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The Management of Corporate Capital Structure: Theory and Evidence

Corporate managers exercise discretion over financial as well as investment policies. We present a model in which a manager controls the firm's dynamic capital structure in her own interest, increasing leverage to fend off takeovers and decreasing leverage to avoid financial distress. An increase in the cost of mounting a hostile takeover is shown to induce a substitution of equity for debt finance; firms which are protected from takeover are less (more) likely to increase (decrease) their leverage and will tend to issue equity rather than debt. We test these implications by examining actual financial policies before and after second- generation state antitakeover laws became effective. As predicted by the model, coverage by antitakeover laws sharply reduces the use of debt finance. Firms which are not covered by antitakeover laws exhibit no such policy shift.