CEO's Inside Debt and Dynamics of Capital Structure

Debt‐type compensation (inside debt) exacerbates the divergence in risk preferences between the chief executive officer (CEO) and shareholders and, in turn, affects capital structure decisions. An excessively risk‐averse CEO tends to use less debt than the shareholders desire, reduce debt quickly when the firm is overlevered, but is reluctant to increase debt when the firm is underlevered. We find that higher CEO's inside debt ratio (i.e., inside debt as a percentage of total incentive compensation) is associated with lower firm leverage and faster (slower) leverage adjustments toward the shareholders’ desired level for overlevered (underlevered) firms. The CEO's inside debt ratio most conducive to capital structure rebalancing is around 10% of the firm's market debt ratio.     

Controlling shareholder,expropriations and firm's leverage decision: Evidence from Chinese Non-tradable share reform

This paper examines the effect of excess control rights on the leverage decisions made by Chinese non-SOEs before and after the Non-tradable share reform (NTS reform). We find that firms with excess control rights have more excess leverage and their controlling shareholders use the resources for tunneling rather than investing in positive NPV projects. We also find that excess leverage in firms with excess control rights decreases and the market reaction to announcements of related party transactions are more positive after NTS reform. This confirms that tunneling by the controlling shareholders actually reduced. We argue that in emerging markets where legal protection for creditors and shareholders is weak, controlling shareholders borrow excess debt to tunnel through inter-corporate loans and related party transactions. Furthermore the privatization of these economies can reduce the controlling shareholders' tunneling activities and associated excess leverage which destroys firm value.     

Debt Management under Corporate and Personal Taxation

The presence of long-term debt in a corporation's capital structure is shown to give rise to a valuable tax-timing option that can be exercised by the firm on behalf of its shareholders. This option, which is not available if the firm is fully equity financed, implies that leverage will have a positive tax effect on total firm value even if there is no such effect associated with the tax deductibility of the coupon interest payments on debt. The more volatile interest rates and bond prices are, the more valuable the tax-timing option and the larger the favorable impact of debt on shareholder wealth.     

The effects on investment incentives of an allowance for corporate equity tax system: the Belgian case as an example

The Modigliani–Miller theorem serves as the standard finance paradigm on corporate capital structure and managerial decision making. Implicitly, it is assumed that the market possesses full information about the firm. However, if firm managers have insider information, they may attempt to ‘signal’ changes in the firm’s financial structure and, in competitive equilibrium, shareholders will draw deductions from such signals. Empirical work shows that the value of underlying firms rises with leverage because investors expect such firms to implement positive NPV projects. We empirically examine this view using a sample of debt issue announcements by publicly traded firms listed on the London Stock Exchange. We argue that the timing of debt issues is fundamental in determining the relationship between leverage and risk-adjusted returns. We show that an announcing firm’s intrinsic value may not rise depending on when management publicly ‘signals’ changes in their firm’s capital structure. Specifically, we show that risk-adjusted returns rise positively for firms that make debt announcements during normal economic conditions while they tend to decline for firms making debt announcements during recessionary periods. During recessionary periods, market risk and loss aversion rise and investors focus less on the potential growth of debt announcing firms and focus more on potential losses instead. We conclude that the timing of new debt is of paramount importance and managers’ inability to prudently time such announcements can lead to exacerbated levels of systematic risk coupled with a significant erosion in shareholder wealth.     

Capital Structure and the Market for Corporate Control: The Defensive Role of Debt Financing

A capital structure theory based on corporate control considerations is presented. The optimal debt level balances a decrease in the probability of acquisition against a higher share of the synergy for the target's shareholders. This leads to the following implications: (i) the probability of firms becoming acquisition targets decreases with their leverage, (ii) acquirers' share of the total equity gain increases with targets' leverage, (iii) when acquisitions are initiated, targets' stock price, targets' debt value, and acquirers' firm value increase, and (iv) during the acquisition, target firms' stock price changes further; the expected change is zero and the variance decreases with targets' debt level.     

Capital Structure, CEO Dominance, and Corporate Performance

We use agency theory to investigate the influence of CEO dominance on variation in capital structure. Due to agency conflicts, managers may not always adopt leverage choices that maximize shareholders’ value. Consistent with the prediction of agency theory, the evidence reveals that, when the CEO plays a more dominant role among top executives, the firm adopts significantly lower leverage, probably to evade the disciplinary mechanisms associated with debt financing. Our results are important as they demonstrate that CEO power matters to critical corporate outcomes such as capital structure decisions. In addition, we find that the impact of changes in capital structure on firm performance is more negative for firms with more powerful CEOs. Overall, the results are in agreement with prior literature, suggesting that strong CEO dominance appears to exacerbate agency costs and is thus detrimental to firm value.     

