Showing papers on "Leverage (finance) published in 1998"

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.

Is the Risk of Bankruptcy a Systematic Risk

Abstract: Several studies suggest that a firm distress risk factor could be behind the size and the book-to-market effects. A natural proxy for firm distress is bankruptcy risk. If bankruptcy risk is systematic, one would expect a positive association between bankruptcy risk and subsequent realized returns. However, resullts demonstrate that bankruptcy risk is not rewarded by higher returns. Thus, a distress factor is unlikely to account for the size and book-to-market effects. Surprisingly, firms with high bankruptcy risk earn lower than average returns since 1980. A risk-based explanation cannot fully explain the anomalous evidence. SEVERAL STUDIES SUGGEST that the effects of firm size and book-to-market, probably the two most powerful predictors of stock returns, could be related to some sort of a firm distress risk factor. For example, Chan and Chen (1991) find that "marginal" firms, or inefficient firms with high leverage and cash flow problems, seem to drive the small firm effect. Fama and French (1992) conjecture that the book-to-market effect might be due to the risk of distress. Chan, Chen, and Hsieh (1985) show that much of the size effect is explained by a default factor, computed as the difference between high-grade and low-grade bond returns. Fama and French (1993) and Chen, Roll, and Ross (1986) find that a similarly defined default factor is significant in explaining stock returns. This study investigates the importance of the firm distress risk factor and its relation to size and book-to-market effects. Probability of bankruptcy is a natural proxy for firm distress, and there is a well-developed literature on bankruptcy prediction that provides powerful measures of ex ante bankruptcy risk (see Altman (1993) for a review). Evidence that bankruptcy risk is systematic would support a distress factor explanation for the size and the book-to-market effects. Existing evidence on the relation of bankruptcy risk to systematic risk is mostly circumstantial and often contradictory. Lang and Stulz (1992) and Denis and Denis (1995) demonstrate that bankruptcy risk is related to aggregate factors, which implies that bankruptcy risk could be positively related

The Financial and Operating Performance of Newly Privatized Firms: Evidence from Developing Countries

Abstract: This paper examines the change in the financial and operating performance of 79 companies from 21 developing countries that experienced full or partial privatization during the period from 1980 to 1992. We use accounting performance measures adjusted for market effects in addition to unadjusted accounting performance measures. Both unadjusted and market-adjusted results show significant increases in profitability, operating efficiency, capital investment spending, output, employment level, and dividends. We also find a decline in leverage following privatization but this change is significant only for unadjusted leverage ratios. Our results are generally robust when we partition our data into various subsamples.

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

An Analysis of Corporate Donations: United Kingdom Evidence

Abstract: Drawing a framework from stakeholder theory, this study uses 1994 data drawn from 100 United Kingdom listed companies to test empirically whether the level of discretionary donations made by companies to charitable, social and political causes is related to four company-specific factors, namely leverage, company size, profitability and ownership structure Consistent with our hypotheses, the results indicate that the decision to contribute funds to charities and other bodies is positively related to company size and profitability and negatively related to leverage However, the study provides no support for the view that there is a link between discretionary donations and a company's ownership structure

The Debt-Equity Choice

Abstract: This paper compares U.S. firms that issued or repurchased significant amounts of equity between 1978 and 1993 to those that issued or repurchased debt. We find that firms are most likely to increase debt and repurchase equity when they have less debt than is predicted by a cross-sectional leverage regression. In addition, the likelihood of issuing debt rises with the firms' past profitability. Our results confirm previous findings that firms are most likely to issue equity after experiencing a share price increase. In contrast to our other findings, this last result appears to be inconsistent with the hypothesis that firms make choices that move them towards a target debt ratio. The paper concludes by exploring a variety of explanations for the positive relation between share price runups and equity issuance.

Hedging, Leverage, and Primitive Risk

Abstract: Only in the last decade have nonfinancial firms begun to develop effective procedures for hedging the increased volatility of exchange rates, interest rates, and commodity prices. We report the first empirical evidence on hedging, leverage, and other firm characteristics from the 1990s, subsequent to the rapid growth of hedging. We unravel a previous puzzle in corporate finance, showing a significant positive relationship between hedging and leverage when we control for primitive risk exposures. Hedging and leverage policies are interrelated because both affect expected costs of financial distress and agency costs. We construct a direct measure of the expected costs of financial distress and find some evidence that hedging mitigates the effects of leverage.

