Debt,hedging and human capital

This paper provides a theory of debt and hedging based on human capital. We distinguish human capital from physical capital in two ways: (1) human capital is inalienable and can exercise a one-sided option to leave the firm and (2) human capital is not perfectly replaceable. We show that a firm may reach the first best solution while issuing debt or equity to outsiders provided that either the insiders receive a senior claim or that the firm hedges. We then show that given asymmetric information concerning costs the only viable solution has the firm issuing debt to outsiders and hedging.     

Multiple corporate governance attributes and the cost of capital – Evidence from Germany

This paper investigates the extent to which corporate governance affects the cost of debt and equity capital of German exchange-listed companies. I examine corporate governance along three dimensions: financial information quality, ownership structure and board structure. The results suggest that firms with high levels of financial transparency and bonus compensations face lower cost of equity. In addition, block ownership is negatively related to firms' cost of equity when the blockholders are other firms, managers or founding-family members. Consistent with the conjecture that agency costs increase with firm size, I find significant cost of debt effects only in the largest German companies. Here, the creditors demand lower cost of debt from firms with block ownerships held by corporations or banks. My findings demonstrate that a uniform set of governance attributes is unlikely to satisfy suppliers of debt and equity capital equally.     

Share‐pledging and the cost of debt

We examine how corporate insiders pledging their equity stakes to collateralise personal loans influences firm cost of debt. Pledging enables managers to diversify personal holdings, potentially increasing risk‐taking incentives. However, exposure to contingent risks creates potentially stronger risk‐reducing incentives. Using hand‐collected data with OLS, difference‐in‐differences, and instrumental variables models, we find significant decreases in yield spreads associated with executive share‐pledging. Reductions in spreads surrounding share‐pledge disclosures suggest investors update their risk assessment to reflect pledging managers’ risk‐taking incentives. Consistent with risk‐reducing incentives, firms with share‐pledging executives subsequently reduce leverage.     

Capital structure and signaling game equilibria

In this article we model the financing decisions of a firm asa sequential signaling game. We prove that, when insiders haveperfect information regarding the firm's future case flows,the application of 'refinements' to the set of admissible equilibrialeads to the dominance of debt over equity financing. However,we show that when insiders observe the firm's cash flows imperfectly,there may exist sequential equilibria in which this 'peckingorder' breaks down and some firms strictly prefer equity todebt financing. We also prove that, despite the breakdown ofthe pecking order, the announcement effect of equity financingwill be negative relative to debt financing.     

CEO inside debt and internal capital market efficiency

Agency theory argues that managerial equity-based incentives are more effective when firm solvency is likely while debt-based incentives are more effective when firms face a greater likelihood of bankruptcy. We examine the relation between chief executive officers' (CEOs') inside debt holdings and the internal capital market allocation of multi-segment firms. We find that CEO inside debt holdings are associated with conservative capital allocation to firm segments, with the result driven by financially distressed firms. Further analysis indicates that although CEO inside debt, on average, is negatively related to firm value, the relation is positive for financially distressed firms. Our evidence indicates that inside debt holdings align the interests of managers and external creditors, inducing managers to pursue conservative capital allocation strategies that appear to be optimal for firms facing insolvency.     

Good cop,bad cop: Complementarities between debt and equity in disciplining management

We demonstrate an inherent conflict between ex ante efficient monitoring and liquidation decisions by outside claimholders. We show it can be useful to commit to inefficient liquidation when monitors fail to produce information: this provides stronger incentives to monitor. The implication for firm capital structure is that more information is generated about firm prospects – and hence firm value increases – when a firm’s cash flow is split into a ‘safe’ claim (debt) and a ‘risky’ claim (equity) compared to when a single claim is sold. We also derive the optimal allocation of control rights between safe and risky claims. This partially resolves the Tirole (2001) puzzle as to why firms issue multiple securities that generate ex post conflicts of interest.     

Managerial risk-reducing incentives and social and exchange capital

This study investigates the impact of managerial risk-reducing incentives on the firm's social and exchange capital. Using CEO inside debt holdings to proxy for the incentives of risk-averse managers, we find that CEOs with more inside debt holdings are likely to invest more in building social capital, which targets broader society and potentially offers anti-risk protection advantages, to shield the value of their inside debt. However, our results further show that managerial risk-reducing incentives have no impact on firms' exchange capital, suggesting the need to recognize the difference between social and exchange capital. These findings corroborate the view that CEOs invest in social capital as a risk management strategy. Furthermore, this paper presents an understanding of the role that institutional investors play in moderating the impact of managerial risk-reducing incentives on social capital. Our results suggest that institutional investors constrain CEOs that have greater inside debt incentives from investing in social capital. However, they are still willing to increase the investment in social capital for risk management purposes when firm risk is high.     

