Subsidiary debt,capital structure and internal capital markets

I study external debt issued by operating subsidiaries of diversified firms. Consistent with Kahn and Winton's [2004. Moral hazard and optimal subsidiary structure for financial institutions. Journal of Finance 59, 2537–2575] model, where subsidiary debt mitigates asset substitution, I find firms are more likely to use subsidiary debt when their divisions vary more in risk. Consistent with subsidiary debt mitigating the free cash flow problem, I find that subsidiaries are more likely to have their own external debt when they have fewer growth options and higher cash flow than the rest of the firm. Finally, I find that subsidiary debt mitigates the “corporate socialism” and “poaching” problems modeled in theories of internal capital markets.     

Internal control and internal capital allocation: evidence from internal capital markets of multi-segment firms

We investigate the impact of internal control over financial reporting on management decisions in directing corporate resources to alternative investment projects in multi-segment firms. Results from cross-sectional and inter-temporal analyses indicate that internal control weaknesses (ICWs) are associated with distortionary internal capital allocations. The adverse impact on internal capital markets is more pronounced for firms with company-level ICWs. Our analyses also show that firms with weak existing governance mechanisms benefit more from maintaining effective internal control. We further document that the negative impact of ICWs on firms’ internal capital transfers manifests in a lower excess value of diversification.     

The internal workings of internal capital markets: Cross-country evidence

We derive empirical predictions from the standard investment-cash flow framework on the functioning of internal capital markets (ICM), but circumvent its criticism by focusing on parent cash flow and investment opportunities. We test these predictions using a unique dataset of parent firms and their listed and unlisted subsidiaries in 90 countries over the period 1995–2006. We find that company and country institutional structures matter. (1) Ownership participation of the parent firm in the subsidiary plays a crucial role for the proper functioning of ICMs. The larger the ownership stake of the parent, the better the functioning of the ICM. (2) The best functioning cross-border ICMs can be found in the sub-sample of firms with parents from a country with “strong” institutions and subsidiaries from a country with “weak” institutions. (3) Unlisted subsidiaries are much more dependent on the ICMs their parents provide than listed subsidiaries. Thus, ICMs are not per se “bright” or “dark”, their proper functioning depends on how they are set up.     

The deep-pocket effect of internal capital markets

We provide evidence that incumbent and entrant firms' access to business group deep pockets affects the entry patterns in product markets. Relying on a unique French data set on business groups, our paper shows that entry into manufacturing industries is negatively related to the cash hoarded by incumbent affiliated groups and positively related to entrant groups' cash. In line with theoretical predictions, we find that the impact of group cash holdingson entry is more important in environments where financial constraints are pronounced. The cash holdings of incumbent and entrant groups also affect the survival rate of entrants in the three- to five-year post-entry window. Overall, our findings suggest that internal capital markets operate within corporate groups and affect the product market behavior of affiliated firms by mitigating financial constraints.     

The capital structure puzzle revisited

Corporate finance researchers have long been puzzled by lowcorporate debt ratios given debt's corporate tax advantage.This article recognizes that firm value typically reflects agrowing stream of earnings, while current debt reflects a nongrowingstream of interest payments. Debt to value is therefore a distortedmeasure of corporate tax shielding. Even with very small debt-relatedcosts, this may explain the observed magnitude and cross-sectionalvariation of debt ratios. Since this variation may be independentof tax shielding, debt ratios provide an inappropriate frameworkfor empirically examining the trade-off theory of capital structure.     

Supply of capital and capital structure: The role of financial development

We explore the effect of financial development on corporate capital structure and the tightness of financial constraints that firms face. We employ an econometric technique that allows us to explicitly test for convergence in capital structure. This technique increases the power of our statistical tests. In doing so, we identify a group of convergent firms. The driving force of convergence is financial development, which positively affects the firms' leverage ratio. We also identify a group of firms, whose leverage is not affected by financial development, because they are financially constrained.     

Collateral and capital structure

We develop a dynamic model of investment, capital structure, leasing, and risk management based on firms' need to collateralize promises to pay with tangible assets. Both financing and risk management involve promises to pay subject to collateral constraints. Leasing is strongly collateralized costly financing and permits greater leverage. More constrained firms hedge less and lease more, both cross-sectionally and dynamically. Mature firms suffering adverse cash flow shocks may cut risk management and sell and lease back assets. Persistence of productivity reduces the benefits to hedging low cash flows and can lead firms not to hedge at all.     

Liquidity and capital structure

We examine the relation between equity market liquidity and capital structure. We find that firms with more liquid equity have lower leverage and prefer equity financing when raising capital. For example, after sorting firms into size quintiles and then into liquidity quintiles, the average debt-to-asset ratio of the most liquid quintiles is about 38% while the average for the least liquid quintiles is 55%. Similar results are observed in panel analyses with clustered errors and using instrumental variables. Our results are consistent with equity market liquidity lowering the cost of equity and, therefore, inducing a greater reliance on equity financing.     

