Showing papers on "Leverage (finance) published in 1997"

International Business Cycles and the ERM: Is There a European Business Cycle?

Abstract: This study uses a combination of quantitative and qualitative models to predict business failure with an appreciable degree of accuracy and/or precision. Quantitatively, the study used Factor Analysis (FA) to reduce the dimensionality of the data and further employed the Generalised Linear Modelling (GLM) technique which skips and/or relaxes the use of the normality assumption test that must be used by the General linear models. Qualitatively, the study adopted the most notable qualitative A- score model of Argenti (1976), which suggests that business failure process follows three predictable sequences: Defects, Mistakes made and Symptoms of failure. Among the three link functions (models) of GLM, the Logit model provides the highest overall accuracy rate with the lowest Akaike Information Criteria (AIC): 49.484. Regarding the 19 corporate determinants classified into 5 distinct categories, namely: Profitability and Employee Efficiency, Leverage and Liquidity, Asset utilization, Growth ability and Size, the significant variables that have appeared as a consistent indicator of financially distressed companies in the best model (logit) are Profitability ratio (Return on total assets) and Leverage ratio (Solvency, Gearing and Interest cover).In terms of the qualitative analysis, it was revealed that organizations that are prone and susceptible to corporate failure display high scores in defects usually in the range of 40 which is a high rate in the scale of 43 (highly unsatisfactory). As far as the three main mistakes are concerned (high gearing, overtrading and the big project) which failed companies exhibit, high gearing had a higher score of 15 which validates the findings in the quantitative analysis. Among symptoms of failure (Financial signs, Creative accounting, Non-financial signs – various signs include frozen management salaries, delayed capital expenditure, Terminal signs – at the end of the failure process, the financial and non-financial signs become so obvious and debilitating that even the casual observer recognises them), Financial signs holds sway posting a higher score of (16).

Transactions Costs and Capital Structure Choice: Evidence from Financially Distressed Firms

Abstract: This study provides evidence that transactions costs discourage debt reductions by financially distressed firms when they restructure their debt out of court. As a result, these firms remain highly leveraged and one-in-three subsequently experience financial distress. Transactions costs are significantly smaller, hence leverage falls by more and there is less recurrence of financial distress, when firms recontract in Chapter 11. Chapter 11 therefore gives financially distressed firms more flexibility to choose optimal capital structures. THIS STUDY INVESTIGATES the impact of transactions costs on leverage choices by financially distressed firms. The "transaction" that I examine is the reduction in corporate debt pursuant to a Chapter 11 bankruptcy reorganization or out of court restructuring. Analysis of sample firms shows that transactions costs are much higher when debt is restructured out of court. When firms recontract this way, financial distress can be chronic: less debt is extinguished, leverage remains higher, and relatively more firms have to go back to their creditors to restructure their debt again in the future. Transactions costs are much smaller, hence debt falls significantly more, when firms recontract in Chapter 11. Chapter 11 therefore gives financially distressed firms more flexibility to choose optimal capital structures. Transactions costs are central in the ongoing academic debate about whether firms have optimal leverage ratios. Those who believe in target

Income and wealth heterogeneity, portfolio choice, and equilibrium asset returns

Abstract: We derive asset-pricing and portfolio-choice implications of a dynamic incomplete-markets model in which consumers are heterogeneous in several respects: labor income, asset wealth, and preferences. In contrast to earlier papers, we insist on at least roughly matching the model's implications for heterogeneity — notably, the equilibrium distributions of income and wealth — with those in U.S. data. This approach seems natural: Models that rely critically on heterogeneity for explaining asset prices are not convincing unless the heterogeneity is quantitatively reasonable. We find that the class of models we consider here is very far from success in explaining the equity premium when parameters are restricted to produce reasonable equilibrium heterogeneity. We express the equity premium as a product of two factors: the standard deviation of the excess return and the market price of risk. The first factor, as expected, is much too low in the model. The size of the market price of risk depends crucially on the constraints on borrowing. If substantial borrowing is allowed, the market price of risk is about one one-hundredth of what it is in the data (and about 15% higher than in the representative-agent model). However, under the most severe borrowing constraints that we consider, the market price of risk is quite close to the observed value.

