We have three papers to read for this chapter. We are not going to discuss the details in this chapter because they are in the Modigliani and Miller 1958 paper, which is included in the reading assignment.

Please read the three papers included in the chapter package and prepare a brief summary on companies' capital structure. To begin with, we want to summarize the advantages and disadvantages of debt and equity financing. And why some companies prefer debt over equity financing, or the other way around, under certain conditions. You can cite as many papers as you want. You do not have to limit yourself to the three papers included. However, if you cite a paper in your summary, please include the paper in the reference. Finally, please elaborate on your preference. Which would you prefer: debt financing, or equity financing?

Two or three pages is adequate, please double-space when formatting your summary.

THE JOURNAL OF FINANCE VOL. LXII, NO. 4 AUGUST 2007 Do Tests of Capital Structure Theory Mean What They Say? ILYA A. STREBULAEV ABSTRACT In the presence of frictions, firms adjust their capital structure infrequently. As a consequence, in a dynamic economy the leverage of most firms is likely to differ from the \"optimum\" leverage at the time of readjustment. This paper explores the empirical implications of this observation. I use a calibrated dynamic trade-off model to simulate firms' capital structure paths. The results of standard cross-sectional tests on these data are consistent with those reported in the empirical literature. In particular, the standard interpretation of some test results leads to the rejection of the underlying model. Taken together, the results suggest a rethinking of the way capital structure tests are conducted. RECENT EMPIRICAL RESEARCH IN CAPITAL STRUCTURE focuses on regularities in the cross section of leverage to discriminate between various theories of financing policy. In this research, book and market leverage are related to profitability, book-to-market, and firm size. Changes in market leverage are largely explained by changes in equity value. Past book-to-market ratios predict current capital structure. Firms seem to use debt financing too conservatively, and the leverage of stable, profitable firms appears particularly low. Even if firms have a target level of leverage, they move toward it slowly. Firms with low leverage react differently to external economic shocks from firms with high leverage.1 Strebulaev is at the Graduate School of Business, Stanford University. Most of the work on this paper was carried out at the London Business School. I wish to acknowledge with deep gratitude the counsel and never-failing kindness of Steve Schaefer. I am much obliged for many illuminating conversations and constructive suggestions to an associate editor, an anonymous referee, Viral Acharya, Anat Admati, Nick Barberis, Dick Brealey, Ian Cooper, Sergei Davydenko, Paul G. Ellis, David Goldreich, Denis Gromb, Rajiv Guha, Tim Johnson, Jan Mahrt-Smith, Pierre Mella-Barral, Felix Meschke, Kjell Nyborg, Sergey Sanzhar, Robert Stambaugh (the editor), Alexander Triantis, Raman Uppal, Rang Wang, Ivo Welch, and Toni Whited, and to the seminar participants at the Anderson School of Business at UCLA, Cambridge, Carnegie-Mellon, Columbia Business School, Cornell, Harvard Business School, Goizueta Business School, Kellogg, London Business School, Michigan Business School, McCombs School of Business, Oxford, Simon School of Business, Stanford GSB, and Stern School of Business. I am also thankful to the participants of the Western Finance Association 2004 meeting in Vancouver and the European Finance Association 2004 meeting in Maastricht. I am solely responsible for all remaining errors. 1 See Graham (2000) on conservatism in financing decisions; Titman and Wessels (1988), Rajan and Zingales (1995), Fama and French (2002), among others, on cross-sectional determinants; Fama and French (2002), Hovakimian, Opler, and Titman (2001), and Graham and Harvey (2001) on slow mean-reversion of debt ratios; Baker and Wurgler (2002) on the inf luence of past book-tomarket ratios; Welch (2004) on the inf luence of changes in the market value of equity; Opler and 1747 1748 The Journal of Finance These findings are typically evaluated in terms of the comparative statics of various capital structure models. Each of these models is supported by some evidence and challenged by other evidence. This paper attempts to understand whether our interpretation of cross-sectional tests would change if firms optimally adjusted their leverage only infrequently. The starting point for this study is a simple but fundamental observation. In a dynamic economy with frictions the leverage of most firms, most of the time, is likely to deviate from the \"optimal leverage,\" as prescribed by models of optimal financial policy, since firms adjust leverage by issuing or retiring securities infrequently, at \"refinancing points.\" Consequently, even if firms follow a certain model of financing, a static model may fail to explain differences between firms in the cross section since actual and optimal leverage differ. It has been long recognized that deviations from optimal leverage may create problems in interpreting the results of empirical research. For example, Myers (1984, p. 578) emphasizes that \"any cross-sectional test of financing behavior should specify whether firms' debt ratios differ because they have different optimal ratios or because their actual ratios diverge from optimal ones.