Dynamic Models of Investment Distortions

This paper studies the interaction between corporate financing decisions and investment decisions in a dynamic framework. When the production decision involves an expansion option, the firm trades off tax benefits of debt against two costs of debt financing, namely the investment distortion related to exercise of the expansion option and the loss of a valuable expansion opportunity if the firm defaults. The optimal capital structure is all equity for firms with more value in growth options (or intangible assets) and tends to involve debt financing for firms with more value in tangible assets. JEL Classification: D81, G13, G31, G32     

Implicit benefits and financing

Social relationship and business connections create implicit benefits between borrowers and lenders. We model how implicit benefits and repayment enforcement costs influence credit allocation, cost, and renegotiation. The optimal solution illustrates that financing with implicit benefits may achieve lower financing costs, higher managerial effort, and better outcomes for both borrowers and lenders. This result is consistent with the continuing expansion of alternative financing despite formal financial intermediation, the rise of corporate insider debt, and joint ownership of debt and equity. The growing size and complexity of projects and changes in community relationships can explain expansion of financing with standard intermediation.     

Optimality of project financing: Theory and empirical implications in finance and accounting

During the 1980s a fairly active market developed in the private placement of limited recourse project financing. Although this form of financing is gaining in importance, we know very little about it. This article presents a theoretical analysis of project financing. In the model of the firm presented, outstanding risky debt gives rise to agency costs of underinvestment that are offset by the benefit of debt-related tax shields. The tradeoff specifies the optimal leverage for a firm. Within this framework, we consider the optimality of financing a new project with a nonrecourse project financing arrangement. We derive implications for 1) the characteristics of a new venture that will be project financed, 2) the wealth gains from project financing over that of financing with straight debt, and 3) the optimal allocation of debt across the different assets (the sponsor firm vs. the new venture). It is shown that a project financing arrangement, where the debt is optimally allocated to the sponsor firm and the new venture, increases value by reducing agency costs and increasing the value of tax shields (compared to the case of straight debt financing). The optimal allocation of debt in project financing involves assigning to the sponsor firm and the new venture debt levels equal to their individual optimal capital structures. Several testable empirical implications in finance and accounting are developed.     

Voluntary Divestitures and the Choice Between Sell-Offs and Spin-Offs

A voluntary divestiture may either be a sell-off or a spin-off. In a sell-off, the divesting firm receives cash (or cash equivalents) and gives up ownership and control of the divested asset. In a spin-off, the divested asset becomes an independent entity under a new management but ownership remains with the old stockholders of the original firm. The study investigates the divestiture decision and the choice between sell-offs and spin-offs by constructing a model of the multi-divisional firm. The results show that firms undertake voluntary divestitures because of low marginal return coupled with high joint operating and financial costs. The form of the divestiture is determined by the operating risk of the division being divested. The implications of the model are empirically tested for the period 1969–87 and the results support the postulates of the model.     

Corporate taxes,capital structure,and valuation: Combining Modigliani/Miller and Miles/Ezzell

The valuation of a firm with discounted cash flow (DCF) approaches requires assumptions about the firm’s financing strategy. The approaches of Modigliani and Miller and Miles and Ezzell assume that either a passive debt management with predetermined debt levels or active debt management with capital structure targets is applied. Over the last decades, various extensions of these approaches have been developed to allow for a more realistic depiction of financial decision making. However, recent empirical analyses indicate that current theories still have limited power to explain large variances in capital structure across time. We provide an alternative explanation for the empirical observation by assuming that firms combine both capital structure targets and predetermined debt within future periods, and we show how to value a firm given such a partially active debt management. The approaches of Modigliani and Miller and Miles and Ezzell are embedded into a common valuation framework, with the familiar valuation formulas shown as special cases. In a simulation analysis, we illustrate that the textbook valuation formulas may produce considerable valuation errors if a firm applies a partially active debt management.     

Corporate Control and the Choice of Investment Financing: The Case of Corporate Acquisitions

We test the proposition that corporate control considerations motivate the means of investment financing—cash (and debt) or stock. Corporate insiders who value control will prefer financing investments by cash or debt rather than by issuing new stock which dilutes their holdings and increases the risk of losing control. Our empirical results support this hypothesis: in corporate acquisitions, the larger the managerial ownership fraction of the acquiring firm the more likely the use of cash financing. Also, the previously observed negative bidders' abnormal returns associated with stock financing are mainly in acquisitions made by firms with low managerial ownership.     

Debt Financing,Corporate Financial Intermediaries and Firm Valuation

In this paper we consider the role of financial intermediaries in the valuation of firms and projects. We show that security prices should reflect both used and unused debt capacity if some corporations can act as financial intermediaries and can capture the tax benefits of debt capacity unused by the operating firm. We also provide some reasons why the value of the firm might be increased if the financing and operating risks of the firm are separated and financial intermediaries issue debt rather than the unit operating the asset.     

