https://www.simon.rochester.edu/fac/warner/Jerry%20Papers/JFE-June%2079.pdf

On financial contracting: An analysis of bond covenants

The agency costs of debt are introduced in this paper to explain the existence of complex financial instruments. Two areas of complexities are discussed in detail: the call provision and the maturity structure of debt. Their existence is rationalized as a means of resolving agency problems associated with informational asymmetry, managerial (stockholder) risk incentives, and foregone growth opportunities. It is also demonstrated that both features of corporate debt serve identical purposes in solving agency problems. Complex financial instruments are required because markets fail to provide complete and costless solutions to the agency problems discussed in the paper. I. Introduction IT IS WELL KNOWN that under perfect capital markets the choice among various financial instruments is inconsequential to the value of the firm. This basic irrelevancy theorem, originally suggested by Modigliani and Miller [17], covers all types of complexities which commonly characterize corporate financial obligations. The more general proof of the irrelevancy statement in the context of risky debt financing is provided by Stiglitz [21] who invokes a costless financial intermediary. This proof is in a multiperiod framework, and hence it includes corporate decisions relating to the maturity structure of debt. Many apparent explanations for the observable complex structure of financial instruments are not consistent with the Stiglitz framework. In particular, call provisions on corporate bonds are commonly attributed to interest rate uncertainty suggesting that since stockholders are able to reap the added value of the bond caused by a decrease in interest rates, they gain, and bondholders lose commensurately, in an ex ante sense. However, in the Stiglitz framework, when arbitrage profits are fully exploited, the value of a non-callable bond will always equal the value of a callable bond plus the value of the call privilege. That is, stockholders pay at issuance an amount which reflects the full value of the call privilege.'

A rationale for debt maturity structure and call provisions in the agency theoretic framework

Stable URL:http://links.jstor.org/sici?sici=0046-3892%28198821%2917%3A1%3C5%3ALAAPFM%3E2.0.CO%3B2-XFinancial Management is currently published by Financial Management Association International.Your use of the JSTOR archive indicates your acceptance of JSTOR's Terms and Conditions of Use, available athttp://www.jstor.org/about/terms.html. JSTOR's Terms and Conditions of Use provides, in part, that unless you have obtainedprior permission, you may not download an entire issue of a journal or multiple copies of articles, and you may use content inthe JSTOR archive only for your personal, non-commercial use.Please contact the publisher regarding any further use of this work. Publisher contact information may be obtained athttp://www.jstor.org/journals/fma.html.Each copy of any part of a JSTOR transmission must contain the same copyright notice that appears on the screen or printedpage of such transmission.The JSTOR Archive is a trusted digital repository providing for long-term preservation and access to leading academicjournals and scholarly literature from around the world. The Archive is supported by libraries, scholarly societies, publishers,and foundations. It is an initiative of JSTOR, a not-for-profit organization with a mission to help the scholarly community takeadvantage of advances in technology. For more information regarding JSTOR, please contact support@jstor.org.http://www.jstor.orgThu Nov 1 15:56:05 2007

Liquidity and Asset Prices: Financial Management Implications

Using a sample of over 5,000 debt issues, I test whether firms with more extensive use of covenants in their public debt contracts exhibit timelier recognition of economic losses in accounting earnings. Covenants govern the transfer of decision-making and control rights from shareholders to bondholders when a company approaches financial distress and thereby limit managers’ abilities to expropriate bondholder wealth. Covenants are expected to constrain managerial opportunism, however, only if the accounting system recognizes economic losses in earnings in a timely fashion. Thus, the demand for timely loss recognition should increase with a contract’s reliance on covenants. Consistent with this conjecture, I find evidence that reliance on covenants in public debt contracts is positively associated with the degree of timely loss recognition. I also find evidence that the presence of prior private debt mitigates this relationship.

