Haas School of Business

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Finance Professor Evaluates Optimal Mix of Debt and Equity in Celebrated Model

Finance Professor Evaluates Optimal Mix of Debt and Equity in Celebrated Model

Fellow academics, corporate financiers, and policymakers are indebted to Hayne Leland: His pioneering research on corporate debt pricing and capital structure offers new and lasting insight into achieving the optimal mix of debt and equity.

Leland earned the inaugural Stephen A. Ross Prize from the Foundation for the Advancement of Research in Financial Economics (FARFE) for his discoveries, published in the 1994 Journal of Finance paper, "Corporate Debt Value, Bond Covenants, and Optimal Capital Structure." The Ross prize is awarded to the work judged by one's peers to have made a highly significant contribution to financial economics over the prior fifteen years. FARFE, a global consortium of finance academics and practitioners, created the $100,000 prize to recognize and encourage research in the field of financial economics, which explains the underpinnings of corporate finance and capital markets.

"Financial economics is an area that is critical to our understanding of complex capital systems and how they work," says to Andrew Carron, president of NERA Economic Consulting and one of the founding members of FARFE. "The recent global financial turmoil has made advancing this understanding especially important."

A Framework for Financing Firms

Quote Leland's paper analyzed how firms determine the optimal mix of debt and stock ("equity") to acquire funds at the lowest cost. The optimal use of debt, or "leverage," balances tax advantages with potential default costs. The analysis suggests, for example, that startup firms should use relatively little debt financing, whereas mature firms with stable cash flows can benefit from substantial leverage.

Leland, who has been teaching at the Haas School since 1974, also examined the determinants of debt value and default. Subsequent research has built on the analysis and insights of this paper to examine how firms adjust the mix of debt and equity over time and how this affects pricing in financial markets. Other extensions include analyzing the interaction between leverage and investment, and the value of corporate risk management.

"Hayne's paper gives CFOs a tractable yet logically rigorous framework for thinking about how they finance their firms," says Haas Finance Group Professor Mark Rubinstein. "However, his paper goes much deeper than that. In terms of the current climate, Hayne's paper also explains how to think about the effect of bond covenants on corporate incentives. Policymakers would gain a lot from understanding the incentives they create when the government fails to insist upon the types of covenants used by private sector investors. Further, Hayne's work illustrates the perils associated with a tax system that rewards excessive use of leverage, via tax deductibility of interest expense"

A Work of Substantial Influence

Ross Prize Committee Chair Paul Pfleiderer says Leland's paper stood out among 350 papers considered for its "elegant and rigorous approach in addressing an important problem in finance." Pfleiderer, the C.O.G. Miller Distinguished Professor of Finance at the Stanford Graduate School of Business, also lauded Leland's work for "the substantial influence it has had over the years on research in capital structure."

Haas School Associate Professor Christopher Hennessy concurs: "Armies of graduate students and assistant professors have extended and refined Hayne's work in order to better understand corporate financing decisions. This is the kind of approach to research that we all envy; make a groundbreaking contribution and let others share some of the lifting.

"Hayne can rest assured of his intellectual legacy, since so many researchers have absorbed and appreciated the import of his work," adds Hennessy. "My only hope is that his work will find its way into the hands of policymakers."

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