Showing papers on "Leverage (finance) published in 2001"

Do Credit Spreads Reflect Stationary Leverage Ratios

Abstract: Most structural models of default preclude the firm from altering its capital structure. In practice, firms adjust outstanding debt levels in response to changes in firm value, thus generating mean-reverting leverage ratios. We propose a structural model of default with stochastic interest rates that captures this mean reversion. Our model generates credit spreads that are larger for low-leverage firms, and less sensitive to changes in firm value, both of which are more consistent with empirical findings than predictions of extant models. Further, the term structure of credit spreads can be upward sloping for speculative-grade debt, consistent with recent empirical findings.

Corporate Governance and Merger Activity in the United States: Making Sense of the 1980s and 1990s

Abstract: Corporate governance in the United States changed dramatically throughout the 1980s and 1990s. Before 1980, corporate governance—meaning the mechanisms by which corporations and their managers are governed—was relatively inactive. Then, the 1980s ushered in a large wave of merger, takeover and restructuring activity. This activity was distinguished by its use of leverage and hostility. The use of leverage was so great that from 1984 to 1990, more than $500 billion of equity was retired on net, as corporations repurchased their own shares, borrowed to finance takeovers, and were taken private in leveraged buyouts. Corporate leverage increased substantially. Leveraged buyouts were extreme in this respect with debt levels typically exceeding 80 percent of total capital. The 1980s also saw the emergence of the hostile takeover and the corporate raider. Raiders like Carl Icahn and T. Boone Pickens became household names. Mitchell and Mulherin (1996) report that nearly half of all major U.S. corporations received a takeover offer in the 1980s. In addition, many firms that were not taken over restructured in response to hostile pressure to make themselves less attractive targets. In the 1990s, the pattern of corporate governance activity changed again. After a steep but brief drop in merger activity around 1990, takeovers rebounded to the levels of the 1980s. Leverage and hostility, however, declined substantially. At the same time, other corporate governance mechanisms began to play a larger role,

Expected Option Returns

Abstract: This paper examines expected option returns in the context of mainstream assetpricing theory. Under mild assumptions, expected call returns exceed those of the underlying security and increase with the strike price. Likewise, expected put returns are below the risk-free rate and increase with the strike price. S&P index option returns consistently exhibit these characteristics. Under stronger assumptions, expected option returns vary linearly with option betas. However, zero-beta, at-the-money straddle positions produce average losses of approximately three percent per week. This suggests that some additional factor, such as systematic stochastic volatility, is priced in option returns. ASSET-PRICING THEORY CLAIMS that options, like all other risky securities in an economy, compensate their holders with expected returns that are in accordance with the systematic risks they require their holders to bear. Options which deliver payoffs in bad states of the world will earn lower returns than those that deliver their payoffs in good states. The enormous popularity of option contracts has arisen, in part, because options allow investors to precisely tailor their risks to their preferences. With this in mind, a study of option returns would appear to offer a unique opportunity in which to investigate what kinds of risks are priced in an economy. However, although researchers have paid substantial attention to the pricing of options conditional on the prices of their underlying securities, relatively little work has focused on understanding the nature of option returns. Understanding option returns is important because options have remarkable risk-return characteristics. Option risk can be thought of as consisting of two separable components. The first component is a leverage effect. Because an option allows investors to assume much of the risk of the option’s underlying asset with a relatively small investment, options have characteristics similar to levered positions in the underlying asset. The Black‐ Scholes model implies that this implicit leverage, which is ref lected in option betas, should be priced. We show that this leverage should be priced under

Demographic structure and asset returns

Abstract: This paper investigates the association between population age structure, particularly the share of the population in the ‘prime saving years’ (40 to 64), and the returns on stocks and bonds. The paper is motivated by recent claims that the aging of the ‘baby boom’ cohort is a key factor in explaining the recent rise in asset values, and by predictions that asset prices will decline when this group reaches retirement age and begins to reduce its asset holdings. This paper begins by considering household age-asset accumulation profiles. Data from repeated cross sections of the Survey of Consumer Finances suggest that, whereas age-wealth profiles rise sharply when households are in their thirties and forties, they decline much more gradually when households are in their retirement years. When these data are used to generate ‘projected asset demands’ based on the projected future age structure of the U.S. population, they do not show a sharp decline in asset demand between 2020 and 2050. The paper considers ...

