Showing papers on "Capital structure published in 1987"

Corporate Insurance and the Underinvestment Problem

Abstract: A casualty loss produces option-like characteristics in assets because their value depends on further discretionary investment. With risky debt in the firm's capital structure, the shareholders can have incentives to forgo the discretionary investment, even though it has a positive net present value. Thus a potential incentive conflict exists between the bondholders who want the investment made and the shareholders who do not. The incentive problem can be controlled by including a covenant in the bond contract requiring insurance coverage. Full coverage is generally not required. The maximum deductible depends on the amount of debt in the firm's capital structure and the feasible set of net casualty losses.

Corporate Strategy: Useful Perspective for the Study of Capital Structure?

Abstract: The idea of joining strategy literature and financial literature to address the capital structure question arose in two ways. Financial scholars, unable to agree on a desirable mix of debt and equity, have called for managerial inputs. Likewise, strategy scholars have called for inputs from functional areas such as finance. The product of this joint review is a set of propositions suggesting that a strategy perspective might help to explain the capital structure decision.

Perquisites, Risk, and Capital Structure

Abstract: In a corporate agency problem, perquisites and risk interact to produce novel, complex comparative statics. For example, even if additional debt induces risk-neutral insiders to increase risk, they never seek to increase the market value of their stock; instead, insiders decrease the present value of their subsequent, conditionally optimal perquisites. Also, the firm's optimal capital structure includes a risky bond with an agreement to remove insiders whenever the bond defaults. However, the optimal sharing rule between corporate claimants cannot be supported solely by standard securities such as bonds, stocks, options, and their hybrids.

Risk‐Shifting Incentives and Signalling Through Corporate Capital Structure

Abstract: This paper examines optimal corporate financing arrangements under asymmetric information for different patterns of temporal resolution of uncertainty in the underlying technology. An agency problem, a signalling problem and an agency-signalling problem arise as special cases. The associated informational equilibria and the optimal financing arrangements are characterized and compared. In the agency-signalling equilibrium the private information of corporate insiders at the time of financing is signalled through capital structure choices which deviate optimally from agency-cost minimizing financing arrangements, which in turn induce risk-shifting incentives in the investment policy. In the pure signalling case the equilibrium is characterized by direct contractual precommitments to implement investment policies which are riskier than paretooptimal levels. Empirical implications for debt covenants and the announcement effect of investment policies and leverage increasing transactions on existing stock and bond prices are explicitly derived. THIS PAPER is an exploratory attempt to relate optimal corporate financing arrangements to patterns of temporal resolution of uncertainty in the underlying technology. Since, in general, the timing of the uncertainty resolution could be different for different agents (say corporate insiders vs. outsiders) some of the issues which arise are those of financing under asymmetric information. However, a systematic analysis of the implications for corporate finance of the interaction of private information and temporal resolution of uncertainty has not been undertaken.' It is hoped that such a program of research will yield better answers to questions of timing of various corporate financing decisions. For instance, is there an optimal maturity structure of corporate claims (debt claims in particular) to be used to finance a technology with given characteristics? Why are projects in their initial phase often financed differently from projects in more advanced phases? For example, growth firms use a larger component of retained earnings for their financing than mature firms, and project financing (incorporated as legally segregated entities) is often used for the start-up phase of some ventures to switch later to more conventional modes. Why do leveraged buy-outs often * New York University and University of Chicago. Earlier versions of this paper have benefitted from the helpful comments of Chris Blake, Yuk-Shee Chan, Gene Fama, Larry Glosten, Rob Heinkel, Max Maksimovic, Merton Miller, Bani Mishra, David Nachman, Roy Radner, Marti Subrahmanyam, Tommy Tan, Joseph Williams and participants in seminars at Buffalo, Baruch, Illinois, Maryland, NYU, Ohio State and the AFA, EFA, and WFA. Financial support in the early stages of the project from a Batterymarch fellowship and later stages from a Salomon Brothers fellowship and an

The Importance of Incomplete Information in Explaining the Existence of Costly Bankruptcy

Abstract: The standard theory of capital structure argues that firms trade off the tax advantage of debt against ba nkruptcy costs. R. A. Haugen and L. W. Senbet (1978) pointed out that there is a problem with this theory: if bankruptcy involves deadweig ht costs, shareholders and bondholders have an incentive to renegotia te before it occurs since in this way bankruptcy, and its costs, can be avoided. This implies costly bankruptcy will not occur and casts d oubt on the validity of the standard theory. This paper uses noncoope rative bargaining theory to formally model this idea. It then shows t hat if there is incomplete information, costly bankruptcy can occur. Copyright 1987 by The Review of Economic Studies Limited.

