Showing papers on "Leverage (finance) published in 1986"

Estimating Hedge Ratios

Abstract: A company's financial performance often depends on the uncertain price of a commodity or financial instrument. For example, a lumber distributor might enter into a fixed-price contract for a particular variety of lumber; or a cable manufacturer might have a short position in copper; or a firm might have debt whose interest rate is linked to the prime rate. Although modem theories of valuation lead some people to conclude that non-market risk (unsystematic risk) need not be hedged, elimination of all non-essential risk is indeed a desirable goal, so long as it can be achieved at reasonable cost. Companies have good reason to be concerned about the total risk that they face. Total risk causes concern among those whose relationships with the firm are not diversified, such as employees, customers, and suppliers. In addition, reducing operating risks permits a company to accept greater financial risk through leverage, which brings with it the tax advantages of debt. (For a fuller discussion, see Adler and Dumas [1], Shapiro and Titman [14], Doherty [4], and Dufey and Srinivasulu [5].) Quite often, hedging is not just a simple matter of "locking in" a price or a rate, since the relevant commodity might not be traded in a futures market (for example, there are no futures in the prime interest rate); even when it is, there may still be differences between the nature of the firm's exposure and the futures contract (the firm may need to deliver in June, but there is no June contract). In circumstances like these, a question arises as to whether the futures contracts that are traded can help to minimize the overall risk faced. Note that we do not need to restrict the hedging possibilities to a futures position that exactly matches the unit size of the exposure. For example, it is clear that other things being equal, the more volatile the firm's exposure, the larger its futures position should be. The size of the risk-minimizing position in the traded commodity in relation to the position that would have been taken had the desired commodity been traded is known as the "hedge ratio," and the position is k own as a "cross-hedge" (see Working [17] and Anerson and Danthine [2]). The appropriate hedge ratio can be determined accurately if the joint probability distribution for all the relevant random variables is known, for then it is simply a problem of mathematics, but the usual practical

The economics of loan commitment contracts: Credit pricing and utilization

Abstract: Our purpose is to examine the circumstances under which enduring customer relationships (such as revolving credit agreements) will become predominant. We compare loan commitment contracts, under which borrowers may take down funds at fixed marginal mark up, to spot lending, under which funds are priced in consideration of customers' leverage. Under the first arrangement, insurance against default risk is priced as a fixed front-end fee. Under the second arrangement, it is priced under a rising leverage-specific markup schedule. We show that when default risk is independent of take down, the loan commitment contract will always dominate spot loans. When default risk increases with credit use, spot loans may become dominant.

The Investment in Housing As a Forward Market Transaction: Implications for Tenure Choice and Portfolio Selection

Abstract: A model of tenure choice is presented which treats the benefits and costs of homeownership from a theory of finance perspective. The incremental benefits from homeownership over renting housing services are from two sources: protection against rental price risk (a forward transaction in the housing market) and from a possible capital gain from the eventual sale of a house (substitutes for portfolio investment). The cost of these benefits is higher initial outlay on housing, which reduces the funds available for portfolio investments. The comparative statics of this model is presented. It is shown that rental risk and portfolio risk add to the value of homeownership. Since homeownership is a partial substitute for portfolio investment, it is shown that the lower the covariance between portfolio returns and future home prices the more valuable is homeownership. In the presence of differential borrowing opportunities it is shown that the leverage available to housing significantly increases the value of homeownership.

Optimal corporate debt financing and real investment decisions under controlled banking systems

Abstract: This paper develops an integrated approach towards the problem of optimal corporate real investment and finance in the context of a financial model of a developing economy characterized by a controlled banking sector and a functioning equity market. These characteristics are typical of the financial market structure of most new industrialized developing countries including, for example, Argentina, Brazil, Chile, Korea and Mexico. In most of these countries, corporations rely heavily on bank borrowing to finance their long-term investment expenditures, and as a result their debt-equity ratio is, in comparison with developed economies, very high. The implications of this high corporate leverage for the conduct of credit and monetary policy have not yet been fully appreciated.

The Asset Devaluation Problem

Abstract: Virtually every economic situation in agriculture has an unmatched pair of implications that may be called the proximate and the ultimate. Devaluation of the fixed assets of agriculture has a meaning of enormous significance in the here-and-now — the proximate. It bears not so much on impersonal gross measures of productivity and output but on the human element. Loss of farm asset values is a major blow to the hopes and aspirations of hundreds of thousands of farmers, bringing intense emotional distress and even suicides.

Taxation and the Firm's Leverage Decision: A Survey of Theoretical Issues

Abstract: This survey outlines various models used to analyze the impact of taxation on the firm's leverage decision. The models incorporate: i) differential taxation of household from a progressive tax system; ii) loss offsetting under the corporate tax; iii) managerial incentive to avoid moral hazard; iv) bankruptcy; and v) asymmetric information between inside and outside investors. The theory is applied to the Canadian tax system.

New Developments in Corporate Finance and Tax Avoidance: Some Evidence

Abstract: The financial behavior of corporations has changed greatly in the last ten years. Previously most of the cash that stockholders received from corporations took the form of dividends, and economists' models that have dividends as the ultimate determinant of equity values were not far off the mark. This paper documents how much things have changed. There are strong tax incentives for nondividend cash payments between corporations and shareholders. These payments can take the form of a repurchase by the company of its own shares, or the acquisition of the shares in another company. There has been tremendous growth in the magnitude of nondividend cash payments. In the early 1970s these payments amounted to roughly 15 percent of dividends. By 1984, they exceeded dividends, and in 1985 the amounted to $120 billion, or almost 50 percent more than total dividends in the economy. The paper shows that dividends per unit equity have not fallen. Rather, the acquisition of equity has allowed firms to retain relatively constant debt equity ratios in the past five years despite strong equity markets. Firms have chosen to absorb equity and issue debt, roughly holding leverage constant, and have thus saved large amounts of taxes. The paper estimates that the cost to the Treasury of treating share purchase payments differently than dividends was more than $25 billion in 1985. It also finds that future corporate tax collections are significantly reduced by the resulting decline in corporate equity. The paper suggests that the existing model of dividend driven equity valuation must be discarded. It simply is not consistent with the facts. Further research on the form of payments between firms and their shareholders is clearly merited.

Leverage: The Key to Multiplying Money

Abstract: Risk Real Estate I: Mortgages Real Estate II: Operating Income and Tax Shelters The Stock Market The Bond Market Financial Futures Options I: Stocks Options II: Alternative Instruments Warrants Gold Foreign Exchange Index.

Profitability in Swedish private rental housing

Abstract: This article is divided into four parts. The first part presents an overview of private rental housing in Sweden with special attention given to property management practices in small as well as large property holdings. The second part includes theoretical considerations of the following topics: building life cycle, inflation effects, and leverage effects. In the third part empirical applications of the theoretical considerations are‐presented in the form of the following four return and profitability measures: net operating income, cash flow before taxes, rate of return on total capital, and rate of return on equity capital.

A note on insurance leverage under skew distributions

Abstract: Insurance leverage denotes the impact of the insurance specific reserves on the return on equity of the insurance company. We analyze insurance leverage on the basis of a stochastic one-period model of the insurance business, especially accounting for the skewness of the involved distributions.

Aspects of Life-Cycle Costs of an Asset

Abstract: Simple simulation is used to demonstrate that: deterministic methods may lead to our recovering less than the cost of a capital asset; our attempting to use an asset to the full extent of its apparent availability will cause late product delivery; any spares holding or replacement policy will be variable in its outcome and cost may not be very sensitive to the policy.