Debt Covenants and Accounting Conservatism

We examine the relationship between stock prices and market segmentation induced by ownership restrictions in Mexico. The focus is on multiple classes of equity that differentiate between foreign and domestic traders, and between domestic individuals and institutions. Significant stock price premia are documented for shares not restricted to a particular investor group. We analyze the theoretical and empirical determinants of premia across firms and over time. In addition to economy-wide factors, segmentation reflects the relative scarcity of unrestricted shares. The results provide additional support for Stulz and Wasserfallen's (1995) hypothesis that firms discriminate between investor groups with different demand elasticities.

Market Segmentation and Stock Prices: Evidence from an Emerging Market

THE AUTHOR OF THE preceding "Comment" argues that any incentive problem created by future investment opportunities must ultimately be caused by some impediment to negotiation between shareholders and bondholders. While we do not disagree with this point, we do disagree with the assertion that it is nowhere hinted at in our paper. In the first place, the reader of our paper will search in vain for the statement that our model assumes away transactions costs. The term "transaction costs" has come to have a rather imprecise catch-all connotation, but at least two separate categories might be distinguished. The first category might be termed "trading" costs and would encompass the costs of trading relatively homogeneous commodities on organized exchanges. Brokerage fees or bid-ask spreads, for example, would reflect trading costs. The second category might be called "negotiating" costs and would include any costs incurred by two parties in making and enforcing a contractual bargain, particularly in the case of non-standardized goods or services. That we had such negotiating costs in mind when we wrote our paper should be clear from the statement in the "Discussion" section that "the call privilege provides a relatively simple and inexpensive way to alleviate the perverse incentives created by debtor-creditor relationships" [1, p. 1199]. If we did not explicitly assume away all transaction costs, is there anything about the structure of our model that implicitly requires them to equal zero? We would argue that there is not. It is true that we have not defined any bid-ask spreads around our expressions for the market values of the firm's securities, so it might be fairly stated that we have implicitly assumed away trading costs. It is also true that our model yields the Modigliani-Miller [3] financial irrelevance result for the case of no growth opportunities. One might be tempted to infer from this that all negotiating costs arising between bondholders and shareholders have also been assumed away, but that would be unwarranted. The ModilgianiMiller Theorem might indeed fail if the debtor-creditor relationship created incentive problems that could not be handled at negligible cost. Recall, however, that within our simplified framework the scope of the firm's discretionary activity is severely limited. If new investment at t = 1 is ruled out, and if current investment is already fixed, shareholders will be unable to alter the risk characteristics of the assets to the bondholders' detriment. Moreover, the firm has no cash flow at t = 1, so it could only harm the bondholders through dividend payments if it sells existing assets or issues new debt to finance these dividends. But these are precisely the kinds of actions that can be dealt with inexpensively through restrictive covenants. The bondholders need only prohibit sale of assets

Future investment opportunities and the value of the call provision on a bond

A CORPORATION'S capital structure is a means for partitioning its return stream among different classes of securityholders and across different states of nature. The primary thrust of capital structure theory has been to determine whether and how this partitioning affects the total value of the firm.1 For a firm subject to rate-of-return regulation, however, the capital structure decision may take on an additional dimension. Under such regulation, the firm's output price is set by an outside agency so as to yield a "fair" return to providers of capital, and, if effective, this process reduces monopoly profits. But if the regulator's price-setting rule depends on the firm's capital structure in some predictable way, the firm may be able to influence price and hence reap additional profits by judiciously choosing its financing mix. The purpose of this paper is to analyze possible "price-influence" effects of a regulated firm's capital structure and to illustrate regulators' attempts to combat them. The determinants of a regulated firm's capital structure have been touched upon in previous papers (Gordon [8], Elton and Gruber [5], Gordon and McCallum [9], Jaffe and Mandelker [11], Meyer [14] and Sherman [24], for example), but that issue has not been their primary concern. The present paper differs from those mentioned above by focusing its attention more directly on the capital structure decision. This issue is of interest in its own right in view of the important position occupied by regulated firms' securities in the capital market, but the approach taken here also serves to highlight and extend some common threads in the previous papers. In particular the results of these papers emerge as straightforward applications of the price-influence principle, and differences among them can be attributed to differing perceptions of the regulator's pricesetting behavior. Section I of the paper discusses the price-influence principle in general terms and describes the circumstances under which it will alter a regulated firm's financing choice. Section II presents three illustrations of how the general principle might work in practice, depending on the price-setting behavior of the regulatory agency. Section III discusses regulators' attempts to thwart the priceinfluence effect, and conclusions are drawn in Section IV.

