Showing papers on "Capital structure published in 1977"

Information Asymmetries, Financial Structure, and Financial Intermediation

Abstract: This essay details a model of capital structure and financial equilibrium, developed in order to provide more theoretical information about informational asymmetries, financial structure, and financial intermediation. Although direct information transfer about the abilities of the entrepreneur and/or the quality of the firm is uncertain, one publicly available signal is investment in the project by the entrepreneur. This model demonstrates how a firm's value increases with the share of the firm shared by the entrepreneur, and a firm's financial structure can be related to a project or firm's value. Other models cannot readily account for the presence of financial intermediaries, in part because they do not incorporate the role of asymmetric information -- with this model, financial intermediation (which provides a validation role for the credibility of information and has a means of recouping the cost of information gathering and legitimation) can be interpreted as a response to asymmetric information. Within this model, it is determined that the set of investment projects undertaken coincides with the set that would be undertaken if direct information transfer were possible. (CBS)

A model of corporate financing decisions

Abstract: IN THIS PAPER, an integrated model of corporate financing patterns is presented. The model draws on the current theory of optimal capital structure, but places this theory in the context of the overall, ongoing financing decision. Estimates of the model make specific allowance for balance sheet constraints and the interdependent nature of the financing decision. A fully integrated theory of corporate financing decisions has not yet been developed, so the results presented cannot be interpreted as a test of any one complete theory. Rather, they represent a search for empirical regularities which may help guide future theoretical studies. Some fragments of a theory of corporate financing decisions do exist, however, and an attempt is made to incorporate them in the model and see if they are useful in explaining past data. In the first section of this paper, previous studies are discussed. In the following section, a new model is developed which attempts to improve on these studies by drawing upon current theory. Finally, estimates of the model are presented which improve on previous studies in their use of an estimation technique which explicitly allows for balance sheet interrelationships. A major conclusion is that movements in the market values of long-term debt and equity are important determinants of corporate security issues.

How Much Growth Can a Firm Afford

Abstract: * For years growth has been second only to profits in the pantheon of corporate virtues. In recent years, however, there are increasing signs that some managements must finally face the fact that unrestrained growth may be inconsistent with established financial policies. The intent of this paper is to demonstrate that the financial policies and growth objectives established by some companies are mutually incompatible, and to explore the options open to firms for remedying this worsening problem. To test the consistency of a company's growth objectives and its financial policies, a concept called sustainable growth is introduced. For those companies that want to maintain a target payout ratio and capital structure without issuing new equity, sustainable growth is defined as the annual percentage of increase in sales that is consistent with the firm's established financial policies. If sales expand at any greater rate, something in the company's constellation of financial objectives will have to give usually to the detriment of financial soundness. Conversely, if sales grow at less than this rate, the firm will be able to increase its dividends, reduce its leverage or build up liquid assets. A note of urgency is added to this discussion because, as will be demonstrated, the effect of inflation generally reduces real sustainable growth. If, for example, a company's sustainable growth rate in the absence of inflation is 8%, its real sustainable growth rate measured as the annual percentage increase in physical volume in the presence of a 10% inflation rate might fall to 3.5%. Inflationary growth therefore consumes limited financial resources almost as

The Weighted Average Cost of Capital as a Cutoff Rate: A Critical Analysis of the Classical Textbook Weighted Average

Abstract: Assuming that the firm has an optimal debt/equity ratio, most textbooks recommend using the weighted average cost of capital as a cutoff rate for investment decision-making. Arditti [1] demonstrates that the components of the weighted after-tax cost of capital, as recommended by most textbooks, have been incorrectly specified. This misspecification implies that the capital structure that minimizes the weighted average after-tax cost of capital is a non-optimal one. In this paper we extend Arditti's argument and demonstrate that the finance textbooks' traditional post-tax cash flow can be misleading. Basically, there are two mistakes in these texts: one in defining the project's cash flow and one in defining the cost of capital. While these two mistakes may offset each other in some cases, therefore presenting the firm with the correct accept-reject decision, generally the two mistakes do not cancel, and the textbook procedure leads the firm to an incorrect decision. The traditional weighted average post-tax cost of capital presented in leading textbooks (cf. [4], [1I], and [12]) and taught in most courses, including those taught by the authors of this paper we denote as ct, defined as

Capital structure rearrangements and me-first rules in an efficient capital market

