Mandated accounting changes and debt covenants: The case of oil and gas accounting

The relationships among mandated accounting changes, bond covenants and security prices has been the focus of several studies. These studies have provided mixed evidence on the existence of a bond covenant effect on security prices. This paper suggests that inconclusive prior results are a consequence of inappropriately measuring the default risk of debt. Using an option pricing framework, it is shown that the debt to equity alone is not an adequate measure of default risk. In particular, both the debt to equity ratio and the total risk of the firm are necessary to adequately model the bond covenant effects of an accounting change. These theoretical propositions are supported by the empirical analysis of the security market reaction to changes in oil and gas accounting.     

OPERATING LEVERAGE AND UNDERINVESTMENT

Using a contingent claims model, we examine the impacts of both operating leverage and financial leverage on a firm's investment decisions in the context of capacity expansion. Our model shows that quasi‐fixed operating costs could significantly mitigate the underinvestment problem for debt‐financed firms. The existing debt induces equity holders to delay equity‐financed expansion because the expanded earnings base will also benefit the debt holders by lowering the bankruptcy risk. The operating costs decrease this type of wealth transfer from equity holders to debt holders by magnifying the bankruptcy risk of the existing debt upon investment. By applying the Cox proportional hazard model on a large sample of publicly traded U.S. firms over 1966–2016, we offer empirical support for the theoretical predictions. The results are robust to various measures of operating leverage.     

Performance choice,executive bonuses and corporate leverage

This study examines the causal link between a firm's leverage decisions and the characteristics of its CEO bonus plans. Results from a simultaneous equations model strongly suggest that highly levered firms are less likely to use return on equity (ROE) or ROE-based accounting performance measures to determine executive bonuses. Estimates also indicate that firms with fewer debt covenants, higher interest rates on debt, and a greater proportion of executive pay in the form of stock options are less likely to adopt ROE-based measures for use in CEO bonus plans. These findings lend strong support to the efficient contracting hypothesis. The conflicting interests of corporate stakeholders, especially between stockholders and creditors, encourage firms to tie executive pay to performance metrics like return on assets (ROA) that will strike the optimal balance between the agency costs of debt and the agency costs of equity.Data availability: all data are available from public sources.     

Are target leverage ratios stable? Investigating the impact of corporate asset restructuring

If firms balance the benefits and costs of leverage, then we might expect corporate asset shocks to trigger a change in corporate target leverage. We investigate the impact of corporate asset restructuring and find that target leverage after restructuring is reduced for downsizing firms and increased for upsizing firms. Changes in target leverage are stabilized by the second year after the restructuring event and are monotonic relative to the degree of restructuring. Decomposition analysis shows that corporate asset restructuring directly and significantly affects target debt ratios. Compared to control firms, downsizing firms adjust claims by repurchasing debt while upsizing firms issue debt securities. As expected, debt repurchases are associated with lower tax liabilities while debt issuance decisions correspond to lower growth proxies and are consistent with a higher adverse selection cost of issuing equity, positive leverage deficit, higher tax liabilities, and lower bankruptcy risk.     

Taxes, Leverage, and the Cost of Equity Capital

We examine the associations among leverage, corporate and investor level taxes, and the firm's implied cost of equity capital. Expanding on Modigliani and Miller [1958, 1963] , the cost of equity capital can be expressed as a function of leverage and corporate and investor level taxes. Based on this expression, we predict that the cost of equity is increasing in leverage, and that corporate taxes mitigate this leverage‐related risk premium, while the personal tax disadvantage of debt increases this premium. We empirically test these predictions using implied cost of equity estimates and proxies for the firm's corporate tax rate and the personal tax disadvantage of debt. Our results suggest that the equity risk premium associated with leverage is decreasing in the corporate tax benefit from debt. We find some evidence that the equity risk premium from leverage is increasing in the personal tax penalty associated with debt.     

Pecking order as a dynamic leverage theory

Static tradeoff theories, which do not explicitly treat the impact of transaction costs, do not explain the policy of asymmetry between frequent small debt transactions and infrequent large equity transactions. Nor do these theories explain why the debt ratio is allowed to wander a considerable distance from its alleged static optimum, or how much of a distance should be tolerated. We offer a class of diffusion models that mimic this behaviour in a stochastic-dynamic framework and are designed to optimize a financing strategy using any static tradeoff theory as input. The models developed reveal the determinants of the size and frequency of equity transactions and the range of values over which leverage variations are tolerated in four generic scenarios. They also yield a new formulation of the cost of capital that recognizes stochastic transaction costs and a penalty for deviation from any static-optimal leverage. Our class of models augments the pecking order theory, provides a flexible quantitative framework for its implementation as a decision tool, and facilitates the formulation of additional hypotheses for its empirical validation. Symmetrically, our results show the importance of dynamic factors in designing and interpreting empirical tests of static tradeoff theories. The results presented have important implications for the role played by static tradeoff theories in a stochastic-dynamic framework. One such implication is that the static-optimal leverage has no direct effect on the firm's leverage policy in this setting. The target leverage for refinancing transactions is different from the static-optimal leverage, and the mean leverage is generally different from both. As a consequence, the latter cannot be used to estimate the former. Another implication is that even when the mean leverage equals the static optimum, mean reversion is not an optimal behaviour and therefore not a legitimate test for the existence of a static tradeoff in a dynamic context. Still another implication is that wide variations in leverage ratios cannot be interpreted as evidence of leverage indifference. It follows that the pecking order theory is consistent with static tradeoff theories and does not require the assumption of leverage indifference.     

