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.     

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.     

A Theory of Capital Structure Relevance under Imperfect Information

Firms raise debt and equity capital to finance a positive net present value project in perfectly competitive capital markets; firm insiders know the function generating the random firm cash flow but potential capital suppliers do not. Taking into account the incentives of insiders to misrepresent their firm type, capital suppliers attempt to design financing mixes of debt and equity that eliminate the adverse incentives of insiders and correctly price securities. Necessary conditions for a costless separating equilibrium are developed to show that the amount of debt used by a firm is monotonically related to its unobservable true value.     

Institutional trading, information production, and the choice between spin-offs, carve-outs, and tracking stock issues

We analyze a firm's choice between spin-offs, equity carve-outs, and tracking stock issues and the role of institutional investors in corporate restructuring. We model a firm with two divisions. Insiders have private information about firm value and face an equity market with retail and institutional investors. We show that restructuring increases information production by institutional investors (relative to that about the consolidated firm): the highest increase in information production arises from spin-offs, the next highest from carve-outs, and the lowest from tracking stock issues. Insiders with the most favorable private information implement spin-offs; those with less favorable private information implement carve-outs; those with even less favorable private information implement tracking stock issues; and those with unfavorable private information remain consolidated. We explain the positive announcement effect and increase in analyst coverage associated with all three forms of restructuring. Our model also generates a number of novel testable predictions for firms' choice between spin-offs, carve-outs, and tracking stock issues, and for institutional trading around these three forms of restructuring.     

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.     

Earnings Momentum,Adaptation Value,and Nonlinearities in the Valuation of Chinese Equity Stocks

We demonstrate that when the variables comprising a firm's investment opportunity set depend on their past values then the present value of the cash flows the firm expects to earn will be stated in terms of the levels and the momentum of the affected variables. It is also shown that the market value of a firm's equity is comprised of the present value of the cash flows it expects to earn from operating under its existing investment opportunity set plus the value of the real options the firm possesses to modify or even completely change its existing investment opportunity set. Our empirical analysis, based on both Chinese and US data, shows that earnings momentum and the adaptation and growth options typically available to firms all appear to have a significant impact on equity prices.     

Do firms follow GAAP when they record share repurchases?

This paper examines U.S. firms' accounting for share repurchases and the accounting choice provided to Delaware-incorporated firms between the treasury and retirement methods. This accounting choice does not affect income, cash flows, or net assets, but it nevertheless affects financial reporting transparency and the allocation of equity between retained earnings and contributed capital. According to Generally Accepted Accounting Principles (GAAP), the accounting choice to record share repurchases should reflect management's intended disposition of the repurchased shares. We compare characteristics of Delaware-incorporated treasury and retirement firms and find that the choice between the two accounting methods is not always consistent with GAAP, but neither is it random; rather, this choice is related to a number of firm characteristics including firm growth, industry membership, trading exchange, and price–earnings ratio. We also find that a firm's accounting method for share repurchases is associated with a firm's propensity to make future share repurchases.     

THE RELATION BETWEEN THE MAGNITUDE OF GROWTH OPPORTUNITIES AND THE DURATION OF EQUITY

I examine the relation between the magnitude of growth opportunities in a firm and the duration of the firm's equity. Conventional wisdom holds that because cash flows from growth opportunities occur late relative to cash flows from existing projects, firms that can be characterized as growth firms have a higher duration. I adopt the real option approach to the valuation of growth opportunities and show that under certain circumstances the opposite can be true; equity duration can be lower for growth firms. I further show that the relation between equity duration and the magnitude of growth opportunities depends on (a) the magnitude of the duration of assets in place, (b) dominance of the firm in its industry, (c) the magnitude of R&D expenditure, and (d) the volatility of expected cash flows generated by the investment project underlying the growth opportunity. I empirically test these predictions and find the predictions are not rejected, particularly for the utility and banking industries. JEL classification: G31, G12.     