Islamic finance and ethical investment

Abstract: Reports that there are lessons which can be learned from the Western ethical “green” finance industry for Islamic investors. States that these are that the criteria for investment selection are different, and the modes of permissible financing may also differ, but there are screening and reporting techniques which are of potential importance to both groups of investors. First addresses ethical fund management issues, which should shed some light on the dilemmas facing Islamic investors. Goes on to consider criteria for haram and halal investment, as well as the implications of company capital gearing or leverage for riba. Covers investment specific issues, including the treatment of capital gains in Islam and the evaluation of the conduct of market participants. Finally, surveys emerging markets in the Islamic world, as these are of obvious interest to Muslim investors wishing to broaden their portfolios.

Ownership Differences and Firms' Income Smoothing Behavior

Abstract: This paper examines the association between differences in ownership structure and income smoothing behavior in firms. The underlying constructs affecting this association include agency relationships, managerial incentives, information asymmetry, and firm profitability. A logistic regression model is used to test the association between income smoothing and variables related to inside ownership, institutional holdings, leverage, managerial compensation, profitability, and firm size. The evidence suggests that ownership differences, managers' incentive structures, and firm profitability are important in explaining income smoothing behavior in firms. By separating inside ownership and levels of debt into different levels, we are able to show the existence of a non-monotonic relationship between ownership differences and firms' income smoothing behavior.

Explaining the cross-section of UK expected stock returns

Abstract: We examine the cross-section of expected returns for UK equities. For the period 1973–1992, we test for a relationship between expected returns and market value, book-to-market equity, leverage, earnings–price ratio, and beta. In simple regressions, we find average returns significantly positively related to β, book-to-market equity and market leverage, and significantly negatively related to market value and book leverage. However, when we include either market value or any accounting based variables along with β, the latter becomes insignificant. Either book-to-market equity or leverage variables also cause market value to become insignificant. We conclude that either book leverage and market leverage or book-to-market equity are the only consistently significant variables for average returns. However, the explanatory power of any combination of variables for average returns is low. We provide a complete analysis of the relation of average return to beta and market value for the period 1960–1992. This analysis confirms the results on β and market value for the shorter period.

Options on Leveraged Equity: Theory and Empirical Tests

Abstract: We develop an option pricing model for calls and puts written on leveraged equity in an economy with corporate taxes and bankruptcy costs. The model explains implied Black-Scholes volatility biases by relating them to the firm's structural characteristics such as leverage and debt covenants. We test the model by comparing predicted pricing biases with biases observed in a large cross-section of firms with liquid exchange traded option contracts. Our empirical study detects leverage related pricing biases. The magnitudes of these biases correspond to those predicted by our model. We also find significant pricing biases for firms financed primarily by shortterm debt. This supports our model because short-term debt introduces net-worth hurdles similar to net-worth covenants. THE DIRECT LINK BETWEEN financing decisions at the firm level and the pricing of derivative securities has, with few exceptions, been ignored in the theoretical and empirical option pricing literature. Most finance literature treats the pricing of securities in the firm's capital structure and the pricing of options on these securities as separate research areas. Securities in the capital structure are priced using an assumption about the value process of the firm's assets; hedging arguments are invoked and the firm's debt and equity are priced as contingent claims.' Most equity option pricing literature, on the other hand, uses an exogenously specified equity price process as the basis for an option pricing formula.2

Debt in Industry Equilibrium

Abstract: This article shows (1) how entry and exit of firms in a competitive industry affect the valuation of securities and optimal capital structure, and (2) how, given a trade-off between tax advantages and agency costs, a firm will optimally adjust its leverage level after it is set up. We derive simple pricing expressions for corporate debt in which the price elasticity of demand for industry output plays a crucial role. When a firm optimally adjusts its leverage over time, we show that total firm value comprises the value of discounted cash flows assuming fixed capital structure, plus a continuum of options for marginal increases in debt. Article published by Oxford University Press on behalf of the Society for Financial Studies in its journal, The Review of Financial Studies.

