Showing papers on "Leverage (finance) published in 2007"

Market liquidity and funding liquidity

Abstract: We provide a model that links an asset's market liquidity - i.e., the ease with which it is traded - and traders' funding liquidity - i.e., the ease with which they can obtain funding. Traders provide market liquidity, and their ability to do so depends on their availability of funding. Conversely, traders' funding, i.e., their capital and the margins they are charged, depend on the assets' market liquidity. We show that, under certain conditions, margins are destabilizing and market liquidity and funding liquidity are mutually reinforcing, leading to liquidity spirals. The model explains the empirically documented features that market liquidity (i) can suddenly dry up, (ii) has commonality across securities, (iii) is related to volatility, (iv) is subject to “flight to quality¶, and (v) comoves with the market, and it provides new testable predictions. Keywords: Liquidity Risk Management, Liquidity, Liquidation, Systemic Risk, Leverage, Margins, Haircuts, Value-at-Risk, Counterparty Credit Risk

How Costly Is External Financing? Evidence from a Structural Estimation

Abstract: We apply simulated method of moments to a dynamic model to infer the magnitude of financing costs. The model features endogenous investment, distributions, leverage, and default. The corporation faces taxation, costly bankruptcy, and linear-quadratic equity flotation costs. For large (small) firms, estimated marginal equity flotation costs start at 5.0% (10.7%) and bankruptcy costs equal to 8.4% (15.1%) of capital. Estimated financing frictions are higher for low-dividend firms and those identified as constrained by the Cleary and Whited-Wu indexes. In simulated data, many common proxies for financing constraints actually decrease when we increase financing cost parameters. CORPORATE FINANCE IS PRIMARILY THE STUDY OF FINANCING FRICTIONS. After all,

Accounting Conservatism and Board of Director Characteristics: an Empirical Analysis

Abstract: Using three different measures of conservatism, we document that (i) the percentage of inside directors is negatively related to conservatism, and (ii) the percentage of outside directors' shareholdings is positively related to conservatism. Our results hold after controlling for industry, firm size, leverage, growth opportunities, institutional ownership, inside director ownership, and unobservable firm characteristics that are stable over time. Overall, the evidence is consistent with accounting conservatism assisting directors in reducing agency costs of firms.

Bankruptcy Codes and Innovation

Abstract: Do legal institutions governing financial contracts affect the nature of real investments in the economy? We develop a simple model and provide evidence that the answer to this question is yes. We consider a levered firm's choice of investment between innovative and conservative technologies, on the one hand, and of financing between debt and equity, on the other. Bankruptcy code plays a central role in these choices by determining whether the firm is continued or liquidated in case of financial distress. When the code is creditor-friendly, excessive liquidations cause the firm to shy away from innovation. In contrast, by promoting continuation upon failure, a debtor-friendly code induces greater innovation. This effect remains robust when the firm attempts to sustain innovation by reducing its debt under creditor-friendly codes. Employing patents as a proxy for innovation, we find support for the real as well as the financial implications of the model: (1) In countries with weaker creditor rights, technologically innovative industries create disproportionately more patents and generate disproportionately more citations to these patents relative to other industries; (2) This difference of difference result is further confirmed by within-country analysis that exploits time-series changes in creditor rights, suggesting a causal effect of bankruptcy codes on innovation; (3) When creditor rights are stronger, innovative industries employ relatively less leverage compared to other industries; and (4) In countries with weaker creditor rights, technologically innovative industries grow disproportionately faster compared to other industries. Finally, while overall financial development fosters innovation, stronger creditor rights weaken this effect, especially for highly innovative industries.

Capital Structure and Firm Efficiency

Abstract: This paper investigates the relationship between firm efficiency and leverage. We consider both the effect of leverage on firm performance as well as the reverse causality relationship. In particular, we address the following questions: Does higher leverage lead to better firm performance? Does efficiency exert a significant effect on leverage over and above that of traditional financial measures of capital structure? Is the effect of efficiency on leverage similar across different capital structures? What is the signalling role of efficiency to creditors or investors? Using a sample of 12,240 New Zealand firms we find evidence supporting the theoretical predictions of the Jensen and Meckling (1976) agency cost model. Efficiency measured as the distance from the industry's ‘best practice’ production frontier is positively related to leverage over the entire range of observed data. The frontier is constructed using the non-parametric Data Envelopment Analysis (DEA) method. Using quantile regression analysis we show that the reverse causality effect of efficiency on leverage is positive at low to mid-leverage levels and negative at high leverage ratios. Firm size also has a non-monotonic effect on leverage: negative at low debt ratios and positive at mid to high debt ratios. The effect of tangibles and profitability on leverage is positive while intangibles and other assets are negatively related to leverage.