\" This paper contributes to the literature by addressing exactly how the above problem has manifested itself in empirical studies. It also offers the intuition behind the ways in which this problem operates. I start by constructing a model of time-consistent optimal dynamic financing in the presence of frictions and then use the model to generate dynamic paths of leverage. The resulting crosssectional data resemble data used in empirical studies along a number of dimensions. This allows me to replicate tests commonly used in such studies and ask to what extent the results are similar. My findings can be summarized as follows: (1) Cross-sectional tests performed on data generated by dynamic models can produce results that are profoundly different from their predictions for corporate financing behavior at refinancing points; (2) moreover, some results may lead to the rejection of precisely the model on which these tests are based, if the null hypothesis is formed on the basis of the relationships at the refinancing point; and (3) even a stylized trade-off model of dynamic capital structure with adjustment costs can produce results that are numerically consistent with some of those observed empirically. The basic economic intuition behind these results lies in the observation that in any cross section firms are at different stages of their refinancing cycles, with almost no firms being at \"date zero\ THE JOURNAL OF FINANCE VOL. LXII, NO. 1 FEBRUARY 2007 Why Do Firms Issue Equity? AMY DITTMAR and ANJAN THAKOR ABSTRACT We develop and test a new theory of security issuance that is consistent with the puzzling stylized fact that firms issue equity when their stock prices are high. The theory also generates new predictions. Our theory predicts that managers use equity to finance projects when they believe that investors' views about project payoffs are likely to be aligned with theirs, thus maximizing the likelihood of agreement with investors. Otherwise, they use debt. We find strong empirical support for our theory and document its incremental explanatory power over other security-issuance theories such as market timing and time-varying adverse selection. A CENTRAL QUESTION IN CORPORATE FINANCE IS: Why and when do firms issue equity? Recent empirical papers have exposed significant gaps between the stylized facts and theories of security issuance and capital structure, so we seem to lack a coherent answer to this question. Our purpose is to develop a new theory of security issuance that is consistent with these difficult-to-explain stylized facts. One empirical regularity is the genesis of the current debate: Firms issue equity when their stock prices are high. This fact is inconsistent with the two main theories of security issuance and capital structure: tradeoff and pecking order. The tradeoff theory asserts that a firm's security issuance decisions move its capital structure toward an optimum that is determined by a tradeoff between the marginal costs (bankruptcy and agency costs) and benefits (debt tax shields and reduction of free cash f low problems) of debt. Thus, an increase in a firm's stock price, which effectively lowers its leverage ratio, should lead to debt issuance. However, the evidence suggests the opposite is true. While CEOs do consider stock prices to be a key factor in security issuance decisions (Graham and Harvey (2001)), firms issue equity rather than debt when stock prices are high (e.g., Asquith and Mullins (1986), Baker and Wurgler (2002), Jung, Kim, and Stulz (1996), Marsh (1982), and Mikkelson and Partch (1986)). Moreover, Welch (2004) finds that firms let their leverage ratios drift with their stock Dittmar is at University of Michigan Business School, Ann Arbor, Michigan and Thakor is at John M. Olin School of Business, Washington University in Saint Louis. Without implicating them for possible errors on our part, we would like to thank Sreedhar Bharath, Kent Daniels, Andrew Ellul, Bob Jennings, Clemens Sialm, Rob Stambaugh, Ivo Welch, and seminar participants at the University of Michigan, University of Oregon, University of New Orleans, and University of Toronto, and particularly an anonymous referee and an associate editor for many useful suggestions. We would also like to thank Brad Bernatek, Brandon Fleming, and Amrita Nain for excellent research assistance, and Art Durnev and Nejat Seyhun for supplying some of the data. 1 2 The Journal of Finance prices, rather than returning to their optimal ratios by issuing equity when prices drop and debt when prices rise. Myers and Majluf's (1984) pecking order theory assumes that managers are better informed than investors, and this generates adverse selection costs that could dominate the costs and benefits embedded in the tradeoff theory. Firms will therefore finance new investments from retained earnings, then riskless debt, then risky debt, and only in extreme circumstances (e.g., financial duress) from equity. Fama and French (2005) provide two strong pieces of evidence against this theory. First, firms frequently issue stock; 86% of the firms in their sample issued equity of some form during the 1993 to 2003 period. Second, equity is typically not issued under duress, nor are repurchases limited to firms with low demand for outside financing. Between 1973 and 2002, the annual equity decisions of more than 50% of the firms in their sample violated the pecking order. Fama and French therefore conclude (p. 551), \"the pecking order, as the stand-model of capital structure alone, is dead.