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".

Equity Carve-Outs and Managerial Discretion

Abstract: This study proposes a managerial discretion hypothesis of equity carve-outs in which managers value control over assets and are reluctant to carve out subsidiaries. Thus, managers undertake carve-outs only when the firm is capital constrained. Consistent with this hypothesis, firms that carve out subsidiaries exhibit poor operating performance and high leverage prior to carve-outs. Also consistent with this hypothesis, in carve-outs wherein funds raised are used to pay down debt, the average excess stock return of +6.63 percent is significantly greater than the average excess stock return of -0.01 percent for carve-outs wherein funds are retained for investment purposes. IN THIS STUDY, WE INVESTIGATE the financial and operating performance of firms that undertake equity carve-outs and analyze the cross section of excess stock returns around the announcement of these transactions. In an equity carve-out, a firm offers to sell shares in a wholly owned subsidiary to the public. As such, a carve-out can be viewed as the sale of an asset or as an equity offering. Schipper and Smith (1986) focus on carve-outs as equity offerings and compare the announcement period stock returns of carve-outs with those of seasoned equity offerings. In this study, we view the carve-out as the sale of an asset which is intended to raise funds to finance other activities of the parent or the subsidiary. In viewing equity carve-outs as asset sales, we borrow -from the work of Lang, Poulsen, and Stulz (1995) who propose and test a "financing hypothesis" to explain the cross section of excess stock returns around announcements of asset sales. The characterization of an equity carve-out as a sale of assets must be tempered by the fact that certain features distinguish carveouts from outright asset sales. Equity carve-outs are asset sales to public shareholders as opposed to a single buyer, carve-outs are undertaken explicitly for the purpose of raising funds in the capital market, and the parent firm typically continues to hold a substantial fraction of the equity of the carved out subsidiary following the offering. Equity carve-outs are similar to asset sales in that funds raised in the offering can be either retained within

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.

Comprehensiveness of disclosure of non‐financial companies: listed on the amman financial market

Abstract: After the ratification of the peace treaty and the establishment of diplomatic relations with Israel, Jordan was expected to play a major role in the Middle East financial market. As a result of the peace treaty Jordan may attract overseas investors to invest in the Amman Financial Market (AFM). Consequently, the level of information disclosed by companies listed on the AFM will become an important issue for prospective investors. This study empirically examined the effect of specific financial characteristics on the comprehensiveness of disclosure in the annual reports of a sample of 54 companies listed on the AFM. The variables tested in this study were market related: industry, audit firm size and market capitalisation; performance related: profit margin, return on equity and liquidity, and structure related: assets, sales, leverage and ownership. The empirical evidence revealed that company size (measured by assets and market capitalisation), leverage and return on equity were statistically related to the comprehensiveness of disclosure of the sample companies listed on the AFM. Reporting improved after international standards were adopted. Large companies were more involved in long term borrowing which requires detailed reporting. Size was the main predictor in comprehensive reporting.

Leverage and Market Stability: The Role of Margin Rules and Price Limits

Abstract: The authors show that, when some investors hold levered portfolios by engaging in margin borrowing, repeated rounds of trading can result in market instability--in the sense that prices can move rationally--even in the absence of any change in fundamentals. They show this with a simple model in which all agents are rational and symmetrically informed. The authors discuss welfare implications of price stability and explore the effects of market composition and market trading rules on the stability of the market. A major result of this article is that price limits might enhance market stability by excluding potentially destabilizing market prices. Copyright 1998 by University of Chicago Press.

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 Determinants of the Leasing Decision of Small and Large Companies

Abstract: We analyse the leasing decision of more than 3000 UK quoted and unquoted companies over the sample period 1982–1996. We show that, for the sample as a whole, companies that use leasing are more likely to have tax losses, high fixed capital investment, high debt-to-equity ratio and to be larger than companies that do not use leasing. We show, however, that the determinants of leasing are not homogeneous across firms of different size. For large companies, leasing, profitability, leverage and taxation are positively correlated. In contrast, for small companies, the leasing decision is not driven by taxation or by profitability, but by growth opportunities. We show that small firms with high Tobin's q and those that are less profitable are more likely to use leasing.