Abstract: PERHAPS THE ISSUE OF FOREMOST CONCERN to the theory of business finance as it has evolved over the past two decades has been the impact of corporate financial policy on the market value of a firm's common stocks and bonds. Building on the foundation laid by Modigliani and Miller (1958, 1961, 1963) numerous authors,1 using a variety of analytic techniques, have shown that in a perfect capital market neither the debt-equity decision nor the dividends-retained earnings decision should have any effect on the total market value of a firm's securities once its investment decision has been determined and made known. Some of these same authors have shown further that the existence of corporate income taxes provides sufficient economic incentive for firms to maximize their use of corporate debt financing. However, even then, it is only the tax deductibility of interest payments that has any effect on firm value. These various analyses typically have assumed that firms have no debt outstanding when they establish their financing policies. Since most firms are on-going entities, the more general case is that firms will make capital structure decisions after they have issued some debt. When a firm has debt outstanding, in the absence of a prior arrangement to protect its bondholders, stockholders may rearrange the firm's capital structure to transfer wealth belonging to the firm's creditors to themselves. This possibility has been noted by Stiglitz (1972, p. 462).

Bankruptcy Costs and the Firm's Optimal Debt Capacity: A Positive Theory of Capital Structure

Abstract: independent of its capital structure is a conceptual subject which continues to receive considerable attention and discussion in recent financial theory literature.1 The basic underlying premise of the M-M proposition is simply that in perfect securities markets, the capital structure decisions by firms belonging to the same risk class do not alter the opportunity set available to investors. Hence any discrepancies in total market values of identical firms in the same risk class arising from differences in financing mix will be removed through arbitrage operations by investors. But as recent financial writers point out, individual investors do not enjoy the limited liability priviledge accorded to firms, and more significantly, there are explicit costs to bankruptcy which may offset the advantage to the firm arising from the tax deductibility of interest payments. Hence the purpose of this paper is to examine in a formal manner, within the context of a mean-variance framework, if recognition of these securities market imperfections are sufficient to establish the traditional finance position that capital structure decisions have a significant impact on total firm value, and thereby provide the theoretical basis for a financial synergy rationale for conglomerate

The theory of recapitalizations and the evidence of dual purpose funds

Abstract: IN A GENERAL CAPITAL MARKET the pattern of state contingent payoffs from existing securities determine the feasible allocations of uncertain future wealth attainable by individuals in the economy. Recapitalizations, which are additions and/or partitions of the vectors of state contingent payoffs from existing securities (e.g., capital structure changes, or non-synergistic mergers and/or divestitures), may render an equilibrium allocation of uncertain wealth unattainable or may induce individuals to trade from the previous allocation to a mutually preferable allocation. Under either of these conditions, the equilibrium allocation of uncertain future wealth would be altered and the total market values of firms in the economy may change. Even when firms' total market values are affected by a recapitalization, as long as the capital market is perfect, the Modigliani-Miller thesis that the relative market of values of firms in the same risk class are independent of recapitalizations would hold as an arbitrage condition. That is, with unrestricted short sales and the absence of transactions costs, portfolios of securities offering identical uncertain future payoffs would sell at the same price or else riskless arbitrage profits would exist. However, under existing institutional arrangements for short selling, where interest is not received on funds impounded from a short position, the relative market values of firms in the same risk class may differ from the relative sizes of their uncertain future returns implying that the relative market values of firms within the same risk class could be affected by capital structure and hence by recapitalizations. Divergences in the relative market values of firms in the same risk class from the relative sizes of their uncertain future payoffs is shown to imply that the allocation of securities is Pareto inefficient. The existence of an inefficient allocation of wealth is shown to be inconsistent with models (capital asset pricing, option

On Mean Variance Models of Capital Structure and the Absurdity of Their Predictions

Abstract: Corporate taxes and default risk are relevant to an understanding of the effect of financial leverage on the total market value of the firm Recently, Kraus and Litzenberger [6] have examined the implications of taxes and default risk for capital structure decisions in a state preference valuation model A parameter preference model as distinct from a state preference model may be applied to continuous probability distributions As the most familiar parameter preference approach, the capital asset pricing model is an obvious alternative approach to incorporate the effects of leverage in a world of taxes and default risks Given the analysis by Hamada [4] of the effects of taxes in absence of default risk and by Stiglitz [16] of the effects of default risk in absence of corporate taxes, such an exercise would superficially appear to be a trivial extension of their studies However, this paper presents a “reduction ad absurdum” argument that, in an economy where corporate interest charges are tax deductible and firms issue risky debt, the total market value of a levered firm using the capital asset pricing model is misspecified

