Showing papers on "Leverage (finance) published in 1972"

The effect of the firm's capital structure on the systematic risk of common stocks

Abstract: ONLY RECENTLY has there been an interest in relating the issues historically associated with corporation finance to those historically associated with investment and portfolio analyses. In fact, rigorous theoretical attempts in this direction were made only since the capital asset pricing model of Sharpe [13], Lintner [6], and Mossin [11], itself an extension of the Markowitz [7] portfolio theory. This study is one of the first empirical works consciously attempting to show and test the relationships between the two fields. In addition, differences in the observed systematic or nondiversifiable risk of common stocks, P, have never really been analyzed before by investigating some of the underlying differences in the firms. In the capital asset pricing model, it was demonstrated that the efficient set of portfolios to any individual investor will always be some combination of lending at the risk-free rate and the "market portfolio," or borrowing at the riskfree rate and the "market portfolio." At the same time, the Modigliani and Miller (MM) propositions [9, 10] on the effect of corporate leverage are well known to the students of corporation finance. In order for their propositions to hold, personal leverage is required to be a perfect substitute for corporate leverage. If this is true, then corporate borrowing could substitute for personal borrowing in the capital asset pricing model as well. Both in the pricing model and the MM theory, borrowing, from whatever source, while maintaining a fixed amount of equity, increases the risk to the investor. Therefore, in the mean-standard deviation version of the capital asset pricing model, the covariance of the asset's rate of return with the market portfolio's rate of return (which measures the nondiversifiable risk of the asset-the proxy P will be used to measure this) should be greater for the stock of a firm with a higher debt-equity ratio than for the stock of another firm in the same risk-class with a lower debt-equity ratio.1 This study, then, has a number of purposes. First, we shall attempt to link empirically corporation finance issues with portfolio and security analyses through the effect of a firm's leverage on the systematic risk of its common

Evidence on the importance of financial structure

Abstract: equity in lower ranges of debt to equity to lower the firm's cost of capital. Beyond an ill-defined point, however, due to excessive risk, the securities markets will not react favorably to further increases in the degree of leverage used by the firm, and its cost of capital will rise. Thus, there is an optimum financial structure that minimizes cost of capital. In basic conceptual disagreement are the proponents of the "independence" hypothesis. Modigliani and Miller [5, 6, 7], in particular, argue that, given certain conditions (i.e., no taxes on corporate income and perfect capital markets), cost of capital is not influenced by a firm's financing mix. The favorable effect upon total market value of substituting nominally low-cost debt for high-cost equity in the firm's financial structure will be offset exactly by a decrease in the price that investors are willing to pay for the firm's common stock. A higher common equity yield is imposed by the market in return for being exposed to greater financial risk. Thus the cost of capital is independent of the financial structure of the firm, and financing decisions are of minimal importance. By strict interpretation, these two theories stand at opposite poles. The principal differences between them disappear, however, in a world where interest exp nse is tax deductible and market imperfections operate to restrict the amount of fixed-income obligations a firm can issue [9, pp. 39-41]. Both schools of thought do in fact subscribe to the optimum financial structure concept under conditions approximating the actual business environment. Accordingly, it is the objective of this article to present evidence on whether the importance of the financial structure of the firm has in practice been confirmed by corporate decision makers. It is hypothesized that, if the financing decision is critical with respect to the valuation of the firm, then decision makers in various industry groups have recognized this fact and developed financial structures suited to their particular business risk. The approach will be to show that an appropriate range of leverage exis s for a particular industry and that firms seek to find this range. In addition, it will be demons rated that inter-industry financial structure differences are persistent over time and are pervasive through ut the industries studied.

Evidence on the Association between Mergers and Capital Structure

Abstract: This article examines whether merger per se may be related to changes in the capital structure of the participating firms. The findings are consistent with the existence of merger-related incentives to increase financial leverage for a significant subset of merging firms. No evidence has been found that supports the latent debt capacity hypothesis. There is a strong relationship between merger accounting procedures (purchase vs. pooling) and relative increases in leverage accompanying mergers. This relationship reflects the potential for increased debt capacity and/or wealth shifting by the managements of acquiring firms. The terms of purchase of the acquired company were consistent with an immediate increase in leverage in the merging entities. Analysis of the year-by-year relative leverage positions of purchase merger firms indicates an immediate and persistent relative increase in financial leverage. Similar investigation of pooling accounting mergers detects no such systematic changes in leverage. Finally, analysis of the relationship between pre-merger cash flow correlation for merging firms and relative changes in leverage tend to support both the increased debt capacity theory and the coinsurance wealth transfer theory.