Managerial autonomy, optimal security issuance and capital structure

In this paper we address two related puzzles: (i) why do firms issue equity when stock prices are high and (ii) why do firms so often not issue securities to counteract the mechanical effect of their stock returns on their leverage ratios? Our theory builds on the importance of managerial autonomy in the face of potential disagreement with investors. The firm’s management values autonomy because it allows management to make decisions it believes are best for shareholders without being blocked by dissenters. The amount of autonomy management has at any point in time depends on how the firm is financed. Debt offers maximum autonomy when it can be backed by assets in place with a sufficiently high value, and minimum autonomy when assets in place have a low value. The managerial autonomy offered by equity depends on the extent to which shareholders are inclined to agree with management’s strategic choices. Equity offers the greatest autonomy when the propensity for shareholder agreement is the highest, and this is also when the firm’s stock price is the highest. Thus, the autonomy benefit of equity and high stock prices go hand in hand. Debt is the optimal security to issue when the probability of the assets in place having a high value is sufficiently high. Otherwise, the firm’s optimal security-issuance choice trades off the autonomy benefit of equity against the tax shield benefit of debt. An implication is that optimal capital structure is essentially dynamic and equity-centered. The optimal debt-equity ratio is decreasing in the firm’s stock price, implying that firms issue equity when stock prices are high and debt when stock prices are low. The theory explains many stylized facts that fly in the face of existing capital structure theories and also generates new testable predictions. Moreover, the theory can rationalize the use of debt in the absence of taxes, agency costs or signaling considerations.