Financial distress and corporate risk management: Theory and evidence

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 data set. 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 (negative) relation between leverage and hedging for moderately (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.     

THE FAMA‐FRENCH MODEL,LEVERAGE, AND THE MODIGLIANI‐MILLER PROPOSITIONS

For a cost‐of‐equity model to conform to the Modigliani‐Miller cost‐of‐capital propositions, any sensitivity coefficients in the model must be related to the firm's leverage. In this paper I apply these principles to the Fama‐French model for the cost of equity and develop the relation between its sensitivity coefficients and firm leverage. I then examine an empirical process developed by Fama and French (1997) to model the evolution through time of their sensitivity coefficients and show that this empirical process is inconsistent with the Modigliani‐Miller propositions. Separable functions are proposed for these sensitivity coefficients that are consistent with the Modigliani‐Miller propositions.     

CONVERTIBLE DEBT AND RISK‐SHIFTING INCENTIVES

I argue that convertible debt, in contrast to its perceived role, can produce shareholders’ risk‐shifting incentives. When a firm's capital structure includes convertible debt, every investment decision affects not only the distribution of the asset value but also the likelihood that the debt will be converted and thereby the distribution of the firm's leverage. This suggests that managers can engage in risk‐increasing projects if a higher asset risk generates a more favorable distribution of leverage. Empirical evidence using 30 years of data supports my argument.     

Corporate capital structure and the characteristics of suppliers and customers

We investigate the link between a firm's leverage and the characteristics of its suppliers and customers. Specifically, we examine whether firms use decreased leverage as a commitment mechanism to induce suppliers/customers to undertake relationship-specific investments. We find that the firm's leverage is negatively related to the R&D intensities of its suppliers and customers. We also find lower debt levels for firms operating in industries in which strategic alliances and joint ventures with firms in supplier and customer industries are more prevalent. Consistent with a bargaining role for debt, we find a positive relation between firm debt level and the degree of concentration in supplier/customer industries.     

Managerial incentives and corporate leverage: evidence from the United Kingdom

This paper investigates the effect of managerial incentives and corporate governance on capital structure using a large sample of UK firms during the period 1999–2004. The analysis revolves around the view that managerial incentives are important in determining a firm's leverage. However, we argue that the exact impact of these incentives on leverage is likely to be determined by firm‐specific governance characteristics. To conduct our investigation, we construct a simple corporate governance measure using detailed ownership and governance information. We present evidence of a significant non‐monotonic relationship between executive ownership and leverage. There is also strong evidence suggesting that corporate governance practices have a significant impact on leverage. More importantly, the results reveal that the nature of the relation between executive ownership and leverage depends on the firm's corporate governance structure.     

Debt financing: Does it boost or hurt firm performance in product markets?

Previous research seeks to establish whether debt boosts or hurts a firm's product market performance. This paper proposes that both of these outcomes can be observed: debt can boost and hurt performance. I first model a nonmonotonic relation between debt-like finance and competitive conduct. I then empirically examine the within-industry relation between leverage and sales performance using data from 115 industries over 30 years. My tests deal with the endogeneity of debt in a novel fashion: I use creditors’ valuation of assets in liquidation to identify financial leverage. I find that moderate debt taking is associated with relative-to-rival sales gains; high indebtedness, however, leads to product market underperformance.     

CEO EXTRAVERSION AND CAPITAL STRUCTURE DECISIONS: THE ROLE OF FIRM DYNAMICS,PRODUCT MARKET COMPETITION,AND FINANCIAL CRISIS

Using panel data of U.S. firms, we focus on an important yet understudied facet of the chief executive officer's (CEO) personality—extraversion—and how it affects corporate capital structure decisions. We examine how this relation is moderated by financing (tax) benefits, financial crisis, firm size, growth opportunities, and collateralization. The results show that firms managed by extraverted CEOs use greater financial leverage, adjusting toward target leverage levels at a faster speed, with about half-life within a year for book and market leverage. In addition, the positive extraversion–leverage relation is enhanced for firms that are large, have greater collateralizable assets, and are more vulnerable to external shocks (financial crisis). Last, although the positive extraversion–leverage relation holds particularly when product market competition is high, the effect is attenuated for high-growth opportunity firms.     