A History of Corporate Finance

Abstract: Jonathan Barron Baskin and Paul J. Miranti, A History of Corporate Finance (New York: Cambridge University Press, 1997, 350 pp., $29.95). This book is a study of the role of institutions and organizations in the historical development of corporate finance in Western Europe and North America. A major goal of this book is to "demonstrate the need for greater recognition of path dependence and historical evolution in the modern theory of finance" [p. 3]. In addition, a number of writers have argued that the study of economic and financial history can be useful in understanding contemporary developments [North, 1978; Braudel, 1982]. However, there are relatively few books on the history of corporate finance and, thus, this book is a particularly welcome addition. This book consists of a preface and an introduction, seven chapters organized into three parts, and an epilogue and two appendices. The introduction notes that business institutions represent constraints that "are, in effect, the rules of the game for pursuing opportunity...and their value lies largely in their ability to reduce uncertainty" [p.4]. It is also noted that "firms bolstered efficiency through financial innovation" [p. 5]. The introduction goes on to explain how finance contributed to business efficiency and growth. First, finance allowed firms the time and stable funding to exploit economies of scale and scope. Second, financial innovation often helped firms cope with and even take advantage of external economic shocks. Financial innovations also lowered perceived risks faced by investors and allowed better monitoring of managers. Finally, financial innovation also allowed better management of corporate resources and gave firms the ability to overcome market imperfections by internalizing high-cost market transactions. The rest of the introduction describes the development of the modern theories of asset pricing, agency costs, asymmetric information, and corporate debt policies. Curiously, in discussing the random behavior of market determined asset prices, this book cites the 1953 study by M.G. Kendall as the beginning of this recognition, ignoring the well-known and much earlier ( 19th century) work of Louis Bachelier and others (e.g., Bernstein, 1996). Part I consists of three chapters that review finance in the preindustrial world (actually just Europe). The two chapters in Part II cover the development of European finance during the era of industrialization. Part III traces the evolution of finance in Western Europe and North America into the modem era. Chapter one describes the development of finance in Italy in the late middle ages and the early Renaissance period. This chapter has some excellent descriptions of international banking and how business financial structures in Florence and Venice of the thirteenth and fourteenth centuries were used to diversify risk and leverage returns on equity. However, it has very little about business financial arrangements prior to that period. Chapter two covers the fifteenth through the eighteenth centuries and traces the rise, along with international trade, of the Joint Stock Companies, like the East India Company, as precursors to modern limited liability corporations. Chapter three covers the early development of public securities markets in England and western Europe in the eighteenth century. Part II consists of two chapters and covers the development of corporate finance in the age of industrialization (late eighteenth to the mid twentieth centuries). Chapter four covers the financing of canals and railroads especially in the United States and chapter five describes the rise of equity markets and managerial capitalism in the first half of the twentieth century. Part III also consists of two chapters and traces the evolution of corporate finance into the modern era. Chapter six focuses on the financing of large US companies in the post-war era until the oil shock of 1973, while chapter seven covers the rise of the conglomerate firm and the leveraged buy-out phenomenon in recent years. …

Differences between the financial characteristics of interest‐free banks and conventional banks

Abstract: Uses logit, probit and discriminant analysis to test for structural differences between the financial characteristics of interest‐free banks and conventional banks. The analysis extends to various financial dimensions which evaluate performance, namely: liquidity, leverage, credit risk, profitability and efficiency. Covers 15 interest‐free banks and 15 conventional banks. The statistical evidence suggests that the two groups of banks may be differentiated in terms of liquidity, leverage and credit risk, but not in terms of profitability and efficiency.

Habit persistence and asset returns in an exchange economy

Abstract: We examine asset prices and returns in the context of a pure exchange economy. Our purpose is to identify the key channels by which changes in preferences affect the equity premium and the risk-free rate and to develop intuition that is useful for understanding asset pricing in more complicated economies. Our analysis suggests that capital gains play a crucial role in generating empirically plausible mean equity premia.

The Effect of Limited Liability on the Market Response to Disclosure

Abstract: . We formalize the effects of an earnings disclosure on security prices under an assumption of limited liability. We derive various nonlinear relations between equity prices and earnings under a variety of capital structure assumptions and. if possible, we tie the relations attained to results from the existing empirical literature. We also characterize how debt prices respond to earnings when holders of debt have limited liability. Finally, we analyze how changes in the degree of leverage and conversion features of debt affect the relation between price and earnings.