Rate‐of‐Return Regulation and Utility Capital Structure Decisions

THE VIEW THAT A corporation's optimal capital structure is determined by balancing tax savings against bankruptcy costs has recently come under heavy attack.' Because this view seems to have stemmed initially from an attempt to reconcile theory with empirical observation,2 it is ironic that some of the most damaging attacks have themselves been based on empirical facts. Jensen and Meckling [7], for example, point out that the tax saving-bankruptcy cost tradeoff implies all-equity capital structures in the absence of corporate taxes, yet this is not what we observe prior to 1913. Similarly, Miller [11] argues that the theory implies dramatic secular increases in corporate debt ratios since 1913 and more widespread issuance of income bonds, yet we observe neither. As an alternative to the previous view, Miller has proposed an appealingly simple general equilibrium model of interest rates and security prices in the face of both corporate and personal income taxes. When ordinary income and capital gains are taxed at different rates, he concludes that the relative values of firms in a risk class must be identical, regardless of their capital structures. The original MM proposition that capital structure doesn't matter is thus reestablished, even in a world of taxes. Since Miller's model is based on a number of simplifying assumptions, it is the purpose of this paper to try to extend the analysis to a less restrictive setting. In particular, the basic model is examined under incomplete capital market conditions, and costs associated with debt are introduced. As in Miller's model, it is found that investors have a positive demand for corporate leverage, and that this demand is curtailed as the taxable interest rate rises relative to the tax-exempt rate. Unlike Miller's model, however, the capital structure of any one firm is not found to be a matter of indifference to all shareholders at a market equilibrium. This is attributable in part to the costs of debt, which dictate a tendency for more debt to be issued by those firms with lower costs. In addition, tax arbitrage restrictions, combined with incompleteness of the capital market, prevent marginal rates of substitution between current and future consumption from being equated for all investors. Shareholder preferences are thus no longer unanimous, and equilibrium capital structures will be those which both satisfy a majority of

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Taxes and Corporate Capital Structure in an Incomplete Market

This paper generalizes Miller's supply-side equilibrium argument to other forms of capital market imperfections and incompleteness If corporations possess a comparative advantage in dealing with these imperfections, they have an incentive to act as financial intermediaries Corporations' attempts to profit from these intermediation activities dictate an optimal capital structure for the corporate sector as a whole, but in equilibrium the capital structure of any single firm is a matter of indifference In addition, the positive role that corporate finance plays in completing the market restores standard perfect market results on asset pricing and the associated portfolio separation properties

Capital Structure Equilibrium under Market Imperfections and Incompleteness

This paper extends Merton Miller's 1977 analysis of corporate capital structure decisions to the incomplete capital markets case. As in Miller's model, aggregate demand for corporate leverage is curtailed as interest rates on taxable bonds rise. Unlike Miller's model, however, capital structure is not a matter of indifference to all equilibrium shareholders. Market incompleteness and tax arbitrage restrictions combine to prevent marginal rates of substitution from being equalized for all investors and hence their preferences are not unanimous. In addition, costs associated with debt induce a tendency for lower cost firms to issue a larger proportion of total corporate debt.

Robert A. Taggart

Papers

Future investment opportunities and the value of the call provision on a bond

Rate‐of‐Return Regulation and Utility Capital Structure Decisions

Taxes and Corporate Capital Structure in an Incomplete Market

Capital Structure Equilibrium under Market Imperfections and Incompleteness

Taxes and Corporate Capital Structure in an Incomplete Market