Showing papers on "Capital structure published in 1998"

The economics of small business finance: The roles of private equity and debt markets in the financial growth cycle

Abstract: This article examines the economics of financing small business in private equity and debt markets. Firms are viewed through a financial growth cycle paradigm in which different capital structures are optimal at different points in the cycle. We show the sources of small business finance, and how capital structure varies with firm size and age. The interconnectedness of small firm finance is discussed along with the impact of the macroeconomic environment. We also analyze a number of research and policy issues, review the literature, and suggest topics for future research.

Agency Costs, Risk Management, and Capital Structure

Abstract: The joint determination of capital structure and investment risk is examined. Optimal capital structure reflects both the tax advantages of debt less default costs (Modigliani and Miller (1958, 1963)), and the agency costs resulting from asset substitution (Jensen and Meckling (1976)). Agency costs restrict leverage and debt maturity and increase yield spreads, but their importance is small for the range of environments considered. Risk management is also examined. Hedging permits greater leverage. Even when a firm cannot precommit to hedging, it will still do so. Surprisingly, hedging benefits often are greater when agency costs are low. THE CHOICE OF INVESTMENT FINANCING, and its link with optimal risk exposure, is central to the economic performance of corporations. Financial economics has a rich literature analyzing the capital structure decision in qualitative terms. But it has provided relatively little specific guidance. In contrast with the precision offered by the Black and Scholes (1973) option pricing model and its extensions, the theory addressing capital structure remains distressingly imprecise. This has limited its application to corporate decision making. Two insights have profoundly shaped the development of capital structure theory. The arbitrage argument of Modigliani and Miller (M-M) (1958, 1963) shows that, with fixed investment decisions, nonfirm claimants must be present for capital structure to affect firm value. The optimal amount of debt balances the tax deductions provided by interest payments against the external costs of potential default. Jensen and Meckling (J-M) (1976) challenge the M-M assumption that investment decisions are independent of capital structure. Equityholders of a levered firm, for example, can potentially extract value from debtholders by increasing investment risk after debt is in place: the "asset substitution" problem. Such predatory behavior creates agency costs that the choice of capital structure must recognize and control.

An EBIT-Based Model of Dynamic Capital Structure

Abstract: Much of the literature on optimal capital structure has taken the unlevered firm value to be the underlying state variable, even though the unlevered firm ceases to exist after a capital structure change occurs. This approach has been a source of confusion, leading to conflicting views on the relationship between the levered and unlevered firm value at the moment of a capital structure change. Moreover, these frameworks imply that the role of government is to create a 'tax benefit' cash-flow into a firm, when in practice much of the cash that flows out of a firm is typically paid to government via taxes. To circumvent these difficulties, we take the claim to future EBIT as the underlying state variable, and assume that it is invariant to changes in capital structure. In such a framework, all claims to EBIT (equity, debt, government) are treated in a consistent fashion. In particular, the government claim is correctly modeled as an outflow of EBIT via taxes, rather than as an inflow of 'tax benefits'. This distinction dramatically affects the payout ratio, which in turn affects both the probability of bankruptcy and predicted yield spreads. In addition, the invariance feature of the state variable makes this framework ideal for investigating optimal dynamic capital structure strategy. When firms are permitted to increase their level of outstanding debt in the future, predicted leverage ratios are consistent with those observed.

Blocks, liquidity and corporate control

Abstract: The paper develops a simple model of corporate ownership structure in which costs and benefits of ownership concentration are analyzed The model cornpares the liquidity benefits obtained through dispersed corporate ownership with the benefits from efficient management control achieved by some degree of ownership concentration The paper reexamines the free-rider problem in corporate control in the presence of liquidity trading, derives predictions for the trade and pricing of blocks, and provides criteria for the optimal choice of ownership structure THE RECENT INCOMPLETE CONTRACTING approach in corporate finance has considerably improved our understanding of how small firms determine their capital structure The basic setting considered in this line of research is one where a founder-manager seeks funding from one or several financiers The main premise is that the founder-manager, in her dealings with the financiers, is primarily concerned with maintaining her private benefits of control For small firms these are often quite large relative to the financial returns Thus, for a small firm the problem of determining the financial structure often reduces to the problem of how to obtain fundingr while giving away as little control as possible to the financiers Of course, most financiers insist on some form of protection, so that the final compromise reached in most financial contracts for small firms is one resembling a debt contract (or a venture capital contract), which protects the founder-manager's control as long as the firm is performing adequately' This perspective for small firms does not extend naturally to large firms because the private benefits of control of the managers for large firms are likely to be small relative to the firm's monetary returns, so that protection of these benefits is not an overriding consideration Moreover, large firms

