Do LBO Supermarkets Charge More? An Empirical Analysis of the Effects of LBOs on Supermarket Pricing

This article examines changes in supermarket prices in local markets following supermarket leveraged buyouts (LBOs). I find that prices rise following LBOs in local markets in which the LBO firm's rivals are also highly leveraged and that LBO firms have higher prices than their less leveraged rivals, suggesting that LBOs create incentives to raise prices. However, I also find that prices fall following LBOs in local markets in which rival firms have low leverage and are concentrated. These price drops are associated with LBO firms exiting the local market, suggesting that rivals attempt to “prey” on LBO chains.     

Predicting systematic risk: Implications from growth options

In accordance with the well-known financial leverage effect, decreases in stock prices cause an increase in the levered equity beta for a given unlevered beta. However, as growth options are more volatile and have higher risk than assets in place, a price decrease may decrease the unlevered equity beta via an operating leverage effect. This is because price decreases are associated with a proportionately higher loss in growth options than in assets in place. Most of the existing literature focuses on the financial leverage effect: This paper examines both effects. We show, with a simple option pricing model, the opposing effects at work when the firm is a portfolio of assets in place and growth options. Our empirical results show that, contrary to common belief, the operating leverage effect largely dominates the financial leverage effect, even for initially highly levered firms with presumably few growth options. We then link variations in betas to measurable firm characteristics that proxy for the fraction of the firm invested in growth options. We show that these proxies jointly predict a large fraction of future cross-sectional differences in betas. These results have important implications on the predictability of equity betas, hence on empirical asset pricing and on portfolio optimization that controls for systematic risk.     

LEVERAGE, RESOURCE ALLOCATION AND GROWTH

The effects of resource allocation on firms comprising the competitive economy are examined within the structure of a simple general equilibrium model. The study shows that capital structure of a firm is independent of its value, — a result that can be characterized as the mirror-image of the celebrated Modigliani-Miller proposition. The structure of present analysis highlights how costs of capital assets change, what affects the prices of the firms, and how these changes are reflected in the operations of the firms in an overall economic set up. The paper then establishes that if debt is increased, and the (relatively) levered firm expands, its stock price goes up and the (relatively) less levered firm shrinks and moves in the opposite direction in all respects. The appropriate conditions for profitable leveraged buyout are spelled out, and other conditions are also specified as to when merger is unprofitable. Finally, the paper is concluded with some thoughts on possible future research along the lines outlined in this work.     

The Intra-Industry Effects of Going-Private Transactions

We demonstrate that bids to take firms private generate significantly positive valuation effects for industry rivals of target firms. These valuation effects cannot reflect either synergy or monopoly since no consolidation of operating firms is involved in such transactions. Participation by buyout specialists in the bid does not significantly affect these gains. Bids by outsiders and bids by incumbent managers generate similar valuation effects for industry rivals. The effect on share prices of industry rivals is inversely related to the capitalized values of rival firms relative to the target firm. We also report valuation effects for target firms.     

Executive Compensation, Strategic Competition, and Relative Performance Evaluation: Theory and Evidence

We examine compensation contracts for managers in imperfectly competitive product markets. We show that strategic interactions among firms can explain the lack of relative performance-based incentives in which compensation decreases with rival firm performance. The need to soften product market competition generates an optimal compensation contract that places a positive weight on both own and rival performance. Firms in more competitive industries place greater weight on rival firm performance relative to own firm performance. We find empirical evidence of a positive sensitivity of compensation to rival firm performance that is increasing in the degree of competition in the industry.     

Cash-flow shortage as an endogenous bankruptcy reason

This paper develops a simple model for a leveraged firm and endogenizes the firm’s bankruptcy point by assuming that equity issuance is costly. Equity-issuance costs reflect the difficulties in issuing new equity for firms that are close to financial distress. The resulting model captures cash-flow shortage as a reason to go bankrupt, though the equity value is positive. I analyze the optimal bankruptcy point as well as corporate bond prices and yield spreads for various levels of equity-issuance costs in order to study the impact of different liquidity constraints. Finally, I discuss the consequences on optimal capital structure.     

Investment policy with time-to-build

Most capital projects have an implementation lag. We examine the effect of implementation lag on a levered firm’s investment decision. The main finding is that implementation lag can potentially have a substantial effect on a levered company’s investment trigger, and this effect can be significantly different from that of an unlevered company. The exact relationship between lag and investment trigger depends on the level of debt used by the firm. For an optimally-levered firm, a crucial determinant of the lag-investment relationship is the fraction of investment cost that has to be incurred upfront. If this fraction is small, investment trigger is a decreasing function of implementation lag and the effect can be economically significant. If this fraction is large, investment trigger can be either increasing or decreasing in lag, depending on parameter values, but the magnitude of the effect is not large. Optimally levering a firm makes the implementation lag more investment-friendly relative to an unlevered firm, thus it is possible that the lag has a negative effect on investment if the firm is unlevered but a positive effect if the same firm is optimally-levered. For an optimally-levered firm, implementation lag generally has a non-negative effect on investment.     

How Big is the Tax Advantage to Debt?

This paper uses an option valuation model of the firm to answer the question, “What magnitude tax advantage to debt is consistent with the range of observed corporate debt ratios?” We incorporate into the model differential personal tax rates on capital gains and ordinary income. We conclude that variations in the magnitude of bankruptcy costs across firms can not by itself account for the simultaneous existence of levered and unlevered firms. When it is possible for the value of the underlying assets to jump discretely to zero, differences across firms in the probability of this jump can account for the simultaneous existence of levered and unlevered firms. Moreover, if the tax advantage to debt is small, the annual rate of return advantage offered by optimal leverage may be so small as to make the firm indifferent about debt policy over a wide range of debt-to-firm value ratios.     

Investment options with debt-financing constraints

A contingent claims model is used to study the impact of debt-financing constraints on firm value, optimal capital structure, the timing of investment and other variables, such as credit spreads. The optimal investment trigger follows a U shape as a function of exogenously imposed constraint. Risky, equity-financed R&D growth options increase firm value by increasing the option value on unlevered assets, while their impact on the net benefits of debt is small.     

Local Risk,Local Factors,and Asset Prices

Firm location affects firm risk through local factor prices. We find more procyclical factor prices such as wages and real estate prices in areas with more cyclical economies, namely, high “local beta” areas. While procyclical wages provide a natural hedge against aggregate shocks and reduce firm risk, procyclical prices of real estate, which are part of firm assets, increase firm risk. We confirm that firms located in higher local beta areas have lower industry‐adjusted returns and conditional betas, and show that the effect is stronger among firms with low real estate holdings. A production‐based equilibrium model explains these empirical findings.