Showing papers on "Capital structure published in 1982"

The Administrative Costs of Corporate Bankruptcy: A Note

Abstract: IN THIS PAPER WE present evidence on the direct administrative costs of corporate bankruptcy. The investigation is directed toward providing evidence that may be helpful in answering questions about the role of bankruptcy costs as a determinant of corporate capital structures. The importance of bankruptcy costs as a determinant of corporate financing policy has been extensively debated in the finance literature. The origins of the debate can be traced to Modigliani and Miller [8] and Robichek and Myers [9]. Under the assumption that debt is default-free and interest payments are taxdeductible, Modigliani and Miller demonstrated that firms will maximize their market values by maximizing their use of debt financing. Robichek and Myers demonstrated that this conclusion also holds when debt is not default-free, but bankruptcy is costless. To explain observed corporate debt to total value ratios, which typically fall in the range of 20 percent to 30 percent, Robichek and Myers [9] and Baxter [1] appealed to the existence of bankruptcy costs as a possible counterweight to the tax-deductibility of interest payments. Subsequently, Kraus and Litzenberger [5], Scott [10], Lee and Barker [6], Kim [4] and Turnbull [13] developed formal models in which firms maximize value by increasing their use of debt financing to the point where the marginal present value of future tax shields equals the marginal present value of future bankruptcy costs.' The bankruptcy cost literature has identified three types of costs as potentially relevant to the determination of a firm's optimal mix of debt and equity financing: (1) the direct administrative expenses paid to various third parties involved in the bankruptcy proceedings; (2) the "shortfall" in realized value when assets are sold in liquidation or the "indirect" costs of reorganization; and (3) the loss of tax credits which the firm would have received had it not gone bankrupt. Contrarily, Haugen and Senbet [3], and to a lesser extent Miller [7] and Warner [14], have argued that the only bankruptcy costs relevant to the determination of a firm's optimal capital structure are the direct administrative costs of bankruptcy. The crux of their argument is that the "shortfall" costs of liquidation, the "indirect" costs of reorganization, and the loss of tax credits which occurs upon dissolution of the firm are, in fact, relevant to the liquidation/investment decisions of the firm. These costs would be borne by the security holders of a failing firm

A Theory of Capital Structure Relevance under Imperfect Information

Abstract: Firms raise debt and equity capital to finance a positive net present value project in perfectly competitive capital markets; firm insiders know the function generating the random firm cash flow but potential capital suppliers do not. Taking into account the incentives of insiders to misrepresent their firm type, capital suppliers attempt to design financing mixes of debt and equity that eliminate the adverse incentives of insiders and correctly price securities. Necessary conditions for a costless separating equilibrium are developed to show that the amount of debt used by a firm is monotonically related to its unobservable true value. STIGLITZ [19] AND FAMA [5] DEMONSTRATE that the Modigliani-Miller [10] capital structure irrelevance theorem holds under a fairly general set of assumptions. One of these assumptions is that investor expectations of the returns of individual firms are independent of their capital structures. This paper introduces asymmetric information into an otherwise perfect, Modigliani-Miller world and develops a signaling equilibrium in which investor expectations about individual firms do depend upon the capital structures of the firms.' In existing equilibrium models of markets with asymmetric information, such as Spence's [17] labor market, Rothschild and Stiglitz's [15] insurance market, or Leland and Pyle's [9] financial structure model, the sellers of higher quality products (higher quality labor, better insurance risks, or more valuable securities) incur some deadweight loss, since buyers are unable to distinguish quality without a signal from the seller; to prevent low quality sellers from sending a misleading signal, the signal must be costly. This paper describes a costless signaling equilibrium, in which sellers incur no deadweight losses and are as well off as they would be in a world of symmetric information. This equilibrium is not subject to the instability problems which may exist in the costly signaling

Evidence on the Existence and Determinants of Inter-Industry Differences in Leverage

Abstract: question of the existence of optimal capital structure. Under certain assumptions,' Miller demonstrates that, while a unique optimal level of aggregate debt exists for the corporate sector as a whole, leverage and value at the individual firm level are independent. In a recent paper, DeAngelo and Masulis (DM) [3] generalize the Miller leverage irrelevancy theorem to incorporate risky debt. The theorem is shown to hold under alter-

Changes in the Financial Market: Welfare and Price Effects and the Basic Theorems of Value Conservation

