Showing papers on "Capital structure published in 1980"

Optimal Capital Structure Under Corporate and Personal Taxation

Abstract: In this paper, a model of corporate leverage choice is formulated in which corporate and differential personal taxes exist and supply side adjustments by firms enter into the determination of equilibrium prices of debt and equity. The presence of corporate tax shield substitutes for debt such as accounting depreciation, depletion allowances, and investment tax credits is shown to imply a market equilibrium in which each firm has a unique interior optimum leverage decision (with or without leverage-related costs). The optimal leverage model yields a number of interesting predictions regarding cross-sectional and time-series properties of firms’ capital structures. Extant evidence bearing on these predictions is examined.

The Importance of a Market-Value Measurement of Debt in Assessing Leverage

Abstract: Leverage (debt-to-equity ratio) is an important variable in issues concerning the risk of a firm and its securities. Hamada [1969] has demonstrated theoretically the relationship between leverage and systematic risk.' Numerous empirical studies have found that leverage is a significant variable in association tests on risk. Yet there is a glaring disparity between the theoretical results and the empirical tests. The theory is based on market-value measures of debt and leverage. With few exceptions, the empirical tests use book-value (accounting) measures.2 Although these studies have generally found leverage to be highly associated with systematic risk, there has been no means to evaluate the potential effect of using the book-value measurement as a surrogate for the market-value measurement. This study provides direct empirical evidence on the comparability of the book-value and market-value measures of leverage in association tests on systematic risk. The first section of this paper provides a brief presentation of the

Taxes, Failure Costs, and Optimal Industry Capital Structure: An Empirical Test

Abstract: SINCE 1958 WHEN FRANCO Modigliani and Merton Miller (M-M) provided the first proof, invariance propositions have been central to the theory of corporate finance. M-M stated their proposition in two equivalent forms: that the "value of a firm is independent of its capital structure" and that "the average cost of capital to any firm is completely independent of its capital structure."' The rationale is well known. Given the expected return on assets for a firm, individual arbitrage2 will ensure that the value of the firm is simply this expected return capitalized at the rate appropriate to firms in the same risk class. This rate is the average cost of capital and does not depend upon financing decisions of the firm. Consequently, the value of the firm does not depend upon its financing decisions but only on its risk class and its investment decisions. If taxes, in particular the preferential treatment of interest payments, and failure costs are included in the analysis, the two forms of the original M-M proposition may no longer be equivalent. Even if the financial decisions of the firm do not affect its cost of capital, they still may change the firm's expected earnings by altering its tax liability and probability of failing.3 These changes in expected earnings would affect the value of the firm. It is thus possible for the second form of the original M-M proposition to be true even if the first form is not. Additionally, by altering characteristics of the firm's income stream besides its expected value, changes in capital structure may affect its average cost of capital.4 Then neither form of the M-M proposition would be true. The empirical validity of either M-M proposition then depends (at least partially) upon the empirical relevance of taxes and failure costs. Little testing has been done. Recently Miller [12] has suggested that the size of the net tax subsidy to debt over all market participants and the direct costs of bankruptcy may be small, but little has been done to relate these factors to variations in capital structure. That is what we attempt here. The form of the M-M proposition that we test in this study is that although taxes and costs of failure do not affect the average cost of capital, they do affect expected income and so imply an optimal capital structure. More precisely, measures are constructed of the tax advantage to debt and the costs of failure for 38 major industries, and an attempt

Taxes and Corporate Capital Structure in an Incomplete Market

Abstract: 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.

Taxes and Corporate Capital Structure in an Incomplete Market

Abstract: 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

Relationships Between the Two Sides of the Balance Sheet: A Canonical Correlation Analysis