Strategy and Financial Policy in UK Small Firms

Abstract: There is growing evidence that capital structure and firm strategy are linked but most studies to date have focused on large, publicly quoted firms, with little attention given to small and medium-sized enterprises (SMEs). A major proposition of the study is that both strategic and financial factors are necessary to explain chosen debt levels. The empirical question adopted for this work, given the best financial model of capital structure, is – does strategy provide any additional explanatory power? Hence strategy and financial variables are seen as complementary rather than competing determinants of capital structure. There appears to be strong evidence supporting the proposition that competitive strategy affects the capital structure of SMEs, but there is little evidence of any impact from corporate strategic factors. The study also supports the notion that there is a ‘pecking order’ in SME financing and that variability in profits results in ‘distress’ borrowing. This study provides important empirical evidence to support work on the capital structure puzzle and the funding problems of SMEs.

Corporate Financial Management

Abstract: Topics covered in the book Introduction to the book Acknowledgements Part I INTRODUCTION 1 The financial world Part II THE INVESTMENT DECISION 2 Project appraisal: Net present value and internal rate of return Appendix 2.1 Mathematical tools for finance 3 Project appraisal: Cash flow and applications 4 The decision-making process for investment 5 Project appraisal: Capital rationing, taxation and inflation Part III RISK AND RETURN 6 Risk and project appraisal 7 Portfolio theory 8 The capital asset pricing model and the arbitrage pricing theory Part IV SOURCES OF FINANCE 9 Stock markets 10 Raising equity capital 11 Long-term debt finance 12 Short-term and medium-term finance 13 Treasury and working capital management 14 Stock market efficiency Part V CORPORATE VALUE 15 Value-based management 16 Managing a value-based company 17 Valuing shares 18 Capital structure 19 Dividend policy 20 Mergers Part VI MANAGING RISK 21 Derivatives Appendix 21.1 Option pricing 22 Managing exchange-rate risk APPENDICES Appendix I Future value of A GBP1 at compound interest Appendix II Present value of A GBP1 at compound interest Appendix III Present value of an annuity of A GBP1 at compound interest Appendix IV Areas under the standardised normal distribution Appendix V Answers to the mathematical tools exercises in Appendix 2.1 Appendix VI Solutions to selected questions and problems Glossary Bibliography Index

Debt, Leases, Taxes, and the Endogeneity of Corporate Tax Status

Abstract: We provide evidence that corporate tax status is endogenous to financing decisions, which induces a spurious relation between measures of financial policy and many commonly used tax proxies. Using a forward-looking estimate of before-financing corporate marginal tax rates, we document a negative relation between operating leases and tax rates, and a positive relation between debt levels and tax rates. This is the first unambiguous evidence supporting the hypothesis that low tax rate firms lease more, and have lower debt levels, than high tax rate firms. MANY THEORIES OF CAPITAL STRUCTURE imply that, all else equal, the incentive to use debt financing increases with a firm's marginal tax rate due to the tax deductibility of interest expense (e.g., Modigliani and Miller (1963), DeAngelo and Masulis (1980)). Conversely, leasing models generally predict that firms with low marginal tax rates employ relatively more leases than do firms with high marginal tax rates. The logic behind the leasinlg prediction is that leases allow for the transfer of tax shields from firms that cannot fully utilize the associated tax deduction (lessees) to firms that can (lessors) (e.g., Myers, Dill, and Bautista (1976), Smith and Wakeman (1985), Ross, Westerfield, and Jaffe (1996)). Despite these straightforward predictions, empirically testing for tax effects is difficult because a spurious relation exists between. the financing decision and many commonly used tax proxies. Specifically, both interest expense and lease payments are tax deductible. Thus, a firm that finances its operations with debt or leases reduces its taxable income, potentially lowering its expected marginal tax rate. If not properly addressed, this endogeneity of the tax rate can bias an experiment in favor of finding a negative