Supply uncertainty of the bond investor base and the leverage of the firm

We examine the effect of the bond capital supply uncertainty of institutional investors (e.g., mutual bond funds and insurance companies) on the leverage of the firm using a novel data set. Our main finding is that the supply uncertainty of the firm's bond investor base — measured as (i) the average portfolio turnover, or (ii) the average flow volatility of investors holding the firm's bonds, or (iii) the prevalence of mutual funds among the firm's bondholders as opposed to insurance companies — has a negative and significant effect on the leverage of the firm. The supply uncertainty of the firm's bond investor base also has a negative and significant effect on the firm's probability of issuing bonds, and a positive and significant effect on the firm's probability of issuing equity and borrowing from banks. We take a multi-pronged approach to address potential endogeneity issues, including use of geography-based instruments and firm fixed effects, subsample analyses, and a placebo test. Our results highlight the fragility of access to the bond market for companies that depend on mutual funds with high turnover/ flow volatility as primary bond investors.     

Do firms have leverage targets? Evidence from acquisitions

In the context of large acquisitions, we provide evidence on whether firms have target capital structures. We examine how deviations from these targets affect how bidders choose to finance acquisitions and how they adjust their capital structure following the acquisitions. We show that when a bidder's leverage is over its target level, it is less likely to finance the acquisition with debt and more likely to finance the acquisition with equity. Also, we find a positive association between the merger-induced changes in target and actual leverage, and we show that bidders incorporate more than two-thirds of the change to the merged firm's new target leverage. Following debt-financed acquisitions, managers actively move the firm back to its target leverage, reversing more than 75% of the acquisition's leverage effect within five years. Overall, our results are consistent with a model of capital structure that includes a target level and adjustment costs.     

Endogenous leverage and expected stock returns

This note clarifies conditions under which endogenous choice of debt induces a negative relation between leverage or default risk and expected stock returns. In the context of the model of George and Hwang [2009. Journal of Financial Economics 96, 56–79], we correct the contention that variation in bankruptcy costs across firms is sufficient. Variation in asset risk parameters can lead to the desired relation, but may not when also controlling for variation in book-to-market ratios. A simple parameterization of cross-sectional heterogeneity in risk and profitability implies a negative association of expected return with leverage and distress risk and a positive association with book-to-market.     

The Net Benefits to Leverage

I estimate the market's valuation of the net benefits to leverage using panel data from 1994 to 2004, identified from market values and betas of a company's debt and equity. The median firm captures net benefits of up to 5.5% of firm value. Small and profitable firms have high optimal leverage ratios, as predicted by theory, but in contrast to existing empirical evidence. Companies are on average slightly underlevered relative to the optimal leverage ratio at refinancing. This result is mainly due to zero leverage firms. I also look at implications for financial policy.     

Equity‐Based Compensation for Employees: Firm Performance and Determinants

I examine the effect of employee equity‐based compensation (EBC) on firm performance and the determinants of EBC. Using two samples, I find that firms have come to rely more heavily on EBC than in the past. For both samples, I document a significant, positive relation between Tobin's q and the percentage of employee compensation that is equity based. For accounting returns, I find a positive relation with the earlier sample. However, for the later sample I find that greater use of EBC leads to lower levels of future accounting returns. I also find that the determinants of the proportion of EBC are different between the two samples.     

Firm level return-volatility analysis using dynamic panels

This paper examines “leverage” and volatility feedback effects at the firm level by considering both market and firm level effects, using 242 individual firm stock data in the US market. We adopt a panel vector autoregressive framework which allows us to control simultaneously for common business cycle effects, unobserved cross correlation effects in return and volatility via industry effects, and heterogeneity across firms. Our results suggest that volatility feedback effects at the firm level are present due to both market and firm effects, though the market volatility feedback effect is stronger than the corresponding firm level effect. We also find that the leverage effect at the firm level is persistent, significant and negative, while the effect of market return on firm volatility is persistent, significant and positive. The presence of these effects is further explored through the responses of the model's variables to market-wide return and volatility shocks.     

Profitability and capital structure: Evidence from import penetration

Firms experiencing increases in import competition significantly reduce their leverage ratios by issuing equity and selling assets to repay debt. Using import tariffs and foreign exchange rates as instrumental variables for import penetration, I show that these results are not manifestations of endogenous relations between import competition and leverage. The results are consistent with traditional trade-off models of capital structure that predict a positive relation between book leverage and expected future profitability. Further evidence suggests that import competition affects leverage through changes in the trade-off between the tax benefits of debt and the costs of financial distress.     