Abstract: AN INDEPENDENCE OF THE asset and liability composition of the firm is implied in much modern financial theory; the independence of investing and financing decisions is a prominent part of Modigliani and Miller's classic capital structure research. While the separation of financing and investing decisions is an invaluable assumption which greatly simplifies many corporate financial decisions, the actual balance sheets of modern corporations do not exhibit an independence between the two sides of the balance sheet. The purposes of this paper are (1) to identify relationships between the two sides of the balance sheet exhibited by these corporations and (2) to explain the nature of these relationships. The independence of asset and liability composition is explicit in Modigliani and Miller's capital structure propositions [15]. In their 1958 article, they demonstrate that, given a stream of risky earnings, the total market value of the firm and cost of capital are independent of capital structure (M & M's Proposition I). Furthermore, the cutoff rate for an investment project is completely independent of the way an investment is financed (M & M's Proposition III), thus implying a complete separation between the investing and financing decisions of the firm.' The teaching of corporate finance, as reflected in the major textbooks, compartmentalizes the decision areas of finance and, within each compartment, management is assumed to attempt to maximize the firm's wealth, holding the other areas of the firm constant. For example, capital budgeting decisions are made given a cost of capital or required rate of return (a capital project is evaluated independent of how it is financed), or the capital structure is chosen given the character of the firm's assets. Cash, receivables, and inventory balances tend to be optimized independently. There is a tradeoff between the rigor afforded by global models of the firm (such as the CAPM) versus the realism afforded by

Corporate Debt and Corporate Taxes: An Extension

Abstract: IN THE SEPTEMBER 1979 issue of this journal, Bierman-Oldfield [1] show that the Modigliani-Miller Proposition I with corporate taxation is unaltered by the existence of risky debt. Bierman-Oldfield state on page 954 that the analysis implies the expected returns on debt, unlevered equity, and levered equity are determined simultaneously and linked together by the capital asset pricing equilibrium. The purpose of this extension is to examine the exact linkage of the aforementioned expectations resulting from pure capital structure rearrangements. Hamada [5], by integrating Modigliani-Miller Proposition I with the standard capital asset pricing model, has shown the exact linkage between the return expectations of unlevered equity and levered equity. The Hamada result assumes returns on corporate debt are risk free. An interesting, and not widely recognized, result is that the correlation between the levered firm and the market portfolio, a primary input to the measurement of diversification relative to the market, can be directly influenced by the financing decision of the firm.' This conclusion will obtain specifically by allowing for risky corporate debt. When considering that individual investors typically hold undiversified portfolios, the result takes on an added dimension [e.g., 2]. In Section II the equilibrium relationship of the return expectations is developed, and extended in Section III to demonstrate the effect of the financing decision on firm diversification relative to the market. The extension is concluded and implications are summarized in Section IV. The Bierman-Oldfield results are assumed throughout.

Taxation and Corporation Finance

Abstract: This paper analyzes the effects of the federal tax structure on corporate financial and investment behavior. We first develop a model of corporate behavior given taxes, taking into account both uncertainty and costs of bankruptcy. Simpler models abstracting from bankruptcy costs had clear counterfactual implications. The forecasts from our model proved to be consistent with both the observed cross-sectional variation in debt-equity ratios and the time series pattern of debt-equity ratios (data that were constructed in the paper). We then attempted to measure the efficiency costs created by corporate tax distortions as implied by the model. The forecasted efficiency cost of the distortion favoring debt finance seemed to be quite large, while the tax distortion affecting investment seemed to be less important than others have claimed. The paper concludes with a study of the efficiency implications of various proposed corporate tax changes.

Future Investment Opportunities and the Value of the Call Provision on a Bond: Comment

Abstract: IN A RECENT ARTICLE in this Journal, Bodie and Taggart [4] (henceforth abbreviated as B-T) argue that the existence of non-callable long-term debt in the firm's capital structure will have an adverse incentive effect on the firm's investment behaviour in the presence of growth opportunities. Specifically, if there is non-callable risky debt in the firm's capital structure, bondholders will share with stockholders in any profitable future investments thus curtailing the firm's incentive to invest the proper amount in such states of the world. This externality to shareholding, B-T maintain, rationalizes the existence of the call provision as a standard feature of long-term bonds since, by calling the debt, stockholders are able to appropriate all of the gains from their discretionary powers over future investment opportunities. Although B-T's conclusions have some merit, their results do not follow from the assumptions of their model. Indeed, by employing their model, which assumes away transactions costs,1 one can show that the firm's future investment decisions are independent of past financing decisions. As we show below, any externalities generated by the existence of non-callable debt, when there are future investment opportunities, will be completely internalized prior to undertaking these investments. This internalization will, in turn, be reflected in the initial contractual agreements entered into by the claimants on the firm. Therefore, Modigliano and Miller are correct irrespective of future growth opportunities. If the B-T paper is to be taken in the spirit of the agency literature-this would be a very generous interpretation of their paper-the authors must specify the type of transaction cost or market imperfection which the call provision presumably reduces. In the agency literature one tries to show why a particular set of transaction or agency costs rationalize a particular contractual arrangement. Such a demonstration is not forthcoming in the B-T paper. However, our discussion below provides one such rationale for the call provision, namely, it eliminates negotiation costs. B-T make the usual assumptions which are a prerequisite for a frictionless financial system to contrast the investment policy of an all equity firm, for which there are no potential externalities, with that of an equivalent firm initially partially- financed with non-callable long-term debt.2 Their equations (15) and