Survival of the Fittest or the Fattest? Exit and Financing in the Trucking Industry

Abstract: This paper studies the impact that capital market imperfections have on the natural selection of the most efficient firms by estimating the effect of the prederegulation level of leverage on the survival of trucking firms after the Carter deregulation. Highly leveraged carriers are less likely to survive the deregulation shock, even after controlling for various measures of efficiency. This effect is stronger in the imperfectly competitive segment of the motor carrier industry. High debt seems to affect survival by curtailing investments and reducing the price per tonmile that a carrier can afford to charge after deregulation. MOST ECONOMIC THEORIES ARE either implicitly or explicitly based on an evolutionary argument: Competition and exit assure that only the most efficient firms survive. This argument implicitly relies on the existence of perfect capital markets. In the presence of capital market imperfections, efficient firms may be forced to exit due to lack of funds. Although this argument is well understood in theory (Telser (1966) and Bolton and Scharfstein (1990)), its empirical relevance is much less clear. The crucial issue in trying to assess the effects of financing choices on the survival of firms and, thus, on the product market competition is the endogeneity of capital structure choices to the industry structure. If leverage affects a firm's competitive position, then the firm's financing decisions will take this into account. As a result, in the absence of a structural model we cannot determine whether it is the product inarket competition that affects capital structure choices or a firm's capital structure that affects its competitive position and its survival. This paper attempts to address the endogeneity problem by looking at the effects of leverage on the survival of trucking firms after the Carter dereg

Optimal Capital Structure, Endogenous Bankruptcy, and the Term Structure of Credit Spreads

Abstract: This paper examines the optimal capital structure of a firm that can choose both the amount and maturity of its debt. Bankruptcy is determined endogenously rather than by the imposition of a positive net worth condition or by a cash flow constraint. The results extend Leland's [1994] closed- form results to a much richer class of possible debt structures and permit study of the optimal maturity of debt as well as the optimal amount of debt. The model predicts leverage, credit spreads, default rates, and writedowns which accord quite closely with historical averages. While short term debt does not exploit tax benefits as completely as long term debt, it is more likely to provide incentive compatibility between debt holders and equity holders. Short term debt reduces or eliminates "asset substitution" agency cost. The tax advantage of debt must be balanced against bankruptcy and agency cost in determining the optimal maturity of the capital structure. The model predicts differently shaped term structures of credit spreads for different levels of risk. These term structures are similar to those found empirically by Sarig and Warga [1989]. The model has important implications for bond portfolio management. In general, Macaulay duration dramatically overstates true duration of risky debt, which may be negative for "junk" bonds. Furthermore, the "convexity" of bond prices can become "concavity".

Linking corporate strategy to capital structure: diversification strategy, type and source of financing

Abstract: This study examines the relationship between corporate strategy and capital structure, specifically the diversfication and financing strategies of a firm. The results show that equity financing is preferred for related diversification and unrelated diversification is associated with debt financing. Additionally, firms diversifying through acquisitions are more likely to use public sources of financing and those emphasizing internal development of new businesses depend primarily on private sources of financing. Using simultaneous equation estimation, we found a reciprocal relationship between a firm’s financial strategy and its corporate diversification strategy. Mode and nature of diversification are also reciprocally interrelated. © 1998 John Wiley & Sons, Ltd.

Pricing Strategy and Financial Policy

Abstract: Recent empirical evidence indicates that capital structure changes affect pricing strategies. In most cases, prices increase following the implementation of a leveraged buyout of a major firm in an industry, with the more leveraged firm in the industry charging higher prices on average. Notable exceptions exist, however, when the leverage increasing firm's rival is relatively unlevered. The first observation is consistent with a model where firms compete for market share on the basis of price. The second observation can be explained within the context of a Stackelberg model where the relatively unlevered rival acts as the Stackelberg price leader.