All Guts,No Glory: Trading and Diversification among Online Investors

I explore cross‐sectional portfolio performance in a sample containing 324,736 transactions conducted by 16,831 Swedish investors at an Internet discount brokerage firm during the period May 1999 to March 2002. On average, investors hold undiversified portfolios, show a strong preference for risk, and trade aggressively. I measure performance using a panel data model, and explain the cross‐sectional variation using investors' turnover, portfolio size and degree of diversification. I find that turnover is harmful to performance due to fees, and is therefore more predominant among investors with small portfolios. I argue that the degree of diversification is a proxy for investor skill, and it has a separate and distinct positive effect on performance. Investors underperform the market by about 8.5% per year on average, of which half can be attributed to trading costs.     

Volatility components, leverage effects, and the return-volatility relations

This paper investigates the risk-return trade-off by taking into account the model specification problem. Market volatility is modeled to have two components, one due to the diffusion risk and the other due to the jump risk. The model implies Merton’s ICAPM in the absence of leverage effects, whereas the return-volatility relations are determined by interactions between risk premia and leverage effects in the presence of leverage effects. Empirically, I find a robust negative relationship between the expected excess return and the jump volatility and a robust negative relationship between the expected excess return and the unexpected diffusion volatility. The latter provides an indirect evidence of the positive relationship between the expected excess return and the diffusion volatility.     

OPERATING LEVERAGE AND UNDERINVESTMENT

Using a contingent claims model, we examine the impacts of both operating leverage and financial leverage on a firm's investment decisions in the context of capacity expansion. Our model shows that quasi‐fixed operating costs could significantly mitigate the underinvestment problem for debt‐financed firms. The existing debt induces equity holders to delay equity‐financed expansion because the expanded earnings base will also benefit the debt holders by lowering the bankruptcy risk. The operating costs decrease this type of wealth transfer from equity holders to debt holders by magnifying the bankruptcy risk of the existing debt upon investment. By applying the Cox proportional hazard model on a large sample of publicly traded U.S. firms over 1966–2016, we offer empirical support for the theoretical predictions. The results are robust to various measures of operating leverage.     

Right‐to‐Work Laws and Financial Leverage

High leverage can be used to improve a firm's bargaining position with unions. I find that this use of leverage in the United States is concentrated in states without right‐to‐work (RTW) laws. The use of high leverage by unionized firms in these states is associated with high market‐to‐book ratios and is more likely when shareholder and manager interests are aligned through compensation contracts. I confirm these findings by examining the adoption of RTW laws in Oklahoma, as well as presidential and congressional elections. Moreover, I confirm the importance of RTW laws using cash balances instead of leverage.     

Preemption,leverage, and financing constraints

This paper investigates the interactions between preemptive competition and leverage in a duopoly market. We investigate both a case in which the firms have optimal financial structures, and a case in which financing constraints require firms to finance their investments by debt. Our findings are that the second mover always leaves the duopoly market before the leader, although the leader may exit before the follower's entry. The leverage effects of debt financing can increase the value of a firm and accelerate investment, even in the presence of preemptive competition. Notably, financing constraints can delay preemptive investment and improve firm values in preemptive equilibrium. Indeed, the leader's high leverage due to financing constraints can lower the first-mover advantage and weaken preemptive competition. Especially with strong first-mover advantage, the financing constraint effects can dominate the leverage effects. These findings are almost consistent with the empirical evidence, which shows that high leverage leads to competitive disadvantage and mitigates product market competition.     

Brand perception,cash flow stability,and financial policy

This paper demonstrates that intangible assets play an important role in financial policy. Using a proprietary database of consumer brand evaluation, I show that positive consumer attitude toward a firm's products alleviates financial frictions and provides additional net debt capacity, as measured by higher leverage and lower cash holdings. Brand perception affects financial policy through reducing overall firm riskiness, as strong consumer evaluations translate into lower future cash flow volatility as well as higher credit ratings for potentially volatile firms. The impact of brand is stronger among small firms, contradicting a number of reverse causality and omitted variables explanations.