\" Two explanations have been offered for these stylized facts. Baker and Wurgler (2002) hypothesize that firms issue equity to \"time\" the market, that is, they issue equity when it is overvalued by irrational investors who do not revise their valuations to ref lect the information conveyed by the equity issuance. The other explanation, \"time-varying adverse selection,\" is a dynamic analog of the static pecking order theory. According to this explanation, firms will issue equity when stock prices are high if a high stock price coincides with low adverse selection. That is, adverse selection costs are time-varying, as are stock prices. One difficulty with the timing hypothesis is that it was formulated to explain the conundrum of equity issuance during periods of high stock prices. Thus, the documented empirical regularity cannot be taken as support for the hypothesis, or in other words, it provides a potential explanation but is not a refutable theory of security issuance. Time-varying adverse selection is potentially more testable,1 and we will examine the incremental explanatory power of our theory relative to it. However, in the original pecking order theory of Myers and Majluf (1984), there is no a priori reason for the amount of asymmetric information to be related to the stock price level and, hence, it is quite plausible to hypothesize that asymmetric information is actually higher when stock prices are higher. Our goal in this paper is to provide an alternative theory of security issuance that is consistent with recent empirical findings, and then test it. The theory rests on the simple idea that the manager's security issuance decision depends on how this decision will affect the firm's investment choice and how this choice in turn will affect the firm's post-investment stock price. The manager cares both about the stock price immediately after he invests in the project for which the financing was raised and about the firm's long-term equity value. The price 1 Lucas and McDonald (1990) extend this theory to an infinite horizon and provide additional implications, including the predictions that firms will issue equity after a stock price run-up. They also generate predictions that go beyond the observed relationship between equity issues and stock prices. Adverse selection that varies over time also appears in Choe, Masulis, and Nanda (1993), who explore the implications for aggregate equity issues. Why Do Firms Issue Equity? 3 reaction to the firm's investment decision depends on whether investors endorse the decision or think it is a bad idea. To the extent that the manager can anticipate the degree of agreement between what he thinks is a good project and what investors think is a good project, he can form an expectation about how the stock price will react when he makes his investment decision. It is this expectation that drives the issuance decision. Thus, the degree of agreement is central to the manager's financing choice. Because the manager's objective function is based on the firm's equity value, there is no divergence of goals between the manager and the shareholders. The shareholders may object to the manager's investment only because they have different beliefs about the value of the project. In our model, this difference in beliefs arises from heterogeneous prior beliefs that lead to different interpretations of the same information. In order to focus on disagreement based on interpretations, we shy away from agency and asymmetric information problems, but discuss why our empirical findings cannot be explained by these problems. The situation is different with debt. Bondholders may object to the manager's project choice either because they disagree with him about project value (like shareholders) or because their objective function differs from that of the manager and shareholders. This dual source of disagreement can make debt financing particularly expensive for the firm. There are conditions under which avoiding this cost makes it ex ante optimal for the manager to accept covenants in the debt contract that limit his choice only to projects that can neither hurt bondholders' interest ex post nor be subject to disagreement. Debt financing is then a double-edged sword. On the one hand the manager gains the debt tax shield, but on the other hand he loses the \"autonomy\" to invest in a project with a potentially higher shareholder value. Equity provides the manager greater autonomy in project choice, although the manager's concern with the stock price immediately after the investment limits this autonomy since the price will drop if shareholders disapprove of the manager's choice. The manager's security issuance choice trades off the greater elbow room in project choice associated with equity against the debt tax shield. The autonomy that equity provides is greater, the smaller the likelihood that shareholders