SIMULTANEOUS DEBT AND EQUITY ISSUES AND CAPITAL STRUCTURE TARGETS

Numerous empirical studies find evidence that managers behave as if they pursue target debt ratios. A possible alternative to the use of conventional, separate issuances of debt and equity to effect desired adjustments toward a target ratio is the simultaneous issuance of such securities. We extend prior research on such issues by exploring their use in the pursuit of capital structure targets. We find that the issuance of securities in general and the use of simultaneous issues of debt and equity in particular are at least partially influenced by where a firm's capital structure is relative to the average position in its industry. Further, shareholders' reactions to the announced plan to issue and to the issuance of securities are influenced, in part, by whether the issue moves the firm toward or away from the average capital structure in the industry. We also find evidence that the infrequent use of simultaneous issues relative to unaccompanied debt and equity issues is explained by their comparative flotation costs.     

Asymmetric Information and Risky Debt Maturity Choice

When capital market investors and firm insiders possess the same information about a company's prospects, its liabilities will be priced in a way that makes the firm indifferent to the composition of its financial liabilities (at least under certain, well-known circumstances). However, if firm insiders are systematically better informed than outside investors, they will choose to issue those types of securities that the market appears to overvalue most. Knowing this, rational investors will try to infer the insiders' information from the firm's financial structure. This paper evaluates the extent to which a firm's choice of risky debt maturity can signal insiders' information about firm quality. If financial market transactions are costless, a firm's financial structure cannot provide a valid signal. With positive transaction costs, however, high-quality firms can sometimes effectively signal their true quality to the market. The existence of a signalling equilibrium is shown to depend on the (exogenous) distribution of firms' quality and the magnitude of underwriting costs for corporate debt.     

Aligning Incentives at Systemically Important Financial Institutions: A Proposal by the Squam Lake Group

To address the moral hazard problem that can motivate bank executives to take excessive risks and to fail to raise capital when needed, a group of 13 distinguished financial economists recommends that systemically important financial institutions be required to issue contingent convertible debt (CoCos) and to hold back a substantial share—as much as 20%—of the compensation of employees who can have a meaningful impact on the survival of the firm. This holdback should be forfeited if the firm's capital ratio falls below a specified threshold. The deferral period should be long enough—the authors suggest five years—to allow much of the uncertainty about managers' activities to be resolved before the bonds mature. Except for forfeiture, the payoff on the bonds should not depend on the firm's performance, nor should managers be permitted to hedge the risk of forfeiture. The threshold for forfeiture should be crossed well before a firm violates its regulatory capital requirements and well before its contingent convertible securities convert into equity. The Swiss Bank UBS has paid bonuses to its top 6,500 executives that have been structured in exactly this way. Management forfeits its deferred compensation if the bank's regulatory capital ratio falls below 7.5%, and its contingent convertible debt is set up to convert into equity if the bank's capital ratio falls below 5%.     

Discretionary Accounting Choices: A Debt covenants Based Signalling Approach

This paper seeks to explain the discretionary accounting choices made by managers in a world characterised by asymmetric information between managers and investors. It considers a firm whose capital structure consists of both debt and equity, a manager who protects the interests of the firm's existing shareholders, and a financial market. The manager is committed to engage in an investment opportunity and needs to raise some equity to finance it. He is furthermore endowed with some private information about his firm's future earnings. The paper shows how, under certain conditions, the manager may credibly communicate his private information to investors through his accounting choices. In this equilibrium, the selection of balance sheet strengthening and income increasing accounting choices signals unfavourable information while the use of balance-sheet weakening and income- decreasing accounting choices signals favourable private information. The latter firms should thus experience positive abnormal returns around the announcement dates of their accounting choices.     

Capital structure with dividend restrictions

This paper develops a symmetric information model of a new firm which incorporates a constraint on dividend payments known as a balance sheet test. This test solves moral hazard problems that arise in credit markets where complete contracting over future actions is not possible. This constraint breaks down the traditional symmetric information result of separability between financial and real variables, and thus maximizing shareholder returns in this setting is not equivalent to maximizing total firm value. As a consequence, more profitable firms, those with a higher average product of capital, will have lower debt/equity ratios. Debt/equity ratios will be positively correlated with the firm's physical capital and negatively correlated with the firm's market power.     

