2011 Vol. 2


Optimal Capital Structure

Pansy Yang, Ph.D. (Bio)
Executive Director of the Fink Center for Finance & Investments

Art, science, or a bit of both? Academics and practitioners often disagree, not only with each other but among themselves. In this issue of the Bulletin, however, they seem to be in agreement that the capital structure decision is both art* and science.

Whether an optimal capital structure exists and if so, what drives firms to adhere to one is a fundamental question in finance. For decades, this topic has been researched extensively by academics. Yet the answer remains elusive.

For this issue's academic perspective, I provide a general overview of the literature culminating with the latest evidence uncovered in a new empirical paper by Richard Roll (UCLA) and Harry DeAngelo (USC). Although there has been conflicting evidence on the stability of leverage ratios, the generally accepted view to date is that firms do indeed have target leverage ratios and seek to maintain them. Contrary to this view, Roll and DeAngelo find that "...capital structure stability is the exception, not the rule."

Timothy Terrell,director of Capital Management at Kroger, offers an insightful view into the highly competitive supermarket industry. They provide the historical background that has helped shape Kroger's capital structure decisions, as well as some guiding principles for their overall financial strategy that has helped them maintain success throughout the ever-changing market conditions.

*Disclaimer: It really ought not to be if we knew how to do it. The leverage decision is an art in the sense that it is a scientific question that has not yet been resolved.


Industry Perspective

Timothy Terrell
Director of Capital Management, Kroger.

The supermarket industry in the United States is highly competitive, has relatively low barriers to entry and is characterized by paper thin net income margins.  Recent history also demonstrates that capital structure decisions are a critical factor to long-term survival.   Public companies with high yield or declining credit ratings lack the financial flexibility to weather economic cycles, combat competitive threats, or have been forced to merge, sell or liquidate.  The listing in Table 1 reveals that only two of the top 10 U.S. grocers in 1983 were still on the list in 2010.

The Kroger Co. is one of the largest traditional grocers in the U.S.  We operate more than 2,400 supermarkets and multi-department stores in 31 states, plus over 1,000 supermarket fuel locations.  Approximately 44% of these supermarkets were operated in company-owned facilities, including some Company-owned buildings on leased land.  Our current strategy emphasizes self-development and ownership of store real estate.  In addition to the supermarkets, we operate approximately 780 convenience stores, 360 fine jewelry stores and 40 manufacturing plants.  Total sales exceed $82 billion.  We hold the #1 or #2 market share in 38 of our 42 major markets.  And we offer a personalized approach to each customer based on proprietary consumer insights that help us grow the total households that shop with us.

Among other responsibilities, the mission statement of The Kroger Co. includes a commitment to deliver a consistent return to our shareholders equal to or above overall market returns.  The connection between capital structure decisions and our mission statement lies in our past.  The finance team at Kroger has inherited a culture shaped by dramatic structural events, including a major recapitalization in 1988, the industry's largest merger in 1998, and the industry's most expensive work stoppage in 2003.  These events helped shape our belief that a solid, investment grade capital structure best supports the operating strategies we employ to meet our responsibilities. 

We define "solid" as maintaining a BBB/Baa2 rating on our public debt.  We believe this rating provides us with the lowest cost of capital, access to liquid capital markets and significant financial flexibility.  To maintain this rating, we employ a financial strategy designed to meet the needs of both equity and fixed income investors.  We also maintain a constant dialogue with ratings agencies and allocate free cash flow to produce a consistent net debt to EBITDA ratio.  (Leverage takes many forms and we assess operating lease commitments and Taft Hartley, Multi-Employer pension obligations in our overall capital structure.) Our public debt portfolio is designed to produce a smooth and sufficiently staggered maturity schedule.  Finally, our revolving credit facility provides cost effective and immediate access to bank capital.

The true value of our financial strategies was clearly revealed during the financial crisis of 2008.  During this time our finance team proactively managed the situation by slowing down share repurchases, temporarily borrowing under our revolver, and subsequently issuing debt (even though there was negative carry) to bring the revolver back down.  Looking back, the greatest risk we faced was the culture shock and resulting impact on customer service that would have occurred had we been unable to fund a weekly payroll or meet vendor payment terms.  Our stable cash flows from operations and ability to access liquid credit markets during the crisis gave our associates the confidence to focus on customers' needs first.



