Showing papers on "Capital structure published in 1994"

What Do We Know About Capital Structure? Some Evidence from International Data

Abstract: We investigate the determinants of capital structure choice by analyzing the financing decisions of public firms in the major industrialized countries. At an aggregate level, firm leverage is fairly similar across the G-7 countries. We find that factors identified by previous studies as important in determining the cross- section of capital structure in the U.S. affect firm leverage in other countries as well. However, a deeper examination of the U.S. and foreign evidence suggests that the theoretical underpinnings of the observed correlations are still largely unresolved.

Corporate Debt Value, Bond Covenants, and Optimal Capital Structure

Abstract: This article examines corporate debt values and capital structure in a unified analytical framework. It derives closed-form results for the value of long-term risky debt and yield spreads, and for optimal capital structure, when firm asset value follows a diffusion process with constant volatility. Debt values and optimal leverage are explicitly linked to firm risk, taxes, bankruptcy costs, risk-free interest rates, payout rates, and bond covenants. The results elucidate the different behavior of junk bonds versus investment-grade bonds, and aspects of asset substitution, debt repurchase, and debt renegotiation.

The Prudential Regulation of Banks

Abstract: The Prudential Regulation of Banks applies modern economic theory to prudential regulation of financial intermediaries. Dewatripont and Tirole tackle the key problem of providing the right incentives to management in banks by looking at how external intervention by claimholders (holders of equity or debt) affects managerial incentives and how that intervention might ideally be implemented. Their primary focus is the regulation of commercial banks and S&Ls, but many of the implications of their theory are also valid for other intermediaries such as insurance companies, pension funds, and securities funds.Observing that the main concern of the regulation of intermediaries is solvency (the relation between equity, debt, and asset riskiness), the authors provide institutional background and develop a case for regulation as performing the monitoring functions (screening, auditing, convenant writing, and intervention) that dispersed depositors are unable or unwilling to perform. They also illustrate the dangers of regulatory failure in a summary of the S&L crisis of the 1980s.Following a survey of banking theory, Dewatripont and Tirole develop their model of the capital structure of banks and show how optimal regulation can be achieved using capital adequacy requirements and external intervention when banks are violated. They explain how regulation can be designed to minimize risks of accounting manipulations and to insulate bank managers from macroeconomic shocks, which are beyond their control. Finally, they provide a detailed evaluation of the existing regulation and of potential alternatives, such as rating agencies, private deposit insurance, and large private depositors. They show that these reforms are, at best, a complement, rather than a substitute, to the existing regulation which combines capital ratios with external intervention in case of insolvency.The Prudential Regulation of Banks is part of the Walras Pareto Lectures, from the Universiy of Lausanne.

Short-Term versus Long-Term Interests: Capital Structure with Multiple Investors

Abstract: We study the problem of financial contracting and renegotiation between a firm and outside investors when the firm cannot commit to future payouts, but assets can be contracted upon. We show that a capital structure with multiple investors specializing in short-term and long-term claims is superior to a structure with only one type of claim, because this hardens the incentives for the entrepreneur to renegotiate the contract ex post. Depending on the parameters, the optimal capital structure also differentiates between state-independent and state-dependent longterm claims, which can be interpreted as long-term debt and equity. © 1994 by the President and Fellows of Harvard College and the Massachusetts Institute of Technology.

What Do We Know About Capital Structure? Some Evidence from International Data

Abstract: We investigate the determinants of capital structure choice by analyzing the financing decisions of public firms in the major industrialized countries. At an aggregate level, firm leverage is fairly similar across the G-7 countries. We find that factors identified by previous studies as correlated in the cross-section with firm leverage in the United States, are similarly correlated in other countries as well. However, a deeper examination of the U.S. and foreign evidence suggests that the theoretical underpinnings of the observed correlations are still largely unresolved.

