Capital Structure Decisions in Small and Large Firms: A Life-cycle Theory of Financing

Abstract

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.