Showing papers on "Leverage (finance) published in 1984"

A Further Empirical Investigation of the Bankruptcy Cost Question

Abstract: In this paper, empirical evidence with respect to both the direct and indirect costs of bankruptcy is assessed. This should be of interest for three related reasons. First, there is a need to provide further evidence as to the size of bankruptcy costs. Second, for the first time a proxy methodology for measuring indirect costs of bankruptcy is presented and actually measured. Third, a simple format for measuring the present value of expected bankruptcy costs is compared with the present value of expected tax benefits from interest payments on leverage. This comparison has important implications for the continuing debate as to whether or not an optimum capital structure exists for corporations. THIS PAPER PRESENTS an empirical investigation of the costs of bankruptcy. The relevance of bankruptcy costs remains as one of the major unresolved issues of financial theory. Empirical evidence, especially as to the amount of the expected bankruptcy costs and its consequent impact on optimum corporate capital structure is extremely sparse. If bankruptcy costs are relatively significant then it may be argued that at some point the expected value of these costs outweighs the tax benefit derived from increasing leverage and the firm will have reached its optimum capital structure point. An alternative view is that bankruptcy costs are relatively trivial and probably cannot explain capital structure decisions. At the extreme, one might argue that these costs are not even relevant to the cost of capital and capital structure decision and therefore should not be considered seriously. This study assumes that the expected bankruptcy cost issue is relevant and that firms do recognize the probability of bankruptcy as an important ingredient when making operating and financial decisions. A simple model is presented for identifying and measuring the expected bankruptcy costs and, then, for a sample of retail and industrial firm failures in the U.S., the following items are investigated: (1) direct bankruptcy costs including legal, accounting, filing and other administrative costs; (2) indirect bankruptcy costs, namely the lost profits that a firm can be expected to suffer due to significant bankruptcy potential; and (3)

How Big is the Tax Advantage to Debt

Abstract: This paper uses an option valuation model of the firm to answer the question, "What magnitude tax advantage to debt is consistent with the range of observed corporate debt ratios?" We incorporate into the model differential personal tax rates on capital gains and ordinary income. We conclude that variations in the magnitude of bankruptcy costs across firms can not by itself account for the simultaneous existence of levered and unlevered firms. When it is possible for the value of the underlying assets to jump discretely to zero, differences across firms in the probability of this jump can account for the simultaneous existence of levered and unlevered firms. Moreover, if the tax, advantage to debt is small, the annual rate of return advantage offered by optimal leverage may be so small as to make the firm indifferent about debt policy over a wide range of debt-to-firm value ratios. THE OBSERVED RANGE OF debt-to-firm-value ratios in the U.S. economy is, roughly speaking, from zero to 60 percent. Traditional explanatory models of capital structure have focused on the tradeoff between the tax shield and bankruptcy costs arising from the use of debt finance [2, 9, 10, 18, 19]. Other

Accounting ratios to locate take‐over targets

Abstract: This paper uses both the univariate and multivariate techniques to discover whether liquidity, leverage, payout, activity, and profitability ratios can distinguish non-taken-over, domestic taken-over and foreign taken-over firms in Canada. The results indicate that the three categories of firms emanate from the same population, and the article concludes that even if a connection between historical accounting information and the firm's expected cash flows were to be hypothesized, the semi-strong efficient capital market would ensure that accounting information would be impounded in the prices of securities of target firms.

Debt Policy and the Rate of Return Premium to Leverage

Abstract: Equilibrium in the market for real assets requires that the price of those assets be bid up to reflect the tax shields they can offer to levered firms.Thus there must be an equality between the market values of real assets and the values of optimally levered firms. The standard measure of the advantage to leverage compares the values of levered and unlevered assets, and can be misleading and difficult to interpret. We show that a meaningful measure of the advantage to debt is the extra rate of return, net of a market premium for bankruptcy risk, earned by a levered firm relative to an otherwise-identical unlevered firm. We construct an option valuation model to calculate such a measure and present extensive simulation results. We use this model to compute optimal debt maturities, show how this approach can be used for capital budgeting, and discuss its implications for the comparison of bankruptcy costs versus tax shields.

How Big is the Tax Advantage to Debt

Abstract: This paper uses an option valuation model of the firm to answer the question, "What magnitude tax advantage to debt is consistent with the range of observed corporate debt ratios?" We incorporate into the model differential personal tax rates on capital gains and ordinary income. We conclude that variations in the magnitude of bankruptcy costs across firms can not by itself account for the simultaneous existence of levered and unlevered firms. When it is possible for the value of the underlying assets to junip discretely to zero, differences across firms in the probability of this jump can account for the simultaneous existence of levered and unlevered firms. Moreover, if the tax advantage to debt is small, the annual rate of return advantage offered by optimal leverage may be so small as to make the firm indifferent about debt policy over a wide range of debt-to-firm value ratios.

How Big is the Tax Advantage to Debt

Abstract: This paper uses an option valuation model of the firm to answer the question, "What magnitude tax advantage to debt is consistent with the range of observed corporate debt ratios?" We incorporate into the model differential personal tax rates on capital gains and ordinary income We conclude that variations in the magnitude of bankruptcy costs across firms can not by itself account for the simultaneous existence of levered and unlevered firms When it is possible for the value of the underlying assets to junip discretely to zero, differences across firms in the probability of this jump can account for the simultaneous existence of levered and unlevered firms Moreover, if the tax advantage to debt is small, the annual rate of return advantage offered by optimal leverage may be so small as to make the firm indifferent about debt policy over a wide range of debt-to-firm value ratios

Portfolio performance in relation to quality, earnings, dividends, firm size, leverage, and return on equity

Abstract: This paper examines the risk-return performance of portfolios formed from S&P quality rankings over the time period 1970–1979. In addition, the risk-return characteristics of the portfolios are compared with performance as measured by fundamental data regarding earnings, dividends, firm size, leverage, and return on equity. The results suggest that the S&P quality rankings are closely correlated to risk as measured by the variability of returns and earnings changes, but the rankings are not correlated with the variability of dividend changes. The quality rankings are not uniformly correlated with mean portfolio returns or mean dividend changes, nor is the relationship between quality and mean earnings changes strong. Finally, quality rankings are related to firm size and return on equity. However, relationships between quality and leverage are discernible only at the extremes.