Debt Management under Corporate and Personal Taxation

Abstract: The presence of long-term debt in a corporation's capital structure is shown to give rise to a valuable tax-timing option that can be exercised by the firm on behalf of its shareholders. This option, which is not available if the firm is fully equity financed, implies that leverage will have a positive tax effect on total firm value even if there is no such effect associated with the tax deductibility of the coupon interest payments on debt. The more volatile interest rates and bond prices are, the more valuable the tax-timing option and the larger the favorable impact of debt on shareholder wealth.

Financial strategy: Planning and managing the corporate leverage position

Abstract: Among the important elements of a company's strategic plan is its decision about the degree of financial leverage it elects to imbed in its capital structure. A simple operational framework that can assist in framing that decision, which concentrates on the likelihood of being unable to meet fixed financial charges, is presented. The model is tested empirically, and support for its potential usefulness in the financial planning process is found.

Holding financial assets as a risk response: a portfolio analysis of illinois grain farms

Abstract: This article explores the possible gains in risk efficiency for the total farm unit from formulating farm portfolios with different proportions of farm and financial assets. The results of a risk programming model for a representative Illinois cash grain farm indicate that low correlations between returns on farm assets and financial assets could reduce the relative variability of the farm's rates of return on assets by 15% to 25%, compared to holding farm assets alone. Extensions of the analysis should account for the effects of asset liquidity, taxation, tenure position, and capital structure.

Capital Structure Among Latin American Companies

Abstract: This paper reports the results of an empirical study of the determinants of capital structure of large Latin American companies. Variations with regard to the country, industry, and size of a company are examined for a sample of two hundred and thirty large companies located in twentytwo Latin American countries. This study is the first to examine the capital structures of this large set of Latin American companies. The results of this study indicate that while size does not seem to be significant, both country and industry are significant determinants of capital structure in Latin America not only in bivariate tests but also in multivariate statistical tests. Multinational and diversified companies, therefore, cannot assume uniformity of capital structure across countries and industries in Latin America and, they must take these differences into account in developing and setting capital structure, financing, evaluation, and management policies for their subsidiaries.

Recent developments in the theory of corporate finance

Abstract: The field of corporate finance is a vast one: in order to keep this paper manageable I shall focus on two well-known puzzles of corporate finance. The first has been described by Black (1976) as the dividend puzzle and the second by Myers (1984) as the capital structure puzzle. Underlying these two puzzles are similar considerations. Both originate in the application of competitive equilibrium analysis to corporate financial behaviour in two classic papers by Modigliani and Miller (Modigliani and Miller 1958, Miller and Modigliani 1961). Modigliani and Miller showed that if firms and investors enjoy the same financial opportunities then under conditions of perfectly competitive capital markets, no asymmetries of information between different agents, and no variations in the tax treatment of different forms of finance corporate financial policy is irrelevant. The value of a firm is determined entirely by its real decisions and is completely unaffected by the ratio of debt to equity finance in its capital structure or by the amount of dividends it pays out (for a given investment plan). The stark contrast between Modigliani and Miller's theoretical analysis and empirical observations of the importance attached to capital structure and dividend decisions by both firms and investors is part of the capital structure and dividend puzzles. But it is not all. For it remains true that nearly thirty years after the original Modigliani-Miller paper was first published, despite enormous efforts on the part of many researchers, a proper understanding of what determines companies' borrowing and dividend decisions is still elusive.

Government loan guarantees and the failure of the canadian northern railway

Abstract: The failure of the Canadian Northern Railway is analyzed with a model of optimal capital structure drawn from finance theory. Ex ante bankruptcy probabilities, which are computed on the basis of different assumptions about investors' expectations, range from 40 to 90 percent; and our best estimate is about 70 percent. These high probabilities were a consequence of loan guarantees provided to the Canadian Northern by the federal and provincial governments. The guarantees induced the railway's promoters to undertake an ex ante unprofitable project and to finance that project almost exclusively with debt.

Corporate acquisitions: method of payment effects, capital structure effects and bidding firms' stock returns

Abstract: This study examines the effects of both the method of payment and the capital structure rearrangements on the common stock returns of bidding firms at the initial announcement of takeover bids. The evidence suggests that cash offers generate consistently higher abnormal returns than do stock exchanges. In both cash offers and stock exchanges, abnormal returns are not affected by the market's perception of changes in the firm's capital structure.

Examining merger synergy with the capital asset pricing model

Abstract: This paper analyzes the impact of mergers on the alphas and betas of actual merged firms compared to those of the homemade mergers an investor could have created by buying proportional shares of the two firms. The results provide some evidence of merger synergy. Where alpha and beta shifts were observed, the evidence did not indicate that either the relative size of target firms or concurrent capital structure changes were related to these shifts as current theory suggests. There is weak evidence that nonconglomerate mergers were more frequently synergistic.