'q,' Corporate Investment, and Balance Sheet Behavior

Abstract: A GOAL OF RESEARCH on the business sector of the flow-offunds model is to analyze real and financial investment decisions of firms. In theory, and in reality, these decisions should be, and are, linked within a simultaneous framework. The cost of capital to a firm is not determined wholly exogenously but depends on its means of financing, and the timing of a firm's capital outlays is contingent upon the availability of funds. Economists have traditionally approached the theory of investment by hypothesizing that decisions first are made about expenditures for physical capital, and then decisions are made about their financing. Such sequential separation of real and financial capital decisions was most elegantly justified in a series of articles by Modigliani and Miller [5]. However, as Stiglitz [7] and others have shown, the proposition depends not only on the existence of perfect capital markets but also on other conditions such as the absence of taxes, equality of borrowing and lending rates, independence of expectations of real returns and firms' financial policies, and the absence of the possibility of bankruptcy (see Scott [6]). In a previous article [2] we presented a two-period model of the firm in which the debt-equity ratio was determined within a framework where firms consider trade-offs of cost and tax advantages of additional debt against real costs of potential bankruptcy. We also indicated, to some extent, how leverage could be expected to influence the firm's real investment decisions. It was shown that the optimum amount of debt in the firm's capital structure depends upon the corporate tax rate, bor-

Inflation Effects on Farm Financial Management

Abstract: The issue of financial management under inflation is a relatively new topic for agricultural finance research. Research in this area traditionally has focused on inflation issues such as land price increases, capital gains in agriculture, and trends in farm prices and costs with an emphasis on aggregate issues rather than firm management. Firm growth research considered inflation, but it was not the major focus of such research (Brake and Melichar). This limited firm research can be related, in part, to the explicit exclusion of inflation in the net present value concept, which is a major theoretical foundation for financial management. This shortcoming has been overcome recently. Aplin, Casler, and Francis were the first to consider explicitly the impact of inflation on net present value calculations in their agricultural finance text, and subsequent texts have done likewise (Barry, Hopkin, Baker; Penson and Lins). This paper has as its major purpose the review of recent developments in finance theory related to the consideration of inflation in a net present value framework. While an exhaustive presentation of the implications of these theoretical models for agricultural firm management is impossible, major methodological and empirical directions for future research are recognized. Theoretical and/or empirical consideration of particular issues, such as optimal replacement decisions, estate management, firm growth, income tax management, leasing versus purchase, optimum capital structure, and operating leverage, would have been beyond the scope of this paper.

Deductibility of Interest Cost, Retention-of Profits and Development-of Stock Market-A Comment