A valuation-based test of market timing

We implement an earnings-based fundamental valuation model to test the impact of market timing on the firm's method of funding the financing deficit. We argue that our valuation metric provides a superior measure of equity misvaluation because it avoids multiple interpretation problems faced by the market-to-book ratio. It also eliminates the need to infer market timing based on the actions of corporate insiders or other indirect measures. We find a strong positive relation between the degree to which a firm is overvalued and the proportion of the firm's financing deficit that is funded with equity. This result is found cross-sectionally and through time and is robust to firm size, and other variables known to impact capital structure. We find evidence that overvaluation in the 1990s led to equity being increasingly preferred over debt. For a broad set of firms, market timing explains a significant portion of the variation in the type of security used to fund the financing deficit.     

An agency theory explanation of SEO underperformance: Evidence from dual-class firms

Using a sample of U.S. dual class companies, we empirically investigate the effects of the divergence between insiders’ voting and cash flow rights on market reaction to seasoned equity offerings (SEOs) and long-run stock performance following SEOs. We find that SEO announcement returns and long-run stock performance following SEOs are negatively related to measures of the divergence between insiders’ voting and cash flow rights. Our results support the view of agency theory as a plausible explanation of SEO underperformance. Misalignment of interests between insiders and outside shareholders can create managerial incentives to undertake value-destroying investments to extract private benefits, ultimately leading to a reduction in firm value.     

Bank Relationship and Firm Performance: Evidence From Thailand Before the Asian Financial Crisis

Abstract:   This study examines the relation between bank relations and market performance in Thailand, an economy in which commercial banks play a crucial role through lending relationship and, for a number of companies, equity ownership. Overall, bank relationships, both equity‐based and debt‐based, positively affect capital investment. However, there is a negative relation between lending relationships, both short‐term and long‐term, and market performance indicating that bank lending may not always be consistent with value maximization. There is also evidence of a positive marginal effect of bank monitoring through equity ownership on market performance. Further, the relation between bank equity ownership and market performance appears to be non‐linear with a concave function. Ownership by corporate insiders is also negatively related to bank equity ownership. Overall, the findings highlight the detrimental effects of excessive short‐term debt usage, one of the factors believed to contribute to the financial crisis in Thailand, and the marginal benefit of the equity‐based relationship on firm value.     

Unbounded liabilities,capital reserve requirements and the taxpayer put option

When firms access unbounded liability exposures and are granted limited liability, then an all equity firm holds a call option, whereby it receives a free option to put losses back to the taxpayers. We call this option the taxpayer put, where the strike is the negative of the level of reserve capital at stake in the firm. We contribute by (i) valuing this taxpayer put, and (ii) determining the level for reserve capital without a reference to ratings. Reserve capital levels are designed to mitigate the adverse incentives for unnecessary risk introduced by the taxpayer put at the firm level. In our approach, the level of reserve capital is set to make the aggregate risk of the firm externally acceptable, where the specific form of acceptability employed is positive expectation under a concave distortion of the cash flow distribution. It is observed that, in the presence of the taxpayer put, debt holders may not be relied upon to monitor risk as their interests are partially aligned with equity holders by participating in the taxpayer put. Furthermore, the taxpayer put leads to an equity pricing model associated with a market discipline that punishes perceived cash shortfalls.     

Optimal capital structures for private firms

This article shows how to construct an optimal capital structure for a private firm. Since the agents who supply the firm’s capital are risk averse, they diversify by holding both debt and equity. This can mitigate, or even eliminate, the classical risk shifting problem. There is a wealth effect since the optimal capital structure, which can involve multiple types of debt, depends on the amount of wealth that each agent contributes to the firm. However, it is shown that the agents’ equity holdings do not depend on the contributed amounts of wealth. Thus the model can produce a wedge between ownership rights and equity cashflow rights. These features are illustrated in a firm with three agents.     