Abstract: This paper analyzes the impact, on both welfare and equilibrium prices, of changes in the financial market in a general equilibrium, two-period context. Previous papers have focussed on the "securities effect," tending to essentially ignore the equally important "endowment effect" that arises when market structure changes are implemented. Two forms of endowment neutrality and market structure changes which either preserve, expand, or shift allocational feasibility differentiate the main theorems, which are based on arbitrary preferences and beliefs and substantially extend and modify extant results; in particular, earlier statements identified with value conservation are sharply moderated. Very roughly, the paper yields the following implications for some of the more common changes in the market: nonsynergistic corporate spinoffs and the opening of option markets have, on balance, strongly positive welfare effects; nonsynergistic mergers tend to have strong negative welfare effects, while the welfare effects of alternative risky debt structures tend to be ambiguous. All of the preceding, however, may under plausible conditions be redistributive. CHANGES IN THE STRUCTURE of the financial market have long been of interest to financial economists. While such changes may take many forms, it is perhaps surprising that only a few of the more common ones have been systematically studied. Foremost among these are changes which involve the firm's capital structure (the relative amounts of debt and equity), mergers, and other special recapitalizations. This paper analyzes the impact, on both welfare and equilibrium prices, of changes in the financial market in a two-period context. It differs from previous studies primarily in that it is based on a fully integrated (general equilibrium) approach similar to that employed in international trade analysis. Thus, while the resulting mosaic contains previous studies as clearly recognizable fragments, such as the classic paper of Modigliani and Miller [33], it also provides the necessary framework and tools for an evaluation of market structure changes of any type, such as changes involving subordinated debt, convertibles, warrants, mergers, spinoffs, and the opening of option markets.

Miller's Equilibrium, Shareholder Leverage Clienteles, and Optimal Capital Structure

Abstract: THE PURPOSE OF THIS paper is twofold. First, we examine the individual portfolio decisions when income from stocks and bonds is taxed at different rates. Second, a rationale for the existence of risky debt in the presence of leverage-related costs and differential personal income taxation is provided. Previous studies on capital structure with differential personal income taxation have ignored either the portfolio risk consideration and/or the possibility of losing personal and corporate interest tax shields due to insufficient taxable earnings (e.g., [8], [2], [3], [14], [13], [6], [7], [1], [9], [19], [20], [21], [23]). In Section I of this paper, both the portfolio risk consideration and the possibility of losing personal and corporate interest tax shields are explicitly introduced. This enables us to provide a rationale for the shareholder leverage clientele phenomenon within a mean-variance framework. We also demonstrate a non-corner solution for the optimal corporate capital structure in a tax environment similar to that of Miller's "Debt and Taxes" [14]. In Sections II and III of this paper, Miller's world is further modified to include risky debt and the attendant costs. We re-examine and synthesize recent studies on the theory of optimal capital structure which have appeared since the publication of "Debt and Taxes" (e.g., [4], [6], [7], [13], [19], [20]).

Some economic determinants of management lobbying for alternative methods of accounting: evidence from the accounting for interest costs issue

Abstract: This paper extends the theory of management lobbying on accounting standards. Specifically, it is hypothesized that, in addition to the variables previously identified in literature, the capital structure of the firm would affect its management's lobbying position on an accounting standard. The results of an empirical investigation of the lobbying position of firms on the accounting for interest costs issue, reported in the paper, confirm the extended theory.

Financing and Investment in Plant and Equipment and Research and Development

Abstract: In this stuy a dynamic model of firm behavior is developed which integrates real and financial decisions. The model combines the effects of capital structure and input adjustirent costs on the process of capital accumulation. The existence, uniqueness and stability conditions of the long-run eguilibrium and the dynamic properties of the factor demand are explored. The equations derived from the theoretical model are estimated using firm cross-section time series data. The results indicate that for both Plant and Equipment (P&E) and Research and Development (R&D),the debt-eguity ratio significantly affects the investment demands and the elasticities are highly inelastic. The effect is stronger for P&E than for R&D capital in the long run, while the effects on P&E and R&D investment are quite similar in the short run.

Stock issues and investment policy when firms have information that investors do not have

Abstract: This paper describes corporate investment and financing decisions when managers have inside information about the value of the firm's existing investment and growth opportunities, but cannot convey that information to investors. Capital markets are otherwise perfect and efficient. In these circumstances, the firm may forego a valuable investment opportunity rather than issue stock to finance it. The decision to issue cannot fully convey the managers' special information. If stock is issued, stock price falls. Liquid assets or financial slack are valuable if they reduce the probability or extent of stock issues. The paper also suggests explanations for some aspects of dividend policy and choice of capital structure.

