Corporate Governance and Capital Structure Dynamics

We develop a dynamic tradeoff model to examine the importance of manager–shareholder conflicts in capital structure choice. In the model, firms face taxation, refinancing costs, and liquidation costs. Managers own a fraction of the firms’ equity, capture part of the free cash flow to equity as private benefits, and have control over financing decisions. Using data on leverage choices and the model's predictions for different statistical moments of leverage, we find that agency costs of 1.5% of equity value on average are sufficient to resolve the low‐leverage puzzle and to explain the dynamics of leverage ratios. Our estimates also reveal that agency costs vary significantly across firms and correlate with commonly used proxies for corporate governance.     

Financial Distress in the Great Depression

We use firm‐level data to study corporate performance during the Great Depression era for all industrial firms on the NYSE. Our goal is to identify the factors that contribute to business insolvency and valuation changes during the period 1928‐1938. We find that firms with more debt and lower bond ratings in 1928 became financially distressed more frequently during the Depression, consistent with the trade‐off theory of leverage and the information production role of credit rating agencies. We also document for the first time that firms responded to tax incentives to use debt during the Depression era but that the extra debt used in response to this tax‐driven “debt bias” did not contribute significantly to the occurrence of distress. Finally, we conduct an out‐of‐sample test during the recent 2008‐2009 Recession and find that higher leverage and lower bond ratings also increased the occurrence of financial distress during this period.     

How Costly Is External Financing? Evidence from a Structural Estimation

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.     

Human Capital,Bankruptcy, and Capital Structure

We derive the optimal labor contract for a levered firm in an economy with perfectly competitive capital and labor markets. Employees become entrenched under this contract and so face large human costs of bankruptcy. The firm's optimal capital structure therefore depends on the trade‐off between these human costs and the tax benefits of debt. Optimal debt levels consistent with those observed in practice emerge without relying on frictions such as moral hazard or asymmetric information. Consistent with empirical evidence, persistent idiosyncratic differences in leverage across firms also result. In addition, wages should have explanatory power for firm leverage.     

A Dynamic Model of the Firm: Structural Explanations of Key Empirical Findings

We derive a dynamic model of the firm in the spirit of the trade‐off theory of capital structure that explains firm behavior in terms of firm characteristics. We show our model is consistent with many important findings about the cross‐section of firms, including the negative relations between profitability and leverage, and between dividends and investment‐cash flow sensitivities. The model also explains the existence of zero‐debt firms and their observed characteristics. These results have been used to challenge the trade‐off theory and the assumption of perfect capital markets. We revisit these critiques and provide structural explanations for the regularities we replicate.     

Asset Sales, Investment Opportunities, and the Use of Proceeds

This study examines the allocation of cash proceeds following 400 subsidiary sales between 1990 and 1998. Retention probabilities are increasing in the divesting firm's contemporaneous growth opportunities and expected investment. Retaining firms, however, also systematically overinvest relative to an industry benchmark. Shareholder returns to retention decisions are positively correlated with growth opportunities and benchmarked investment, but negatively correlated with benchmarked investment for firms with poor growth opportunities. Shareholder returns to debt distributions are increasing in industry‐benchmarked leverage. Overall, the results of this study cohere with the hypothesized trade‐off between the investment efficiencies associated with retained proceeds and the agency costs of managerial discretion and debt.     

Leverage Choice and Credit Spreads when Managers Risk Shift

We model the debt and asset risk choice of a manager with performance‐insensitive pay (cash) and performance‐sensitive pay (stock) to theoretically link compensation structure, leverage, and credit spreads. The model predicts that optimal leverage trades off the tax benefit of debt against the utility cost of ex‐post asset substitution and that credit spreads are increasing in the ratio of cash‐to‐stock. Using a large cross‐section of U.S.‐based corporate credit default swaps (CDS) covering 2001 to 2006, we find a positive association between cash‐to‐stock and CDS rates, and between cash‐to‐stock and leverage ratios.     

Optimal Debt and Profitability in the Trade‐Off Theory

I develop a dynamic model of leverage with tax deductible interest and an endogenous cost of default. The interest rate includes a premium to compensate lenders for expected losses in default. A borrowing constraint is generated by lenders' unwillingness to lend an amount that would trigger immediate default. When the borrowing constraint is not binding, the trade‐off theory of debt holds: optimal debt equates the marginal interest tax shield and the marginal expected cost of default. Contrary to conventional interpretation, but consistent with empirical findings, increases in current or future profitability reduce the optimal leverage ratio when the trade‐off theory holds.     

