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Essay on Capital Structure Theory and Decisions with analysis
Capital structure theory is one of the most puzzling issues in the corporate finance literature. Numerous empirical studies have shown that announcements of seasoned equity offerings (SEOs) cause negative price reactions, whereas the news of an additional debt issue is followed by an increase in stock prices. The majority of these studies use capital structure arguments emphasizing the importance of tax shield benefits from debt financing, as the explanation for this phenomenon. The idea to test whether tax arguments can account for market reactions to the news of security issues by investigating tax-exempt companies is not novel. Howe and Shilling (1988) investigated the stock price reactions to the announcements of new security issues, both debt and equity, of tax-exempt Real Estate Investment Trusts (REITs). They found both the classical positive price reaction on debt issue announcements and the negative price reaction on equity issues. Documenting these typical price reactions in the absence of corporate taxation caused them to attribute these market reactions to the alternative negative signaling explanations. Ghosh, Nag and Sirmans (1999, 2000) repeated this effort by investigating a larger and more recent REIT-sample and reported results that corroborate with those of Howe and Shilling. But although the issue has been analyzed frequently over the years, some of the most fundamental questions on the cause of price reactions remain unanswered.
The key question with which we are concerned is whether a firm can affect its total valuation debt plus equity and its cost of capital by changing its financing mix. We must be careful no to confuse any effects of a change in the financing mix with the results of investment or asset management decisions made by the firm. Therefore, changes in the financing mix are assumed to occur by issuing debt and repurchasing common stock or by issuing common stock and teetering debt.........
