Showing papers on "Leverage (finance) published in 2003"

Governance Mechanisms and Equity Prices

Abstract: We investigate how the market for corporate control (external governance) and shareholder activism (internal governance) interact. A portfolio that buys firms with the highest level of takeover vulnerability and shorts firms with the lowest level of takeover vulnerability generates an annualized abnormal return of 10 - 15% only when public pension fund (blockholder) ownership is high as well. A similar portfolio created to capture the importance of internal governance generates annualized abnormal returns of 8%, though only in the presence of high vulnerability to takeovers. Further, we show that the complementary relation exists for firms with lower industry-adjusted leverage and is stronger for smaller firms. The complementary relation is confirmed using accounting measures of profitability. Using data on acquisitions, firm level Q's and accounting performance, we explore possible interpretations, providing preliminary evidence for a risk effect as well.

Founding‐Family Ownership, Corporate Diversification, and Firm Leverage*

Abstract: Anecdotal accounts imply that founding families routinely engage in opportunistic activities that exploit minority shareholders. We gauge the severity of these moral hazard conflicts by examining whether founding families—as large, undiversified blockholders—seek to reduce firm‐specific risk by influencing the firm’s diversification and capital structure decisions. Surprisingly, we find that family firms actually experience less diversification than, and use similar levels of debt as, nonfamily firms. Consistent with these findings, we also find that direct measures of equity risk are not related to founding‐family ownership, which suggests that family holdings are not limited to low‐risk businesses or industries. Although founding‐family ownership and influence are prevalent and significant in U.S. industrial firms, the results do not support the hypothesis that continued founding‐family ownership in public firms leads to minority‐shareholder wealth expropriation. Instead, our results show that ...

Corporate Investment and Asset Price Dynamics: Implications for the Cross-Section of Returns

Abstract: We show that corporate investment decisions can explain conditional dynamics in expected asset returns. Our approach is similar in spirit to Berk, Green, and Naik (1999), but we introduce to the investment problem operating leverage, reversible real options, fixed adjustment costs, and finite growth opportunities. We assume constant revenue betas, but still obtain asset betas that vary through time as a reflection of historical investment decisions and product market demand. Book-to-market effects emerge and relate to operating leverage, while size captures the importance of growth options relative to assets in place. We first develop these results in a simple setting that permits closed-form solutions. Next, we empirically evaluate a more realistic specification that is solved numerically and estimated using simulated method of moments. This provides new quantitative evidence on the importance of operating leverage and growth options to the cross-section of returns.

Debt Maturity and the Effects of Growth Opportunities and Liquidity Risk on Leverage

Abstract: I test the hypothesis that short debt maturity attenuates the negative effect of growth opportunities on leverage. Using simultaneous equations with leverage and maturity endogenous, I find strong support for an economically significant attenuation effect. The negative effect of growth opportunities on leverage for firms with all shorter-term debt is less than one-sixth as large as the effect for firms with all longer-term debt. Short maturity also increases liquidity risk, however, which negatively affects leverage. The results suggest that firms trade off the cost of underinvestment problems against the cost of liquidity risk when choosing short maturity. Copyright 2003, Oxford University Press.

How Persistent is the Impact of Market Timing on Capital Structure

Abstract: This paper examines the capital structure implications of market timing. I isolate timing attempts in a single major financing event, the initial public offering, by identifying market timers as firms that go public in a hot issue market. I find that hot-market IPO firms issue substantially more equity than cold-market firms. The difference represents a genuine timing effect, as it cannot be explained by firm-level characteristics. Market timing depresses the leverage ratio substantially in the very short-run. However, the timing effect on leverage quickly reverses. Immediately after going public, hot-market firms start increasing their leverage ratios by issuing more debt and less equity relative to cold-market firms. This active reversal policy is strongly visible for two years. At the end of the second year following the IPO, the market timing impact on leverage completely vanishes. The results contrast with recent findings that suggest high persistence of market timing effects on capital structure.

Do Better Institutions Mitigate Agency Problems? Evidence from Corporate Finance Choices

Abstract: This paper examines how firm characteristics, legal rules, and financial development affect corporate finance decisions. In contrast to the existing literature, I use data on unlisted companies to show that institutions play an important role in determining the extent of agency problems. In particular, I find that in countries with good creditor protection, it is easier for firms investing in intangible assets to obtain loans. The protection of creditor rights is also important for ensuring access to long-term debt for firms operating in sectors with highly volatile returns. Ceteris paribus, firms are more leveraged in countries where the stock market is less developed. Unlisted firms appear more indebted than listed companies even after controlling for firm characteristics such as profitability, size, and the ability to provide collateral. Finally, institutions that favor creditor rights and ensure stricter enforcement not only are associated with higher leverage, but also with greater availability of long-term debt.