Concentrating on Governance

This paper develops a novel trade‐off view of corporate governance. Using a model that integrates agency costs and bargaining benefits of management‐friendly provisions, we identify the economic determinants of the resulting trade‐offs for shareholder value. Consistent with the theory, our empirical analysis shows that provisions that allow managers to delay takeovers have significant bargaining effects and a positive relation with shareholder value in concentrated industries. By contrast, non‐delay provisions have an unambiguously negative relation with value, particularly in concentrated industries. Our analysis suggests that there are governance trade‐offs for shareholders and that industry concentration is an important determinant of their severity.     

Excess cash holdings and shareholder value

We examine the determinants of corporate cash holdings in Australia and the impact on shareholder wealth of holding excess cash. Our results show that a trade‐off model best explains the level of a firm’s cash holdings in Australia. We find that ‘transitory’ excess cash firms earn significantly higher risk‐adjusted returns compared to ‘persistent’ excess cash firms, suggesting that the market penalises firms that hoard cash. The marginal value of cash also declines with larger cash balances, and the longer firms hold on to excess cash. The results are consistent with agency costs associated with persistence in excess cash holdings.     

DOES FINANCIAL FLEXIBILITY REDUCE INVESTMENT DISTORTIONS?

The average U.S. firm has less leverage than one would expect based on the trade‐off between tax shields and bankruptcy costs. We focus on firms’ financial flexibility and examine whether firms preserve debt capacity to reduce investment distortions in the future. We find that firms with high unused debt capacity invest more in future years than do firms with low unused debt capacity. Furthermore, firms that are reluctant to borrow in unconstrained periods are more likely to issue debt in periods in which access to capital markets is more constrained.     

Leverage and debt maturity choices by undiversified owner-managers

We examine the financing choices of undiversified owner-managers in a continuous-time model. Managers' financing choices as well as their dynamic equity stakes, which trade off their private benefits and the costs they incur due to their lack of diversification, are simultaneously and endogenously determined. Our analysis leads to the novel, empirically testable implications that leverage increases with the drift or expected growth rate of the firm's earnings. Debt maturity varies non-monotonically in a U-shaped manner with the project's drift and with its volatility. The predicted variations of leverage and debt maturity with the actual drift of earnings (controlling for the risk-neutral drift) are key implications of our theory that arise from the incorporation of agency conflicts between undiversified managers and well-diversified outside investors. They cannot, therefore, be obtained in traditional capital structure models in which all agents are well-diversified. Our predictions for the variation of leverage and debt maturity with project characteristics potentially reconcile empirical findings that are not consistent with previous theories. We also derive additional novel implications that link manager-specific characteristics - the discount rate or “degree of myopia” and the risk aversion - to leverage and debt maturity. These implications provide support for growing empirical evidence of the significant impact of manager characteristics and manager “fixed effects” on corporate financial policies.     

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

We show that corporate investment decisions can explain the 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. Asset betas vary over time with historical investment decisions and the current product market demand. Book‐to‐market effects emerge and relate to operating leverage, while size captures the residual importance of growth options relative to assets in place. We estimate and test the model using simulation methods and reproduce portfolio excess returns comparable to the data.     

Leverage Constraints and the International Transmission of Shocks

Recent macroeconomic experience has drawn attention to the importance of interdependence among countries through financial markets and institutions, independently of traditional trade linkages. This paper develops a model of the international transmission of shocks due to interdependent portfolio holdings among leverage‐constrained investors. In our model, without leverage constraints on investment, financial integration itself has no implication for international macro comovements. When leverage constraints bind, however, the presence of these constraints in combination with diversified portfolios introduces a powerful financial transmission channel that results in a positive comovement of production, independently of the size of international trade linkages. In addition, the paper shows that with binding leverage constraints, the type of financial integration is critical for international comovement. If international financial markets allow for trade only in noncontingent bonds, but not equities, then the international comovement of shocks is negative. Thus, with leverage constraints, moving from bond trade to equity trade reverses the sign of the international transmission of shocks.     

The Value of Corporate Risk Management

We model and estimate the value of corporate risk management. We show how risk management can add value when revenues and costs are nonlinearly related to prices and estimate the model by regressing quarterly firm sales and costs on the second and higher moments of output and input prices. For a sample of 34 oil refiners, we find that hedging concave revenues and leaving concave costs exposed each represent between 2% and 3% of firm value. We validate our approach by regressing Tobin's q on the estimated value and level of risk management and find results consistent with the model.     

