Corporate liquidity and dividend policy under uncertainty

We examine optimal liquidity (retained earnings) and dividend choice incorporating debt financing with risk of default and bankruptcy costs as well as growth options under revenue uncertainty. We revisit the conditions for dividend policy irrelevancy and the broader role of retained earnings and dividends. Retained earnings have a net positive impact on firm value in the presence of growth options, high external financing costs and low default risk. High levels of retained earnings enhance debt capacity but have a negative effect on equity value due to the likelihood of losing accumulated cash balances in case of default, unless offset by high external financing costs. Opposite directional effects of retained earnings on equity and debt create a U-shaped relation with firm value. The framework is extended to analyze management-shareholder conflicts, demonstrating that managers accumulate higher than optimal cash.     

Dividend policy and the earned/contributed capital mix: a test of the life-cycle theory

Consistent with a life-cycle theory of dividends, the fraction of publicly traded industrial firms that pay dividends is high when retained earnings are a large portion of total equity (and of total assets) and falls to near zero when most equity is contributed rather than earned. We observe a highly significant relation between the decision to pay dividends and the earned/contributed capital mix, controlling for profitability, growth, firm size, total equity, cash balances, and dividend history, a relation that also holds for dividend initiations and omissions. In our regressions, the mix of earned/contributed capital has a quantitatively greater impact than measures of profitability and growth opportunities. We document a massive increase in firms with negative retained earnings (from 11.8% of industrials in 1978 to 50.2% in 2002). Controlling for the earned/contributed capital mix, firms with negative retained earnings show virtually no change in their propensity to pay dividends from the mid-1970s to 2002, while those whose earned equity makes them reasonable candidates to pay dividends have a propensity reduction that is twice the overall reduction in Fama and French [2000, Journal of Financial Economics 76, 549–582]. Finally, our simulations show that, if well-established firms had not paid dividends, their cash balances would be enormous and their long-term debt trivial, thus granting extreme discretion to managers of these mature firms.     

Agency Cost,Dividend Policy and Growth: The Special Case of REITs

Dividend distribution enhances information transmission, and mitigates agency conflicts by restricting managers’ access to free cash flow, and exposing firms to the scrutiny and monitoring by market participants when raising external capital. The reduction in agency costs and improvement in information dissemination reduce the cost of funds, and investment at more competitive cost of capital enhances firm value. For REITs, because of the mandated high dividend distribution, growth depends on the availability of external capital at competitive rates, such that mitigation of agency costs is critical to sustain growth. We examine the relation between dividends and growth with a sample of U.S. equity REITs. Our data reveal a significantly positive relation between externally financed growth and dividend payments. The relation is stronger among REITs with more growth opportunities, and REITs that issue new equity and debt. We interpret this evidence as consistent with the notion that by reducing agency costs and facilitating capital raising, dividends enhance growth.     

Asymmetric valuation of sustained growth by bond- and equity-holders

Viewing equity as a call option on the firm’s assets with a strike price equal to contractual debt obligations yields an asymmetric prediction on how debt and equity markets view sustained growth. Debt holders are expected to benefit from sustained growth when the default risk is high, while equity holders value such growth when risk is low. Using Altman’s z-score and debt ratings as alternative proxies for the default risk, we document a negative association between bond yield spreads and sustained growth in earnings for firms with high risk only. In sharp contrast, using earnings multiples from returns-earnings regressions as a proxy for equity market rewards, we find that earnings multiples are larger when earnings growth is sustained for the low risk sample only. Decomposing earnings growth into revenue and nonrevenue growth, we find that the debt market rewards for firms with revenue growth are confined to the high risk sample only, while nonrevenue growth firms are not rewarded for either sample. Equity investors value revenue-led earnings growth for low and high risk samples while nonrevenue growth is rewarded for the low risk sample only. Our study adds to our understanding of how changes in firm value from sustained earnings and revenue growth are divided between key providers of capital and how default risk plays an instrumental role in this valuation process.     