"Overreaction" of Asset Prices in General Equilibrium

Abstract: We attempt to explain the overreaction of asset prices to movements in short-term interest rates, dividends, and asset supplies The key element of our explanation is a margin constraint that traders face which limits their leverage to a fraction of the value of their assets Traders may lever themselves, further, either directly by borrowing short term or indirectly by engaging in futures and option trading, so that the scenario is relevant to contemporary financial markets

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.

Population Age Structure and Asset Returns: an Empirical Investigation

Abstract: This paper investigates the association between population age structure, particularly the share of the population in the saving years is motivated by the claim that the aging of the in the United States is a key factor in explaining the recent rise in asset values. It also addresses the associated claim that asset prices will decline when this large cohort reaches retirement age and begins to reduce its asset holdings. This paper begins by considering household age-asset accumulation profiles. Data from the Survey of Consumer Finances suggest that while cross-sectional age-wealth profiles peak for households in their early 60s, cohort data on the asset ownership of the same households show a much less pronounced peak. Wealthy households with substantial asset holdings appear to decumulate slowly, if at all, after retirement. This casts doubt on the (excluding defined benefit pension assets) that households control directly. The paper then considers the historical relationship between demographic structure and real returns on Treasury bills, long-term government bonds, and corporate stock. The results do not suggest any robust relationship between demographic structure and asset returns. This is partly due to the limited power of statistical tests based on the few structure and asset returns in the United States and other developed economies. The paper concludes by discussing factors such as international capital flows and forward-looking behavior on the part of market participants that could weaken the relationship between age structure and asset returns in a single nation.

State-Owned and Privately-Owned Firms: An Empirical Analysis of Profitability, Leverage, and Labor Intensity

Abstract: We present empirical evidence on the relative profitability, leverage, and labor intensity of government-owned and privately-owned firms. Cross-sectional analysis of a sample of very large firms indicates that those owned by governments are significantly less profitable than those held privately. They are also more highly leveraged and more labor intensive. We conduct a time series analysis of privatized firms and find little evidence that privatization enhances profitability. In our sample profitability improves immediately before privatization. The evidence on subsequent improvement is mixed. Some measures of profitability are significantly less after privatization than just beforehand. The evidence suggests that governments efficiently restructure at least some firms before selling them, but that the actual change of ownership does not give rise to further efficiency gains subsequently.

Delivering on the Promise: How to Attract, Manage and Retain Human Capital

Abstract: Over the past couple of decades, management styles have evolved from strategic planning to total quality management to reengineering. Now in the newest and most cost effective trend to hit the boardrooms, there is a concentrated effort to view employment not as a perishible resource to be consumed but as a valuable commodity to be developed. While research shows that investments in capital result in higher returns to shareholders, the question is how should these investments be made, and how can returns on these investments be measured? DELIVERING ON THE PROMISE reveals Arthur Andersen's proprietry, technically based methodology - called The Five Square Approach - that will enable any manager to measure, manage and leverage human capital. Drawing on case-studies and research, this book is for any business manager who wants to evaluate and improve the current worth of their company's human resources.

Determinants of the leasing decision in United Kingdom listed companies

Abstract: The study tests empirically whether the leasing decision of United Kingdom companies is determined by four company-specific characteristics. The findings suggest that there is a positive relationship between the propensity to lease and both leverage and ownership structure. The study offers only limited support for the view that the propensity to lease is likely to fall as company size increases, and provides no support for the hypothesis that companies with more growth options in their investment opportunity sets will be more likely to lease than companies with more assets-in-place.

The long-run performance of convertible debt issuers

Abstract: We examine the long-run operating and stock price performance of 828 convertible debt issuers. Relative to matched, nonissuing firms, convertible debt issuers have small improvements in operating performance before the offer and significant declines in operating performance from pre- to post-issue. We examine the relation between several factors and operating performance. We find that for some pre- to post-issue periods, operating performance changes are positively related to firm leverage and the callability of the bond, and negatively related to performance run-up before the offer and investment in new assets. We also find some evidence that firms that issued equity in the three years before their convertible debt issue have larger declines in performance after the offer. Relative to matched, nonissuing firms, convertible debt issuers have superior stock price performance before the offer and significantly poor performance after the issue.