The application of the Modigliani-Miller theorem to Japanese industry

Abstract: The purpose of this thesis is to study some aspects of Japanese corporate finance, using the analytical tools of the Modigliani-Miller theorem The Modigliani Miller theorem is a fundamental element in the theory of finance, and establishes the conditions under which the financial structure of the firm is irrelevant to the determination of real corporate values In its simplest form the theorem requires the presence of perfect capital markets In the real world,- however, in which perfect capital markets dont exist the validity of the theorem depends upon a number of additional restrictions which can be viewed as special case extensions of the general form One set of sufficient conditions ensuring the validity of the theorem, is obtained by imposing the assumption of riskless debt Large groups of major Japanese corporations can be characterized as operating virtually free of bankruptcy risk The thesis attributes this to the Japanese system of values underlying economic relationships, to the system of corporate groupings (known as keiretsu), and to the strategic objectives of industrial policy which provide industry with a safety-net It argues that the popular belief that Japanese industry is subject to excessive risk exposure because of its high degree of leverage is misleading The belief arises from data based on accounting conventions which distort the true position of firms own wealth The thesis undertakes an empirical study of the validity of the MM theorem Although the focus of the analysis is on the period 1978-80, the study is run on a second and very different time period, 1970-72 The major finding for the most recent period is that debt, after adjustment for tax advantages, makes no significant contribution to the valuation of companies in keiretsu groups Interestingly, however, in the earlier period debt is found to make a positive and significant contribution to valuation

The U.S.--U.S.S.R. grain agreement

Abstract: 1. Introduction 2. U.S. - Soviet grain trade before 1974 3. The 1974 experience 4. The Russians return 5. First steps 6. A strategy emerges 7. Agreement to seek a long-term arrangement 8. Refining the details 9. Ebbing leverage: the waiting game 10. Evaluations 11. Reflections Epilogue.

Japanese management and labor relations in US subsidiaries

Abstract: Here the author surveys Japanese executives and American workers in Japanese subsidiaries in the US. American employees welcome Japanese labor practices which increase employment stability, cash wages and individual leverage, but oppose those requiring collective behaviour and loyalty to the firm.

Leverage and the value of a firm under a progressive income tax

Abstract: Gordon develops a model where he concludes that “the equilibrium value of a firm is a convex function of its leverage rate and … the optimal (value maximizing) policy for all firms is the maximum possible leverage rate’ Using Gordon's model, we show below that Gordon's conclusions are incorrect We develop a correct version of the Gordon model where the firm's value is invariant to the debt-equity ratio

Debt Policy and the Rate of Return Premium to Leverage

Abstract: Equilibrium in the market for real assets requires that the price of those assets be bid up to reflect the tax shields they can offer to levered firms.Thus there must be an equality between the market values of real assets and the values of optimally levered firms. The standard measure of the advantage to leverage compares the values of levered and unlevered assets, and can be misleading and difficult to interpret. We show that a meaningful measure of the advantage to debt is the extra rate of return, net of a market premium for bankruptcy risk, earned by a levered firm relative to an otherwise-identical unlevered firm. We construct an option valuation model to calculate such a measure and present extensive simulation results. We use this model to compute optimal debt maturities, show how this approach can be used for capital budgeting, and discuss its implications for the comparison of bankruptcy costs versus tax shields.

Leverage and the value of a firm under a progressive personal income tax Reply

Abstract: In his ‘Debt and Taxes’ Miller argued that the value of a firm is independent of its leverage rate and each firm's leverage rate is therefore indeterminate. My paper showed that under the Miller assumptions the value of a firm is a convex function of its leverage rate, and all value-maximizing firms would be at the maximum leverge rate. The Jaffe and Westerfield extension of my analysis established the conditions under which some firms would be at a zero leverage rate. Their analysis does not lead to their statement that ‘the firm's value is invariant to the debt-equity ratio’.

The Taxation of Risky Investments: An Asset Pricing Approach

Abstract: Some economists have argued that offsetting effects on risk and return may make capital income taxes nondistorting. This paper performs three tasks. First, the conditions under which the argument is true are studied in an asset pricing model that unlike earlier models allows the timing of depreciation deductions to vary and incorporates the effectiveness and distribution of government expenditures. One result is that it is plausible that the nondistortion result holds regardless of that timing or of the distribution and effectiveness of expenditures if the pre-tax riskless rate is zero. A second task concerns the cases where the pre-tax riskless rate is not negligible and the nondistortion result does not hold. Then the degree and pattern of distortion depends on the general equilibrium impact of taxes and expenditures on average risk aversion and on the pre-tax riskless rate. An interesting result emerges concerning the impact of the timing of depreciation allowances. When average risk aversion stays constant, the conventionally expected effect that faster write-offs result in more investment will occur if and only if the pre-tax riskless rate falls when timing is accelerated. This is true because in the absence of any change in the pre-tax riskless rate, changes in depreciation timing cause changes in risk and expected return that exactly off set each other. Finally, the paper shows that the failure to add a premium for "capital risk" to the standard economic depreciation allowance based on expected decline in asset value does not change that result unless the income tax system has the pathology of allowing used asset sales to be tax free. The current U.S. tax system seems to be free of that pathology.