will disagree with the manager. Moreover, the firm's stock price is also high when the likelihood of this disagreement is lower, since the shareholders face a smaller probability that the manager will do something of which they disapprove. The model therefore predicts that equity will be issued when stock prices and agreement are high and debt will be issued when stock prices and agreement are low. Our analysis also predicts that the manager will not issue equity but may issue debt if the firm does not have a project. Our prediction regarding the link between equity issuance and stock price is consistent with the main implication of timing and time-varying adverse selection. The difference is that in our model this link emerges because a high stock price is evidence of market agreement, whereas in the timing hypothesis it is because the firm is overvalued and in the time-varying adverse selection hypothesis it is because information asymmetry is low. For sharper delineation 4 The Journal of Finance between these hypotheses, we conduct an empirical horse race. We separate firms into equity issuers and non-equity issuers, defining non-equity issuers as debt issuers, rather than nonissuers, because the predictions versus this group are the most clear. We use several \"price variables\" to determine whether a firm has a \"high\" stock price. We also choose several proxies unrelated to market timing or information asymmetry to measure the extent of investor-manager agreement and test our model's predictions using other variables to control for information asymmetry and the implications of market timing. We take a four-pronged empirical approach to test our theory. First, we confirm that equity is issued when stock prices are high. Second, we examine whether firms with high agreement parameters issue equity regardless of their stock price. We find that they do. Third, we show that firms that issue equity have significantly higher agreement parameters than firms that do not. We then ask if our agreement proxy has incremental power in explaining equity issuance beyond timing considerations and proxies for information asymmetry. Again, we find that it does, supporting our theory. Fourth, while the other hypotheses imply that the manager will issue equity when the stock price is high, regardless of whether the firm has a project, our theory implies that equity will be issued only to finance a project. Hence, we further discriminate among the different hypotheses by asking whether capital expenditures (CAPEX) increase after equity issues. We find a significant increase in CAPEX after equity issues, but not after debt issues. We also find that this increase is greatest when investor-manager agreement is the highest. In a nutshell, the empirical results provide support for our theory's central prediction that anticipated investor endorsement of future managerial investment decisions is an important determinant of the security issuance decision. Our findings do not rule out market timing or time-varying adverse selection as possible motivations for equity issues. Rather, we make a strong case that anticipated investor agreement has incremental explanatory power relative to these motivations. Because agreement among agents is the driving force of our model, it is useful to note that our main idea has a f lavor that is the opposite of one interpretation of the recent literature on disagreement-based overpricing. Chen, Hong, and Stein (2002), Diether, Malloy, and Scherbina (2002), and others suggest that the combination of differences of opinion among investors and short-sale constraints can cause overpricing. This observation together with the markettiming hypothesis implies that managers may issue equity when disagreement among investors is high. That is, whereas our theory predicts that equity will be issued when agreement between the manager and investors is high, the overpricing-based timing argument asserts that equity will be issued when disagreement among investors is high. We address this contrast in two ways. First, our findings are not necessarily inconsistent with those of the overpricing literature since our focus is on a difference of opinion between the managers and investors as a group, whereas the overpricing literature is concerned with disagreement among investors. Second, we perform three kinds of tests to distinguish our predictions from overvaluation; two of which are \"one-sided\" tests, where the proxies we use have an unambiguous prediction with respect to either our theory or overvaluation but not both, and one is a \"two-sided\" test, where Why Do Firms Issue Equity? 