Creditor rights and capital structure: Evidence from international data

For a large sample of 48 countries, we find robust evidence that strong creditor rights are associated with low long-term leverage across countries. We further find that strong creditor protection lowers long-term debt issuance, the extent to which investments are financed with long-term debt, and target leverage ratios. Finally, we find that firm and country characteristics influence the link between creditor protection and long-term leverage. Our results support the demand-side view that strong creditor protection discourages firms from making long-term cash flow commitments to service debt because managers and shareholders avoid the risk of losing control in the case of financial distress.     

EXCHANGEABLE DEBT CALLS AND SECURITY RETURNS

Exchangeable calls are not convertible into the calling firm's common stock but into the common stock of a target firm in which the calling firm has an ownership position. In addition to reducing leverage, exchangeables change the asset composition of the calling firm through the divestiture of the calling firm's ownership stake in the target firm. In contrast to the evidence on convertible calls, our findings indicate that announcements of exchangeable debt calls are not associated with an abnormal capital loss for the calling firm shareholders. For target firms, announcements of exchangeable calls reduce shareholder wealth. A lower probability of takeover resulting from diffusion of ownership concentration of the target firm's common stock may contribute to this result.     

Ownership structure and debt leverage: Empirical test of a trade-off hypothesis on French firms

Debt may help to manage type II corporate agency conflicts because it is easier for controlling shareholders to modify the leverage ratio than to modify their share of capital. A sample of 112 firms listed on the French stock market over the period 1998–2009 is empirically tested. It supports an inverted U-shape relationship between shareholders’ ownership and leverage. At low levels of ownership, controlling shareholders use more debt in order to inflate their stake in capital and to resist unfriendly takeovers attempts. When ownership reaches a certain point, controlling shareholders’ objectives further converge with those of outside shareholders. Moreover, financial distress will prompt controlling shareholders to reduce the firm's leverage ratio. Empirically, it is shown that the inflection point where the sign of the relationship between ownership and debt changes is around 40%. Debts may help in curbing private appropriation and appears also as a governance variable.     

Group Affiliation and Ownership Concentration as Determinants of Capital Structure Decisions: Contextualizing the Facts for an Emerging Economy

This study considers the firm’s affiliation with business groups and the ownership structure as determinants of leverage decisions in Chilean firms. The major findings show that group-affiliated firms take advantage of internal capital markets and transactions with related parties (e.g., low transference price or loans at competitive interest rates) that reduces the demand for external debt. Majority shareholders in affiliated firms behave as controllers of managers, on the one hand, and avoid the supervisory role of debt, on the other hand. In stand-alone firms, supervision led by majority shareholders is complemented by the monitoring role of debt through higher levels of leverage. We conclude that further developments in capital structure theories adjusted to the particularities of the different institutional contexts are needed.     

Corporate Debt Value,Bond Covenants,and Optimal Capital Structure

This article examines corporate debt values and capital structure in a unified analytical framework. It derives closed-form results for the value of long-term risky debt and yield spreads, and for optimal capital structure, when firm asset value follows a diffusion process with constant volatility. Debt values and optimal leverage are explicitly linked to firm risk, taxes, bankruptcy costs, risk-free interest rates, payout rates, and bond covenants. The results elucidate the different behavior of junk bonds versus investment-grade bonds, and aspects of asset substitution, debt repurchase, and debt renegotiation.     

Leverage and the Complexity of Takeovers

There is scant empirical evidence on how the leverage of target firms affects gains to their shareholders, although there are several widely cited economic theories offered in the literature. The limited available evidence shows that shareholders of targets with greater leverage experience higher returns. However, even this observed effect of debt on takeovers cannot be distinguished from a mere mechanical pure leveraging effect, leaving the economic explanations untested. Consequently, we adopt an alternative approach here to examine if targets' debt truly matters in takeovers. We report that acquisition processes involving targets with higher leverage tend to be significantly more complex in several ways. We find that such acquisitions tend to take a longer time to consume, are more likely to be associated with multiple bidder auctions, and experience greater revisions in offer prices. Finally, we find that factors that make takeovers more complex also lead to greater target gains.     

Aligning debt and equity claimant interests: Evidence from dual claim investors

This study investigates how investors that own both equity and debt in the same firm affect other shareholders in the firm. It documents that dual claim investors are quite prevalent among the industrial firms listed in the Russell 3000, with over 20% of them having a bank holding company that owns both debt and equity in the firm. The results imply that shareholders are substantially impacted by the presence of dual claim investors in firms, suggesting that relatively small ownership stakes by dual claim banks are associated with greater conflicts of interest among shareholders and debt holders; while relatively large bank equity stakes may benefit outside shareholders when aligned with loan by dual claim banks because they improve bank monitoring incentives and reduce the agency cost of debt.     

Capital structure,executive compensation,and investment efficiency

This paper examines how the similarity between the executive compensation leverage ratio and the firm leverage ratio affects the quality of the firm’s investment decisions. A larger leverage gap (i.e., a bigger difference between these two ratios) leads to more investment distortions. Managers with more debt-like compensation components tend to under-invest, whereas managers with larger equity-based compensation engage more in over-investment. Furthermore, investment distortion is likely to increase the equity (debt) value when compensation leverage is lower (higher) than firm leverage. These findings suggest that managers can deviate from an optimal investment policy to increase the value of their portfolio, and that a lower leverage gap can reduce agency costs.     