Downscoping: How to Tame the Diversified Firm

Abstract: Large, diversified firms face unique challenges as they compete worldwide, and corporate restructuring is one way multinationals strive for competitive advantage. Weighing the pros and cons of a variety of approaches to restructuring, Downscoping offers executives a clear, strategic path through the maze. The authors show that when a multinational conglomerate fails to compete effectively, too much diversification may be the culprit. Whether the result of weak corporate governance or poor corporate strategy, over-diversification can make managers, unfamiliar with some of the markets in which they compete, opt for safety over innovation. This risk-aversion and lack of long-range commitment to innovation lead inevitably to stagnation over the longer term. The answer is not downsizing-closing offices and laying off personnel-but downscoping: a strategic approach to restructuring. The options include incentive and compensation adjustments for executives, leveraged buy-outs and capital structure changes, focusing on core skills, diversifying internationally while focusing on businesses in which a firm has strong competencies, and buying and selling mature businesses where product development is not a great concern. Regardless of the approach, executives must exercise strategic leadership during and after restructuring, including providing strategic direction, exploiting core competencies, deeloping human capital and sustaining the corporate culture. Based on systematic research rather than casual observation, Downscoping provides a strong description of restructuring alternatives and their resulting tradeoffs. Its specific guidelines for maintaining competitiveness will be essential reading for managers involved in corporate restructuring.

The Combined Effects of Free Cash Flow and Financial Slack on Bidder and Target Stock Returns

Abstract: This article examines the extent to which takeovers mitigate the underinvestment problem of S. C. Myers and N. S. Majluf (1984) and the free-cash-flow problem of M. C. Jansen (1986). Using accounting data, bidders are classified as 'high free cash flow,' 'slack poor,' or 'other.' Bidder, target, and total returns are highest for acquisitions that combine slack-poor and free-cash-flow firms. The widely cited negative returns of bidders are concentrated among combinations where bidders and targets are similarly classified. Cross-sectionally, bidder returns are more positive when associated with capital structure and liquid asset changes that mitigate bidder slack or free-cash-flow problems. Copyright 1994 by University of Chicago Press.

Stock Splits: Signalling or Liquidity? The Case of ADR 'Solo-Splits'

Abstract: Stock splits are a common capital structure alteration which ought to have no effect on firm value in perfect capital markets. Empirical studies find that stock prices increase upon announcement of stock splits. The two traditional explanations for the rise in prices are information signaling on the part of managers and improved liquidity for shares that trade at lower prices. We investigate these explanations by studying splits of American Deposit Receipt (ADR) securities which are not associated with splits in the home country stock. We argue that these splits are likely to be motivated by the desire for liquidity improvements only. The results indicate that ADR prices rise by a statistically significant 1 to 2 percent at the announcement. We interpret this evidence as supportive of the liquidity explanation of stock split announcement effects.

The capital structure of a regulated firm

Abstract: We examine the equilibrium price, investment, and capital structure of a regulated firm using a sequential model of regulation. We show that the firm's capital structure has a significant effect on the regulated price. Consequently, the firm chooses its equity and debt strategically to affect the outcome of the regulatory process. In equilibrium, the firm issues a positive amount of debt and the likelihood of bankruptcy is positive. Debt raises the regulated price, thus mitigating regulatory opportunism. However, underinvestment due to lack of regulatory commitment to prices persists in equilibrium.

The Relationship Between Capital and Earnings in Banking

Abstract: Conventional wisdom in banking suggests a higher capital-asset ratio (CAR) is associated with a lower after-tax return on equity (ROE). Despite the arguments in favor of this hypothesis, data on U.S. banks in the mid- to late-1980s tell a very different story. Bank values of CAR and ROE are positively related, and this relationship is both statistically and economically significant. The positive relationship between CAR and ROE holds both cross-sectionally and over time, holds when lags are included, and becomes even stronger when an extensive set of control variables is added to the regres-ions. The author regresses CAR and ROE on three years of lagged CAR and ROE and a number of control variables. The model suggests positive causation in the Granger sense to run in both directions between capital and earnings, consistent with the hypothesis that banks retain some of their marginal earnings in the form of equity increases. The evidence suggests that higher capital is followed by higher earnings over the next few years primarily through reduced interest rates on uninsured purchased funds. These findings are strongest for banks with low capital and high portfolio risk who decreased their portfolio risks as well as increased their capital positions relative to what they otherwise would have been. These results are consistent with the hypotheses that, because of factors making banks riskier in the 1980s, some banks may have had greater than optimal risk of bankruptcy and the associated deadweight liquidation costs, and as a result paid very high risk premiums on uninsured funds and suffered lower earnings. Those banks with increased expected bankruptcy costs that reacted by increasing capital quickly appear to have paid lower uninsured debt rates and had higher earnings than those that did not react this way. The tests generally do not support the signalling hypothesis - bank management signals private information that future prospects are "good" by increasing capital. The tests also show that the positive Granger-causality from capital to earnings of the 1980 does not apply to the 1990-1992 time period. The data suggest that banks may have "overshot" their optimal capital in the early 1990s because of regulatory changes, decline in bank risk, or unexpected high earnings that raised capital above optimal levels.