A Survey on the Effects of Defeasing Debt

Abstract: Defeasance of debt is a relatively new tool for the management of the corporate balance sheet. The accounting rules for reporting these transactions have generated a great deal of controversy. Critics claim that the ability to record an extraordinary gain from the defeasance of debt permits the reporting of paper profits. Additionally, some were concerned about the disclosure requirements and with potential for the promotion of wholesale major changes in corporate capital structure. A survey was conducted to gain insight as to why companies might defease debt, to examine the impact of defeasance on the firm's financial characteristics, and to investigate the type of disclosure provided in the annual reports. Analysis of the results indicates that the critics have little practical concern. The paper profits and balance sheet changes in this sample were relatively minimal. The major problem found was with the relatively little information that corporations provided regarding these transactions.

Tax Policy and Corporate Financial Structure in Korea

Abstract: One of the issues of great policy concern in Korea has been the unusually high degree of financial leverage and the continuous deterioration of corporate capital structure. The capital structure existing at any one time and its change over time reflects corporate responses to the surrounding stimuli. To analyze the excessive leverage and the change in the corporate capital structure, this paper develops a theoretical model which takes into account the tax and nontax factors, both of which include general and Korea-specific aspects. The empirical test using the data of the last 25 years supports the hypotheses derived from the theoretical model. [320]

Taxes, unequal access, public debt and corporate financial policy in the United Kingdom

Abstract: The effect of corporate and personal taxes on the capital structure of the firm has been a subject of intense research in finance over several decades. However, specific features of tax systems are often overlooked in order to retain analytical tractability. The exclusion of public debt is another simplifying feature used in the modelling of the capital structure problem. In this paper we present a general equilibrium analysis of capital structure theory incorporating the impacts of the specific tax features of Government debt and financial intermediation in the United Kingdom. The implications of our model are shown to be consistent with the recent situation in the United Kingdom. That is, companies were not borrowing via the corporate debenture market; corporate borrowing was effected by the medium of bank loans.

Target Debt Maintenance Under Alternative Net Present Value Specifications and Implications for Investment and Finance Decisions

Abstract: Two alternative specifications of weighted average cost of capital are prevalent in finance literature. Though both the specifications result in consistent accept/reject or ranking decisions the net present value arrived is different under each method. This paper traces the origin of this difference and resolves the same. It is shown that if projects are funded in such a way that resulting debt to equity is the optimal leverage then both specifications will yield identical net present values. In cases where such capital structure maintenance is not feasible there is loss of value due to unused debt capacity. We arrive at a lower bound for such a loss and also show that in such situations there exists a possibility of a synergy between projects which are otherwise independent.

A multiperiod mean-variance model of optimal capital structure

Abstract: The continuing interest in the capital structure issue among financial researchers is evidenced by the stream of capital structure models that have appeared in the literature. Much of this research has used a risk-neutral and/or a single-period framework. In this paper, we develop a capital structure model for multiperiod firms and allow for the firm's cash flows to grow over time, for the firm to issue new debt, and for two types of bankruptcy costs to occur. The types of bankruptcy costs that occur are determined by the firm's uncertain operating cash flows and negotiations between the firm and creditors. Risk is priced via the Sharpe-Lintner capital asset pricing model. Multiperiod risk-priced models, we argue, realistically represent actual firms and are thus an important step toward the development of more testable and usable models of capital structure. We execute a demonstration example in which the value of the levered firm achieves a maximum and discuss the steps the firm would take to maximize shareholder wealth within this example. The example illustrates that the value of the firm passes through an interior optimum as the promised debt payment is increased. A simulation of the effect of changes in firm-specific parameters shows that the model exhibits expected and appealing relationships between these parameters and the value of the levered firm.

The Liquidation Decision as a Principal Agent Problem

Abstract: Substantial insights into the capital structure problem can be won if it is understood as a principal agent problem. Many principals (equity holders, debt holders, customers, tax authority etc.) employ or are dependent on an agent or a group of agents (managers). In this paper a special aspect of this comprehensive principal agent problem is analyzed: the influence of financial structure on the liquidation decision of the firm. In chapter 2 only debt holders as principals are considered. In chapter 3 a further group of principals, the customers, are introduced. Titman (1984) was the first to deal with the influence of the claims of customers on the liquidation decision. Therefore, in a first step the problem as formulated and solved by Titman (1984) is presented and it is shown that his solution is deficient. In a second step alternative solutions are considered. The concluding remarks in chapter 4 refer to the introduction of still further principals into the analysis.

Capital structure of real estate assets: Theory and empirical evidence

Abstract: This paper presents a model which intends to explain the capital structure of real estate assets. The model is cast in classical portfolio choice framework, but special attention is paid to the liquidity constraint. The test of this model on two assets with different capital structures (new housing and old housing in France) revealed the importance of return indicators as well as liquidity constraint in the household's financing decisions.