How Entrenchment, Incentives and Governance Influence REIT Capital Structure

Although recent literature has confirmed the importance of viewing a firm??s capital structure choices of leverage and debt maturity as jointly determined, to date there has been little analysis of the importance of traditional governance variables on a firm??s capital structure decisions using a simultaneous equations approach. We examine the influence of managerial incentives, traditional managerial monitoring mechanisms and managerial entrenchment on the capital structure of Real Estate Investment Trusts (REITs). Using panel data, we estimate a system of simultaneous equations for leverage and maturity and find that firms with entrenched CEOs use less leverage and shorter maturity debt. This is consistent with the expectation that managers acting in their own self interest will choose lower leverage to reduce liquidity risk and use short maturity debt to preserve their ability to enhance their compensation and reputations by empire building. We also find evidence that traditional alignment mechanisms such as equity and option ownership have an offsetting effect; and that firms where the founder serves as CEO choose higher leverage and longer maturity debt. The results also provide evidence that leverage and maturity are substitutes, firms with high profitability and growth opportunities use less leverage and firms with liquid assets use more leverage and longer maturity debt.     

The Relation Between Insider-Trading Restrictions and Executive Compensation

In this study I investigate the relation between firm‐level insider‐trading restrictions and executive compensation. Using a trading‐window proxy for the existence of such restrictions, I test predictions that insiders will demand compensation for these restrictions and that firms will need to increase incentives to restricted insiders. I find that firms that restrict insider trading pay a premium in total compensation relative to firms not restricting insider trading, after controlling for economic determinants of pay. Furthermore, these firms use more incentive‐based compensation and their insiders hold larger equity incentives relative to firms that do not restrict insider trading. These results hold after controlling for the endogenous decision to restrict insiders and are consistent with the notion that insider trading plays a role in rewarding and motivating executives.     

Bank stability and market discipline: The effect of contingent capital on risk taking and default probability

This paper investigates the effects of financial institutions issuing contingent capital, a debt security that automatically converts into equity if assets fall below a predetermined threshold. We decompose bank liabilities into sets of barrier options and present closed-form solutions for their prices. We quantify the reduction in default probability associated with issuing contingent capital instead of subordinated debt. We then show that appropriate choice of contingent capital terms (in particular the conversion ratio) can virtually eliminate stockholders' incentives to risk-shift, a motivation that is present when bank liabilities instead include either subordinated debt or additional equity. Importantly, risk-taking incentives continue to be weak during times of financial distress. Our findings imply that contingent capital may be an effective tool for stabilizing financial institutions.     

Aligning debt and equity claimant interests: Evidence from dual claim investors

This study investigates how investors that own both equity and debt in the same firm affect other shareholders in the firm. It documents that dual claim investors are quite prevalent among the industrial firms listed in the Russell 3000, with over 20% of them having a bank holding company that owns both debt and equity in the firm. The results imply that shareholders are substantially impacted by the presence of dual claim investors in firms, suggesting that relatively small ownership stakes by dual claim banks are associated with greater conflicts of interest among shareholders and debt holders; while relatively large bank equity stakes may benefit outside shareholders when aligned with loan by dual claim banks because they improve bank monitoring incentives and reduce the agency cost of debt.     

FINANCIAL STRUCTURE AND FINANCIAL STRATEGY

Even if the value of the firm is unaffected by its capital structure, managers may have reasons to choose a particular structure. The prices of the firm's securities reflect the “market's” assessment of the value and riskiness of the firm. Should managers disagree with the market's assessment of the firm's risk or value, they will also disagree about the relative returns on the firm's securities. Concern about shareholder welfare may, therefore, lead them to prefer a specific capital structure. If managers believe the market has underestimated the firm's value, they will prefer debt financing; if the market has overestimated risk, they will prefer equity; and, if managers disagree about both risk and value, they may prefer to finance using both debt and equity.     

Do firms’ earnings management practices affect their equity liquidity?

This study investigates the relationship between earnings management and equity liquidity, positing that as incentives arise for the manipulation of firm performance through earnings management (due partly to conflicts of interest between firm insiders and outsiders), greater earnings management may signal higher adverse selection costs. If earnings manipulation reveals aggressive accounting practices, liquidity providers tend to widen bid-ask spreads to protect themselves. The empirical results indicate that companies with higher earnings management suffer lower equity liquidity.     

Callable Bonds: A Risk-Reducing Signalling Mechanism

The theory of financial economics has failed to distinguish advantages of callable bonds from those of short-term debt. This paper shows that either type of borrowing can signal a firm's better prospects but that short-term debt does so at the cost of weakened risk-sharing with capital markets. By issuing either equity or long-term, non-callable debt, a firm with poor investment opportunities will not pool its prospects with those of a better firm. But equity produces superior risk-sharing. Perhaps this explains the almost complete absence of long-term, non-callable bonds from observed corporate capital structures.