Capital Structure Decisions in Small and Large Firms: A Life-cycle Theory of Financing
October 31, 1999
Zsuzsanna Fluck
ABSTRACT
This paper focuses on the dynamic capital structure of firms: Why firms choose very different capital structure
in different stages of their life-cycles? In a model of optimal financial contracting, we investigate whether subsequent
financing decisions
of firms are affected by the outcome of previous financing decisions. We find that the initial and subsequent financing
decisions of the same firm may lead to different security choices. The firms' financing decisions will differ in
two respect. First, there will be equilibrium contracts that investors would reject for some small firm, but accept
them for an otherwise identical large firm (i.e. when the two firms have identical projects). Secondly, even the
set of the equilibrium financial contracts differs in different stages of the firm's lifecycle: some contracts
which are never sustainable as an initial contract for a small firm become sustainable for large firms. The reason
is the stage-dependency of the control rights of subsequent claimholders: in addition to their own rights, holders
of subsequent security issues may also rely on the firm's existing investors to enforce their claims. Whether or
not they can do so, depends on the priority structure of the claims.
Consistent with empirical evidence, our theory implies a life-cycle pattern of financing: firms will issue outside
equity, short-term debt or convertible debt first, then use their retained earnings, issue longer-term debt, or
outside equity to satisfy sub-sequent financing needs. A novel result of our analysis is that, despite the presence
of severe market imperfections, the Modigliani-Miller indifference result between debt and equity does hold for
large firms in our model, but at the same time, it fails to hold for small firms. The intuition is again the interaction
between the control rights of subsequent claimholders. Since the control rights of previous securityholders represent
an externality for subsequent claimholders, the marginal decision of which security to issue next becomes irrelevant
once a firm has sufficient contractual complexity in place.
Fluck: (212) 998-0341 zfluck@stern.nyu.edu
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