LAPM: A Liquidity-Based Asset Pricing Model

Abstract: The intertemporal CAPM predicts that an asset's price is equal to the expectation of the product of the asset's payoff and a representative consumer's intertemporal marginal rate of substitution. This paper develops an alternative approach to asset pricing based on corporations' desire to hoard liquidity. Our corporate finance approach suggests new determinants of asset prices such as the distribution of wealth within the corporate sector and between the corporate sector and the consumers. Also, leverage ratios, capital adequacy requirements, and the composition of savings affect the corporate demand for liquid assets and, thereby, interest rates. STARTING WITH THE CAPITAL ASSET PRICING MODEL (CAPM, derived by Sharpe (1964), Lintner (1965), and Mossin (1966)), market finance has emphasized the role of consumers' time preference and risk aversion in determining asset prices. The intertemporal consumption-based asset pricing model (e.g., Rubinstein (1976), Lucas (1978), Breeden (1979), Harrison and Kreps (1979), Cox, Ingersoll, and Ross (1985), Hansen and Jagannathan (1991)) predicts that an asset's current price is equal to the expectation, conditioned on current information, of the product of the asset's payoff and a representative consumer's intertemporal marginal rate of substitution (IMRS). While fundamental, this dominant paradigm for pricing assets has some wellrecognized shortcomings (see below), and there is clearly scope for alternative and complementary approaches. This paper begins developing one such approach based on aggregate liquidity considerations.1 Our starting point is that the productive and financial spheres of the economy have autonomous demands for financial assets and that their valuations for these assets are often disconnected from the representative consumer's. Corporate demand for financial assets is driven by the desire to hoard liquidity in order to fulfill future cash needs. In contrast with the

Assessing the Performance of Islamic Banks: Some Evidence from the Middle East

Abstract: The study examines the determinants of Islamic banks’ performance across eight Middle Eastern countries between 1993 and 1998. A variety of internal and external banking characteristics were used to predict profitability and efficiency. In general, our analysis of determinants of Islamic bank profitability confirms previous findings. Controlling for macroeconomic environment, financial market structure, and taxation, the results indicate that high leverage and large loans to asset ratios lead to higher profitability. The results also indicate that foreign-owned banks are more profitable than their domestic counterparts. Everything remaining equal, there is evidence that implicit and explicit taxes affect the bank performance measures negatively. Furthermore, favorable macroeconomic conditions impact performance measures positively. Our results also show that stock markets are complementary to bank financing

Financial Conservatism: Evidence on Capital Structure from Low Leverage Firms

Abstract: A persistent and puzzling empirical regularity is the fact that many firms adopt conservative financial policies. These "under-leveraged" firms carry substantially less debt than predicted by dominant theories of capital structure (Graham (2000) and Myers (1984)). This paper examines the phenomenon of financial conservatism by studying firms that adopt a persistent policy of low leverage. Our major findings are as follows. 1) Conservative firms follow a pecking order style financial policy. A high flow of funds and substantial cash balances allow them to fund the bulk of discretionary expenditures internally. 2) Financial conservatism is largely transitory. Seventy percent of low leverage firms drop their conservative financial policy; almost 50% do so within five years. 3) Conservative firms stockpile financial slack or debt capacity. Their "stockpiles" are utilized later to finance discretionary expenditures, particularly acquisitions and capital expenditures. 4) Financial conservatism is not an industry-based phenomenon. Conservative firms do, however, have relatively high market-to-book and operate relatively frequently in industries thought to be sensitive to financial distress. 5) Conservative firms do not have low tax rates, high non-debt tax shields or face severe information asymmetries.

Sources of Performance Improvements in Privatized Firms: A Clinical Study of the Global Telecommunications Industry

Abstract: This paper examines the financial and operating performance of 31 national telecommunication companies in 25 countries that were fully or partially privatised through public share offering between October 1981 and November 1998. Using conventional pre- versus post-privatisation comparisons, we find that profitability, output, operating efficiency and capital investment spending increase significantly after privatisation, while employment and leverage decline significantly. However, these univariate comparisons do not account for separate regulatory and ownership effects (retained government stake), and almost all telecoms are subjected to material new regulatory regimes around the time they are privatised. We examine these separate effects using both random and fixed-effect panel data estimation techniques for a seven-year period around privatisation. We verify that privatisation is significantly related to higher profitability, output and efficiency, and with significant declines in leverage. However, we also find numerous separable effects for variables measuring regulation, competition, retained government ownership and foreign listing (on U.S. and U.K. exchanges). Competition significantly reduces profitability, employment and, surprisingly, efficiency after privatisation, while creation of an independent regulatory agency significantly increases output. Mandating third party access to an incumbent - network is associated with a significant decrease in the incumbent - investment and an increase in employment. Retained government ownership is associated with a significant increase in leverage and a significant decrease in employment, while price regulation significantly increases profitability. Major efficiency gains result from better incentives and productivity, rather than from wholesale firing of employees and profitability increases appear to be caused by significant reductions in costs - rather than price increases. On balance, we conclude that the financial and operating performance of telecommunications companies improves significantly after privatisation, but that a sizeable fraction of the observed improvement results from regulatory changes - alone or in combination with ownership changes - rather than from privatisation alone.