Sales Forecasting Practices of Large U.S. Industrial Firms

Abstract: * Sales forecasting is a crucial part of many financial management activities, including profit planning, capital expenditure analysis, capital structure planning, cash budgeting and merger analysis. In all of these and other financial management areas, accurate sales projections are extremely important. Because of this importance, any prescriptive finance theory should be cognizant of and influenced by the projection and forecasting practices of the firms we prescribe for. Very little is known today about sales forecasting practices in industry, however, and a systematic cataloguing of current sales forecasting practices would assist in documenting and comparing current practices. The purpose of this study is to present some evidence regarding the current state of the art of business sales forecasting practices. Because of the nature of the topic, we necessarily use data from a questionnaire. In the following sections we present this questionnaire, the nature of the data obtained from it and draw some conclusions about the evidence. Data

Financial Aspects of Rate-of-Return Regulation

Abstract: profit opportunities independently of its financial structure (absent the corporate income tax), may not apply to a regulated firm whose profit is held well below the level it could earn if unregulated. For the resulting unexercised monopoly power will provide a large reserve of potential profit, allowing a regulatory authority to set returns to debt and equity quite independently of the firm's profit opportunities. Regulatory decisions would determine the value of the firm for any given capital structure, and a change in capital structure might change the value of the firm. Then rate-of-return regulation could distort financial decisions of the firm as well

A profitability model for tactical planning

Abstract: Simple models reflecting changes in aggregate company behaviour in response to changes imposed by management decisions and/or factors outside the direct control of management provide useful tools for tactical planning purposes One such model is discussed in this paper The model enables management to assess explicitly and quantitatively the effect on the rate of return on capital employed of primary causes of change in any of the key variables affecting company performance, such as the unit price, the unit cost, the output level and the capital employed Simple functional relationships are proposed between the major variables in the model, such as the level of output and the unit cost, the unit price and the volume of sales, the working capital requirements and the general level of the firm's activity, etc and these are based on analytical considerations, empirical evidence and a series of assumptions These relationships give rise to a set of parameters which are incorporated in the model and describe the operational (cost structure), financial (capital structure) and marketing (elasticity of demand) position of the company under study Numerical results obtained from the model seem to suggest that the sensitivity of the rate of return to some of the parameters and underlying assumptions is relatively small, implying that the inter-dependence between some of the variables can be ignored, thus simplifying the problems associated with data collection and model evaluation Both the model and the methodology of analysis employed are flexible enough to allow: (1) application of the model to alternative sets of functional relationships between variables and/or underlying assumptions; (2) further decomposition of the model to include additional variables depending on the particular objectives of the study; (3) modification of the model to explore the effects of management decisions or those of changes in external factors on productive unit and product profitability; and (4) analysis of models reflecting the effects of changes which are imposed on the system on measures of business performance other than the rate of return on capital employed

The Relationship between Risk of Default and Return on Equity: An Empirical Investigation

Abstract: The focus of this study is the role of default risk in capital market theory. The impact of default risk on the value of securities has been a major concern of investors and academics alike. Several authors have examined the relationship between bond ratings, the probability of default, and security value [5, 12]. In this context, the ability to avoid or reduce expected bankruptcy costs and thereby increase value has been suggested as a reason for mergers and consolidations [16, 18]. In other studies, models have been developed for predicting ratings [17, 20, 21, 28], for predicting bankruptcy using accounting and other financial variables [1, 6, 7], and for approximating default premiums in the credit markets [22]. Finally a question which has received considerable attention is the effect of bankruptcy on a company's cost of capital. When bankruptcy is possible and there exists a positive bankruptcy transaction cost, it has been argued that there is an optimal capital structure [24, 26].

An analysis of optimal farm capital structure

Abstract: Use of debt in financing agricultural firms is an weak theoretical framework. Many earlier writings issue of perennial interest. Much of this interest have been conceptualized in a marginal returns and reflects farmers' disastrous experience with debt marginal costs framework. Conceptual and empirical during the Great Depression. The foreclosed mort- difficulties in including risk in this standard framegages and bankruptcies of that era reaffirmed an work limit its usefulness in analyzing situations where historical feeling that achieving a level of zero debt or risk is important. In corporate finance theory, the financial leverage was a high priority goal. E.G. concept of cost of capital is utilized to analyze Johnson, who was Chief of the Economic and Credit optimum level of financial leverage [1, 11]. While Research Division of the Farm Credit Administration, Hopkin, Barry and Baker present a theoretical disarticulated the position in the 1940 Yearbook of cussion of this concept in their textbook [5, pp. Agriculture that this goal is even more important than 251-256], it has not been integrated into empirical increasing profits: "It may be well to emphasize again analysis in agricultural finance. The purpose of this that while credit properly used may help farmers to paper is to explore applicability of the concept of increase their income and raise their standard of cost of capital in analyzing farmers' decisions to living, the fact must not be overlooked that more utilize financial leverage. Specific objectives include: credit will not cure all the ills of agriculture. The (1) a brief discussion of the concept of cost of greatest need is to assist the farmers in getting out of capital, (2) derivation of an empirical model from the debt, not deeper into it," [6, p. 754]. As memories cost of capital concept to analyze the decision to of the Great Depression faded, agricultural econo- employ financial leverage and (3) presentation of a mists tended to emphasize the effect of debt on farm discriminant analysis which tests the model for a size and therefore net income. Heady emphasized sample of Georgia farmers. increased income from obtaining more resources through use of debt [3, pp. 535-561], and Hopkin, Barry and Baker stressed that leverage could increase