The Effect of Limited Liability on the Market Response to Disclosure

Abstract: We formalize the effects of an earnings disclosure on security prices under an assumption of limited liability. We derive various non-linear relations between equity prices and earnings under a variety of capital structure assumptions and, if possible, tie the relations attained to results from the existing empirical literature. We also characterize how debt prices respond to earnings when holders of debt have limited liability. Finally, we analyze how changes in the degree of leverage and conversion features of debt affect the relation between price and earnings.

The Maturity Structure of Debt: Determinants and Effects on Firms' Performance? Evidence from the United Kingdom and Italy

Abstract: Firms tend to match assets with liabilities, and more profitable firms have more long-term debt. Long-term debt has a positive effect on firms' performance, but this is not true when a large fraction of that debt is subsidized. The authors empirically investigate the determinants and consequences of the maturity structure of debt, using data from a panel of UK and Italian firms. They find that in choosing a maturity structure for debt, firms tend to match assets and liabilities, as both conventional wisdom and some recent theoretical models suggest. They conclude that more profitable firms (as measured by the ratio of cash flow to capital) tend to have more long-term debt. This finding is consistent with the dominant role played by firms' fear of liquidation and loss of control associated with short-term debt. It may also reflect the willingness of financial markets to provide long-term finance only to quality firms. The data do not support the hypothesis that short-term debt, through better monitoring and control, boosts efficiency and growth -rather, the opposite can be concluded. In both countries, the data suggest a positive relationship between initial debt maturity and the firms' subsequent medium-term performance (i.e., profitability and growth in real sales). In both countries total factor productivity (TFP) depends positively on the length of debt maturity when the maturity variable is entered both contemporaneously and lagged. But in Italy the positive effect of the length of maturity on productivity is substantially reduced or even reversed when the proportion of subsidized credit increases. The authors document the relationship between firms' characteristics and their choice of shorter or long-term debt by estimating a maturity equation and interpreting the results in light of insights from theoretical literature, and by analyzing the effects of maturity on firms' later performance in terms of profitability, growth, and productivity; assess how TFP depends on the degree of leverage and the proportion of longer and shorter-term debt; and analyze the relationship between firms' debt maturity and investment. This paper - a product of the Finance and Private Sector Development Division, Policy Research Department - is part of a larger effort in the department to study the effects of financial structure on economic performance. The study was funded by the Bank's Research Support Budget under the research project Term Finance: Theory and Evidence (RPO 679-62).

Asset market hangovers and economic growth: the OECD during 1984-93

Abstract: Asses prices and investment were unusually weak throughout the industrial world during the early 1990s. This paper highlights this stylized fact, and connects it with another: in most of the industrial world, asset markets boomed for several years before collapsing around 1989. The paper suggests that asset market bubbles during the late 1980s may have left the industrial world with an 'asset market hangover' in the early 1990s, in the form of sluggish asset markets and investment. Empirical support for this hypothesis is provided based on cross-country data for equity and real estate markets in most industrial countries. We suggest that financial market developments not justified by fundamentals can substantially affect real activity.

The Structure of Corporate Finance in Belgium: An Empirical Investigation

Abstract: This paper studies the factors influencing the capital structure of Belgian corporate finance since 1984. Using three different datasets, aggregate balance sheets, aggregate flows of funds and a large panel of individual firms followed up during 10 years, we are able to give some empirical evidence for the importance of institutional features in the choice of corporate financing decisions. At the aggregate level, large firms are generally more highly levered; however, in the past ten years we observe a clear reduction in bank debt and a sharp increase in financial assets. Small firms on the other hand are less highly levered but have shifted toward greater long-term debt in recent years. Using flows of funds, we find that small firms have corporate financing decisions that remain roughly constant through time with a clear dominance of self-finance. In contrast we note for large firms an increased reliance on external sources of finance. Possible explanations of these patterns are investigated in our econometric study of panel data. We find that Belgian firms rely primarily on internal funds which seems to confirm the ''pecking order'' story of Myers and Majluf (1984). We also find that the emergence of coordination centers in the late 1980's explain much of the changing financial structure of large Belgian firms. These structures allow a higher leverage while they reduce the proportion of bank finance. Finally, control considerations are shown to explain the high level of financial assets on large firms' balance sheets.