How Firm Characteristics Affect Capital Structure: An International Comparison

Abstract: In this empirical study I examine the factors correlated with capital structure in the United States, Japan, United Kingdom, France, and Germany. Although both mean leverage and many firm factors appear to be similar across countries, some significant differences remain. Specifically, differences appear in the correlation between long-term debt/asset ratios and the firms' riskiness, profitability, size, and growth. These correlations may be explained by differences in tax policies and agency problems, including differences in bankruptcy costs, information asymmetries, and shareholder/creditor conflicts. The findings of this study suggest links between varying choices in capital structure across countries and legal and institutional differences.

Dividend Policy and Cash Flow Uncertainty

Abstract: We explore the role of expected cash flow volatility as a determinant of dividend policy both theoretically and empirically. Our simple one period model demonstrates that, given the existence of a stock-price penalty associated with dividend cuts, managers rationally pay out lower levels of dividends when future cash flows are less certain. The empirical results use a sample of REITS from 1985-1992 and confirm that payout ratios are lower for firms with higher expected cash flow volatility as measured by leverage, size and property level diversification. These results are consistent with information-based explanations of dividend policy but not with agency cost theories.

The Global Asset Management Industry: Competitive Structure, Conduct and Performance

Abstract: The asset management industry represents one of the most dynamic parts of the global financial services sector. Funds under institutional management are massive and growing rapidly, particularly as part of the resolution of pension pressures in various parts of the world. The industry is not, however, well understood from the perspective if industrial organization and international competition, which is the focus of this paper. It begins with a schematic of asset management in a national and global flow-of-funds context, identifying the types of asset-management functions that are preformed and how they are linked into the financial system. It then assesses in some detail the three principal sectors of the asset management industry mutual funds, pension funds, and private-client assets, as well as foundations, endowments, central bank reserves and other large financial pools requiring institutional asset management services. Relevant comparisons are drawn between the United States, Europe, Japan and selected emerging-market countries. This is followed by a discussion of the competitive structure, conduct and performance of the asset management industry, and its impact on global capital markets.

Do LBO Supermarkets Charge More? An Empirical Analysis of the Effects of LBOs on Supermarket Pricing

Abstract: This paper examines changes in supermarket prices in local markets following supermarket leveraged buyouts (LBOs). I find that prices rise following LBOs in local markets in which the LBO firm's rivals are also highly leveraged and that LBO firms have higher prices than their less leveraged rivals, suggesting that LBOs create incentives to raise prices. However, I also find that prices fall following LBOs in local markets in which rival firms have low leverage and are concentrated. These price drops are associated with LBO firms exiting the local market, suggesting that rivals attempt to "prey" on LBO chains.

Central Bank Policy in a More Perfect Financial System

Abstract: Financial innovation increases markets' liquidity and provides economic agents with new instruments to better handle risks, but it reduces the efficacy of monetary policy while strengthening the logic and force of the “unholy trinity”. Increased liquidity of financial markets and increased leverage of financial positions imply that speculators can attack unsustainable fixed exchange rates faster and more powerfully than ever. The rapid innovation of new financial instruments in these markets also implies the futility to “throw sand in the wheels” through regulation or the introduction of transaction taxes. The higher asset substitutability generated by the emergence of derivatives makes the definition of “money,” particularly of broad monetary aggregates, increasingly difficult. In a more complete financial market system central banks find it harder to predict the effect of a given monetary impulse on real output and employment with any reasonable precision. Discretionary monetary policies aimed at output and employment become more uncertain. Consequently, central banks should focus on the long-run goal of price stability.

Managerial Compensation and Capital Structure

Abstract: We investigate the interaction between financial structure and managerial compensation in the context of a managerial entrenchment model in the spirit of Shleifer and Vishny (1989). We show that risky debt affects both the probability of managerial replacement and the manager's wage if he is retained by the firm. Our model yields a rich set of predictions including the following: The market values of equity and debt decrease if the manager is replaced. Moreover, the expected cash flow of firms that retain their managers exceeds that of firms that replace their managers. Firms that publicly announce the adoption of a new managerial compensation plan should experience positive price reactions in the capital market as well as strong positive performance following the adoption. Managers of firms with risky debt outstanding are promised lower severance payments (golden parachute) than managers of firms that do not have risky debt. Controlling for firm's size, leverage, managerial compensation, and the cash flow of firms that retain their managers are positively correlated. Controlling for firm's size, the probability of managerial turnover and firm value are negatively correlated.