Disagreement and Flexibility: A Theory of Optimal Security Issuance and Capital Structure

In this Paper we introduce flexibility as an economic concept and apply it to the firm’s security-issuance decisions and capital structure choice. Flexibility is the ability to make decisions that one thinks are best even when others disagree. Firms value flexibility because it allows management to make decisions it believes are best for shareholders without being blocked by dissenters. The amount of flexibility management has at any point in time depends on how the firm is financed. Debt offers little flexibility relative to equity. The flexibility offered by equity depends, however, on the extent to which shareholders are inclined to agree with management’s strategic choices. Equity offers the greatest flexibility when the propensity for shareholder agreement is the highest. It turns out that the firm stock price also increases with shareholders’ propensity to agree with management. Thus, the flexibility benefit of equity is high only when the share price is high. The firm’s optimal security-issuance choice trades the flexibility benefit of equity against the now-familiar debt tax shield, and the firm’s capital structure is the consequence of a sequence of past security-issuance choices. The strongest implication of this theory of capital structure evolution is that optimal capital structure is essentially dynamic, and depends on 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 signalling considerations.