Leverage determinants in the absence of corporate tax system: the case of non‐financial publicly traded corporations in Saudi Arabia

Abstract: Reviews previous research on the factors affecting the proportions of debt and equity used to finance firms, describes the Saudi Arabian tax system (based on net worth) and stock market; and examines the capital structure 1993‐1997 of a sample of 35 publicly traded Saudi companies. Uses multi‐linear regression models to investigate the relationships between capital structure and other variables in 5 sectors and illustrates their varied leverage ratios. Discusses and analyses the positive links between leverage ratios, firm size and share of government ownership; and negative links with growth, return on assets and profitability margin.

An Analysis of Bank Charter Value and Its Risk-Constraining Incentives

Abstract: Valuable bank charters have been hypothesized to provide bank managers self-regulatory incentives to constrain their risk taking. However, this paper presents evidence that charter value itself may derive from high-risk activities, indicating that minimizing risk taking also would limit the value of the charter. During economic expansions, bank charter values increase to reflect growth opportunities. In turn, high-charter-value banks gain easier access to equity capital sources for expansion. The result is a positive relationship between charter value and capital ratios during expansions. However, this relationship may invert during economic contractions. Panel regressions demonstrate that the charter value and bank leverage relationship is sensitive to market conditions.

Should monetary policy respond to asset price bubbles? some experimental results

Abstract: Should central banks respond to asset price bubbles? This paper explores this monetary policy question in a hypothetical economy subject to asset price bubbles. Despite the highly stylized structure of the model, the results reveal several practical monetary policy lessons. First, a monetary authority should generally respond to asset prices as long as asset prices contain reliable information about inflation and output. Second, this finding holds even if a monetary authority cannot distinguish between fundamental and bubble asset price behavior. Third, a monetary authority's desire to respond to asset prices falls dramatically as its preference to smooth interest rates rises. Finally, a monetary authority should not respond to asset prices if there is considerable uncertainty about the macroeconomic role of asset prices.

Executive compensation structure and corporate governance choices

Abstract: Using data that reflect the significant growth in incentive compensation during the last decade, we extend research in this area by specifying a more complete model that addresses both corporate governance and risk-sharing factors that theory suggests should influence compensation policy. We find that the extent of incentive compensation is systematically related to other features of corporate governance, as well as to factors affecting managerial risk aversion. The results support the following conclusions: (a) the presence of outside directors and blockholders facilitates the use of incentive compensation, (b) incentive compensation is inversely related to use of leverage, and (c) the incentive pay component of compensation is lower for CEOs near or at retirement age and is decreasing in the percentage of firm stock already owned by the CEO. JEL classification: G34

Financial Statement Analysis of Leverage and How it Informs About Profitability and Price-to-Book Ratios

Abstract: This paper presents a financial statement analysis that distinguishes leverage that arises in financing activities from leverage that arises in operations. The analysis yields two leveraging equations, one for borrowing to finance operations and one for borrowing in the course of operations. These leveraging equations describe how the two types of leverage affect book rates of return on equity. An empirical analysis shows that the financial statement analysis explains cross-sectional differences in current and future rates of return as well as in price-to-book ratios, which are based on expected rates of return on equity. The paper therefore concludes that balance sheet line items for operating liabilities are priced differently than those dealing with financing liabilities. Accordingly, financial statement analysis that distinguishes the two types of liabilities aids in the forecasting of future profitability and the evaluation of appropriate price-to-book ratios.

