Hayne E. Leland

Bio: Hayne E. Leland is an academic researcher from University of California, Berkeley. The author has contributed to research in topics: Capital structure & Debt. The author has an hindex of 39, co-authored 82 publications receiving 22101 citations. Previous affiliations of Hayne E. Leland include University of California & Stanford University.

Informational asymmetries, financial structure, and financial intermediation

Abstract: NUMEROUS MARKETS ARE characterized by informational differences between buyers and sellers. In financial markets, informational asymmetries are particularly pronounced. Borrowers typically know their collateral, industriousness, and moral rectitude better than do lenders; entrepreneurs possess "inside" information about their own projects for which they seek financing. Lenders would benefit from knowing the true characteristics of borrowers. But moral hazard hampers the direct transfer of information between market participants. Borrowers cannot be expected to be entirely straightforward about their characteristics, nor entrepreneurs about their projects, since there may be substantial rewards for exaggerating positive qualities. And verification of true characteristics by outside parties may be costly or impossible. Without information transfer, markets may perform poorly. Consider the financing of projects whose quality is highly variable. While entrepreneurs know the quality of their own projects, lenders cannot distinguish among them. Market value, therefore, must reflect average project quality. If the market were to place an average value greater than average cost on projects, the potential supply of low quality projects may be very large, since entrepreneurs could foist these upon an uninformed market (retaining little or no equity) and make a sure profit. But this argues that the average quality is likely to be low, with the consequence that even projects which are known (by the entrepreneur) to merit financing cannot be undertaken because of the high cost of capital resulting from low average project quality. Thus, where substantial information asymmetries exist and where the supply of poor projects is large relative to the supply of good projects, venture capital markets may fail to exist. For projects of good quality to be financed, information transfer must occur. We have argued that moral hazard prevents direct information transfer. Nonetheless, information on project quality may be transferred if the actions of entrepreneurs ("which speak louder than words") can be observed. One such action, observable because of disclosure rules, is the willingness of the person(s) with inside information to invest in the project or firm. This willingness to invest may serve as a signal to the lending market of the true quality of the project; lenders will place a value

Corporate Debt Value, Bond Covenants, and Optimal Capital Structure

Abstract: This article examines corporate debt values and capital structure in a unified analytical framework. It derives closed-form results for the value of long-term risky debt and yield spreads, and for optimal capital structure, when firm asset value follows a diffusion process with constant volatility. Debt values and optimal leverage are explicitly linked to firm risk, taxes, bankruptcy costs, risk-free interest rates, payout rates, and bond covenants. The results elucidate the different behavior of junk bonds versus investment-grade bonds, and aspects of asset substitution, debt repurchase, and debt renegotiation.

Optimal Capital Structure, Endogenous Bankruptcy, and the Term Structure of Credit Spreads

Abstract: This article examines the optimal capital structure of a firm that can choose both the amount and maturity of its debt. Bankruptcy is determined endogenously rather than by the imposition of a positive net worth condition or by a cash flow constraint. The results extend Leland's (1994a) closed-form results to a much richer class of possible debt structures and permit study of the optimal maturity of debt as well as the optimal amount of debt. The model predicts leverage, credit spreads, default rates, and writedowns, which accord quite closely with historical averages. While short term debt does not exploit tax benefits as completely as long term debt, it is more likely to provide incentive compatibility between debt holders and equity holders. Short term debt reduces or eliminates "asset substitution" agency costs. The tax advantage of debt must be balanced against bankruptcy and agency costs in determining the optimal maturity of the capital structure. The model predicts differently shaped term structures of credit spreads for different levels of risk. These term structures are similar to those found empirically by Sarig and Warga (1989). Our results have important implications for bond portfolio management. In general, Macaulay duration dramatically overstates true duration of risky debt, which may be negative for "junk" bonds. Furthermore, the "convexity" of bond prices can become "concavity." IN AN EARLIER ARTICLE, LELAND (1994a) considered optimal capital structure and the pricing of debt with credit risk. His assumption of infinite life debtconsistent with Modigliani-Miller (1958)-permitted closed form solutions for debt values and equity values with endogenous bankruptcy. But the assumption of infinite life debt is clearly restrictive. Firms must choose the maturity as well as the amount of debt.1

Agency Costs, Risk Management, and Capital Structure

Abstract: The joint determination of capital structure and investment risk is examined. Optimal capital structure reflects both the tax advantages of debt less default costs (Modigliani and Miller (1958, 1963)), and the agency costs resulting from asset substitution (Jensen and Meckling (1976)). Agency costs restrict leverage and debt maturity and increase yield spreads, but their importance is small for the range of environments considered. Risk management is also examined. Hedging permits greater leverage. Even when a firm cannot precommit to hedging, it will still do so. Surprisingly, hedging benefits often are greater when agency costs are low. THE CHOICE OF INVESTMENT FINANCING, and its link with optimal risk exposure, is central to the economic performance of corporations. Financial economics has a rich literature analyzing the capital structure decision in qualitative terms. But it has provided relatively little specific guidance. In contrast with the precision offered by the Black and Scholes (1973) option pricing model and its extensions, the theory addressing capital structure remains distressingly imprecise. This has limited its application to corporate decision making. Two insights have profoundly shaped the development of capital structure theory. The arbitrage argument of Modigliani and Miller (M-M) (1958, 1963) shows that, with fixed investment decisions, nonfirm claimants must be present for capital structure to affect firm value. The optimal amount of debt balances the tax deductions provided by interest payments against the external costs of potential default. Jensen and Meckling (J-M) (1976) challenge the M-M assumption that investment decisions are independent of capital structure. Equityholders of a levered firm, for example, can potentially extract value from debtholders by increasing investment risk after debt is in place: the "asset substitution" problem. Such predatory behavior creates agency costs that the choice of capital structure must recognize and control.

Saving and Uncertainty: The Precautionary Demand for Saving

Abstract: Publisher Summary This chapter discusses a two-period model developed to analyze rigorously the precautionary demand for saving. The precautionary demand for saving is usually described as the extra saving caused by future income being random rather than determinate. The effect of uncertainty on saving becomes obfuscated by generality. Many of the usual outlets for consumer saving, including saving deposits and government bonds, offer a fixed monetary rate of return. A multi-period model would be necessary to explore fully the effect of assets on the precautionary demand for saving. Until further progress is made with the more powerful inter-temporal models of optimization under uncertainty, the two-period model must be accepted along with its conclusion that states that under reasonable assumptions, there exists a positive precautionary demand for saving.

Financial Intermediation and Delegated Monitoring

Abstract: This paper develops a theory of financial intermediation based on minimizing the cost of monitoring information which is useful for resolving incentive problems between borrowers and lenders. It presents a characterization of the costs of providing incentives for delegated monitoring by a financial intermediary. Diversification within an intermediary serves to reduce these costs, even in a risk neutral economy. The paper presents some more general analysis of the effect of diversification on resolving incentive problems. In the environment assumed in the model, debt contracts with costly bankruptcy are shown to be optimal. The analysis has implications for the portfolio structure and capital structure of intermediaries.

The Benefits of Lending Relationships: Evidence from Small Business Data

Abstract: This paper empirically examines how ties between a firm and its creditors affect the availability and cost of funds to the firm. We analyze data collected in a survey of small firms by the Small Business Administration. The primary benefit of building close ties with an institutional creditor is that the availability of financing increases. We find smaller effects on the price of credit. Attempts to widen the circle of relationships by borrowing from multiple lenders increases the price and reduces the availability of credit. In sum, relationships are valuable and appear to operate more through quantities rather than prices.