Financial leverage changes associated with corporate mergers

We empirically examine whether firms increase financial leverage following mergers. Firms could increase financial leverage either because of an increase in debt capacity or because of unused debt capacity from pre-merger years. We find that financial leverage of combined firms increases significantly following mergers. A cross-sectional analysis shows that the change in financial leverage around mergers is significantly positively correlated with the announcement period market-adjusted returns. Further tests indicate that the increase in financial leverage is an outcome of an increase in debt capacity, although there is weak evidence that some of the increase in financial leverage is a result of past unused debt capacity.     

Firm-level political risk and corporate leverage decisions

This study examines the effects of firm-level political risk on firm leverage decisions and speed of adjustment. We uncover that firm-level political risk has a negative impact on a firm's total and long-term leverage. We also find that firms facing high political risk tend to prefer debts with short-term maturity. However, firm-level political risk is positively related to debt specialisation, suggesting that firms are more inclined to adopt fewer debt types when they face high political risk. Further analysis reveals that firms with high political risk are associated with a faster speed of adjustment to target than those with low political risk. Our results are robust to endogeneity concerns and the effects of financial crisis.     

A NOTE ON THE MARGINAL COST OF DEBT CAPITAL

The firms marginal cost of debt capital was interpreted in this author's previous publications as the "full marginal cost of relaxing the money capital availability constraint' when the incremental money capital employed takes the form of debt capital. Account is thereby taken of the effects on financing costs of the increased risk exposure that debt financing implies for both debt and equity holders. The present paper clarifies a misconception in a recently published paper by Draper and Findlay, and exhibits the linkage between concepts relevant to the firm's fmancing decision and the general marginal analysis.     

Optimal leverage strategy: Capital structure in real estate investments

This article examines the optimal leverage strategy for real estate investors who are investing in income-producing properties. Within a discounted cash-flow context, the investment objective for the equity investor is to maximize the contribution to net present value of using mortgage financing. Utilizing more debt decreases the required equity investment and increases the size of the tax shelter. On the other hand, as the loan-to-value ratio increases, the interest rate charged by the lender increases, which indicates a higher cost of debt. This article goes beyond the simple conventional wisdom that debt financing should be used when financial leverage is positive by developing an equation that allows one to determine the optimal level of debt financing to use when positive leverage is possible. The optimal loan-to-value ratio is found to be a function of the investor's characteristics. Several hypotheses about the relationships between such an optimal loan-to-value ratio and the investor's characteristics are derived.     

What determines the financing decision in corporate takeovers: Cost of capital,agency problems,or the means of payment?

How is a takeover bid financed and what is its impact on the expected value creation of the takeover? An analysis of the sources of transaction financing has been largely ignored in the takeover literature. Using a unique dataset, we show that external sources of financing (debt and equity) are frequently employed in takeovers involving cash payments. Acquisitions with the same means of payment but different sources of transaction funding are in fact quite distinct. Acquisitions financed with internally generated funds significantly underperform those financed with debt. The takeover financing decision is influenced by the bidder's pecking order preferences, its growth potential, and its corporate governance environment, all of which are related to the cost of external capital. The choice of equity versus internal cash or debt financing also depends on the bidder's strategic preferences with respect to the means of payment.     

The collateral channel: Evidence on leverage and asset tangibility

We examine how asset structure is related to leverage in different institutional environments, using tens of thousands of firm-level observations from small, privately held, emerging market firms that are likely to face financing constraints. Our empirical analysis indicates that the linkage between asset tangibility (fixed assets as a portion of total assets) and leverage (measured as long-term debt over total assets) varies, such that in countries with fewer restrictions on collateral (land transferability), the relationship between these variables is much tighter. This also applies to the linkage between tangibility and debt maturity structure (measured as long-term debt over total debt). We find no evidence that industry concentration in different countries or changing composition of firms over time is driving our findings. The results are robust to using firm-level fixed effects specifications, to clustering error terms at the country level, and to using an alternative proxy for collateral law regime.     

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.     

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.     