Can Emerging Market Bank Regulators Establish Credible Discipline? The Case of Argentina, 1992-99

Abstract: In the early 1990s, after decades of high inflation and financial repression, Argentina embarked on a course of macroeconomic and bank regulatory reform. Bank regulatory policy promoted privatization, financial liberalization, and free entry, limited safety net support, and established a novel mix of regulatory and market discipline to ensure stable growth of the banking system during the liberalization process. Argentina suffered some fallout from the Mexican tequila crisis of 1995, but its response to that crisis (allowing weak banks to close) and the redoubling of regulatory efforts to promote market discipline after the crisis made Argentina's banking system quite resilient during the Asian, Russian, and Brazilian crises. Argentina's bank regulatory system now is widely regarded as one of the two or three most successful among emerging market economies. This paper traces the evolution of the regulatory policy changes of the 1990s and shows that the reliance on market discipline has played an important role in prudential regulation by encouraging proper risk management by banks. There is substantial heterogeneity among banks in the interest rates they pay for debt and the rate of growth of their deposits, and that heterogeneity is traceable to fundamental attributes of banks that affect the riskiness of deposits (i.e. asset risk and leverage). Moreover, market perceptions of default risk are mean-reverting, indicating that market discipline encourages banks to respond to increases in default risk by limiting asset risk or lowering leverage.

Democratising Globalisation: The Leverage of the Tobin Tax

Abstract: * Preface: Erkki Tuomioja, Finnish Minister of Foreign Affairs * Introduction * 1. Economics of Financial Instability * 2. Power Analysis of the Global Financial Markets * 3. The Case for the Tobin Tax and Global Re-Regulation * 4. Is It Realistic? Overcoming the Technical Problems * 5. Is It Politically Possible? Emancipation by Means of the Two Phases-Model * 6. Towards Democratic Politics of Global Governance * Conclusion

Agency costs, asset specificity, and the capital structure of the firm

Abstract: We develop a dynamic model that incorporates the insights of both the agency cost and asset specificity literature about corporate finance. In general, we find that neither can be ignored, and that the optimal capital structure minimizes agency cost and asset specificity considerations. A key finding is that the conditions most favorable for reducing transaction costs due to asset specificity are the same as those for reducing the agency costs of debt. Empirically, we find that agency costs and asset specificity are significant determinants of a firm’s capital structure in the transportation equipment and the printing and publishing industries.

Capital structure theory : Evidence from European property companies' capital offerings

Abstract: This study examines the stock price reactions on announcements of both equity and debt offerings by European property companies. The unique setting in which corporate tax rates vary between different countries enables us to test established theories in the field of capital structure. In accordance with theory, we find a negative price reaction on equity offering announcements, which is less severe for low-tax countries and positive price reactions on the announcements of debt offerings. Besides tax arguments, we also test alternative explanations by analyzing variations in stock reactions based on differences in the relative size of the issue, the pre-offer leverage, the underlying property types, and operational performance. The results show that corporate taxation, issue size, and operational performance are significant explanatory factors in the negative price reactions. Capital structure theory is one of the most puzzling issues in the corporate finance literature. Numerous empirical studies have shown that announcements of seasoned equity offerings (SEOs) cause negative price reactions, whereas the news of an additional debt issue is followed by an increase in stock prices. The majority of these studies use capital structure arguments emphasizing the importance of tax shield benefits from debt financing as the explanation for this phenomenon. In this paper, we investigate whether differences in tax regimes, the relative size of the issues, the pre-offer debt-to-equity ratio, the underlying property type, and/or the operational performance can account for the price reactions to issue announcements that occurred in various European property share markets over the last decade. The idea to test whether tax arguments can account for market reactions to the news of security issues by investigating tax-exempt companies is not novel. Howe and Shilling (1988) investigated the stock price reactions to the

Balance Sheet Management: The Case of Short-Term Obligations Reclassified as Long-Term Debt

Abstract: We investigate potential management of balance sheet ratios by a sample of firms that reclassify short-term obligations to long-term debt and subsequently declassify that debt (return it to the current liability section). Although aggregate measures of liabilities and equity remain unchanged when firms reclassify (declassify), the practice does increase (decrease) reported measures of liquidity, such as the current ratio, and long-term leverage. Our results suggest that firms reclassify and declassify to smooth reported liquidity and leverage, relative to the prior year and to industry benchmarks. Our evidence is also consistent with firms working around restrictive debt covenants.

Can managerial discretion explain observed leverage ratios

Abstract: This paper analyzes the impact of managerial discretion and corporate control mechanisms on leverage and firm value within a contingent claims model where the manager derives perquisites from investment. Optimal capital structure reflects both the tax adavantage of debt less bankruptcy costs and the agency costs of managerial discretion. Actual capital structure reflects the trade-off made by the manager between his empire-building desires and the need to ensure sufficient efficiency to prevent control challenges. The model shows that manager-shareholder conflicts can explain the low debt levels observed in practice. It also examines the impact of these conflicts on the cross-sectional variation in capital structures.