5 the proxies are such that our theory and overvaluation generate diametrically opposite predictions. In our first set of one-sided tests, we use three proxies for agreement between investors and the managertwo related to managers' performance in delivering earnings per share (EPS) exceeding analysts' forecasts and one representing abnormal returns associated with acquisition announcementsthat have nothing to do with disagreement among investors. We find strong support for our theory. In the second set of one-sided tests, we use two proxies for disagreement among investorschange in ownership breadth and turnover that have little to do with agreement between the manager and investors. In these tests, we also include one of our measures of agreement. We find modest support for overvaluation-based issuance timing based on disagreement among investors, but our measure of agreement between the manager and investors remains significant in these tests. Finally, in our two-sided tests, we use dispersion of analyst forecasts and the premia in the prices of dual-class stocks. Our theory predicts that equity should be issued when dispersion and dual-class premia are small, whereas market timing predicts the opposite. Again, we find strong support for our theory. The rest of this paper is organized as follows. Section I has the literature review. Section II develops the theory. The analysis and derivations of the testable hypotheses appear in Section III. Section IV describes the data, and Section V discusses the empirical results. Section VI concludes. I. Related Literature on Disagreement Since the notion that the manager and the shareholders can disagree about project value even when faced with the same information and objectives plays a central role in our theory, we brief ly review why we believe such disagreement is common in economic interactions. In our model, disagreement arises because of heterogeneous prior beliefs. Although rational agents must use Bayes rule to update beliefs, economic theory does not restrict prior beliefs. Kreps (1990) argues that prior beliefs should be viewed in the same way as preferences and endowmentsas primitives in the description of the economic environmentand that heterogeneous priors are a more general specification than homogeneous priors.2 Kurz (1994) provides the foundations for heterogeneous but rational priors.3 2 Kreps (1990, p. 370) notes, \"First, it is conventionally assumed that all players share the same assessments over nature's actions. This convention follows from deeply held 'religious' beliefs of many game theorists. Of course one hesitates to criticize another individual's religion, but to my own mind this convention has little basis in philosophy or logic. Accordingly, one might prefer being more general, to have probability distributions and t , which are indexed by i, reflecting the possibly different subjective beliefs of each player.\" See also Morris (1995). 3 A related issue is whether heterogeneous beliefs will converge to the same posterior beliefs. The rational learning literature asserts that agents cannot disagree forever (e.g., Aumann (1976) and Blackwell and Dubins (1962)). However, convergence may not occur if there is insufficient time to exchange information, lack of sufficient objective data, or heterogeneous priors that are drawn randomly from distributions that are not absolutely continuous with respect to each other (Miller and Sanchirico (1999)). 6 The Journal of Finance There are previous models of heterogeneous priors. Allen and Gale (1999) examine how heterogeneous priors affect new firm financing. Coval and Thakor (2005) show that heterogeneous priors can give rise to financial intermediation. Garmaise (2001) examines the implications of heterogeneous beliefs for security design. Harris and Raviv (1993) use differences of opinion to explain empirical regularities about the relation between stock price and volume. Kandel and Pearson (1995) make the case that their evidence of trading volume around public information announcements can be best understood within a framework in which agents interpret the same information differently. Boot and Thakor (2006) use heterogeneous priors to develop a theory of \"managerial autonomy\" that characterizes the allocation of control rights among financiers and its capital structure implications. In their survey, Barberis and Thaler (2002) note that a key ingredient of behavioral models that provide explanations for asset pricing anomalies is disagreement among market participants. II. The Model A. Preferences and Time Line There are four points in time. All agents are risk-neutral, the financial market is perfectly competitive, and the riskless rate of interest is zero. Thus, there is no discounting of payoffs. At t = 0, the firm is all-equity financed and has existing assets in place, with an expected (after-tax) value of V at t = 3 that everybody agrees on. The firm's equity is traded and its stock price is observed. It is known at t = 0 that a new investment may arrive at t = 1. This investment opportunity is actually a portfolio of projects. Every project in the portfolio requires an investment of $I at t = 2. This portfolio consists of three mutually exclusive projects: a safe mundane project that pays off $M > I for sure at t = 3, a risky innovative project that pays off a random amount $Z at t = 3, where Z {L,H}, with L 1, the manager maximizes5 y W = P2 + P2x , (3) where P x2 is the expected value of the firm at t = 2 to the shareholders at t = 0, as assessed by the manager at t = 2 based on his interpretation x of the signal y S, and P 2 is the firm's value to its t = 0 shareholders based on the stock price at t = 2 as set by investors based on their assessment of the firm's terminal value at t = 3 using their interpretation y of the signal S after they have noted the firm's investment decision at t = 2. D. Manager's Choice of Security at t = 1 The manager can issue either debt or equity at t = 1. If equity is chosen, we assume that a fraction (0, 1) of the firm will have to be sold, so the initial 4 However, this does not mean that our model cannot accommodate situations of asymmetric information. All we are arguing is that after the initial updating in case of asymmetric information, there will be some (possibly soft) information on which the two parties may simply disagree. 