Capital Structure, Payout Policy, and Financial Flexibility

Abstract: We combine elements of the pecking order and trade-off theories of capital structure to develop a more powerful and empirically descriptive theory in which firms have low long-run leverage targets, debt issuances are temporary deviations from target to meet unanticipated capital needs, firms rebalance to target with a lag despite zero adjustment costs, and mature firms pay substantial dividends to foster access to external equity while limiting internal funds to control agency costs and reduce corporate taxes. The theory generates new testable hypotheses and resolves the main capital structure puzzles including (i) why equity is not "last resort" financing, (ii) why profitable firms pay dividends and maintain low leverage despite the corporate tax benefits of debt, (iii) why firms fail to "lever up" after stock price increases, and (iv) why leverage rebalancing occurs with a lag despite trivial adjustment costs.

Asset Price Dynamics, Volatility, and Prediction

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Buyer-Supplier Relationships and the Stakeholder Theory of Capital Structure

Abstract: Leverage affects a firm's liquidation decision and may therefore affect the value of relation-specific investments made by the firm's stakeholders (Titman, 1984). As a result, firms may want to maintain lower debt ratios if stakeholder relationships are especially important. We compile a database of firms' principal customers (those that account for at least 10% of sales or are otherwise considered important for business) from the Business Information File of Compustat 98 and test the predictions of this theory. We argue that a firm with suppliers that rely heavily on its purchases ("dependent suppliers") is likely to be particularly concerned about the effect its leverage ratio may have on the supplier firms' incentives to make specific investments. Consistent with our expectation, we find that the customers' leverage ratios are lower if their purchases from "dependent suppliers" constitute a higher proportion of their cost of goods sold. Moreover, consistent with Titman (1984) and Titman and Wessels (1988), only the proportion of purchases from suppliers in industries producing durable products (where specific investments are likely to be more important) drives this result. We also examine whether the supplier's leverage ratios are affected by the presence of principal customers. We find evidence of a negative relationship between the supplier's leverage ratio and the proportion of sales to principal customers; however, again, this result only holds for suppliers in industries producing durable products. Additional results suggest that firms producing durable products maintain lower leverage to attenuate potential stakeholder-driven costs associated with the loss of principal customers.

Hedge Fund Risk Dynamics: Implications for Performance Appraisal

Abstract: Accurate appraisal of hedge fund performance must recognize the freedom with which managers shift asset classes, strategies, and leverage in response to changing market conditions and arbitrage opportunities. The standard measure of performance is the abnormal return defined by a hedge fund's exposure to risk factors. If exposures are assumed constant when, in fact, they vary through time, estimated abnormal returns may be incorrect. We employ an optimal changepoint regression that allows risk exposures to shift, and illustrate the impact on performance appraisal using a sample of live and dead funds during the period January 1994 through December 2005.

Financial Distress and Corporate Risk Management: Theory & Evidence

Abstract: This paper extends the current theoretical models of corporate risk-management in the presence of financial distress costs and tests the model's predictions using a comprehensive dataset. I show that the shareholders optimally engage in ex-post (i.e., after the debt issuance) risk-management activities even without a pre-commitment to do so. The model predicts a positive relation between leverage and hedging for moderately leveraged firms, which reverses for highly leveraged firms. Consistent with the theory, empirically I find a non-monotonic relation between leverage and hedging. Further, the effect of leverage on hedging is higher for firms in highly concentrated industries.

Why Do U.S. Firms Hold So Much More Cash Than They Used To

Abstract: The average cash to assets ratio for US industrial firms increases by 129% from 1980 to 2004 Because of this increase in the average cash ratio, firms at the end of the sample period can pay back all of their debt obligations with their cash holdings, so that the average firm has no leverage when leverage is measured by net debt This change in cash ratios and net debt is the result of a secular trend rather than the outcome of the recent buildup in cash holdings of some large firms, but is more pronounced for firms that do not pay dividends The average cash ratio increases over the sample period because firms change: their cash flow becomes riskier, they hold fewer inventories and accounts receivable, and are increasingly R&D intensive The precautionary motive for cash holdings appears to explain the increase in the average cash ratio

Corporate Leverage: How Much Do Managers Really Matter?

Abstract: This paper studies the effect of top managers on corporate financing decisions. Differences among CEOs account for a great deal of the variation in leverage among firms. After a CEO is forced out, leverage typically declines. Firms that offer higher pay-for-performance to the top executives adjust leverage to target more rapidly. CEO personal characteristics are not closely connected to corporate leverage choices. To some extent the CEO may be serving as a proxy for an entire management team. The CFO seems to play at least as important a role as the CEO in determining corporate leverage. JEL classification: G32

On the Capital Structure of Real Estate Investment Trusts (REITs)

Abstract: Much of the literature on capital structure excludes Real Estate Investment Trusts (REITs) due mainly to the unique regulatory environment of these firms. As such, the issue of how REITs choose among different financing options when they raise external capital is largely unexplored. In this paper, we explore two issues on the capital structure of REITs: is there a relationship between market-to-book and leverage ratios, and, is the relationship between market-to-book and leverage ratio temporary or persistent. Our results suggest that REITs with historically high market-to-book ratio tend to have persistently high leverage ratio. In essence, REITs with high growth opportunity and high market valuation raise funds through debt issues. This finding, which is robust to various specifications and econometric tests, is contrary to the financing decisions of non-regulated firms. We attribute it to the special regulatory environment of REITs where, despite no apparent benefits to debt financing, management issues debt.