Performance Consequences of Privatizing Egyptian State-Owned Enterprises: The Effect of Post-Privatization Ownership Structure on Firm Performance

Abstract: This paper evaluates the financial and operating performance of newly privatized Egyptian state-owned enterprises and determines whether such performance differs across firms according to their new ownership structure. The Egyptian privatization program provides unique post-privatization data on different ownership structures. Since most studies do not distinguish between the types of ownership, this paper provides new insight into the impact that post-privatization ownership structure has on firm performance. The study covers 69 firms, which were privatized between 1994 and 1998. For these newly privatized firms, this study documents significant increases in profitability, operating efficiency, capital expenditures, and dividends. Conversely, significant decreases in employment, leverage, and risk are found, although output shows an insignificant decrease following privatization. The empirical results also show that Egyptian state-owned enterprises, which were sold to anchor-investors and employee shareholder associations, seem to outperform other types of privatization, such as minority and majority initial public offerings. Keywords: Privatization, SOEs, Egypt, Ownership Structure

The United Kingdom's small banks' crisis of the early 1990s: what were the leading indicators of failure?

Abstract: The announcement of BCCI's closure on 5 July 1991 rapidly accelerated the withdrawal of wholesale funds from small and medium-sized UK banks. Within three years, a quarter of the banks in this sector, had in some sense, failed. This study employs a logit model to analyse at two points prior to the crisis the distinct characteristics of the banks that failed compared with those that survived. Perhaps not surprisingly, a number of measures of bank weakness - low loan growth, poor profitability and illiquidity - are found to be good short-term predictors of failure, as are a high dependence on net interest income and low leverage. The best longer-term leading indicator of future failure, however, is rapid loan growth at the peak of the previous boom.

Asset specificity and a firm’s borrowing ability: an empirical analysis of manufacturing firms

Abstract: This paper investigates the importance of asset specificity in explaining differences in firms’ ability to borrow money. With empirical research, we investigated whether there is a relationship between asset specificity and the debt ratio of a Slovene manufacturing firm. The basic idea of the research was to link the sources of finance that define property rights and the attributes of the assets that are the objects of finance. A firm’s capital structure can be viewed as a description of the allocation of risk and control among investors.

Corporate Diversification: What Gets Discounted?

Abstract: Prior literature finds that diversified firms sell at a discount relative to the sum of the imputed values of their business segments. We explore this documented diversification discount and argue that it stems from the risk reducing effects of corporate diversification. Consistent with this risk reduction hypothesis, we find that (i) shareholder losses in diversification are a function of firm leverage, (ii) all equity firms do not exhibit a diversification discount, and (iii) using book values of debt to compute excess value creates a downward bias for diversified firms. When considering the joint impact to both debt and equity holders, we find that, on average, diversification is insignificantly related to excess firm value.

Institutional Ownership, Strategic Choices and Corporate Efficiency: Evidence from Japan

Abstract: Based on the tenets of capital allocation systems theory, stewardship theory, and ‘going concern’ concept of business, institutional ownership is proposed to affect corporate productivity, both directly and indirectly, in large Japanese corporations through a set of four firm-level choices: product/market development, R&D intensity, capital intensity, and leverage. Using data on 118 corporations drawn from five industry sectors in Japan, and applying a partial mediation technique, this study tests an integrated, causal model of the relationships among these variables. Results show mixed support for the model. No direct relationship between institutional ownership and productivity is observed. However, institutional ownership affects productivity indirectly through R&D intensity and leverage. Although product/market development and capital intensity also affect productivity, institutional ownership has no significant relationship with them.

The Investment Opportunity Set and Acquired Goodwill

Abstract: This paper examines how managers in New Zealand allocate the cost of firms' investments in subsidiaries between net tangible assets and acquired goodwill. We find a negative relation between acquired goodwill and leverage. This could be interpreted as the result of managers of highly leveraged acquiring firms opportunistically allocating a lower portion of the acquisition price to acquired goodwill. However, this analysis, like much of the research on accounting choice, suffers from an omitted variables problem. We present evidence that the observed negative relation between acquired goodwill and leverage may stem from each variable's relation to the investment opportunity set. Further, we find no evidence that acquired goodwill is related to the existence of debt covenants. Together, these results suggest an endogenous relation between the firm's asset structure, its financing policy, and the allocation of acquisition price to acquired goodwill.