Regulation and Corporate Investment Policy

Abstract: IN A PREVIOUS PAPER' it was shown that the traditional rule that the allowed return on the equity of a regulated firm should be set equal to its cost of equity capital was conceptually deficient.2 This deficiency arises because the cost of equity capital of a regulated firm depends upon its risk, which depends in turn upon the regulatory policy that will be followed in the future, including the allowed rate of return. It was argued therefore that this traditional rule should be replaced by the requirement that the regulatory policy be consistent. A consistent regulatory policy achieves what the traditional rule only attempts: it ensures that at the time of a regulatory hearing the market value of the firm equity is equal to the equity financed portion of the rate base. To devise a consistent regulatory policy, it is necessary to have a valuation model which takes explicit account of regulatory policy. Such a model was developed in the above-mentioned paper. In this paper we generalize the earlier valuation model so that the investment policy of the regulated firm is determined by the value maximizing decisions of the management instead of being taken as exogenous. To the extent that investment policy is discretionary, its endogeneity must be taken into account in devising a consistent regulatory policy, and this is made possible by the generalized model. In reality it seems unclear to what extent the investment policies of regulated firms are predetermined by the requirement that they meet demand, and to what extent they are discretionary. Since the model presented here easily accommodates constraints on the investment policy it is the more appropriate model so long as there exists any element of discretionary investment behaviour, and permits a more adequate approach to the determination of consistent regulatory policies. With discretionary investment policy, an important consequence of any particular consistent regulatory policy is the investment policy it induces. In Section 4 we show how the value maximizing investment policy is affected by the choice of regulatory policy. On the other hand, regulated firms are wont to argue that their investments are in the main predetermined by demand and must be undertaken regardless of their profitability. This putative lack of discretion, it is maintained, means that the appropriate allowed rate of return is higher than would otherwise be the case. In Section 4 also we evaluate the strength of this consideration by comparing the allowed rate of return under consistent regulatory policies when investment policy is and is not discretionary. Section 5 shows briefly how the analysis can be extended to account for the effect of debt in the capital structure.

Divisional Cost of Capital: A Practical Approach

Abstract: According to one study [3], almost one-half of the industrial firms surveyed there used a single screening rate, such as the cost of capital, to evaluate investment proposals. Another study revealed that the use of a firm's cost of capital as a screening rate could lead to non-optimal decisions if the expected cash flows from the investment are not proportional to those of the firm and have different maturities and growth rates [9]. It follows that a firm's cost of capital may not be the appropriate screening rate to evaluate investment proposals in multi-division firms where the divisions have substantially different degrees of risk and financial characteristics from those of the parent company. Consequently, it is necessary to determine the cost of capital for each division. Divisional cost of capital has been addressed in finance textbooks by Brigham [3] and Van Horne [11], and in the finance literature by Bower and Jenks [1], Fuller and Kerr [4], Gordon and Halpern [5], and others [10, 13]. The studies cited use various derivatives of the capital asset pricing model (CAPM) to estimate the divisional cost of capital. A division is treated as though it were a separate company, and market data, when available, are used to derive the CAPM and the cost of capital. When market data for the division are not available, data from a similar company can be used as a proxy. Other studies dealing with systematic risk and debt capacity [1, 6, 7, 8] are also applicable here because the divisions may not have the same capital structure as their parent companies. This article presents a different approach to determine the divisional cost of capital. The method is based on the one used by Fuqua Industries, Inc., a multi-market manufacturing, distribution, and service company in the areas of recreational products and services, farm and home products, transportation, petroleum, and other operations. Stated otherwise,

Capital Structure and the Financing of the Multinational Corporation: A Fractional Multiobjective Approach

Abstract: The financial manager of the multinational corporation (MNC) is faced with various tax structures, changing exchange rates, barriers to capital flows, and the possibility of financial market segmentation. The manager must be concerned with determining an optimal capital structure as well as identifying the sources of the relevant funds. Likewise, the manager must be concerned not only with funds flows, but also with the risk that the value of these flows will change owing to changing exchange rates. Finally, the manager must be concerned with operating under widely differing governmental philosophies.

Shareholder Goals, Firm Goals and Firm Financing Decisions

Abstract: nancial behavior based on a shareholder perspective and those based on a management perspective. Following a review of the two main lines of financial structure theory shareholder oriented and management oriented this article focuses on management compensation arrangements in large United States firms. Building on the agency theory work of Jensen and Meckling [I ], it is argued that proper recognition of the relationship between shareholders and managers in these firms leads to predictions of financial structure choices (and capital investment decisions) that differ from the predictions of shareholder oriented models and that are specific enough to serve as testable hypotheses with only weak assumptions about management preferences. Thus, the potential for acquiring new evidence with regard to both capital structure decisions and firm objectives is increased.

On Valuation, Beta, and the Cost of Equity Capital: A Note

Abstract: The issue of capital structure has been intensively examined in the finance literature, particularly after the appearance of the landmark 1958 paper by Modigliani and Miller [8], hereafter MM. In that paper, MM derived a relationship in terms of the expected return on equity of a levered and unlevered firm, known as MM Proposition II. Their analysis was extended later by researchers such as Hamada [5] and Rubinstein [9] who derived the corresponding relationship in terms of the systematic risk (beta). Both these risk-return relationships have been derived for the case of perfect capital markets and the case in which corporate income taxes are the only type of market imperfection. Although effects of other types of market imperfections such as personal income taxes and bankruptcy costs have been examined in numerous studies, neither MM Proposition II nor the “beta” relationship were extended to include the effects of personal income taxes and bankruptcy costs.