5 Objective functions of this type have been used before, for example Miller and Rock (1985) and Ofer and Thakor (1987), and can be justified via a management compensation scheme as in Holmstrom and Tirole (1993). Why Do Firms Issue Equity? t=0 t=1 All-equity finance firm. Probability (0,1) that a project opportunity will arrive at t=1. Assets in place have value V. t=2 Project opportunity arrives or does not. If project opportunity arrives, the firm can choose between an innovative, a mundane, and a lemon project. Firm makes a security issuance decision: debt or equity, after observing whether a project opportunity has arrived. 9 t=3 Manager and investors observe the same signal S about the payoff on innovative project. Manager interprets signal as x {L,H}, investors as y {L,H}. Project choice is made. Payoff realization. Figure 1. Sequencing of events. shareholders will have a claim to a fraction (1 ) of the terminal payoff. If debt is chosen, repayment will have to be made at t = 3. E. Manager's Actions in the Face of Disagreement We assume equity does not contractually restrict the manager's project choice. Debt may restrict it, depending on the manager's choice of covenants. Consider equity first. The manager will clearly have a stronger incentive to invest in the innovative project when x = H than when x = L. If the manager was concerned solely with the firm's terminal value, he would always invest in the innovative project when x = H and the mundane project when x = L. But his concern with the interim stock price at t = 2 makes him consider the expected stock price reaction to his decision, given x and the agreement parameter . It is clear that the manager will never invest in the lemon if he issues equity. Now consider debt. The manager can either issue debt with no covenant restrictions on his project choice at t = 2 or he can issue debt with a covenant that allows the bondholders to dictate project choice at t = 2. Figure 1 summarizes the sequence of events in our model, which is a special case of the more general framework in Boot and Thakor (2006). F. Parametric Restrictions We restrict the exogenous parameters to focus on the cases of interest. First, [M L] > [H M ]. (4) This restriction states that the mundane project is sufficiently attractive than the innovative project would not be preferred independently of the interpretation of the signal about the innovative project's value. Given (4), the manager 10 The Journal of Finance will choose the mundane project when x = L and, given high enough, will choose the innovative project when x = H. Our second restriction is V +L IT . [1 T ] [1 + ] (7) This inequality guarantees that the set of exogenous parameters for which equity issuance will be chosen is nonempty. This will happen when the highest possible value of the innovative project relative to the mundane project is high enough relative to the value of the debt tax shield. III. Analysis The analysis proceeds by backward induction. Since there is nothing of any significance happening at t = 3 other than the realization of payoffs, we begin at t = 2, and then work back to t = 1. A. Events at t = 2 At t = 2, the manager either has debt, equity, or nothing, based on the security issuance decision made earlier at t = 1. Consider first the scenario in which debt was issued at t = 1. We can prove LEMMA 1: If debt issued at t = 1 gives the manager the latitude to select whichever project he wants, the manager will unconditionally prefer the lemon project at t = 2. This result is a consequence of the asset-substitution moral hazard at play in the model, and will affect the type of debt contract that will be feasible at t = 1. We now turn to the case in which equity was raised at t = 1. LEMMA 2: Suppose equity was issued at t = 1. Then at t = 2, the manager prefers the mundane project regardless of his interpretation of the signal about the Why Do Firms Issue Equity? 11 payoff on the innovative project if the agreement parameter 1, so that the manager cares more about the terminal value of the firm than the interim stock price. We now move back to t = 1. B. Events at t = 1 We will focus on events after is realized and the manager knows he has a project. Our first result is about the kind of debt contract that will be chosen. LEMMA 3: If the manager prefers to issue debt at t = 1, he will issue debt that has a covenant that forces him to invest in the mundane project at t = 2. The intuition is straightforward. From Lemma 1, we know that the manager invests in the lemon at t = 2 if he has issued debt at t = 1. But, since the lemon has negative-NPV, bondholders will refuse funding. Given this, the manager finds it optimal to issue debt at t = 1 with a covenant that ties the firm's hands at t = 2. Our next result is one of the key empirical predictions. PROPOSITION 1: There exists a critical cutoff value of the agreement parameter ( , 1] such that the manager prefers to issue equity at t = 1 if and debt if