An empirical model of capital structure: Some new evidence

Abstract: Using a general autoregressive distributed lag model, we estimate the longrun steady state determinants of corporate capital structure. We find that, in the long run, the leverage ratio is related positively to the corporate tax rate and firm size and negatively to future growth opportunities and stock returns. By contrast, there appears to be no relation between leverage and the corporate tax rate on a short-run year to year basis. Our results suggest that prior empirical evidence on capital structure is of questionable value precisely because of its failure to clearly separate the short-run relationship between leverage and its determinants from its long-run relationship.

Firm-Specific Human Capital amd Optimal Capital Structure

Abstract: The authors consider the moral hazard in managers undersupplying imperfectly-marketable, firm-specific human capital. Firms may cope by granting long-term wage contracts that protect managers against employment termination. Although ex ante efficient, these contracts may be ex post inefficient when managerial ability is discovered to be low. Precommitted firms must honor these contracts, unless there is ownership transfer that permits their legal invalidation. Bankruptcy is one such transfer mechanism. Since managers anticipate the contractual consequence of bankruptcy, leverage worsens moral hazard; this cost provides a counterbalance to the debt tax shield and leads to an optimal capital structure. Copyright 1994 by Economics Department of the University of Pennsylvania and the Osaka University Institute of Social and Economic Research Association.

Determinants of capital structure choice and empirics on leverage behavior: a comparative analysis of hotel and manufacturing firms.

Abstract: The relationship between a firm's capital structure, its cost of capital, and its stock value is an important financial and investment issue today. Using a cross- sectional regression analysis, the leverage behavior of 33 firms in 2 industry groups-the hotel industry and the manufacturing sector-was examined. Findings showed that all leverage determinants studied, excepting firm size, are significant in explaining leverage variations in debt behavior. In addition, although more industry- specific variables are needed, leverage behavior in hotel firms can be analyzed using traditionally theorized capital structure determinants. As such, the capital structure in the hotel industry is better understood, and some important distinctions between short-term and long-term debt behavior in hotel and manufacturing firms are revealed.

Corporate Debt Value, Bond Covenants, and Optimal Capital Structure

Abstract: This paper examines corporate debt values and capital structure in a unified analytical framework. It derives closed form results for the value of long-term risky debt and yield spreads, and for optimal capital structure, when firm asset value follows a diffusion process with constant volatility. Debt values and optimal leverage are explicitly linked to firm risk, taxes, bankruptcy costs, riskfree interest rates, payout rates, and bond covenants. The results elucidate the different behavior of junk bonds vs. investment grade bonds, and aspects of asset substitution, debt repurchase, and debt renegotiation.

The Effect of a Rating Downgrade on Outstanding Commercial Paper

Abstract: Diamond (1991) argues that a firm's reputation determines whether it borrows directly or through an intermediary. We test the Diamond model by examining the quantity response of commercial paper issued by bank holding companies to a rating downgrade. From 1986 to 1991, cumulative abnormal declines averaged 6.69 percent in the first two weeks after the downgrade and 11.05 percent in the subsequent 12 weeks. In contrast to commercial paper issued by bank holding companies, large CDs issued by affiliated banks did not change significantly in the period around a downgrade, suggesting that deposit insurance may have removed market discipline from the CD market. THE OBJECTIVE OF THIS study is to test Diamond's (1991) theory of corporate capital structure in which a firm's reputation determines whether it borrows directly or through an intermediary. In Diamond's model, a firm without an established reputation will borrow through, and be monitored by, an intermediary. By building a good reputation, a firm may gain access to the nonintermediated markets, such as the commercial paper market, and, consequently, avoid the cost of monitoring. In the process of maintaining its reputation, a firm may eliminate the conflict of interest between borrowers and lenders about the choice of risk in investment decisions. Such firms have an incentive to maintain their reputation because the reputation itself has become a valuable asset that reduces borrowing costs. In the model, a firm that loses its reputation will find the cost of placing debt directly prohibitively expensive. Using event study methodology, we test the Diamond model by examining the quantity response of commercial paper (CP) to a rating downgrade of the issuing company. We focus on ratings because firms that borrow in the CP market usually have high ratings. In part, these ratings reflect the firms' reputation for selecting safe investments. In the Diamond framework, if credit ratings proxy for reputation, then a rating downgrade may be associated with a decline in the amount of outstanding CP. This change in capital structure may occur relatively rapidly because outstanding CP typically has a