自由现金流量创造力与违约风险——来自A股公司的经验证据

本文基于我国A股上市公司数据,研究了企业自由现金流量创造力与违约风险之间的关系。研究发现:(1)企业自由现金流量创造力越强,其违约风险越低。经过一系列稳健性检验后,该结论依旧成立。(2)自由现金流量创造力越强的企业往往有更低的债务规模、更高的资产收益率和更低的股票波动,因而其违约风险更低。(3)自由现金流量创造力与违约风险的负相关关系,主要存在于货币政策紧缩时期以及外部信息环境较差的企业。本文发现意味着,监管部门和投资者应重视上市公司自由现金流量创造力不足所带来的潜在债务违约风险,通过不断提高公司自由现金流量创造力,助力我国宏观经济与微观企业高质量发展。     

Bloomberg Intelligence Roundtable on The Theory and Practice of Capital Structure Management

Since the formulation of the M&M propositions almost 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 maximizes shareholder value. Some finance scholars have followed M&M in arguing that both capital structure and dividend policy are largely “irrelevant” in the sense that they have 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 greater debt against the costs of financial distress. Yet another theory says that companies do not have capital structure targets, but simply follow a financial “pecking order” in which retained earnings are preferred to outside financing, and debt is preferred to equity when outside funding is required. In this roundtable, a leading finance professor is joined by six practitioners in discussing whether and how capital structure decisions and payout policies can create value, with special attention to the healthcare industry. The consensus is that for those parts of the pharma industry with large growth opportunities, equity financing should be the main source of capital. But for those parts of the industry with shrinking prospects, increasing levels of debt and raising dividends are recommended.     

Sources of Corporate Financing and Operating Performance: The effects of strategic ownership and financial restatements

Using a sample from European markets this study documents that changes in external financing, both in the form of equity and debt, can predict future operating performance (profitability and cash flows). In terms of future profitability, increases in equity (debt) financing particularly benefit large-size growth firms (large-size value firms). It is notable that a firm environment of low information quality, indicated by the presence of accounting restatements, intensifies the association between external financing and operating performance, due to the heightened scrutiny investors/lenders apply to firms that have recently restated their financials. In addition, strategic ownership in the firm has no significant effect on the financing – operating profitability association but may amplify the positive effects of equity financing on future operating cash flows. Moreover, financial analysts' forecasts of operating profitability and operating cash flows reflect the impact of external financing changes on future operating performance but exhibit a financing-related systematic inefficiency particularly for firms that have recently announced a material restatement of their prior financial results. Finally, controlling for information contained in analyst forecast surprises, the market is efficient overall and incorporates the effects of equity and debt financing changes into stock prices.     

Free Cash Flow,Issuance Costs,and Stock Prices

We develop a dynamic model of a firm facing agency costs of free cash flow and external financing costs, and derive an explicit solution for the firm's optimal balance sheet dynamics. Financial frictions affect issuance and dividend policies, the value of cash holdings, and the dynamics of stock prices. The model predicts that the marginal value of cash varies negatively with the stock price, and positively with the volatility of the stock price. This yields novel insights on the asymmetric volatility phenomenon, on risk management policies, and on how business cycles and agency costs affect the volatility of stock returns.     

Monetary policy and regional availability of debt financing

The relative availability of bond and bank financing should affect the firm's external financing and investment decisions. We define a measure that proxies for the regional borrowing inflexibility to substitute between bank and bond financing: “debt inflexibility”. Debt inflexibility tilts the firm's financial structure towards equity and reduces investment. The impact is stronger during the period of tight monetary policy, particularly for smaller firms and firms without banking relationships. Debt inflexibility increases the sensitivity of cash holdings to cash flows, reduces the likelihood of dividend payment and makes the firm more likely to pay equity in mergers and acquisitions.     