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.     

CONVERTIBLE DEBT AND RISK‐SHIFTING INCENTIVES

I argue that convertible debt, in contrast to its perceived role, can produce shareholders’ risk‐shifting incentives. When a firm's capital structure includes convertible debt, every investment decision affects not only the distribution of the asset value but also the likelihood that the debt will be converted and thereby the distribution of the firm's leverage. This suggests that managers can engage in risk‐increasing projects if a higher asset risk generates a more favorable distribution of leverage. Empirical evidence using 30 years of data supports my argument.     

Capital Structure Swaps and Shareholder Wealth

We show how capital structure swaps can increase the wealth of a firm's long‐term shareholders when a firm's debt or equity is misvalued. We review the conventional rule that a firm should issue equity and use the proceeds to retire outstanding debt (an equity‐for‐debt swap) when equity is overvalued, or repurchase equity with proceeds of new debt (a debt‐for‐equity swap) when equity is undervalued. We also analyse the more complex case where a firm's debt and equity are both undervalued, showing the optimal swap may be to issue undervalued equity, contrary to the conventional rule.     

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.     

CONVERTIBLE BONDS: MATCHING FINANCIAL AND REAL OPTIONS

For companies whose value consists in large part of “real options”‐ growth opportunities that may (or may not) materialize‐convertible bonds may offer the ideal financing vehicle because of the matching financial options built into the securities. This paper proposes that convertible debt can be a key element in a financing strategy that aims not only to fund current activities, but to give companies access to low‐cost capital if and when their real investment options turn out to be valuable. In this sense, convertibles can be seen as the most cost‐effective solution to a sequential financing problem‐how to fund not only today's activities, but also tomorrow's growth opportunities (some of them not yet even foreseeable). For companies with real options, the ability of convertibles to match capital inflows with corporate outlays adds value by minimizing two sets of costs: those associated with having too much (particularly equity) capital (known as “agency costs of free cash flow”) and those associated with having too little (“new issue” costs). The key to the cost‐effectiveness of convertibles in funding real options is the call provision. Provided the stock price is “in the money” (and the call protection period is over), the call gives managers the option to force conversion of the bonds into equity. If and when the company's investment opportunity materializes, exercise of the call feature gives the firm an infusion of new equity (while eliminating the debt service burden associated with the convertible) that enables it to carry out its new investment plan. Consistent with this argument, the author's recent study of the investment and financing activities of 289 companies around the time of convertible calls reports significant increases in capital expenditures starting in the year of the call and extending three years after. The companies also showed increased financing activity following the call, mainly new long‐term debt issues (many of them also convertibles) in the year of the call.     

TEXTBOOK INCONSISTENCIES IN GRAPHING VALUATION EQUATIONS: A FURTHER NOTE

In this note, the authors demonstrate that if a firm's leverage ratio is measured by debt-to-total value (debt-to-equity) in the pure capital structure rearrangement framework implicit in research reported by Modigliani and Miller (e.g., debt-to-equity exchanges), the market value of levered equity will be a concave (convex) function, and the market value of debt will be a convex (concave) function. These nonlinearities exist even without bankruptcy costs.     

Does equity market timing have a persistent impact on capital structure? Evidence from China

This paper uses the change in individual securities accounts as a measure of equity funding supply to examine whether the persistent timing effect on capital structure exists for the Chinese equity market. This new equity timing measure avoids previous criticisms over a timing measure not being independent of a firm's characteristics of capital structure. Our empirical results show that this new measure is an effective market timing variable for issuing equity in the Chinese equity market, and that a persistent effect of equity market timing on firm capital structure exists for more than 7 years. This paper offers evidence that the market conditions of equity funding supply play an important role in corporate financing decisions in China.     