Single vs. Multiple Discount Rates: How to Limit “Influence Costs” in the Capital Allocation Process*

Most finance textbooks suggest that companies evaluate investment projects using discount rates that reflect both the debt capacity and the unique risks of the project. In practice, however, companies often use their company‐wide WACC to evaluate such investments because of the difficulty of (and subjectivity involved in) estimating the risk of individual projects, and the potential for managerial bias and influence to distort the estimates. This article proposes a practicable method for calculating the cost of capital that produces different discount rates for investment projects with different risks while minimizing the “influence costs” that arise when managers have discretion in the choice of discount rates. The proposed approach makes use of market information (in the form of the firm‐wide costs of debt and equity), thereby limiting managerial discretion, while typically still providing a good approximation of theoretically correct, project‐specific discount rates. The key to the method's effectiveness is its use of a project's debt capacity to define the capital structure weights, where debt capacity is defined by the amount of debt financing the project will support without lowering the firm's credit rating.     

On the neutrality of debt in investment intensity

This paper examines the interaction between investment and financing decisions of a firm using a real options approach. The firm is endowed with a perpetual option to invest in a project at any time by incurring an irreversible investment cost at that instant. The amount of the irreversible investment cost is directly related to the intensity of investment that is endogenously chosen by the firm. At the investment instant, the firm can finance the project by issuing debt and equity, albeit subject to an exogenously given credit constraint that prohibits the firm’s debt-to-asset ratio from exceeding a prespecified threshold. The optimal capital structure of the firm is determined by the trade-off between interest tax-shield benefits and bankruptcy costs of debt. Irrespective of whether the exogenously given credit constraint is binding or not, we show that leverage has no impact on the firm’s optimal investment intensity, thereby rendering the neutrality of debt in investment intensity. Similar to earlier work, we show that debt is not neutral to investment timing in general, and the levered firm invests earlier than the unlevered firm in particular.     

RETURNS ON PROJECT-FINANCED INVESTMENTS: EVOLUTION AND MANAGERIAL IMPLICATIONS

In the past, project finance was used primarily to fund relatively low-risk natural resource projects with highly predictable cash flows. Today project finance is used for a wide range of assets, such as satellite telecommunications systems, amusement parks, and microprocessor factories, and in developing as well as developed countries. The author explores how the evolution into riskier assets has changed expected returns on project-financed investments. Higher return variability and greater failure rates have caused project debt capacities to fall. What is notable about project-financed investments, however, is that the best returns are not very high. And because the nature of most projects limits the upside potential, a much higher fraction of project-financed investments must be successful for capital providers to earn acceptable returns on their investments.
The move into riskier assets has also led to increased emphasis on the risk management role of project finance; that is, through careful structure and design, a firm can use project finance to reduce the collateral damage caused by a failing investment and also to limit sovereign risks. But even so, the author suggests that the original structures were never designed to handle projects with significant asset risk. For this reason, in cases of riskier projects, single-asset project loans are likely to be replaced by either traditional corporate financing vehicles or hybrid structures involving elements of both project and corporate finance. One example of such hybrid financing is Calpine's revolving construction facilities that are used to finance portfolios of merchant power plants.     

Bankruptcy, Warrants, and State-Contingent Changes in the Ownership of Control

We consider the design of securities that govern the distribution of cash flows and control rights for an investment project. An entrepreneur, endowed with managerial talent, contracts with an outside investor for required capital. Optimal contracts stipulate that the ownership of control and the distribution of cash flows are specified on a state contingent basis to manage the distortions that develop from the use of outside financing and so make the best use of the advantage in project management enjoyed by insiders. Our results illustrate that the use of warrants and convertible securities, which transfer control of the firm to outsiders in good states, and bankruptcy, which transfers control to outsiders in bad states, are related features of optimal contracts. Our model also indicates that firms will benefit from direct access to two types of bankruptcy processes resembling Chapter 7 and Chapter 11 (including deviations from absolute priority) of the bankruptcy code. This results differs from observed practices since stockholders cannot waive their rights for protection under Chapter 11. We show that when direct access to Chapter 7 is highly valuable, market participants have found clever ways to obtain it.Journal of Economic LiteratureClassification Numbers: G32 and G33.     

Information Revelation, Lock-In, and Bank Loan Commitments

This paper considers the extent to which loan commitments mitigate the problems of information monopolies that arise when the firm contracts with a private lender. Loan commitments in conjunction with short-term debt often provide the firm with superior investment incentives by influencing both the states in which bargaining occurs as well as the outcomes from bargaining. Commitment contracts are particularly valuable when there is a high likelihood that information about the firm will be publicly revealed ex post. We also identify circumstances under which the firm foregoes commitment financing, relying on short-term debt instead. Journal of Economic Literature Classification Numbers G21, G32, D82.     