Abstract: Deductibility of Interest Cost, Retention of Profits and Development of Stock Market A Comment L M Bhole A CONSIDERABLE degree of deve- lopment of the financial system has occurred in India during the post- independence period. In the course of this financial development, investors have increasingly preferred to hold secondary (indirect) rather than primary (direct) securities. This has been naturally reflected in the pattern of financing of different deficit-spending units, particularly the corporate sector which happens to be one of the major deficit sectors in the economy. While its dependence on borrowed capital has steadily increased, the contribution of the stock market to its financing has been subsidiary. Sometimes an unwarranted concern has been exhibited in certain quarters about these developments and different people have come out with conflicting policy suggestions which, if implemented, would supposedly lead to the development of 'active', 'healthy', and 'effective' stock markets, and to the evolution of the right balance in the capital structure of the companies. A case has been made for lowering of interest rates to channelise investible funds to the stock market It has been argued that the average return on shares has remained lower than the return on bank deposits, therefore interest rates on bank deposits should be reduced. It has been further argued that this would lead to reduction in interest rates on public deposits with companies and to the boosting of the investment market.1 We have elsewhere discussed in detail as to how such a policy is ill-advised and how the correct measure to discourage the growth of public deposits with companies is to raise interest rates on bank deposits rather than to reduce them,2 That the authorities had to reverse the cheap money policy both the times (in 1968 and 1978) within a short period after its adoption itself indicates the untenability of the case for low interest rates in India, Recently two other policy measures have been suggested to activise the stock market in two articles which have appeared in this journal.3 In contrast to Parekh's view, Patil has argued for higher cost of debt capital to achieve the same purpose. However, Patil would like to raise the cost of debt capital not by increasing interest rates but by removing the deductibility of interest cost clause In our tax laws. Chitale has opposed Patil's suggestion and has recommended that companies should be discouraged from retaining profits if the current yield on equities is to be made attractive. The purpose of this note is to show that Patil's suggestion has no valid

An Implicit Clientele Test of the Relationship between Taxation and Capital Structure

Abstract: This paper presents a test for the existence of debt clienteles in which the latter are represented by progressive personal tax brackets. The test generates some evidence consistent with the implication of debt clientele theory that, over time, firms' debt ratios should vary with the relative tax incentives which their investors have to hold debt. Changes in the relative structure of taxes, however, at best only partially account for the time series behavior of debt ratios, especially in the case of high debt firms.

The crumbling of apartheid: An application of managerial economics

Abstract: The thesis of this examination of Apartheid in the Republic of South Africa is that the sophistication of capital structure, whether viewed macro-economically or at the level of the firm, passes nigh-irrestible power to even unorganized workers. This non-Marxist social system model is empirically substantiated by South African economic history but, more particularly, from managerial decisions in respect of the production function – especially in the critical gold-mining industry – over time. This leads to the logical conclusion that the dynamic intensification of foreign capital investment in the Republic alone can end that country's system of Apartheid.

Taxes and Corporate Capital Structure in an Incomplete Market

Abstract: 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.

Taxation, bankruptcy costs, and capital structure decisions within the context of a multi-period capital asset pricing model

Abstract: In this paper, a multi-period version of the CAPM is used to establish conditions for an optimal capital structure in the presence of a tax on corporate earnings, and bankruptcy costs. It is shown that the optimal point is reached when the marginal tax advantage arising from an increase in debt, is equal to the marginal increase in expected bankruptcy penalties.

Financial Impacts of Government Support Price Programs: Comment

Abstract: Michael Boehlje and Steven Griffin (BG) provide a timely, relevant analysis of the financial impacts of U.S. government price programs that is rigorous in its use of valuation concepts under risk, practical in its simulation approach, and clearly in the spirit of responding to needs for policy-related research. Their major objective is to evaluate how price support programs influence investment and financing behavior of agricultural producers with different financial characteristics and sizes of operation. They reason that indexed support prices will provide greater certainty in farmers' cash flows and thereby reduce financial risks, with more rapid farm growth resulting from increased bid prices for durable assets, especially land, increased debt capacity, and higher financial leverage. Their simulation analyses for farms differing in size, capital structure, and farmer characteristics under selected parameter values indicate that smaller, more highly leveraged operations generally will receive fewer benefits from a cost-of-production-indexed price support program than will larger operations with lower financial leverage. As a result larger, higher-equity operations can bid higher prices for land and should show more rapid growth in net worth, land ownership, and standard of living. The authors conclude with a plea that future analyses more fully account for policy impacts on farms with different financial, economic, and producer characteristics. My response to this kind of analyses is quite positive and I fully support BG's efforts. My comments here consist of two sets of concerns whose resolution should further clarify their analytical approach, strengthen the generality of their results, and perhaps provide for extended analysis. One set of concerns addresses the need for more information to understand fully the specifications and assumptions embodied in their simulation model. The second set, which is closely related to the first, considers how the initial estimates of bid prices for land might respond to changes in some of these model specifications and assumptions. While Boehlje and Griffin attribute much of their results to differences in farms' financial characteristics and debt-servicing capacity, I suspect that the interrelationships of those financial characteristics with the influences of several other factors are more impor