The Impact of Ownership Structure On Corporate Debt Policy: a Time‐Series Cross‐Sectional Analysis

Abstract: This study examines the influence of agency costs and ownership concentration on the capital structure of the firm. Of particular interest is the composition of equity ownership as a determinant of overall capital structure and the dynamic adjustment of capital structure to changes in the equity ownership. Results indicate that the distribution of equity ownership is important in explaining overall capital structure and that managers do reduce the level of debt as their own wealth is increasingly tied to the firm. It is also noted that the time-series component is important in resolving the conflicting results reported in prior research.

Corporate Finance: Principles & Practice

Abstract: *The Finance Function *The Efficient Market Hypothesis *An Overview of Investment Appraisal Techniques *Applications of Investment Appraisal and Considerations of Risk *Sources of Long-Run Finance: Equity Finance *Sources of Long-Run Finance: Debt and Hybrid Financing *Dividend Policy and the Valuation of Equity *Cost of Capital and the Capital Structure Debate *Portfolio Selection and the Capital Asset Pricing Model *Working Capital Management *Integrated Topics in Corporate Finance *Acquisitions and Restructuring *The Management of Interest Rate and Exchange Rate Risk *International Investment Decisions *Answers, Tables, Index

The capital structure of firms in Central and Eastern Europe

Abstract: According to more recent theories on the optimal capital structure, the availability of external financing is not always guaranteed, or it may come at different costs, depending on the methods of financing used (debt vs. equity, long-term debt vs. short-term debt, etc.). Under such circumstances, firms’ investment and financing decisions are interdependent. This paper studies the optimal capital structure for enterprises in transition economies and investigates the actual capital structure and its determinance in Hungary and Poland.

Corporate Hedging: What, Why and How?

Abstract: This paper explores the rationale for corporate risk management. Following Smith and Stulz (1985) and Mayers and Smith (1987), the assumption is made that firms can contractually commit to bondholders to maintain a particular risk management policy, or asset volatility. With that as a starting point, the essay derives the optimal hedge portfolio, examines this portfolio's robustness to variance-covariance misestimation, and proposes a new motive for corporate risk management; a firm that hedges its risk increases its optimal amount of debt and so realizes more tax benefits from leverage. Using the capital structure model of Leland (1994), three impacts of risk-reduction on shareholder value are measured: the increase in tax benefits, the reduction of bankruptcy costs and the reduction in the potential cost of the underinvestment problem. The essay's motivation is to serve as a guide to chief financial officers regarding the benefits of risk management and the sources of those benefits, so that risk management can be undertaken in a way that enhances shareholder value, rather than for its own sake.

The Effect of Bank Debt on Optimal Capital Structure

Abstract: Professor of Finance at the University of Cincinnati. I examine the relation between leverage and bank debt use to analyze the effects of bank screening and monitoring on capital structure. The analysis joins capital structure models in which asymmetric-information problems reduce optimal leverage with recent banking firm models in which screening and monitoring mitigate these problems. I find a positive relation between leverage and the use of bank debt, which is robust to controlling for other determinants of leverage. The relation appears to be created partly by bank debt use attenuating potential asset-substitution problems. The results imply that the choice of debt source is an important element of the capital structure decision.

Targeting Capital Structure: The Relationship between Risky Debt and the Firm's Likelihood of Being Acquired

Abstract: In a takeover, wealth transfers from bidder and target equityholders to target debtholders can occur if target debt is coinsured by either the bidder's assets or by the synergy itself. Such wealth transfers reduce bidder and target shareholder gains and could poison the acquisition. With a sample from 1979-90, I find that as the coinsurance potential of a firm's debt, measured as the amount of relatively risky debt outstanding, increases, its likelihood of being acquired decreases. In particular, I find this coinsurance deterrent to be strongest during the 1985-90 period, and strongest for firms with public debt outstanding.