Tax-Exempt Debt and the Capital Structure of Nonprofit Organizations: An Application to Hospitals

The availability of tax-exempt financing provides nonprofit (NP) organizations with their own tax-based incentives to issue debt. In this article, we develop a theoretical model in which NPs gain an indirect arbitrage from tax-exempt debt issuance, constrained by: 1) the requirement that fixed investment exceed tax-exempt debt flows (the project financing constraint), and 2) the constraint against share issuance. These constraints cause them to impute tax benefits to projects that afford access to the tax-exempt bond market. Empirical tests indicate that NP hospitals behave as if they have target levels of tax-exempt debt. Debt targeting is constrained by the availability of capital projects, while excess debt capacity stimulates investment.     

The Role of Investment,Financing and Dividend Decisions in Explaining Corporate Ownership Structure: Empirical Evidence from Spain

This paper analyses the determinants of ownership structure by focusing on the role played by investment, financing and dividend decisions. The use of the Generalised Method of Moments allows us to provide new evidence on this important corporate governance topic, since it controls for the endogeneity problem. Our most relevant findings show that: i) increases in debt lead insiders to limit the risk they bear by reducing their holdings; ii) monitoring by large outside owners substitutes for the disciplinary role of debt; and iii) both inside and outside owners are encouraged to increase their stakes in the firm in view of higher dividends. Our results hold after controlling for equity issues and share repurchases.     

Shareholders' control rights,family ownership and the firm's leverage decisions

We investigate the association between controlling shareholders' ownership (CS_Own) and firms' leverage decisions in the Singaporean context. We examine whether the impact of ownership concentration on leverage differs across excess and lower control. We report that shareholders with excess control prefer leverage financing for an optimal capital structure and focus on value maximisation rather using leverage as a tool of minority shareholders' expropriation. Our analysis shows that firms capital structure significantly influences by the coalition of shareholders particularly decisions about leverage financing in addition to the firms' specific characteristics and institutional arrangements. Our empirical evidence shows that controlling shareholders with a lower fraction of equity are more concerned about limited holding thus prefer leverage over equity financing to inflate their equity stake to protect them from the potential takeovers and mergers. We report that capital structure decisions in Singapore are linked with the trade-off between the controlling shareholders' target of mitigating firm risk and their non-dilution entrenchment needs. Further, we found an inverted U-shaped association between control ownership and leverage financing. In terms of moderating effect of family-controlled ownership, our findings exhibit that leverage financing is less pronounced for family firms in Singapore due to the under-diversified investment portfolio.     

Credit Ratings and Capital Structure

This paper examines to what extent credit ratings directly affect capital structure decisions. The paper outlines discrete costs (benefits) associated with firm credit rating level differences and tests whether concerns for these costs (benefits) directly affect debt and equity financing decisions. Firms near a credit rating upgrade or downgrade issue less debt relative to equity than firms not near a change in rating. This behavior is consistent with discrete costs (benefits) of rating changes but is not explained by traditional capital structure theories. The results persist within previous empirical tests of the pecking order and tradeoff capital structure theories.     

The Determinants of Financial Structure: New Insights from Business Start‐ups

Business start‐ups lack prior history and reputation, face high failure risk, and have highly concentrated ownership. The resulting information and incentive problems, combined with entrepreneurial private benefits of control, affect initial financing decisions. This paper examines simultaneously the impact of these issues on leverage, debt mix and maturity. We find that start‐ups with high adverse selection and risk shifting problems contract less bank debt but compensate with other debt sources. Start‐ups in growing industries have lower leverage, but raise more bank debt. Entrepreneurs with large private control benefits contract less but longer term bank loans to lower the default probability.     

MANAGERIAL OWNERSHIP,TAKEOVER DEFENSES,AND DEBT FINANCING

We examine the effect of agency conflicts on debt financing and show that managerial ownership and its interaction with takeover defenses affect these decisions. We find that (1) the relation between leverage and takeover defenses becomes insignificant when we control for the interaction of these defenses with managerial ownership, and (2) firms with large managerial ownership operate at high debt levels unless they have a large number of takeover defenses. Therefore, a two‐dimensional aspect of governance that includes the interaction between managerial ownership and takeover defenses is useful in understanding the effect of agency conflicts on firms' debt financing decisions.     

Capital and ownership structures, and the market for corporate control

I analyze optimal capital and ownership structures as resultingfrom anticipated future control contests. I focus on leverageas a device that enables the incumbent management to extractthe maximum value from the rival. I show that firm value dependson both capital and ownership structures. The analysis leadsto the following predictions: (i) more efficient managers useless debt, (ii) firms facing better rivals for control issuemore debt, and (iii) firms with supermajority rules issue lessdebt. Several predictions are consistent with known empiricalregularities.     

Determinants of Bank Debt in a Continental Financial System: Evidence from Spanish Companies

We test hypotheses about the structure of corporate debt ownership and the use of bank debt by firms in a civil‐law country, Spain. We focus on bank debt effects in the presence of information asymmetries and agency costs, and on efficient versus inefficient firm liquidation. We find that the relation between growth opportunities and bank financing is not as strong as the one found in common‐law countries, that there is a positive relation between firm size and the proportion of bank debt used, and that firms closer to bankruptcy and highly leveraged are more likely to use bank debt.