On the Firm's Production, Capital Structure and Demand for Debt

Abstract: SOME economists have ignored corporate financing decisions on the assumption that they do not affect the investment and production decisions of firms. Yet even if this extreme position is accepted, firms must still make financing decisions which in turn have impacts on other sectors of the economy. Since interest payments on corporate debt are tax deductible, the reliance of firms on debt as opposed to equity financing directly affects the revenue the federal government collects through taxation of corporate profits. The corporate presence in bond markets and corporate borrowing from banks can be expected to affect both interest rates and the demand for money. Thus any large macro model must somehow account for the borrowing behavior of firms. Yet in assessing this portion of the 1965 Brookings Quarterly Econometric Model of the United States, de Leeuw (1965, p. 506) writes that the "regressions for business borrowing are the least successful of the model." In this paper we derive an equation for the long-term debt ratio (capital structure) of a firm which can be estimated using available data. Unlike some recent qualitative studies' on the aggregate corporate debt ratio as related to inflation and taxation over time, our primary aim is to explain differences in the debt behavior among individual firms. Tobit estimation results, explicitly allowing for the fact that some firms have no long-term debt, are presented for both U.S. and Japanese firms. Our theoretical model implies that the long-term debt ratio which maximizes the present value of the existing stockholder's equity depends positively on the cost of equity and negatively on the cost of debt, capital productivity, and retained earnings. Our estimation results are generally in agreement with these expectations. In particular, we find that capital productivity, which has not been included as an explanatory variable in most previous studies,2 and the cost of equity capital are both important determinants of the firm's capital structure. Our empirical results also support the view put forward by Komiya3 that debt ratios for Japanese firms are higher than those for U.S. firms in part because the cost of equity has been historically higher in Japan than in the United States in relation to the cost of debt. Other important attempts to explain the debt ratio as a behavioral function of the price of debt and other variables include the studies of de Leeuw (1965) and Goldfeld (1969).4 Certain conceptual problems mar these studies, however. Short-term and long-term debt are not distinguished, despite the fact that long-term debt is usually used to finance capital spending while short-term debt is used to finance inventory and

The Impact on Firm Value of Capital Structure Change, Some Estimates

Abstract: This study develops a model based on current corporate finance theories which explains stock returns associated with the announcement of issuer exchange offers. The major independent variables are changes in leverage multiplied by senior security claims outstanding and changes in debt tax shields. Parameter estimates are statistically significant and consistent in sign and relative magnitude with model predictions. Overall, 55 percent of the variance in stock announcement period returns is explained. The evidence is consistent with tax-based theories of optimal capital structure, a positive debt level information effect, and leverage induced wealth transfers across security classes.

The effects of complex capital structure on the market values of firms

Abstract: The familiar Modigliani and Miller risk class model is the basis of a test for differences in value between simple and complex capital structure groups of firms. Cluster analysis, using market risk measures and debt-equity ratio as input, provides the method for obtaining the risk class sample of firms. Crosssectional tests at three annual dates are made on twenty-six simple and twentysix complex capital structure firms. For all periods examined, the complex capital structure firms are valued lower than the simple capital structure firms. Possible explanations for the results include failure of the arbitrage mechanism and the presence of certain costs associated with different types of capital structures.

Debt Financing, Corporate Financial Intermediaries and Firm Valuation

Abstract: In this paper we consider the role of financial intermediaries in the valuation of firms and projects. We show that security prices should reflect both used and unused debt capacity if some corporations can act as financial intermediaries and can capture the tax benefits of debt capacity unused by the operating firm. We also provide some reasons why the value of the firm might be increased if the financing and operating risks of the firm are separated and financial intermediaries issue debt rather than the unit operating the asset.

Financing and Investment in Plant and Equipment and Research and Development

Abstract: In this stuy a dynamic model of firm behavior is developed which integrates real and financial decisions. The model combines the effects of capital structure and input adjustirent costs on the process of capital accumulation. The existence, uniqueness and stability conditions of the long-run eguilibrium and the dynamic properties of the factor demand are explored. The equations derived from the theoretical model are estimated using firm cross-section time series data. The results indicate that for both Plant and Equipment (P&E) and Research and Development (R&D),the debt-eguity ratio significantly affects the investment demands and the elasticities are highly inelastic. The effect is stronger for P&E than for R&D capital in the long run, while the effects on P&E and R&D investment are quite similar in the short run.

The Capital Structure of the Firm: The Leverage Decision

Abstract: In this chapter we examine the factors that managers take into account when deciding how much debt to use in the capital structure of the firm. This decision is important, because it determines the cost of capital to the firm, which is a widely used criterion for optimal investment decisions (see Chapter 11).