Journal of Finance2014-09-28 5:05 PM

The Capital Structure Puzzle

This paper's title is intended to remind you of Fischer Black's well-known note on “The Dividend Puzzle,” which he closed by saying, “What should the corporation do about dividend policy? We don't know.” [6, p. 8] I will start by asking, “How do firms choose their capital structures?” Again, the answer is, “We don't know.”




The capital structure puzzle is tougher than the dividend one. We know quite a bit about dividend policy. John Lintner's model of how firms set dividends [20] dates back to 1956, and it still seems to work. We know stock prices respond to unanticipated dividend changes, so it is clear that dividends have information content—this observation dates back at least to Miller and Modigliani (MM) in 1961 [28]. We do not know whether high dividend yield increases the expected rate of return demanded by investors, as adding taxes to the MM proof of dividend irrelevance suggests, but financial economists are at least hammering away at this issue.

By contrast, we know very little about capital structure. We do not know how firms choose the debt, equity or hybrid securities they issue. We have only recently discovered that capital structure changes convey information to investors. There has been little if any research testing whether the relationship between financial leverage and investors' required return is as the pure MM theory predicts. In general, we have inadequate understanding of corporate financing behavior, and of how that behavior affects security returns.


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Journal of Finance

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