- ameliorate conflicts of interest among various groups with claims to the firm's resources, including managers (the agency approach),
- convey private information to capital markets or mitigate adverse selection effects (the asymmetric information approach),
- influence the nature of products or competition in the product/input market, or
- affect the outcome of corporate control contests.
The theories that it is to "ameliorate conflict of interest" and "affect the outcome of corporate control contests" have nothing to do with the basic purpose of the firm - to create value for stakeholders - and in all probability, these are satanic designs that ruin the firm in the end. If all the stakeholders are working according to the well defined norms of justice and fair play than why there is conflict of interest? The theory of Capital Structure to avoid agency costs that Jensen and Meckling identified lead the managers on the path of destruction since the managers are given incentives such as based on EVA etc. and managers when faced with -ve results try to manipulate the earnings in order to achieve the target and earn incentives, the examples are "Enron", "Worldcom", etc. Debt provides incentive to engage in suboptimal investment because in debt contract there is an implicit provision that if an investment yields large returns, well above the face value of the debt, equityholders capture most of the gain. If, however, the investment fails, because of limited liability, debtholders bear the consequences in case liquidation is insufficient to cover the entire amount of debt. So clever managers who would like to hold on to power would go for the higher debt equity ratio and this is the strategy that comes to mind immediately there is any threat of take over. But that is a dangerous path to move on because debt has to be paid at some fixed time in future and that future is highly uncertain. Uncertainty coupled with fixed nature of debt commitment puts the managers under pressure for results and that is where the best laid out plans fall apart and lead the managers to play games.
The theory that capital structure decison is to convey inside / private information to market means it is used / can be used as a deception. Why can't we convey inside information in a straight forward manner without taking any steps that can lead the firm on the road to destruction? If the answer is no, then something is wrong that is being dragged under the rug. Information asymmetry between insiders and outsiders cause different value for the firms' assets and that may result in financing a new project / investment opportunity by existing owners / managers with debt if internal fund are insufficient - pecking order theory of capital structure. This pecking order begins when outsiders have some serious doubts about the information not available to them and that makes them suspicious. The question is why such asymmetry of information in the first place? Market, it seems always thinks of the information asymmetry that is why "Noe shows that the average quality of firms issuing debt is higher in equilibrium than that of firms issuing equity. Therefore, like Myers-Majluf, Noe's model predicts a negative stock market response to an announcement of an equity issue. Noe also predicts a positive market response to an announcement of a debt issue." There is always mistrust of managers by the market about firm's inside information. Why can't insiders speak the truth? Or why can't market take the words of insiders to be true on its face value unless otherwise proved? Is there lack of trust or lack of reputation? Because of lack of trust and distortion of communication between management and market, the market tends to heavily tilted towards the debt, which promises a fixed return irrespective of any reference to profit / (loss) - a figure that is highly questionable from the point of view of the outsiders for numbers of reasons but mainly on account of asymmetry of information.
Leverage changes the behavior of the firm and its strategy because a levered firm assumes a sure commitment of periodic fixed payment to debtholders to remain in business. In the face of debt, it is very difficult to sustain high quality. Because quality can only be achieved through truth - speaking truth about its systems, products, people and speaking truth to its suppliers, customers, but when a firm has a debt to pay its ability to speak truth is highly undermined. This is even more true in case of an adverse forecast or less than expected results then the deviations from the straight path take start. All information asymmetries, conflicts of interests, contests for control of firm and competitive strategies move in different directions than the relevant theoretical models predict.
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