Debt or Equity?: How Firms in Developing Countries Choose

Abstract: Long stifled by government controls, emerging market (EM) corporate finance is changing dramatically as recent liberalization is revitalizing stagnant domestic capital markets and permitting increased access to overseas markets. This paper examines how EM firms choose between debt and equity in their financing decisions. The paper starts with a discussion of the traditional features of EM corporate finance. It then presents a simple framework for the debt-equity choice based on the standard considerations of cost, risk, control and disclosure. The unique manner in which these considerations could be influenced by government control is illustrated with examples from several EM countries. The central conclusion of this report is that, like Western firms, EM firms seek to minimize the cost of capital and retain control in the hands of existing shareholders. But they also face many non-market constraints, which are now disappearing. The concluding section remarks upon a number of interesting empirical regularities across countries as they embark on financial liberalization.

Bond Prices, Yield Spreads, and Optimal Capital Structure with Default Risk

Abstract: This paper examines the value of debt subject to default risk in a continuous time framework. By considering debt with regular principal repayments (e.g. through a sinking fund), we are able to examine bonds with arbitrary maturity while retaining a time-homogeneous environment. This extends Leland's [1994] earlier closed-form results to a much richer class of possible debt structures. We examine the term structure of yield spreads and find that a rise in interest rates will reduce yield spreads of current debt issues. It may tilt the term structure as well. Duration is also affected by default risk. The traditional Macaulay duration measure overstates effective duration, which for junk bonds may even be negative. While short term debt does not exploit tax benefits as completely as does long term debt, it is more likely to provide incentive compatibility between debt holders and equity holders. The agency costs of asset substitution are minimized when firms use shorter term debt. Optimal capital structure depends upon debt maturity. Optimal leverage ratios are smaller, and maximal firm values are less, when short term debt is used. The yield spread at the optimal leverage ratio increases with debt maturity.

Dividend Policy and Corporate Monitoring: Evidence from the Regulated Electric Utility Industry

Abstract: The payment of dividends imposes costs on the firm's shareholders in the form of higher taxes (relative to capital gains) and issuance costs arising from the dividend-induced need to acquire external equity, given the firm's investment and capital structure policies. Why, then, do firms pay dividends? In particular, why do the more capital intensive electric utilities have a dividend payout rate more than twice that of industrial firms? In simpler terms, why are utilities among the largest suppliers of dividends and simultaneously among the largest sellers of common stock? In this study, we provide some possible insights into the larger dividend puzzle through an empirical investigation of the seemingly extraordinary dividend payout policies of regulated electric utilities.

Capital Structure Decision Making in Privately Held Firms: Beyond the Finance Paradigm

Abstract: Capital structure theories grounded in the finance paradigm (agency theory, transaction cost theory) have contributed to our understanding of capital structure decision making. However, they do not address the intricacies of capital structure decision making from a managerial choice perspective, especially in privately held firms. This article brings together research from strategic management, decision sciences, and social psychology to develop a conceptual model for understanding capital structure decision making in privately held firms. In general, it is posited that capital structure decisions are influenced by the firm owner's attitude toward debt as moderated by external environmental conditions. Attitude toward debt is a function of one's belief about debt as influenced by the individual's need for control, risk propensity, experience, social norms, and personal net worth. The integration of theoretical perspectives yields eight propositions for understanding the determinants of privately held firm...