Academic Perspective

Pansy Yang, Ph.D. (Bio)
Executive Director of the Fink Center for Finance & Investments 

What factors propel firms to choose one form of financing over another? How should firms make decisions on what proportions to put in debt, equity or alternatives? Does an optimal capital structure exist? This topic has been heavily researched and hotly debated by the academic finance community for over half a century, resulting in little consensus and a lot of controversy. Many consider the motivation for firms to issue debt one of the top 10 unsolved mysteries in modern finance.

The literature dates back to a paper by Modigliani and Miller (MM) in 1958, which contained the first rigorous theory of capital structure. MM states that a firm's value is unaffected by its financing choices. In other words, capital structure is irrelevant to the market value of the firm. MM is logically valid in a perfect world without market frictions. But imperfections such as taxes, bankruptcy costs, transactions costs, agency conflicts, information asymmetry, to name a few, might compromise its MM irrelevancy conclusion. Some view MM as pure theory, but nonetheless important because it represents an idealized framework for examining real world reasons why capital structure is relevant to the value of the firm.

Miller and Modigliani (1963) specifically address the tax benefit of debt, which laid the groundwork for the trade-off theory. Trade-off theory states that there is benefit to financing with debt that arises from the corporate tax shield. This would imply 100% debt financing though, so there must be something to offset the benefit of debt. The answer lies in bankruptcy costs, that loom with ever greater probability as leverage increases. This implies that firms should establish a target determined by balancing the advantages of debt tax shields against the costs of financial distress and bankruptcy. If leverage is off target, firms should gradually move toward it. The optimal speed of adjustment to the target is an important empirical issue.

Miller's seminal paper on debt and taxes in 1977 questions whether expected bankruptcy costs could be large enough to explain why firms does not take more advantage of the benefits of corporate debt. His skepticism led to his famous comment that "the supposed trade-off between tax gains and bankruptcy costs looks suspiciously like the recipe for the fabled horse-and-rabbit stew - one horse and one rabbit." In his paper, Miller specifically argues that the corporate tax advantage of debt is offset by a personal tax disadvantage, so in equilibrium there might be no optimal leverage ratio except that very high leverage is excluded because of bankruptcy costs. In other words, the cost of capital is flat for a wide range of leverage ratios from zero to at least fifty percent.

Myers and Majluf (1984) offer an alternative explanation, called the pecking order theory. Pecking order theory postulates that firms prioritize their sources of financing, with an initial preference for internal financing, followed by debt financing when internal sources are depleted, followed lastly by issuing equity when it is no longer sensible to issue more debt. In other words, there exists a hierarchy in the various sources of capital. This model is based on asymmetric information, in which managers are assumed to possess more knowledge about the true value of the firm than investors. Thus, when firms issue new equity, investors believe that managers may consider the firm to be overvalued and therefore take advantage of the overvaluation (and investors). It follows that astute investors will assign a lower value to new equity issuance, which explains why equity is the least preferred form of financing.



The past year has been memorable, to say the least, for the ASAM Class of 2011. We have seen turbulence in not only the U.S. financial markets, but in the global political and socio‐economic environment as well. Since inheriting the ASAM portfolio in May 2010, the current ASAM class has managed the portfolio amidst major macroeconomic headwinds, ranging from the ramifications of the Deepwater Horizon oil spill in the Gulf of Mexico, sovereign bailouts in the European Union, escalation of tensions on the Korean peninsula, social unrest and upheaval in the Middle East and North Africa, a devastating earthquake and tsunami in Japan, and fiscal deficits in the US at the federal, state and municipal level. May 2010 was also noteworthy in that we witnessed an intraday decline, the Flash Crash, of over 900 points (9%) on the Dow, the largest intraday point decline in the history of the Dow Jones Industrial Average.

Despite these macroeconomic headwinds, the S&P 500 rallied about 15% over the past year, buoyed by unprecedented monetary stimulus (QE1 and QE2) by the Federal Reserve. The 30% market rally since August 2010 was broad and mostly beta driven. Since February 2011, however, the S&P 500 has returned just over 1% in choppy trading, signaling the end of the beta trade and marking the beginning of a period in which investors will have to rely increasingly on stock selection to drive returns. In this environment, the FSCORE and EAR stock selection  strategies should perform well, particularly given enhancements by this year's class regarding stock selection, sell discipline and risk management. Additionally, this yearʹs class implemented a new strategy (BCD) based on a variation of the Gordon growth model, which has shown promise in back‐testing as a strong alpha generation tool.  