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     

How do firms finance their investments?: The relative importance of equity issuance and debt contracting costs

This paper examines the financing decisions of firms in response to changes in investments and profits. We find that information frictions play important roles in firms' financing decisions. However, we find no evidence that asymmetric information about the value of a firm's assets causes equity to be used only as a last resort. Indeed equity is the predominant source of finance in situations, such as profit shortfalls, investment in intangible assets, and internally generated growth opportunities, where informational asymmetries and agency costs are likely to be high. We also find that firms respond asymmetrically to positive and negative profit shocks. In financing fixed assets, high asymmetric information firms use more short-term debt and less long-term debt, whereas firms with high potential agency problems use significantly more equity and less long-term debt and cash.     

The Capital Structure Puzzle: The Evidence Revisited

Since the formulation of the M&M propositions almost 50 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 maximizes shareholder value. Some finance scholars have followed M&M in arguing that both capital structure and dividend policy are largely "irrelevant" in the sense that they have 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 greater debt against the costs of financial distress. Yet another theory says that companies do not have capital structure targets, but simply follow a financial "pecking order" in which retained earnings are 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 an important role in corporate financing decisions. While much of the evidence is consistent with the argument that companies set target leverage ratios, there is also considerable support for the pecking order theory's contention that firms 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 (the levels of debt and equity in relation to the target) and flows (or which security to issue at a particular time).     

An Integrated Model of Debt Issuance, Refunding, and Maturity

We integrate previous work in this area and develop a multiperiod model that simultaneously determines bond refunding, bond issuance, maturity structure, cash holdings, and bank borrowing policies. The focus here is on providing the required debt funds in the most cost efficient fashion. A strength of the model is that it allows for time varying interest costs, transaction costs, issuance costs, and refunding costs to be firm specific. The output of the model lays out the optimal financing decisions for each time interval that minimize the total discounted cost of providing the funds that match the requisite funds. By limiting the surplus funds available, the model minimizes the management incentive to over invest and thereby reduces the agency costs. The model has economic implications for the financing decisions and the firm's default risk, growth opportunities, riskiness of cash flows, and firm size. JEL Classification: G30     

The Persistence and Pricing of the Cash Component of Earnings

Prior research shows that the cash component of earnings is more persistent than the accrual component. We decompose the cash component into: (1) the change in the cash balance, (2) issuances/distributions to debt, and (3) issuances/distributions to equity. We find that the higher persistence of the cash component is entirely due to the subcomponent related to equity. The other subcomponents have persistence levels almost identical to accruals. We investigate whether investors understand the implications of the differential persistence of the three subcomponents. Our results suggest that investors correctly price debt and equity issuances/distributions but misprice the change in the cash balance in a similar manner to accruals. Our tests enable us to empirically distinguish the “accrual” and “external financing” anomalies with results implying that the accrual anomaly subsumes the external financing anomaly. Our results also suggest that naive fixation on earnings is unlikely to be a complete explanation for the accrual anomaly. Our findings are more consistent with investors misunderstanding diminishing returns to new investments.     

THE CAPITAL STRUCTURE PUZZLE: ANOTHER LOOK AT THE EVIDENCE

Since the formulation of the M & M irrelevance propositions 40 years ago, financial economists have been debating whether there is such a thing as optimal capital structure—a proportion of debt to equity that maximizes current firm value. Some finance scholars have followed M & M by arguing that both capital structure and dividend policy are largely “irrelevant” in the sense that they have 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 greater debt against the increased probability and costs of financial distress. Yet another theory says that companies do not have capital structure targets, but instead follow a financial pecking order in which retained earnings are 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 (the main factor in the pecking order theory) all appear to play an important role in corporate financing decisions. While much if not most of the evidence is consistent with the argument that companies set target leverage ratios, there is also considerable support for the pecking order theory's contention that firms 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 (leverage ratios) and flows (specific choices between debt and equity). Even if companies have target leverage ratios, there will be an optimal deviation from those targets—one that will depend on the transactions and information costs associated with adjusting back to the target relative to the costs of deviating from the target. 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 target.     