Optimal capital structure under corporate and personal taxation

In this paper, a model of corporate leverage choice is formulated in which corporate and differential personal taxes exist and supply side adjustments by firms enter into the determination of equilibrium relative prices of debt and equity. The presence of corporate tax shield substitutes for debt such as accounting depreciation, depletion allowances, and investment tax credits is shown to imply a market equilibrium in which each firm has a unique interior optimum leverage decision (with or without leverage-related costs). The optimal leverage model yields a number of interesting predictions regarding cross-sectional and time-series properties of firms' capital structures. Extant evidence bearing on these predictions is examined.     

The Capital Structure Puzzle: Another Look at the Evidence

Since the formulation of the Miller and Modigliani propositions over 60 years ago, financial economists have been debating whether there is such a thing as an optimal capital structure—a proportion of debt to equity that can be expected to maximize long‐run shareholder value. Some finance scholars have followed M&M in arguing that both capital structure and dividend policy are irrelevant in the sense of having no significant, predictable effects on corporate market values. Another school of thought holds that corporate financing choices reflect an attempt by corporate managers to balance the tax shields and disciplinary benefits of more debt against the costs of financial distress. Still another theory says that companies do not have capital structure targets, but instead follow a financial pecking order in which retained earnings are generally preferred to outside financing, and debt is preferred to equity when outside funding is required. In reviewing the evidence that has accumulated since M&M, the authors argue that taxes, bankruptcy and other contracting costs, and information costs all appear to play important roles in corporate financing decisions. While much, if not most, of the evidence is consistent with the idea that companies set target leverage ratios, there is also considerable support for the pecking order theory's contention that managements are willing to deviate widely from their targets for long periods of time. According to the authors, the key to reconciling the different theories—and thus to solving the capital structure puzzle—lies in achieving a better understanding of the relation between corporate financing stocks (that is, total amounts of debt and equity) and flows (which security to issue at a particular time). Even when companies have leverage targets, it can make sense to deviate from those targets depending on the costs associated with moving back toward the target. And as the authors argue in closing, a complete theory of capital structure must take account of these adjustment costs and how they affect expected deviations from the targets.     

Real Wage Rigidities and the New Keynesian Model

Most central banks perceive a trade‐off between stabilizing inflation and stabilizing the gap between output and desired output. However, the standard new Keynesian framework implies no such trade‐off. In that framework, stabilizing inflation is equivalent to stabilizing the welfare‐relevant output gap. In this paper, we argue that this property of the new Keynesian framework, which we call the divine coincidence, is due to a special feature of the model: the absence of nontrivial real imperfections. We focus on one such real imperfection, namely, real wage rigidities. When the baseline new Keynesian model is extended to allow for real wage rigidities, the divine coincidence disappears, and central banks indeed face a trade‐off between stabilizing inflation and stabilizing the welfare‐relevant output gap. We show that not only does the extended model have more realistic normative implications, but it also has appealing positive properties. In particular, it provides a natural interpretation for the dynamic inflation–unemployment relation found in the data.     

Corporate Sell‐offs in the UK: Use of Proceeds,Financial Distress and Long‐run Impact on Shareholder Wealth

This study examines the long‐run return performance following UK corporate sell‐off announcements. We observe significant negative abnormal returns up to five years subsequent to sell‐off announcements. Our finding is robust to various specifications, irrespective of the intended use of proceeds. We also find a significantly positive association between long‐run abnormal returns and the magnitude of cash proceeds for sellers reducing corporate debt as well as for sellers with deeper financial distress or higher growth prospects. Overall, we find that UK corporate sell‐offs are associated with declines in subsequent shareholder wealth.     

Do Tests of Capital Structure Theory Mean What They Say?

In the presence of frictions, firms adjust their capital structure infrequently. As a consequence, in a dynamic economy the leverage of most firms is likely to differ from the “optimum” leverage at the time of readjustment. This paper explores the empirical implications of this observation. I use a calibrated dynamic trade‐off model to simulate firms' capital structure paths. The results of standard cross‐sectional tests on these data are consistent with those reported in the empirical literature. In particular, the standard interpretation of some test results leads to the rejection of the underlying model. Taken together, the results suggest a rethinking of the way capital structure tests are conducted.