A Framework for Valuing Corporate Securities

Abstract: We suggest a methodology for valuing corporate securities that allows the straightforward derivation of closed form solutions for complex capital structure scenarios. The tractability of the approach stems from its modularity - we provide a number of intuitive building blocks that are sufficient for valuation in most typical situations. A further advantage of our approach is that it makes economic interpretation far easier than what is typically possible with other approaches such as solving partial differential equations. As examples we consider a corporate coupon bond with discrete payments and debt subject to strategic debt service.

A Model of Capital Structure Decision-making in Small Firms

Abstract: Although earlier capital structure theories, grounded within the finance paradigm (agency theory, transaction cost theory etc), have contributed to a deeper understanding of the capital structure puzzle, recent efforts suggest that research for the missing pieces of the puzzle should continue. This paper considers that these missing pieces of the puzzle could be diverse non‐financial and behavioural factors influencing capital structure decisions, that have received relatively little attention from finance researchers. The paper reports on an exploratory attempt to use interview techniques for the study of capital structure in small firms. Interviews can provide evidence about non‐financial and behavioural variables that quantitative analysis cannot. The paper develops a model for understanding capital structure decision making in small firms. It analyses the responses of small business owners/managers concerning the management of the financial structure of their firms and the factors that influence their capital structure decisions. Small business owners’ responses indicate that although a number of different financial variables may affect their capital structure decisions, other non‐financial and behavioural factors such as the need for control, risk propensity, experience, knowledge and goals may be more important in influencing the capital structure of their firms, at any time. The results indicate that significant progress in understanding the factors that influence capital structure may be achieved if financial researchers incorporate management theory in their studies, so that financial as well as non‐financial and behavioural factors are explored.

Foreign Tax Credit Limitations and Capital Structure Decisions

Abstract: This paper extends prior studies by Collins and Shackelford [1992] and Froot and Hines [1995] that investigate the impact of foreign tax credit (FTC) limitations on firms' capital structure decisions. Binding FTC limitations reduce the marginal tax benefit of domestic interest deductions and provide incentives for firms to substitute equity financing for domestic debt. Collins and Shackelford [1992] document a positive relation between the impact of FTC limitations and changes in firms' preferred stock accounts during 1986-89. Froot and Hines [1995] (unable to isolate domestic debt changes) document that firms with excess FTCs decreased their worldwide debt growth in 1986-91, but they do not find evidence that FTC limitations influence a shift away from debt and into preferred stock financing. Thus, these two studies find conflicting evidence regarding whether FTC limitations influence firms to use preferred stock as a financing vehicle, and neither study provides direct evidence regarding a decline in domestic debt or a potential common

The effect of leverage on bargaining with a corporation

Abstract: This paper shows that the choice of a capital structure by a firm affects the bargaining posture of its shareholders vis-a-vis its suppliers of specialized production factors. The pricing of the firm's securities and the choice of a capital structure are analyzed in light of this effect of debt financing.

