Modigliani and Miller Meet Chandler: Organizational Complexity and Capital Structure [Archive.org URL]

We study how the degree of organizational complexity of a firm relates to its corporate financial policies. We measure complexity as the number of layers in the firm’s subsidiary structure, and focus on a sample of US firms over the period 1996-2006. We argue that organizational complexity makes the firm opaque and increases the asymmetry of information between it and the market. We show that organizational complexity is strongly related to stock market-based measures of information asymmetry – i.e., Amihud’s (2002) illiquidity, Llorente et al.’s (2002) information asymmetry coefficient, the number of analysts tracking the firm, and the equity bid-ask spread. In line with the predictions of the pecking order theory, firms characterized by a more complex organizational structure resort less to equity and more to debt financing, have higher leverage, display a higher investment-cash flow sensitivity and hold more cash to finance future investment. Complexity, while related to information asymmetry, is not just another proxy for the existing measures of asymmetry of information (e.g., Bharath et al., 2008) and its impact on firm financial policies is stronger than that of other conventional proxies for information asymmetry. Given its high persistence over time, complexity is an ideal candidate for the fixed firm-specific effect that has been identified as one of the main determinants of leverage (Kayhan and Titman, 2007, Lemmon et al., 2008). By making the firm more opaque and increasing information asymmetry, complexity reduces the value of equity (Tobin’s Q and Rhodes-Kropf et al.’s (2005) overvaluation measures). Moreover, by limiting the divisional managers’ incentives to engage in risk taking behavior, complexity reduces the overall riskiness of the firm and its probability of distress. This improves the value for the bondholders, reducing the cost of debt: more complex firms have lower bond yield spreads on the secondary market. [Hat tip to FinanceProfessor.com]

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