Accelerated investment effect of risky debt

In this paper we examine a new effect of risky debt on a firm’s investment strategy. We call this effect “accelerated investment”. It stems from a potential loss of investment option in the event of default. The possibility of default reduces the value of the option to wait and provides equity holders with an incentive to speed up investment. As a result, in the absence of wealth expropriation by a levered firm’s debt holders, its shareholders exercise their investment option earlier than the shareholders of an otherwise identical all-equity firm. This result is at odds with the generally accepted intuition that in the absence of potential wealth transfers and taxes the shareholders of a levered firm would follow the same investment policy as that of an unlevered firm. In addition to providing various illustrations of the accelerated investment effect, we relate its magnitude to the presence of competition for investment opportunities.     

AN ANALYSIS OF REGULATED RATES OF RETURN FOR WHOLLY OWNED SUBSIDIARIES

Two methods are used by public utility regulators to set the allowed rate of return to a wholly owned subsidiary: the “independent firm” approach and the “double leverage” approach. Neither approach is consistent with any existing theory of firm valuation. The contribution of this paper is to derive from standard valuation theory a “divisional cost of capital” specification of the allowed rate of return to a wholly owned subsidiary. On the basis of this specification it is shown that the independent firm approach allows shareholders to capture the value created by the interest tax savings on parent debt. It is also reconfirmed that the double leverage approach induces cross-subsidization since it allows each subsidiary to earn the same rate of return on equity regardless of the level of risk specific to the subsidiary.     

How Entrenchment, Incentives and Governance Influence REIT Capital Structure

Although recent literature has confirmed the importance of viewing a firm??s capital structure choices of leverage and debt maturity as jointly determined, to date there has been little analysis of the importance of traditional governance variables on a firm??s capital structure decisions using a simultaneous equations approach. We examine the influence of managerial incentives, traditional managerial monitoring mechanisms and managerial entrenchment on the capital structure of Real Estate Investment Trusts (REITs). Using panel data, we estimate a system of simultaneous equations for leverage and maturity and find that firms with entrenched CEOs use less leverage and shorter maturity debt. This is consistent with the expectation that managers acting in their own self interest will choose lower leverage to reduce liquidity risk and use short maturity debt to preserve their ability to enhance their compensation and reputations by empire building. We also find evidence that traditional alignment mechanisms such as equity and option ownership have an offsetting effect; and that firms where the founder serves as CEO choose higher leverage and longer maturity debt. The results also provide evidence that leverage and maturity are substitutes, firms with high profitability and growth opportunities use less leverage and firms with liquid assets use more leverage and longer maturity debt.     

Optimal capital structure and the impact of time-to-build

We develop a dynamic investment options model with optimal capital structure and evaluate the effect of time-to-build on firm value and leverage choices. With time-to-build the firm increases initial leverage in order to reduce the impact of delayed cash flows resulting from time-to-build. The impact of time-to-build is more severe the higher the revenue volatility and competitive erosion, and when the firm issues long-term debt. Time-to-build is shown to have a substantial impact on firm values for plausible parameter values.     

Does Board Independence Reduce the Cost of Debt?

Using the passage of the Sarbanes‐Oxley Act and the associated changes in listing standards as a natural experiment, we find that while board independence decreases the cost of debt when credit conditions are strong or leverage is low, it increases the cost of debt when credit conditions are poor or leverage is high. We also document that independent directors set corporate policies that increase firm risk. These results suggest that independent directors act in the interests of shareholders and are increasingly costly to bondholders with the intensification of the agency conflict between these two stakeholder groups.     

Top-Management Compensation and Capital Structure

The interrelationship between top-management compensation and the design and mix of external claims issued by a firm is studied. The optimal managerial compensation structures depend on not only the agency relationship between shareholders and management, but also the conflicts of interests which arise in the other contracting relationships for which the firm serves as a nexus. We analyze in detail the optimal management compensation for the cases when the external claims are (1) equity and risky debt, and (2) equity and convertible debt. In addition to the role of aligning managerial incentives with shareholder interests, managerial compensation in a levered firm also serves as a precommitment device to minimize the agency costs of debt. The optimal management compensation derived has low pay-performance sensitivity. With convertible debt, instead of straight debt, the corresponding optimal managerial compensation has high pay-to-performance sensitivity. A negative relationship between pay-performance sensitivity and leverage is derived. Our results provide a reconciliation of the puzzling evidence of Jensen and Murphy ( 1990 ) with agency theory. Other testable implications include (1) a relationship between the risk premium in corporate bond yields and top-management compensation structures, and (2) the announcement effect of adoption of executive stock option plans on bond prices. The model yields implications for management compensation in banks and Federal Deposit Insurance reform. Our results explain the dynamics of top-management compensation in firms going through financial distress and reorganization.