The accuracy of analysts' dividend forecasts around the world

We examine the link between the accuracy of consensus analysts' dividend forecasts, earnings predictability and dividend policies of firms in 39 countries from 1995 to 2004. For firms that display stronger dividend smoothing, as modeled by Lintner [Lintner, J., 1956. Distribution of incomes of corporations among dividends, retained earnings and taxes. American Economic Review 46, 97–113], there is a lower correlation between dividend and earnings forecast errors, with less of the earnings uncertainty being passed into dividend uncertainty. The link between earnings and dividend forecast errors is weaker in common-law, capital market-based countries and in countries with well-developed financial (debt and equity) markets, where firm managers have greater incentives to smooth dividends and to use dividends for signaling.     

The Value of Financial Flexibility

We develop a model that endogenizes dynamic financing, investment, and cash retention/payout policies in order to analyze the effect of financial flexibility on firm value. We show that the value of financing flexibility depends on the costs of external financing, the level of corporate and personal tax rates that determine the effective cost of holding cash, the firm's growth potential and maturity, and the reversibility of capital. Through simulations, we demonstrate that firms facing financing frictions should simultaneously borrow and lend, and we examine the nature of dynamic debt and liquidity policies and the value associated with corporate liquidity.     

GROWTH,BETA AND AGENCY COSTS AS DETERMINANTS OF DIVIDEND PAYOUT RATIOS

A model of optimal dividend payout is presented in which increased dividends lower agency costs but raise the transactions cost of external financing. The optimal dividend payout minimizes the sum of these two costs. A cross-sectional test of the model relates dividend payout to the fraction of equity held by insiders, the past and expected future revenue growth of the firm, the firm's beta coefficient, and the number of common stockholders. The coefficients of all variables are significant in the predicted directions. The results indicate that investment policy influences dividend policy.     

Financial Contracting and Leverage Induced Over- and Under-Investment Incentives

This paper investigates the effects of seniority rules and restrictive dividend convenants on the over- and under-investment incentives associated with risky debt. We show that increasing seniority of new debt decreases the incidence of under-investment but increases over-investment, and vice versa. Under symmetric information, the optimal seniority rule is to give new debtholders first claim on a new project without recourse to existing assets (i.e., project financing). Under asymmetric information, the optimal debt contract requires equating the expected return to new debtholders in the default state to the new project's cash flow in the same rate. If this is not possible, the optimal seniority rule calls for strict subordination of new debt if the expected cash flow in default is small and full seniority if it is large. With regard to dividend convenants, we show that their effect depends on whether or not dividend payments are conditioned on future investments. When they are unconditioned, allowing more dividends increases the under-investment incentive. In contrast, conditional dividends decrease the underinvestment incentive and increase the over-investment incentive.     

Sources of Financing,Profitability and Productivity: First Evidence from Matched Firms

This paper contributes to the literature on capital structure and firm performance. Using firm‐level data covering over 11,000 firms from 47 countries over a recent period of 1997‐2007, we address the effect of different sources of financing on corporate performance, employing a matching process, which allows an adequate `like‐for‐like’ comparison between high and low level of financing by firms. Robust to different matching estimators, the main findings are consistent with the theories of capital structure, in that firms with high debt‐to‐equity ratio tend to have lower returns to shareholders (profitability) and lower internal efficiency (productivity). The results become more robust when we separate the firms into advanced and emerging country‐groups or countries with high/low levels of financial development. Given the lower level of leverage below 50% on average in emerging markets (or in countries with lower level of financial reforms), firms in these economies face lower risk of financial distress and thereby less adverse effect on firm profitability and productivity, relative to their counterparts in advanced economies. We also find that retained earnings and equity financing improve performance, while debt financing by firms particularly in the form of bank loans leads to lower performance, although not so in the case of debt raised through issuing bonds.