Accounting Losses and Earnings Response Coefficients: The Impact of Leverage and Growth Opportunities

Abstract: This paper investigates how accounting losses affect the relationship between accounting earnings and stock returns, i.e. earnings response coefficients (ERCs), in different leverage and growth categories. In a sample of NYSE firms between 1975 and 1990, the exclusion of losses improves the ERCs considerably. While the impact of losses on ERCs is highest in the subgroup including high growth opportunity firms, the exclusion of losses does not improve ERCs as significantly among firms with low growth opportunities. The results further support the hypothesis that the impact of losses on ERCs is different in different financial leverage subgroups. The measured increase in ERCs is most significant among the least levered firms. The observation that the impact of losses on ERCs is related to growth opportunities and financial leverage is clearly observable also in different size categories. The effects of growth opportunities and financial leverage are also incrementally important with respect to each other. In general, the results indicate that the impact of growth opportunities and financial leverage on ERCs is clearly observable especially when losses and profits are analyzed separately.

Agency problems and risk taking at banks

Abstract: The moral hazard problem associated with deposit insurance generates the potential for excessive risk taking on the part of bank owners. The banking literature identifies franchise value--a firm's profit-generating potential--as one force mitigating that risk taking. We argue that in the presence of owner/manager agency problems, managerial risk aversion may also offset the excessive risk taking that stems from moral hazard. Empirical models of bank risk tend to focus either on the disciplinary role of franchise value or on owner/manager agency problems. We estimate a unified model and find that both franchise value and ownership structure affect risk at banks. More important, we identify an interesting interaction effect: The relationship between ownership structure and risk is significant only at low-franchise value banks--those where moral hazard problems are most severe and where conflicts between owner and manager risk preferences are therefore strongest. For these banks, insider holdings affect risk taking through asset risk, while ownership concentration affects risk taking through leverage. This is consistent with the idea that outside blockholders more readily control managerial risk-taking by influencing leverage than by influencing asset risk.

The Capital Structure of Listed Companies in Poland

Abstract: This paper examines the capital structure of listed firms in Poland, using firm-level panel data to study the determinants of leverage. Polish firms had extremely low leverage levels, suggesting a growing stock market and a potential reluctance of banks to grant loans to old and risky firms. The empirical exercise finds that large, new, foreign-owned firms, and firms with strong cash positions have higher levels of leverage. Finally, shareholder concentration has a neutral or even a beneficial influence on firm leverage. The nature of ownership may be primarily responsible for this finding.

The determinants of capital structure choice in the US restaurant industry.

Abstract: This paper presents an empirical analysis of an important element of capital structure of the restaurant industry which is represented by SIC code 58, eating and drinking places. The study focuses on explaining important characteristics affecting the capital structure of US restaurant firms. This is a cross-sectional analysis which assesses the role of size, earning volatility, profitability, growth opportunities, asset structure, non-debt tax shields, franchising, and leasing expense on various leverage ratios.

Leverage and House-Price Dynamics in U.S. Cities

Abstract: In this paper, we use city-level data to analyze the relationship between homeowner borrowing patterns and house-price dynamics. Our principal finding is that in cities where homeowners are more leveraged--i.e., have higher loan-to-value ratios--house prices react more sensitively to city-specific shocks, such as changes in per-capita income. This finding is consistent with recent theories which emphasize the role of collateralized borrowing in shaping the behavior of asset prices.

The Capital Structure of Listed Companies in Poland

Abstract: This paper examines the capital structure of listed firms in Poland, using firm-level panel data to study the determinants of leverage. Polish firms had extremely low leverage levels, suggesting a growing stock market and a potential reluctance of banks to grant loans to old and risky firms. The empirical exercise finds that large, new, foreign-owned firms, and firms with strong cash positions have higher levels of leverage. Finally, shareholder concentration has a neutral or even a beneficial influence on firm leverage. The nature of ownership may be primarily responsible for this finding.