The Role of Capital in Optimal Banking Supervision and Regulation

Abstract: It is my pleasure to join President McDonough and our colleagues from the Bank of Japan and the Bank of England in hosting this timely conference. Capital, of course, is a topic of never-ending importance to bankers and their counterparties, not to mention the regulators and central bankers whose job it is to oversee the stability of the financial system. Moreover, this conference comes at a most critical and opportune time. As you are aware, the current structure of regulatory bank capital standards is under the most intense scrutiny since the deliberations leading to the watershed Basle Accord of 1988 and the Federal Deposit Insurance Corporation Improvement Act of 1991. In this tenth anniversary year of the Accord, its architects can look back with pride at the role played by the regulation in reversing the decades-long decline in bank capital cushions. At the time that the Accord was drafted, the use of differential risk weights to distinguish among broad asset categories represented a truly innovative and, I believe, effective approach to formulating prudential regulations. The risk-based capital rules also set the stage for the emergence of more general risk-based policies within the supervisory process. Of course, the focus of this conference is on the future of prudential capital standards. In our deliberations, we must therefore take note that observers both within the regulatory agencies and in the banking industry itself are raising warning flags about the current standard. These concerns pertain to the rapid technological, financial, and institutional changes that are rendering the regulatory capital framework less effectual, if it is not on the verge of becoming outmoded, with respect to our largest, most complex banking organizations. In particular, it is argued that the heightened complexity of these large banks' risk-taking activities, along with the expanding scope of regulatory capital arbitrage, may cause capital ratios as calculated under the existing rules to become increasingly misleading. I, too, share these concerns. In my remarks this evening, however, I would like to step back from the technical discourse of the conference's sessions and place these concerns within their broad historical and policy contexts. Specifically, I would like to highlight the evolutionary nature of capital regulation and then discuss the policy concerns that have arisen with respect to the current capital structure. I will end with some suggestions regarding basic principles for assessing possible future changes to our system of prudential supervision and regulation. To begin, financial innovation is nothing new, and the rapidity of financial evolution is itself a relative concept--what is "rapid" must be judged in the context of the degree of development of the economic and banking structure. Prior to World War II, banks in this country did not make commercial real estate mortgages or auto loans. Prior to the 1960s, securitization, as an alternative to the traditional "buy and hold" strategy of commercial banks, did not exist. Now banks have expanded their securitization activities well beyond the mortgage programs of the 1970s and 1980s to include almost all asset types, including corporate loans. And most recently, credit derivatives have been added to the growing list of financial products. Many of these products, which would have been perceived as too risky for banks in earlier periods, are now judged to be safe owing to today's more sophisticated risk measurement and containment systems. Both banking and regulation are continuously evolving disciplines, with the latter, of course, continuously adjusting to the former. Technological advances in computers and in telecommunications, together with theoretical advances--principally in option-pricing models--have contributed to this proliferation of ever more complex financial products. The increased product complexity, in turn, is often cited as the primary reason that the Basle standard is in need of periodic restructuring. …

Credit spreads and interest rates: a cointegration approach

Abstract: This paper uses cointegration to model the time-series of corporate and government bond rates. We show that corporate rates are cointegrated with government rates and the relation between credit spreads and Treasury rates depends on the time horizon. In the short-run, an increase in Treasury rates causes credit spreads to narrow. This effect is reversed over the long-run and higher rates cause spreads to widen. The positive long-run relation between spreads and Treasuries is inconsistent with prominent models for pricing corporate bonds, analyzing capital structure, and measuring the interest rate sensitivity of corporate bonds.

The Place of Institutions in the Economy: A Theoretical Perspective

Abstract: Standard economic theory is only apparently institution-free. More importantly, the failures of the theory serve as a fruitful way to examine the need for institutions and explain why they emerge. It is, however, less useful, but not entirely useless, in analyzing which institutions will emerge.1

Financial structure: theories and stylized facts for six EU-countries

Abstract: The article provides a survey of one of the most important elements of financial structure, namely credit to firms and households, by means of five distinguished theoretical issues. It is complemented by a survey of relevant stylized facts for six European countries. A cross-country comparison across Europe shows that indirect credit markets with banks as the main players are far more important than direct credit markets, and that the most striking difference in financial structure among the countries considered relates to debt maturity.

Investment and Debt Constraints: Evidence from Dutch Panel Data

Abstract: It is generally accepted that real markets are sometimes affected by imperfections and their consequences. In contrast, the functioning of financial markets is mostly assumed to be perfect and efficient. Modigliani and Miller (1958, hereafter MM) show that in the latter case the capital structure of the firm is irrelevant for the user cost of capital and does neither affect investment nor the value of the firm. Since the publication of their seminal paper a large number of studies has pointed out that the empirical relevance of the MM-proposition is small. Financial markets suffer from several (institutional) market imperfections. In the first twenty years after the MM-publication, papers showed that distortionary taxes, transaction, bankruptcy and agency costs cause the financial structure to affect investment decisions. In recent studies the focus is directed towards information asymmetries. Agents have different sets of information. Firms know more about the quality of their investment project than, for instance, a bank. It can be shown that in such a case external funds (for instance bank credit) are more expensive than internal funds, because problems like adverse selection and moral hazard may occur. This might explain the empirical phenomenon that firms preferably use internal funds to finance Investment.1