Multi-Period Corporate Failure Prediction with Stochastic Covariates

Abstract: We provide maximum likelihood estimators of term structures of conditional probabilities of bankruptcy over relatively long time horizons, incorporating the dynamics of firm-specific and macroeconomic covariates. We find evidence in the U.S. industrial machinery and instruments sector, based on over 28,000 firm-quarters of data spanning 1971 to 2001, of significant dependence of the level and shape of the term structure of conditional future bankruptcy probabilities on a firm's distance to default (a volatility-adjusted measure of leverage) and on U.S. personal income growth, among other covariates. Variation in a firm's distance to default has a greater relative effect on the term structure of future failure hazard rates than does a comparatively sized change in U.S. personal income growth, especially at dates more than a year into the future.

Incentive Features in CEO Compensation in the Banking Industry

Abstract: 1. INTRODUCTION The topic of corporate governance in general, and top-management compensation in particular, has received enormous attention in recent years. (1) Although an increasing literature has examined various aspects of the corporate governance of manufacturing firms in the United States and abroad, the corporate governance of banks and financial institutions has received relatively less focus. Alignment of the incentives of top management with the interests of shareholders has been characterized as an important mechanism of corporate governance. (2) Managerial ownership of equity and options in the firm, as well as other incentive features in managers' compensation structures (such as performance-related bonuses and performance-contingent promotions and dismissals), serves to align managerial incentives with shareholder interests. In fact, there is a large theoretical and empirical literature on the role of incentive contracts in ameliorating agency problems. (3) The empirical literature has emphasized the role of the relationship between pay and performance, measured as the pay-performance sensitivity of managerial compensation structures. Jensen and Murphy (1990) document that the pay-performance sensitivity of large manufacturing firms is only $3.25 per $1,000 increase in shareholder value. Recent studies show that this sensitivity has increased over time, and most of it comes from option and stock holdings (see Murphy [1999]). (4) It is important to understand corporate governance and the degree of managerial alignment in banks for several reasons. First, banks differ from manufacturing firms in several key respects. For one, banks are regulated to a higher degree than manufacturing firms. Do the regulatory mechanisms play a corporate governance role? (5) For example, supervision that ensures that banks comply with regulatory requirements may play a general monitoring role. Does this monitoring substitute for or complement other mechanisms of corporate governance? In particular, does regulatory monitoring substitute for the need for incentive features in managerial compensation? (6) By understanding the interaction of regulation and corporate governance, we can gain insight into the optimal design of regulation and corporate governance of banks. An understanding of the incentive structure that motivates the key decision makers in banks can also be important in designing effective regulation. For example, if top management is very closely aligned with equity interests in banks, which are highly leveraged institutions, it will have strong incentives to undertake high-risk investments (risky loans, risky real estate investments), even when they are not positive net-present-value investments. (7) Regulatory oversight has to take such incentive distortions into account when regulatory procedures are established. John, Saunders, and Senbet (2000) argue that regulation that takes into account the incentives of top management will be more effective than capital regulation in ameliorating risk-shifting incentives. They argue that pay-performance sensitivity of top-management compensation in banks may be a useful input in pricing Federal Deposit Insurance Corporation (FDIC) insurance premiums and designing bank regulation. Another important aspect that differentiates banks from manufacturing firms is the significantly higher leverage of banks. How does leverage interact with corporate governance and managerial alignment? In addition to conventional agency problems, these highly leveraged financial institutions are susceptible to the well-known risk-shifting agency problems. In these institutions, where depositors are the primary claimholders, the objective of corporate governance is not to align top management closely with the equity holders. Top management should also be given incentives to act on behalf of debtholders to an adequate degree. In such cases, providing managers with compensation structures that have low pay-performance sensitivity may be optimal. …

Evidence of predictability in the cross-section of bank stock returns

Abstract: In this paper, we examine the predictability of the cross-section of bank stock returns by taking advantage of the unique set of industry characteristics that prevail in the financial services sector. We examine predictability in the cross-section of bank stock returns using information contained in individual bank fundamental variables such as income from derivative usage, previous loan commitments, loan-loss reserves, earnings, and leverage. We find that variables related to non-interest income, loan-loss reserves, earnings, leverage, and standby letters of credit are all univariately important in forecasting the cross-section of bank stock returns. Surprisingly, neither book-to-market nor firm size is important in our sample. We examine whether this cross-sectional predictability is due to increased risk, or another explanation, such as investor under or overreaction. Our results suggest that this predictability is not due to increased risk, but rather is consistent with investor underreaction to changes in banks fundamental variables. Furthermore, out-of-sample testing demonstrates this underreaction appears to be exploitable using simple cross-sectional trading strategies. 2003 Elsevier Science B.V. All rights reserved.

