Framework for Capital Structure Changes

A firm whose actual debt ratio is very different from its optimal has several choices to make. First, it has to decide whether to move towards the optimal or to preserve the status quo. Second, once it decides to move towards the optimal, the firm has to choose between changing its leverage quickly or moving more deliberately. This decision may also be governed by pressure from external sources, such as impatient stockholders or bond ratings agency concerns. Third, if the firm decides to move gradually to the optimal, it has to decide whether to use new financing to take new projects, or to shift its financing mix on existing projects.

In the last chapter, we presented the rationale for moving towards the optimal in terms of the value that could be gained for stockholders by doing so. Conversely, the cost of preserving the status quo is this potential value increment. While managers nominally make this decision, they will often find themselves under some pressure from stockholders, if they are under levered, or under threat of bankruptcy, if they are over levered, to move towards their optimal debt ratios.

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