Faculty Highlights

Bruce Carlin

Professor Bruce Carlin has been promoted to Associate Professor with tenure.  Bruce joined the finance faculty at UCLA Anderson in 2007. Carlin's primary research interests are in the areas of theoretical corporate finance and consumer finance.  He has published in leading journals, including the Journal of Finance, Journal of Financial Economics and Review of Financial Studies. He is a dedicated teacher, and was awarded the 2008 Dean W. Robbins Award for teaching excellence.  He has been recognized previously for his teaching acumen at both Duke University and the University of North Carolina.  Please join us in congratulating Bruce!


Professor Mark Garmaise Selected 2011 Outstanding Teacher of the Year by MBA Students

Mark Garmaise

Our MBA students selected Professor Mark Garmaise as the 2011 Outstanding Teacher of the Year.  Garmaise teaches the core Corporate Finance course, as well as the Venture Capital and Private Equity course.  His primary research interests are in the areas of corporate finance, real estate, entrepreneurship and banking.   This honor is additional to Garmaise's many prior awards.  He has received the 2005 Dean George W. Robbins Assistant Professor Teaching Award, the 2006 Eric and "E" Juline Excellence in Research Award, the 2007 Citibank Teaching Award for most outstanding MBA teacher, and the 2009 Fully Employed MBA Teaching Excellence Award. He has also published in many of the top finance journals, including the Review of Financial Studies, Journal of Finance and Quarterly Journal of Economics


Professor Avanidhar Subramanyam is Keynote Speaker for European Financial Management Annual Meeting

Avanidhar SubrahmanyamProfessor Avanidhar Subrahmanyam is the invited keynote speaker at the European Financial Management Association's (EFMA) 21th Annual Meeting in Barcelona, Spain from June 27-30th.  The EFMA was founded in 1994 to encourage research and disseminate knowledge about financial decision making in all areas of finance as it relates to European corporations, financial institutions and capital markets. Members consist of academics, practitioners and students from Europe and the rest of the world who are interested in the practice of sound financial management techniques and are dedicated to understanding and solving financial problems.  Over 500 people attend the meetings.

Subrahmanyam is an expert in behavioral finance and economics, known for his path-breaking research in the use of psychological principles to explain stock price movements.  Co-editor of the Journal of Financial Markets, Subrahmanyam is the author or co-author of numerous refereed journal articles in leading finance and economics journals.  For his scholarly efforts, he has received best paper awards at the Western Finance Association meetings and the International Conference of Finance in Taiwan and was honored with the Fama-DFA prize for the best paper in investments published in the Journal of Financial Economics (2000) and the Smith Breeden Prize for the best paper published in the Journal of Finance (1999).

Professor Bhagwan Chowdhry is Panelist at the Israeli Presidential Conference

Bhagwan ChowdhryFacing Tomorrow 2011, the third annual conference under the auspices of the president of the State of Israel, Mr. Shimon Peres, took place in Jerusalem from June 21-23rd. The Israeli Presidential Conference was held for the first time in May 2008, one week following the 60 year anniversary of the State of Israel. It was defined by many as the most impressive event that took place in honor of the 60th celebration. Conferences have been privileged with the presence of global leaders, international scholars, activists, poets, scientists, artists, clergy, entrepreneurs, economists and industrialists. The 2011 Conference focused on the vital issues, initiatives and decisions that must be implemented today in order to guarantee a better tomorrow for the world, the Jewish people, and the State of Israel.

Professor Bhagwan Chowdhry is an invited panelist at the Israeli Presidential Conference.  Chowdhry is a Professor of Finance, and Faculty Director of the Master of Financial Engineering program. His research interests, on which he has published several papers in finance and economics journals, are in International Finance and Corporate Finance and Strategy. He has been on the editorial board of a number of finance journals. Microfinance has been his recent teaching, research and applied interest. 

Professor Bhagwan Chowdhry Makes Special Appearance on Entourage

Professor Bhagwan Chowdhry was approached by "Entourage's" casting director Susan Abramson and Executive Producer Doug Ellin to make a cameo appearance on the show for his Financial Access at Birth (FAB) initiative. FAB is trying to convince world leaders as well as private donors to open a $100 savings account for every child born in the world. He plays himself, a professor in finance at UCLA Anderson.  The show will air on Episode 6 during the upcoming and last season on Sunday, August 28th.


Professor Richard Roll and Karlheinz Muhr ('85) Ring NYSE Opening Bell

Richard RollFactor Advisors, a New York-based asset management firm, visited the NYSE and rang the Opening Bell on June 1st to celebrate the successful launch of FactorShares.  The firm was founded in 2009 by investment banker and Fink Center board member Karlheinz Muhr, Stuart Rosenthal, and UCLA Anderson's Professor Richard Roll.  The three men believed that Roll's risk factor-based investment approach could be the basis for creating simple and cost-effective spread ETFs and by this shared viewpoint FactorShares products were created.  Earlier this year, they announced the launch of FactorShares, the first family of spread exchange traded funds (ETFs) that allow sophisticated investors to simultaneously hold both a bull and a bear position in one leveraged ETF.  These innovative, first-to-market products are now trading on the NYSE Arca. 