The financial and operating performance of China's newly privatized firms

Abstract: This study examines the pre- and post-privatization financial and operating performance of 208 firms privatized in China during the period 1990-97. The full sample results show significant improvements in real output, real assets, and sales efficiency, and significant declines in leverage following privatization, but no significant change in profitability. Further analysis shows that privatized firms experience significant improvements in profitability compared to fully state- owned enterprises during the same period. Firms in which more than 50% voting control is conveyed to private investors via privatization experience significantly greater improvements in profitability, employment, and sales efficiency compared to those that remain under the state’s control. Privatization seems to work in China, especially the more private firms become.

The Capital Structure of Swiss Companies: An Empirical Analysis Using Dynamic Panel Data

Abstract: In this paper, we analyze the determinants of the capital structure for a panel of 106 Swiss companies listed in the Swiss stock exchange. Both static and dynamic tests are performed for the period 1991-2000. It is found that the size of companies, the importance of tangible assets and business risk are positively related to leverage, while growth and profitability are negatively associated with leverage. The sign of these relations suggest that both the pecking order theory and trade off hypothesis are at work in explaining the capital structure of Swiss companies, although more evidence exists to validate the latter theory. Our analysis also shows that Swiss firms adjust toward a target debt ratio, but the adjustment process is much slower than in most other countries. It is argued that reasons for this can be found in the institutional context.

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 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 informs on future profitability and aids in the evaluation of appropriate price-to-book ratios.

Hard Times or Great Expectations? Dividend Omissions and Dividend Cuts by UK Firms

Abstract: This paper uncovers an increasing proportion of quoted UK companies omitting cash dividends. Using a large panel of quoted UK firms, we estimate panel data probit models for the incidence of dividend omissions and cuts as functions of financial characteristics including cash flow, leverage, investment opportunities, investment and company size. These variables account for most of the increase in omission since 1995. There is relatively little evidence to link this to the major tax reform of 1997 that abolished tax refunds on dividend income payable to tax‐exempt institutions. Significant persistence effects indicate companies are slow to adjust their balance sheets through their dividend.

The Effect of Managerial Incentives to Bear Risk on Corporate Capital Structure and R&D Investment

Abstract: In this study we use estimates of the sensitivities of managers’ portfolios to stock return volatility and stock price to directly test the relationship between managerial incentives to bear risk and two important corporate decisions. We find that as the sensitivity of managers’ stock option portfolios to stock return volatility increases firms tend to choose higher debt ratios and make higher levels of R&D investment. These results are even stronger in a subsample of firms with relatively low outside monitoring. For these firms, managerial incentives to bear risk play a particularly pivotal role in determining leverage and R&D investment.

Insuring September 11th: Market Recovery and Transparency

Abstract: The terrorist attacks on the World Trade Center caused unprecedented economic and structural ramifications in the insurance markets, resulting in considerable uncertainty and informational asymmetry We test several theoretical models of how markets respond to and recover from extreme capital shocks Using the capacity constraint, post-loss investment and implicit insurance contract models, we develop testable hypotheses predicting the temporal and cross sectional variation in insurance company stock prices following September 11th We find evidence consistent with the models’ predictions, in particular, the predictions regarding relations between net losses and leverage and stock price performance after the shock

Executive compensation and managerial risk-taking

Abstract: This paper provides empirical evidence of a strong relation between the structure of managerial compensation and both investment policy and debt policy. Higher sensitivity of CEO wealth to stock volatility (vega) is associated with riskier policy choices, including relatively more investment in R&D, more focus on fewer lines of business, and higher leverage. These results are consistent with the hypothesis that higher vega in the managerial compensation scheme gives executives the incentive to implement policy choices that increase risk. Our results also indicate that these investment and financial policy choices are among the primary mechanisms through which vega affects stock price volatility.

Interaction of Debt Agency Problems and Optimal Capital Structure: Theory and Evidence

Abstract: Does more leverage always worsen the debt agency problem? This paper presents a unified analysis that accounts for both risk-shifting and under-investment debt agency problems. For firms with positive marginal volatility of investment (defined as the change in cash flow volatility corresponding to a change of investment scale), equity holders' risk-shifting incentive will mitigate the under-investment problem. This implies that, contrary to conventional views, the total agency cost of debt does not uniformly increase with leverage. This model further predicts that, for high growth firms in which the under-investment problem is severe, the optimal debt ratio is positively related to the marginal volatility of investment. Empirical results support this prediction.