Accounting Treatment of Inherent versus Incentive Uncertainties and the Capital Structure of the Firm

This paper studies the accounting treatment of uncertainty and how it affects a firm's capital structure. We distinguish two sources of uncertainty that raise reliability concerns: inherent uncertainty and incentive uncertainty. By inherent uncertainty, we refer to uncertainty about the quality of raw information regarding future cash flows. By incentive uncertainty, we refer to uncertainty about the quality of accounting numbers conveying the raw information. We explore features of accounting that can effectively deal with these two types of uncertainties in order to aid in the debt‐equity decision of the firm. To handle inherent uncertainty, preferable accounting involves flexible revenue/expense recognition rules that recognize more profit when the uncertainty level is low. To deal with incentive uncertainty, a stringent revenue/expense recognition rule may be desirable to fend off management's opportunistic reporting behavior. Inflexible accounting rules cause a firm's financing choices to deviate from what would hold with complete information. Given any accounting rule, an information environment with a lower (higher) uncertainty regarding future cash inflows leads to higher (lower) expected debt financing. This is because assessed default risk is increasing in the uncertainty of future cash inflows, holding the uncertainty of the outflows constant.     

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.     

Consolidating Corporate Control: Divisional Versus Whole-Company Leveraged Buyouts

We examine the empirical relation between firm characteristics and the likelihood of choosing a restructuring choice between two types of leveraged buyouts: a whole‐company leveraged buyout (WLBO) and a divisional leveraged buyout (DLBO). Our findings suggest that firm characteristics such as volatility of cash flow and growth potential play an important role in determining a firm's restructuring choice between a WLBO and a DLBO. In particular, firms with greater volatility of cash flow and/or greater future growth potential are more likely to adopt a DLBO than a WLBO as their restructuring choice. These results are consistent with the notion that although low‐growth, high‐cash‐flow firms would create the most value for stockholders by paying out cash and tying future cash flows to the firm's debt service through a WLBO, high‐growth, low‐cash‐flow firms would be better off by selling assets if those assets would be better managed under a DLBO.     

DIVIDENDS,UNCERTAINTY, AND UNDERWRITING COSTS UNDER ASYMMETRIC INFORMATION

This paper presents a two-period model in which dividends act as a signal of the stability of the firm's future cash flows. It is demonstrated that firms with more stable future cash flows pay a higher dividend. Dividends are a credible signal because the promise of a higher dividend, ceteris paribus, increases the probability that the firm will have to issue equity and pay underwriting costs. Empirically testable implications of the model relating to the cross-sectional determinants of the level of dividends are also discussed.     

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.     

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.     

Morgan Stanley Roundtable on Capital Structure and Payout Policy

A group of finance academics and practitioners discusses a number of topical issues in corporate financial management: Is there such a thing as an optimal, or value‐maximizing, capital structure for a given company? What proportion of a firm's current earnings should be distributed to the firm's shareholders? And under what circumstances should such distributions take the form of stock repurchases rather than dividends? The consensus that emerged was that a company's financing and payout policies should be designed to support its business strategy. For growth companies, the emphasis is on preserving financial fl exibility to carry out the business plan, which means heavy reliance on equity financing and limited payouts. But for companies in mature industries with few major investment opportunities, more aggressive use of debt and higher payouts can add value by reducing taxes and controlling the corporate “free cash flow problem.” Both leveraged financing and cash distributions through dividends and stock buybacks represent a commitment by management to shareholders that the firm's excess cash will not be wasted on projects that produce growth at the expense of profitability. As for the choice between dividends and stock repurchases, dividends appear to provide a stronger commitment to pay out excess cash than open market repurchase programs. Stock buybacks, at least of the open market variety, preserve a higher degree of managerial fl exibility for companies that want to be able to capitalize on unpredictable investment opportunities. But, as with the debt‐equity decision, there is an optimal level of financial fl exibility; too little can mean lost investment opportunities but too much can lead to overinvestment.     

Organizational Capital and Investment‐Cash Flow Sensitivity: The Effect of Management Quality Practices

This paper examines the influence of organizational capital, as evident in management quality practices, on the response of firm investment to internal cash flows. We provide novel and strong evidence that investment sensitivity to internal cash flows decreases in the presence of superior management practices. We also find that superior management practices reduce the firm's financing frictions, evident in lower capital constraints. Our results are robust to numerous tests. Overall, our findings suggest that intangible organizational capital is important for investment decisions and that superior management practices contribute to value‐maximizing behavior.     