Credit Risk in Corporate Securities and Derivatives Valuation and Optimal Capital Structure Choice

Abstract: This volume consists of four papers, which in principle could be read in any order. The common denominator is that they deal with contingent claims models of a firm's securities or related derivatives. A Framework for Valuing Corporate Securities Early applications of contingent claims analysis to the pricing of corporate liabilities tend to restrict themselves to situations where debt is perpetual or where financial distress can only occur at debt maturity. This paper relaxes these restrictions and provides an exposition of how most corporate liabilities can be valued as packages of two fundamental barrier contingent claims: a down-and-out call and a binary option. Furthermore, it is shown how the comparative statics of the resulting pricing formulae can be derived.A New Compound Option Pricing ModelThis paper extends the Geske (1979) compound option pricing model to the case where the security on which the option is written is a down-and-out call as opposed to a standard Black and Scholes call. Furthermore, we develop a general and flexible framework for valuing options on more complex packages of contingent claims - any claim that can be valued using the ideas in chapter 1. This allows us to study the interaction between the detailed characteristics of a firm's capital structure and the prices of for example stock options.Implementing Firm Value Based ModelsThis paper evaluates an implementation procedure for contingent claims models suggested by Duan (1994). Duan's idea is to use time series data of traded securities such as shares of common stock in order to estimate the dynamics of the firm's asset value. Furthermore, we provide an argument which allows us to relax the (common) assumption that the firm's assets may be continuously traded. It is sufficient to assume that the firm's assets are traded at one particular point in time.Asset Substitution, Debt Pricing, Optimal Leverage and MaturityChapters 1-3 have focused on the problem of pricing corporate securities.They have thus abstracted strategic aspects of corporate finance theory. This paper is an attempt to combine the contingent claims literature with the non-dynamic corporate finance literature. I allow the management of the firm to alter its investment policy strategically. This yields a model which allows us to examine the relationship between bond prices, agency costs, optimal leverage and maturity.

Options on Leveraged Equity: Theory and Empirical Tests

Abstract: We develop an option pricing model for calls and puts written on leveraged equity in an economy with corporate taxes and bankruptcy costs. The model explains implied Black-Scholes volatility biases by relating them to the firm's structural characteristics such as leverage and debt covenants. We test the model by comparing predicted pricing biases with biases observed in a large cross-section of firms with liquid exchange traded option contracts. Our empirical study detects leverage related pricing biases. The magnitudes of these biases correspond to those predicted by our model. We also find significant pricing biases for firms financed primarily by short-term debt. This supports our model because short-term debt introduces net-worth hurdles similar to net-worth covenants.

Population Growth and Asset Prices

Abstract: This paper explores the theoretical relationship between the population growth rate and asset prices implied by an overlapping-generations model. The model shows that changes in a population's age distribution affect asset prices but such changes generate low frequency movements in asset prices. The model also shows that the treatment of expectations matter; a small response of individuals to changes in asset prices has large implications for the path of asset prices. Finally, the model shows that incorporating a supply of assets by interpreting an asset as a claim on physical capital diminishes the magnitude of the relationship but does not change the sign or timing of the relationship between a population's age distribution and asset prices.

Small Firm Investment and Financing Decisions: An Option Value Approach

Abstract: This paper reviews and discusses recent developments undergone by investment theory, and tries to address both financial and real decisions within an uncertain environment, here, the Italian economy. According to the recent "option value" approach to investment, if differing degrees of reversibility characterize the accumulation process by groups of firms (small and larger firms), we should expect their investment decisions to differ under uncertainty. On the other hand, asset reversibility has an influence on firm financing policy, given the observed relationship between asset and liability composition. Assuming a different degree of investment reversibility for small and larger firms, we explore how they react to interest rate uncertainty using the Italian experience during the 1980s as a benchmark. The main result of this paper is that interest rate uncertainty exerts a negative influence on firms' investment demand. The relationship is stronger for large firms than for small firms. Another result is that firm leverage also shows a negative relationship with interest rate uncertainty.

Debt and Corporate Performance: Evidence from Unsuccessful Takeovers

Abstract: This paper examines how debt affects firms following failed takeovers Using a sample of 573 unsuccessful takeovers, we find that, on average, targets significantly increase their debt levels Targets that increase their debt levels more than the median amount reduce their levels of capital expenditures, sell off assets, reduce employment, increase focus and increase their operating cash flows These leverage-increasing targets also realize superior stock price performance over the five years following the failed takeover In contrast, those firms that increase their leverage the least show insignificant changes in their level of investment and their operating cash flows and realize stock price performance that is no different than their benchmarks Those failed targets that increase their leverage the least, and fail to get taken over in the future, realize significant negative stock returns following their initial failed takeovers The evidence is consistent with the hypothesis that debt helps firms remain independent not because it entrenches managers, but because it commits the manager to making the improvements that would be made by potential raiders