Determinants of Corporate Capital Structure: Evidence from an Emerging Economy

Abstract: Purpose – This research paper aims at examining the determinants of corporate leverage in Egypt according to the assumptions of three theories of capital structure: tradeoff, pecking order, and free cash flow.Design/methodology/approach – The methodology utilizes the benefits of the partial adjustment autoregressive model to measure the speed of adjusting long-term and short-term debts to a target level.Findings – The results indicate that companies use both long-term and short-term debt to adjust the leverage with a relative dependence on long-term debt; the tradeoff-related determinants of capital structure are taxes, debt/equity ratio and bankruptcy risk; the pecking order-related determinants of capital structure are growth and profitability; borrowing decisions are not affected by the assumptions of free cash flow. Overall, the explanatory powers of the three regression equations are high and significant which indicate that the model construction is quite indicative.Originality/value – The paper contributes to the literature in that it shows that the determinants of capital structure conform to those reported by other related studies in emerging markets as well as developed markets which supports the general conclusion that the determinants of capital structure in emerging and developed markets are converging.

The Rise in U.S. Household Indebtedness: Causes and Consequences

Abstract: The ratio of total household debt to aggregate personal income in the United States has risen from an average of 0.6 in the 1980s to an average of 1.0 so far this decade. In this paper we explore the causes and consequences of this dramatic increase. Demographic shifts, house price increases, and financial innovation all appear to have contributed to the rise. Households have become more exposed to shocks to asset prices through the greater leverage in their balance sheets, and more exposed to unexpected changes in income and interest rates because of higher debt payments relative to income. At the same time, an increase in access to credit and higher levels of assets should give households, on average, a greater ability to smooth through shocks. We conclude by discussing some of the risks associated with some households having become very highly indebted relative to their assets.

The Determinants of Capital Structure of Stock Exchange-Listed Non-Financial Firms in Pakistan

Abstract: In this paper, we study the potential determinates of the capital structure of non-financial firms listed on Karachi Stock Exchange. We analyse a sample of 445 firms listed on the KSE for the period 1997-2001. We have chosen tangibility of assets, size, firm growth rate, and profitability as independent variables, and measure their effect on debt/total asset ratio (proxy for leverage). Using the technique of panel data analysis, we observe that of the four independent variables, growth, size, and profitability have significant effect on leverage. However, we do not find tangibility as significantly correlated with leverage.

Asset Liquidity and Capital Structure

Abstract: This paper tests alternative theories about the effect of asset liquidity on capital structure. Using data from a broad sample of U.S. public companies, I find that leverage is positively related to asset liquidity. Further analysis reveals that the relation between asset liquidity and secured debt is positive, whereas the relation between asset liquidity and unsecured debt is curvilinear. The results are consistent with the view that the costs of financial distress and inefficient liquidation are economically important and that they affect capital structure decisions. In addition, the results are consistent with the hypothesis that the costs of managerial discretion increase with asset liquidity.

Fatores determinantes da estrutura de capital das maiores empresas que atuam no Brasil

Abstract: Capital structure is still a still controversial issue in finance theory. Since the discussion between traditional theory, which asserts the existence of an optimal capital structure that maximizes the firm’s value, and Modigliani and Miller’s theory (1958), which considers that the value of a firm is unaffected by how it is financed, many empirical studies have been carried out to identify the factors that explain how a firm finances itself. This research analyses the capital structure of the largest firms in Brazil and investigates the relationship between the leverage ratio and the factors indicated by theory as determinant. The study is based on accounting data extracted from the financial statements of publicly traded and private companies. Multiple linear regression was applied as a statistical technique. The results indicate that risk, firm size, fixed assets and growth are determinants of the firms’ capital structure, while profitability is not a determinant factor. The results also show that the firms’ leverage is unaffected by whether a firm is publicly-traded or private.

Who is afraid of political risk? Multinational firms and their choice of capital structure

Abstract: This paper investigates how multinational firms choose the capital structure of their foreign affiliates in response to political risk. We focus on two choice variables, the leverage and the ownership structure of the foreign affiliate, and we distinguish different types of political risk, such as expropriation, unreliable intellectual property rights and confiscatory taxation. In our theoretical analysis we find that, as political risk increases, the ownership share tends to decrease, whereas leverage can both increase or decrease, depending on the type of political risk. Using the Microdatabase Direct Investment of the Deutsche Bundesbank, we find supportive evidence for these different effects.

The rise in U.S. household indebtedness: causes and consequences

Abstract: The ratio of total household debt to aggregate personal income in the United States has risen from an average of 0.6 in the 1980s to an average of 1.0 so far this decade. In this paper we explore the causes and consequences of this dramatic increase. Demographic shifts, house price increases, and financial innovation all appear to have contributed to the rise. Households have become more exposed to shocks to asset prices through the greater leverage in their balance sheets, and more exposed to unexpected changes in income and interest rates because of higher debt payments relative to income. At the same time, an increase in access to credit and higher levels of assets should give households, on average, a greater ability to smooth through shocks. We conclude by discussing some of the risks associated with some households having become very highly indebted relative to their assets.