Asset Price Inflation and Monetary Policy

Abstract: It is crucial that central banks and regulatory authorities be aware of effects of asset price inflation on the stability of the financial system. Lending activity based on asset collateral during the boom is hazardous to the health of lenders when the boom collapses. One way that authorities can curb the distortion of lenders' portfolios during asset price booms is to have in place capital requirements that increase with the growth of credit extensions collateralized by assets whose prices have escalated. If financial institutions avoid this pitfall, their soundness will not be impaired when assets backing loans fall in value. Rather than trying to gauge the effects of asset prices on core inflation, central banks may be better advised to be alert to the weakening of financial balance sheets in the aftermath of a fall in value of asset collateral backing loans.

The Design of Financial Policies in Corporate Spin-offs

Abstract: We examine differences in financial leverage between parent and spun-off firms that emerge from corporate spin-offs. Our tests control for past financing choices and the costs of adjusting capital structure, factors that can obscure cross-sectional patterns among firms' target leverage ratios. We find that firms that emerge from spin-offs with more financial leverage have a higher cash flow return on assets, lower variability of industry operating income, and a greater proportion of fixed assets. The positive relation between profitability and the use of financial leverage, in a setting that is free of pecking order effects, is particularly important because it contrasts with existing evidence. Our results indicate that the ability to cover debt payments and default-related costs are important determinants of the use of financial leverage, as implied by the trade-off theory of capital structure. We find no evidence that managerial incentives or governance characteristics affect the difference in leverage ratios in firms that emerge from spin-offs. Copyright 2003, Oxford University Press.

A new perspective on the knowledge value chain

Abstract: This article presents an interpretation of some major changes affecting the competitive behaviour of firms today. The underlying postulate is a shift from tangible to intangible factors of competitive advantage – from natural resources, machinery and financial capital, now regarded as commodities, to “non‐price” factors of competition. The accelerating pace of value‐chain erosion is driving a relentless search for new factors of differentiation and market leverage, with the result that firms are trying to create, maintain or invade monopolies founded on intangibles. This has led to some subtle, but highly significant, shifts in the economy, which have gone largely undetected. Accordingly, the paper argues the case for transparency, and calls for much richer disclosure of the real asset base of firms and public enterprises. In developing these ideas, the paper presents a new perspective on the knowledge value chain, and concludes by examining some of the challenges for the European policy community, based on the preliminary results of the PRISM research initiative.

How SME Uniqueness Affects Capital Structure: Evidence From a 1994-1998 Spanish Data Panel

Abstract: The principal aim of this paper is to test how firm characteristics affect Small and Medium Enterprise (SME) capital structure. We carry out an empirical analysis of panel data of 6482 non-financial Spanish SMEs during the five year period 1994-1998, modelling the leverage ratio as a function of firm specific attributes hypothesized by capital structure theory. Our results suggest that non-debt tax shields and profitability are both negatively related to SME leverage, while size, growth options and asset structure influence positively SME capital structure; they also confirm a maturity matching behaviour in this firm group.

Financing Decisions when Managers are Risk Averse

Abstract: This paper studies the impact of financing decisions on risk-averse managers. Leverage raises stock volatility, driving a wedge between the cost of debt to shareholders and the cost to undiversified, risk-averse managers. I quantify these "volatility costs" of debt and examine their impact on financing decisions. The paper finds: (1) the volatility costs of debt can be large, particularly if the CEO owns in-the-money options; (2) higher option ownership tends to increase, not decrease, the volatility costs of debt; (3) a stock price increase typically reduces managerial preference for leverage, consistent with prior evidence on security issues. Empirically, I estimate the volatility costs of debt for a large sample of U.S. firms and test whether these costs affect financing decisions. I find evidence that volatility costs affect both the level of and short-term changes in debt. Further, a probit model of security issues suggests that managerial preferences help explain a firm's choice between debt and equity.

Capital Structure Decisions

Abstract: This paper examines the relative importance of 39 factors in the leverage decisions of publicly traded U.S. firms. The pecking order and market timing theories do not provide good descriptions of the data. The evidence is generally consistent with tax/bankruptcy tradeoff theory and with stakeholder co-investment theory. The most reliable factors are median industry leverage (+ effect on leverage), bankruptcy risk as measured by Altman's Z-Score (- effect on leverage), firm size as measured by the log of sales (+), dividend- paying (-), intangibles (+), market-to-book ratio (-), and collateral (+). Somewhat less reliable effects are the variance of own stock returns (-), net operating loss carry forwards (-), financially constrained (-), profitability (-), change in total corporate assets (+), the top corporate income tax rate (+), and the Treasury bill rate (+). Using Markov Chain Monte Carlo multiple imputation to correct for missing-data-bias we find that the effect of profits and net operating loss carry forwards are not robust.