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 funding of subsidiaries equity,double leverage and the risk of bank holding companies

Banking groups exploit double leverage when ‘debt is issued by the parent company and the proceeds are invested in subsidiaries as equity’. Financial authorities have frequently raised concerns about the issue of double leverage because this type of intra‐firm financing appears to allow for both the arbitrage of capital and the assumption of risk. This article focuses on the relationship between double leverage and risk‐taking within banking groups. First, we discuss this relationship based on an examination of balance sheet figures. Second, we analyze a large sample of United States Bank Holding Companies (BHCs) from 1990–2014. The results show that BHCs are more prone to risk when they increase their double leverage, namely, when the stake of the parent within subsidiaries is larger than the stand‐alone capital of the parent. This paper's primary implication for policymakers is that the regulators of complex financial entities should more efficiently address the issue of double leverage, thereby limiting the potential negative consequences that arise from corporate instability.     

Shareholders' control rights,family ownership and the firm's leverage decisions

We investigate the association between controlling shareholders' ownership (CS_Own) and firms' leverage decisions in the Singaporean context. We examine whether the impact of ownership concentration on leverage differs across excess and lower control. We report that shareholders with excess control prefer leverage financing for an optimal capital structure and focus on value maximisation rather using leverage as a tool of minority shareholders' expropriation. Our analysis shows that firms capital structure significantly influences by the coalition of shareholders particularly decisions about leverage financing in addition to the firms' specific characteristics and institutional arrangements. Our empirical evidence shows that controlling shareholders with a lower fraction of equity are more concerned about limited holding thus prefer leverage over equity financing to inflate their equity stake to protect them from the potential takeovers and mergers. We report that capital structure decisions in Singapore are linked with the trade-off between the controlling shareholders' target of mitigating firm risk and their non-dilution entrenchment needs. Further, we found an inverted U-shaped association between control ownership and leverage financing. In terms of moderating effect of family-controlled ownership, our findings exhibit that leverage financing is less pronounced for family firms in Singapore due to the under-diversified investment portfolio.     

ON THE CAPITAL STRUCTURE OF NON‐PROFIT ORGANISATIONS: A REPLICATION AND EXTENSION WITH BELGIAN DATA

The empirical tests of non‐profit organisations' capital structure theories by Jegers and Verschueren (2006) on a sample of Californian non‐profit organisations (data on 1999) are replicated and extended for a more recent Belgian sample (844 observations pertaining to 2007). Three complementary theories to explain the presence and levels of overall debt and financial debt are examined: equity constraints, agency, and borrowing constraints. The decision to borrow and the amount to be borrowed are analysed separately. The estimations obtained reveal that both are driven by different mechanisms. After having removed outliers, the results show effective equity constraints when explaining debt levels, as observed in the Californian sample with respect to the overall amount of debt. The results also indicate an agency explanation of debt: both the decision to borrow from financial institutions, and the overall amount of (financial) debt are positively affected by the presence of a potential agency gap between board and management. In the Californian sample, the results on this were mixed. Borrowing constraints were almost never discovered, similar to the conclusions reached by Jegers and Verschueren. However, slightly reducing the sample by removing outliers makes borrowing constraints apparent. As to the control variables, size positively affects the probability of borrowing, but, for the organisations taking on debt, negatively affects the level of borrowing. As could be expected, the amount of tangible fixed assets in place is positively related to the amount of financial debt.     

Evidence on the Trade-Off between Risk and Return for IPO and SEO Firms

Do the low long‐run average returns of equity issuers reflect underperformance due to mispricing or the risk characteristics of the issuing firms? We shed new light on this question by examining how institutional lenders price loans of equity issuing firms. Accounting for standard risk factors, we find that equity issuing firms' expected debt return is equivalent to the expected debt return of nonissuing firms, implying that institutional lenders perceive equity issuers to be as risky as similar nonissuing firms. In general, institutional lenders perceive small and high book‐to‐market borrowers as systematically riskier than larger borrowers with low book‐to‐market ratios, consistent with the asset pricing approach in Fama and French (1993) . Finally, we find that firms' expected debt returns decline after equity offerings, consistent with recent theoretical arguments suggesting that firm risk should decline following an equity offering. Overall, our analysis provides novel evidence consistent with risk‐based explanations for the observed equity returns following IPOs and SEOs.     

Do multinational and domestic corporations differ in their leverage policies?

This paper examines the leverage policies of multinational corporations (MNCs) in comparison to those of domestic corporations (DCs). Prior studies document that MNCs have lower leverage levels. However, our analysis of U.S. firms over the period 1981–2010 reveals that the leverage levels of MNCs are not significantly lower than those of DCs if we control for key firm characteristics related to leverage levels. We also find that MNCs and DCs do not differ significantly in terms of their debt maturity structure, the speed of leverage adjustments, or the propensity to issue debt vs. equity (or vs. not to issue debt). The results suggest that MNCs' financial policies at the corporate level are not significantly influenced by their greater exposures, in comparison to DCs, to market imperfections such as taxes and regulations. Interestingly, however, our additional analysis of MNCs from outside the U.S. reveals that non-U.S. MNCs issue securities more frequently and adjust leverage faster than their domestic peers.