Perquisites,Risk, and Capital Structure

In a corporate agency problem, perquisites and risk interact to produce novel, complex comparative statics. For example, even if additional debt induces risk-neutral insiders to increase risk, they never seek to increase the market value of their stock; instead, insiders decrease the present value of their subsequent, conditionally optimal perquisites. Also, the firm's optimal capital structure includes a risky bond with an agreement to remove insiders whenever the bond defaults. However, the optimal sharing rule between corporate claimants cannot be supported solely by standard securities such as bonds, stocks, options, and their hybrids.     

Managerial Preference,Asymmetric Information,and Financial Structure

If firm performance affects managers' wealth or reputation, preferences of managers dominate firms' financing decisions. When information about real asset investment is symmetric, managers finance exclusively with equity. If managers know more about asset quality than do investors and if managers are sufficiently risk averse, they signal high-quality projects with debt. Increases in collateral value decrease risky debt use. Increases in interest rates that do not change productive opportunities increase debt use. The explanation for these and further results is based on underpricing of equity and overpricing of debt at the margin.     

The Effect of Lender Identity on a Borrowing Firm's Equity Return

Previous research demonstrates that a firm's common stock price tends to fall when it issues new public securities. By contrast, commercial bank loans elicit significantly positive borrower returns. This article investigates whether the lender's identity influences the market's reaction to a loan announcement. Although we find no significant difference between the market's response to bank and nonbank loans, we do find that lenders with a higher credit rating are associated with larger abnormal borrower returns. This evidence complements earlier findings that an auditor's or investment banker's perceived “quality” signals valuable information about firm value to uninformed market investors.     

Capital Structure and Debt Priority

We study a defaultable firm's debt priority structure in a simple structural model where the firm issues senior and junior bonds and is subject to both liquidity and solvency risks. Assuming that the absolute priority rule prevails and that liquidation is immediate upon default, we determine the firm's interior optimal priority structure along with its optimal capital structure. We also obtain closed‐form solutions for the market values of the firm's debt and equity. We find that the magnitude of the spread differential between junior and senior bond yields is positively, but not linearly related to the total debt level and the riskiness of assets. Finally, we provide an in‐depth analysis of probabilities of default and the term structure of credit spreads.     

Optimal Security Design and Dynamic Capital Structure in a Continuous-Time Agency Model

We derive the optimal dynamic contract in a continuous‐time principal‐agent setting, and implement it with a capital structure (credit line, long‐term debt, and equity) over which the agent controls the payout policy. While the project's volatility and liquidation cost have little impact on the firm's total debt capacity, they increase the use of credit versus debt. Leverage is nonstationary, and declines with past profitability. The firm may hold a compensating cash balance while borrowing (at a higher rate) through the credit line. Surprisingly, the usual conflicts between debt and equity (asset substitution, strategic default) need not arise.     

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.     

The effect of leverage on bargaining with a corporation

This paper shows that the choice of a capital structure by a firm affects the bargaining posture of its shareholders vis-a-vis its suppliers of specialized production factors. The pricing of the firm's securities and the choice of a capital structure are analyzed in light of this effect of debt financing.     

Beta Geared and Ungeared: Further Analysis of the Case of Active Debt Management

This paper extends previous work by Appleyard and Strong (1989) concerned with the implications of an active debt management policy (ADMP) for de-gearing a geared firm's equity beta. First, alternative derivations of the ADMP beta de-gearing formulae for an MM perfect capital market with corporation tax and for a world with corporation and personal taxes are presented. These derivations do not require the assumption of level perpetuity expected cash flows and therefore indicate a broader basis for the ADMP beta de-gearing formulae than previously demonstrated. Secondly, possible investor valuation errors from use of a PDMP (passive debt management policy) valuation methodology to value firms pursuing an ADMP are analysed in the context of an MM perfect capital market with corporation tax. Given constant (or zero) growth in the firm's expected unlevered cash flows, this analysis indicates that degearing errors from use of the PDMP beta de-gearing formula will only be associated with valuation errors if there is a change in the firm's target debt ratio and that the significance of such valuation errors will be largely dependent on the expected growth rate.