus sur l’investissement initial. La formule de base est : Profit/ Moyenne pondérée des actions ordinaires.


Price/Earning (P/E) Ratio

It measures the price paid for a share relative to the annual net income or profit earned by the firm per share. P/E ratio serves a measure to compare the price of a share relative to another. A higher P/E ratio means a share is more expensive than   another one and could mean (but not necessarily) that it is believed to have more growth potential, or simply that, all things equal, it is overvalued. The P/E ratio can be calculated by dividing the Price per Share for the Annual earnings per Share, or by simply dividing the company’s market capitalization for its total annual earnings.

Cet indicateur mesure le cours boursier d’une action par rapport au bénéfice après impôts de l’entreprise ou au profit de l’entreprise pour chaque action. Le P/E Ratio sert à comparer le prix du cours d’une action à celui d’une autre. Un P/E Ratio plus élevé signifie qu’une action est plus chère qu’une autre. Cela pourrait signifier que celle-là a un plus grand potentiel de croissance ou plus simplement que, ceteribus paribus, le cours de cette action est surévalué. Le P/E Ratio peut être calculé en divisant le prix de l’action par les bénéfices annuels par action, ou simplement divisant la capitalisation boursière de la société par ses bénéfices annuels.


Yield Spread

The Yield spread is the difference between the rates of two or more investment instruments. Generally it reflects the different (real or perceived) credit worthiness of the securities considered (and of the issuing authorities), i.e. a wider spread reflects a greater riskiness (and consequently a greater return) of one instrument compared to the other and vice versa. L’écart de rendement représente la différence entre les taux de deux ou plusieurs instruments financiers. En général, il reflète la différence de solvabilité (réelle ou perçue) des instruments considérés (et des institutions qui les ont émis). Cela signifie qu’un spread plus marqué reflète un risque plus élevé (et un rendement supérieur) d’un instrument financier par rapport à  un autre, et vice versa.



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