Two Finance Chair Transitions

Richard RollRichard Roll will become the first Joel Fried Chair in Applied Finance, a new endowed chair created thanks to the generosity of alumnus and Fink Center board member Joel Fried ('86) to recognize excellence in applied finance teaching and research.  Mark Grinblatt, the J. Clayburn LaForce Professor of Finance, has been named to the Japan Alumni Chair in International Finance, the chair held previously by Richard Roll, created in 1997 thanks to the collective generosity of over 130 Japan alumni.

Richard Roll, a distinguished member of our faculty since 1976, is among the leading finance scholars in the world, having contributed seminal works on asset pricing, portfolio theory, and interest rates.  He was president of the American Finance Association, and has led the Fink Center for Finance and Investments since its founding in 2006.  He has worked for the Boeing Company and Goldman Sachs, and consulted with many firms in the financial services industry.  Roll has been the recipient of some of the most prestigious prizes in the field, including the Graham and Dodd award for financial writing three times, and the Leo Melamed Award for the best financial research.

Mark GrinblattMark Grinblatt, who has been on our faculty since 1981, is Senior Associate Dean of the UCLA Anderson Ph.D. Program.   He is a former president of the Western Finance Association and a founding member of the Foundation for the Advancement of Research in Financial Economics.  His research focuses on asset pricing, corporate finance, and investor behavior.  His recent work on IQ and investor performance won the 2010 Goldman Sachs international prize for best paper.  He currently serves as advisory editor to both the Journal of Finance and the Journal of Financial and Quantitative Analysis, on the executive committee of the National Bureau of Economic Research, and on the board of Citi Swapco, Inc. He formerly was Vice President at Salomon Brothers, a board member of the American Finance Association, and the keynote speaker at several major academic conferences. 

Upcoming Events

Save the Date

Date Event
September 15, 2011 MBA Orientation Breakfast
November 17, 2011 Conversation with Larry Fink (BlackRock) and Bill Gross (PIMCO)
February 10, 2012 2nd Annual Private Equity Summit
March 14-16 2012 Young Presidents' Organization (YPO) Raising Capital Seminar

For more information about any of the above events, please contact us at fink.center@anderson.ucla.edu.


Recent Events

Join the UCLA Anderson finance faculty, ranked #1 in intellectual capital by BusinessWeek, for a weekly seminar given by renowned academics visiting from leading universities all over the world. Seminars are open to the public and held at UCLA Anderson from 11:00 a.m.- 12:15 p.m.




March 18

Jeremy Stein

Harvard University

Title of paper: "A Comparative-Advantage Approach to Government Debt Maturity"

April 1

Dean Karlan

Yale University

Title of paper: "Getting to the Top of Mind: How Reminders Increase Saving"

April 8

Fernando Ferreira

The Wharton School

Title of paper: "Anatomy of the Housing Boom in U.S. Neighborhoods and Metropolitan Areas, 1993-2009"

April 15

Steve Ross


Title of paper: "Notes from the Vol Surface"

May 6

Adriano Rampini


Title of paper: "Dynamic Risk Management"

May 13 Vojislav Maksimovic

University of Maryland

Title of paper: "Redefining Financial Constraints: a Text-Based Analysis"

May 20 Christine Parlour

UC Berkeley

Title of paper: "Competition, Quality and Managerial Slack"

June 3 Kai Li

University of British Columbia

Title of Paper: "Determinants of Corporate Cash Policy: A Comparison of Public and Private Firms"


Special Guest Speakers

David Windreich ('83) visited Professor Hanno Lustig's Securities Analysis and Investment Management class on Monday, May 23rd. David is the head of U.S. Investing and Executive Managing Director at Och Ziff Capital Management Group and a Fink Center board member. He started his talk with an outline of the fundamental economics of the hedge fund industry. David emphasized the absence of significant barriers to entry in the hedge fund industry and the importance of human capital (identification and retention). After that, there was a lively Q&A session. Students asked a variety of questions about the future of the hedge fund industry, the challenges of adequately measuring value added in investment management and the lessons learned from the recent financial crisis.

The Fink Center for Finance & Investments
UCLA Anderson School of Management
110 Westwood Plaza, Los Angeles, CA 90095