The Costs of Bankruptcy

Abstract: Our study of the bankruptcy process provides the occasion to consider again the role that the state should play in adjusting relationships which have their origin in private contract. One cannot venture too far into this subject before encountering substantial controversy. The range of philosophical viewpoints does not suffer from a lack of contrast. Some would regard government intrusions into the area of private contract as a transgression of the highest order. Others would contend that many of the relationships affected by government action-such as those in consumer bankruptcy cases-cannot be characterized as contractual in the traditional sense.1 This group regards the defense of the "sanctity of contract" as beside the point and would urge that our main concern should be with the role of the state in protecting its citizens from overreaching by creditors. There is much that remains to be added to our understanding of the role of private contracts in a modern credit society. It will not, however, be found in the pages of this commentary. My purpose is the much less ambitious one of attempting to identify what ought to be the area of debate as we examine the process of bankruptcy. While I conclude that Dean Meckling's paper has headed us in the right direction, there are some additional notions that warrant attention.

The Organization and Capital Structure of the Irish North Western Railway

Abstract: based on common origins. The incomes and standard of living of the Catholic clergy, similarly, were relatively modest, but at times of economic hardship their financial demands could nevertheless give rise to resentment and protest. The social origins and status of the Catholic clergy prevented the development of conflicts that might otherwise have arisen, and any attempt to account for the influence exerted by them over the last century or so will have to take account of the place which the priest occupied in the local community, and of such matters as the political role which the Catholic clergy had acquired. The argument of this thesis, however, is that to understand that influence one must also look more closely at the workings of Catholicism as a religion, and at the ways in which its particular system of internal constraints and imperatives was communicated and reinforced.

Some Long-Run Implications of Border Tax Adjustments for Factor Taxes

Abstract: The model, 558.—Product taxes, 563.—Capital taxes, 565.—Imposition of capital taxes, 566.—Application of BTA's to capital taxes, 568.—Adjustments to the earnings of capital, 574.—Conclusions, 577.

Financial leverage and the cost of capital

Abstract: The objective of the research reported in this dissertation is to conduct an empirical test of the hypothesis that, excluding income tax effects, the cost of capital to a firm is independent of the degree of financial leverage employed by the firm. This hypothesis, set forth by Franco Modigliani and Merton Miller in 1958, represents a challenge to the traditional view on the subject, a challenge which carries implications of considerable importance in the field of finance. The challenge has led to a lengthy controversy which can ultimately be resolved only by subjecting the hypothesis to empirical test. The basis of the test was Modigliani and Miller's Proposition II, a corollary of their fundamental hypothesis. Proposition II, in effect, states that equity investors fully discount any increase in risk due to financial leverage so that there is no possibility for the firm to reduce its cost of capital by employing financial leverage. The results of the research reported in this dissertation do not support that contention. The study indicates that, if equity investors require any increase in premium for increasing financial leverage, the premium required is significantly less than that predicted by the Modigliani-Miller Proposition II, over the range of debt-equity ratios covered by this study. The conclusion, then, is that it is possible for a firm to reduce its cost of capital by employing financial leverage. A secondary conclusion that can be drawn from this study is that earning power is an important variable to consider for inclusion in a regression model intended for use in investigating the effect of financial leverage on the cost of capital. The estimated partial regression coefficient of the earning-power variable was negative and highly significant in every cross-section year. Furthermore, earning power showed strong negative partial correlation with the debt-equity ratio. Therefore, omission of the earning-power variable from the regression model would have introduced upward bias into the estimated regression coefficient of the debt-equity ratio, making it appear that investors were reacting adversely to increasing debt-equity ratio. However, models used in previous tests of the Modigliani-Miller hypothesis have not included earning power.

An inter-industry analysis of capital structure policy

Abstract: Thesis. 1977. M.S.--Massachusetts Institute of Technology. Alfred P. Sloan School of Management.