Product market advertising and new equity issues

We analyze the interaction between a firm's product market advertising and its corporate financing decisions. We consider a firm that faces asymmetric information in both the product and financial markets and that needs to raise external financing to fund its growth opportunity (new project). Any product market advertising undertaken by the firm is visible to the financial market as well. In equilibrium, the firm uses a combination of product market advertising, equity underpricing, and underfinancing (raising a smaller amount of external capital than the full information optimum) to convey its true product quality and the intrinsic value of its projects to consumers and investors. The following two predictions arise from our theoretical analysis for the relation between product market advertising and equity underpricing around new equity issues. First, firms choose a higher level of product market advertising when they are planning to issue new equity, compared with situations in which they have no immediate plans to do so. Second, product market advertising and equity underpricing are substitutes for a firm issuing new equity. We empirically test the above two predictions and find supporting evidence in the context of firms making initial public offerings and seasoned equity offerings.     

An option pricing approach to corporate dividends and the capital investment financing decision

In light of a growing trend toward viewing dividends as an investable asset class, this article opens up a new perspective on their valuation. We show that dividends can be viewed as options on the cash flow of the firm. That is, a firm either pays zero dividends, in which case the option expires out‐of‐the‐money, or it pays a positive dividend, the value of which corresponds to the option's moneyness. The exercise price is determined by the capital budget, the flexibility of the company to use external financing, and whether it has minimum and maximum dividends. The model is also capable of accommodating a stochastic capital budget, which allows for uncertain growth opportunities and their correlation with the firm's cash flows. We also present an application of the model using actual data for a large multinational company.     

Accounting Information, Disclosure, and the Cost of Capital

In this paper we examine whether and how accounting information about a firm manifests in its cost of capital, despite the forces of diversification. We build a model that is consistent with the Capital Asset Pricing Model and explicitly allows for multiple securities whose cash flows are correlated. We demonstrate that the quality of accounting information can influence the cost of capital, both directly and indirectly. The direct effect occurs because higher quality disclosures affect the firm's assessed covariances with other firms' cash flows, which is nondiversifiable. The indirect effect occurs because higher quality disclosures affect a firm's real decisions, which likely changes the firm's ratio of the expected future cash flows to the covariance of these cash flows with the sum of all the cash flows in the market. We show that this effect can go in either direction, but also derive conditions under which an increase in information quality leads to an unambiguous decline in the cost of capital.     

Valuation of Corporate Innovation and the Pricing of Risk in the Biopharmaceutical Industry: The Case of Gilead

Much of a firm's market value derives from expected future growth value rather than from the value of current operations or assets in place. Pharmaceutical companies are good examples of firms where much market value comes from expectations about drugs still in the development “pipeline.” Using a new osteoporosis drug being developed by Gilead Sciences, Inc., the author combines discounted cash flow methods values and real option models to value it. Alone, discounted cash flow (DCF) calculations are vulnerable to the assumptions of growth, cost of capital, and cash flows. But by integrating the real options approach with the DCF technique, one can value a new product in the highly regulated, risky and research‐intensive Biopharmaceutical industry. This article shows how to value a Biopharmaceutical product, tracked from discovery to market launch in a step‐by‐step manner. Improving over early real option models, this framework explicitly captures competition, speed of innovation, risk, financing need, the size of the market potential in valuing corporate innovation using a firm‐specific measure of risk and the industry‐wide value of growth operating cash flows. This framework shows how the risk of corporate innovation, which is not fully captured by the standard valuation models, is priced into the value of a firm's growth opportunity. The DCF approach permits top‐down estimation of the size of the industry‐wide growth opportunity that competing firms must race to capture, while the contingency‐claims technique allows bottom‐up incorporation of the firm's successful R&D investment and the timing of introduction of the new product to market. It also specifically prices the risk of innovation by modeling its two components: the consumer validation of technology and the expert validation of technology. Overall, it estimates the value contribution per share of a new product for the firm.