The impact of corporate strategy on the capital structure of Australian companies

Abstract: Research into the capital structure of firms has been the subject of extensive empirical investigation but further progress may be constrained by the conventional paradigm underlying most of this work. This paper seeks to extend the debate by examining the endogenous influence of corporate strategy on financing decisions made by firms. While the theoretical specification of the possible relationship has to be developed further, various models were constructed and company data from Australia, an economy with some notoriety for fairly loose corporate debt management, was used to examine various hypothesized relationships. Our analysis suggests that corporate strategy influences capital structure, particularly for the most diversified firms, and that the emerging relationship is complex. Profit, cash flow, the rate of growth and the level of earnings risk are important additional internal influences on capital structure. The results are reasonably robust and indicate that this focus of enquiry has considerable potential for further resolution of the capital structure puzzle, as well as contributing to the debate on the impact of institutional shareholders on the corporate strategy of the firms in which they invest.

Capital structures in developing countries : evidence from ten countries

Abstract: The authors investigate capital structures in a sample of the largest publicly traded firms in ten developing countries - Brazil, India, Jordan, the Republic of Korea, Malaysia, Mexico, Pakistan, Thailand, Turkey, and Zimbabwe - for 1980 - 91. The firms in the sample are smaller than comparable U.S. firms, and the financial systems and regulations in these countries differ significantly from those in the United States. Not every country has well-functioning liquid financial markets in which investors can diversify risks. Nor do all countries have efficient legal systems in which a broad range of property rights can be enforced. Still, variables that predict capital structures in the United States also predict choices of capital structures in the countries sampled. Variables suggested by agency theory explain more of the variation than variables suggested by tax-based theories. For both short-term and long-term equations in most countries, the asset structure, liquidity, and industry effects have more explanatory power than firm size, growth opportunities, and tax effects. In several countries, total indebtedness is negatively related to net fixed assets, suggesting that markets for long-term debt do not function effectively.

The capital structure and investment of regulated firms under alternative regulatory regimes

Abstract: This paper explains how regulated firms choose their capital structure and examines the effects of this choice on investment and on regulated prices. It is shown that in equilibrium, firms have an optimal debt level and that given this debt level, the regulated price is set high enough to ensure that firms never become financially distressed. The analysis of the equilibrium yields testable hypotheses concerning the effects of changes in cost parameters and in the regulatory climate on the equilibrium investment level, capital structure, and regulated price. The analysis also shows that a regulatory restriction on the ability of the firm to issue securities may have an adverse effect on investment and consequently may harm consumers.

Capital structure and the cost of equity capital in the property-liability insurance industry☆

Abstract: Financial pricing models are now widely used in insurance pricing and price regulation. However, most practical applications of these models have not taken into account either the effects of firm capital structure or the differences in financial risk across lines of insurance. The objective of this paper is to provide a first step towards remedying these deficiencies by providing theoretical and empirical evidence on the effects of capital structure and line of business risk on the cost of equity capital in property-liability insurance. A theoretical model is developed that expresses the cost of capital as a function of both insurance leverage (the ratio of policy reserves to assets) and financial leverage (the ratio of financial debt to assets). The model is tested using data on traded stock property-liability insurers over the period 1980–1989. The results indicate that the cost of equity capital is sensitive to both insurance and financial leverage and that the cost of equity is higher for firms writing long-tail commercial lines such as general liability and workers' compensation. Thus, both leverage and line of business specialization should be taken into account in using the cost of equity capital in pricing property-liability insurance.

The interaction between the financial and investment decisions of the firm: the case of issuing warrants in a levered firm

Abstract: In this paper we analyze the value of warrants and stock in a firm that has both equity and debt in its capital structure, and assume that the proceeds from exercising the warrants are reinvested in the firm. The effect of potential future scale investment on the firm's stock, debt and warrants are investigated. The warrants in our analysis are European. In this framework there are two sources for the nonstationarity of the rate of return on any kind of financial claim; the first stems from changes in the firm's capital structure, and the second is due to the potential scale increase in the value of the firm should the warrants be exercised. The effect of a potential transfer of wealth from equity-holders to debt-holders at time of exercise is analyzed. When warrants are exercised and the proceeds are reinvested in a scale expansion project, the probability of default may decrease. It follows, therefore, that ceteris paribus debt is likely to appreciate in value at the expense of equity. The method of pricing by arbitrage, as proposed by Harrison and Kreps is used to derive values for claims on the firm. Problems associated with measuring the volatility of equity are discussed.