Dynamic capital structure and the contingent capital option

The financial crisis has emphasized the difficulties for financial companies to raise funds through conventional liabilities. In this environment, hybrid securities are becoming popular. In this paper we study the optimal capital structure of a company issuing a particular type of hybrid security: perpetual contingent capital, i.e., debt that converts into equity under some conditions. A two-period model with endogenous bankruptcy for a company with equity, straight debt and contingent capital is analyzed. We investigate the instrument under different conversion rules: automatic or optimally chosen by equity holders. We show that contingent capital reduces the coupon of straight debt and expected bankruptcy costs but can require a high spread. A trigger imposed by the regulatory authority in terms of par value of debt may induce a little use of contingent capital with an increase of bankruptcy costs.     

Executive compensation and internal capital market efficiency

We document that chief executive officer (CEO) incentive compensation plays an important role in determining internal capital market (ICM) allocation efficiency. Our results suggest that CEO equity-based compensation can be effective in ameliorating inefficiencies in internal capital allocation decisions. We find that while stock grants play an important role in motivating CEOs to make more efficient internal capital allocation decisions, there is surprisingly no discernible influence of stock options. Our analysis supports the view that private benefits derived by managers are increasing in internal capital misallocation. We also document a strong positive link between CEO incentive compensation and excess value of diversified firms suggesting that the diversification discount can be ameliorated with CEO incentive compensation. The study contributes to the ICM literature and the literature on conglomerate diversification discount.     

基于耗散结构理论的内部控制系统属性分析

本文以耗散结构理论为基础,分析了内部控制系统的耗散特性,以此说明内部控制系统同时具备维持组织静态稳定和促进组织动态稳定的特性。然而,当从企业整体系统的耗散特性来审视内部控制系统时,发现内部控制虽具备耗散特性,但是其自身耗散特性难以与企业耗散特性相吻合,从而影响了控制功能的发挥。     

Managerial discretion and efficiency of internal capital markets

I use the staggered adoption of state-level antitakeover laws to provide causal evidence that managerial agency problems reduce the allocative efficiency of conglomerate firms. I find that increases in control slack following the passage of antitakeover laws reduces q-sensitivity of investment by 64%. The adverse impact of the laws appears mostly at conglomerate firms that benefited from disciplinary takeover threats prior to the passage of the laws, lacked alternative sources of pressure on management, or had the structural makings to fuel wasteful influence activities and power struggles among managers. These findings suggest that takeover threats impact the efficiency of resource allocation.     

The effect of state laws on capital structure

US manufacturing firms incorporated in states with stronger payout restrictions use less debt, while antitakeover statutes do not significantly reduce long-run leverage. Correcting for the endogenously determined choice of where to incorporate, we find that firms sort themselves according to state laws and capital structure needs. After accounting for self-selection, state antitakeover laws are positively associated with debt as a fraction of market value, possibly due to lower market values for these firms. Payout restrictions appear to reduce leverage for firms that have not reincorporated outside their home states. These constraints explain part of the negative relation between profitability and leverage.     

Payout policy, capital structure, and compensation contracts when managers value control

The optimal contract between managers and investors is endogenouslyderived when managers have preferences for both monetary compensationand corporate resources under their control. When the optimalpayout is privately known to managers, they can be induced tomake payouts by linking their compensation to the payout. Publicequity is a claim on this discretionary payout. If investorscan obtain new information about the firm's optimal payout level,it can be utilized by transferring the control from managementto investors. The new information allows the firm to achievea more efficient allocation through recontracting. We show thatthe new information will be obtained if and only if the payoutfalls below a promised level     

Stock options and capital structure

We show that value-maximizing CEOs compensated with stock options prefer debt to equity. Our pecking order result does not depend on managerial risk aversion, managerial firm-specific human capital, or asymmetric information. Moreover, our result holds at least weakly regardless of the distribution of firm cash flows and strictly as long as the support of the cash flow distribution is big enough to bring all features of the stock option contract into play with positive probability JEL Classification Numbers: G0, G3 An earlier version of this paper was completed while Page was visiting CERMSEM at Paris 1 and the University of Warwick. Page gratefully acknowledges the support and hospitality of CERMSEM, Paris 1 and Warwick. Page also gratefully acknowledges financial support from the Department of Economics, Finance, and Legal Studies and the Culverhouse College of Business at the University of Alabama. Both authors are grateful to seminar participants in the Financial Markets Group Workshop at LSE for many helpful comments and both authors are especially grateful to an anonymous referee whose detailed and insightful comments led to substantial improvements in the paper     

Book-tax conformity and capital structure

We examine the effect of increased book-tax conformity on corporate capital structure. Prior studies document a decrease in the informativeness of accounting earnings for equity markets resulting from higher book-tax conformity. We argue that the decrease in earnings informativeness impacts equity holders more than debt holders because of the differences in payoff structures between debt and equity investments such that increases in book-tax conformity lead to increases in firms’ reliance on debt capital. We exploit a natural experiment in the U.S. and find that firms facing an increase in required book-tax conformity increase leverage relative to other firms. We also provide evidence of an increase in the cost of equity (but not of debt) capital for firms facing an increase in required book-tax conformity, relative to control firms, and show that these increases in cost of equity capital are positively associated with an increase in leverage. Our findings are consistent with firms substituting away from equity and toward more debt in the presence of higher book-tax conformity.     

Serial SEOs and capital structure

This study investigates whether a firm's serial seasoned equity offerings (SEOs) have an impact on its capital structure that is distinct from that of a single SEO firm. Serial SEOs are pervasive in our sample of 1033 UK public firms listed on the London markets. Some two thirds are serial SEO issuers—or have made more than one such issue—during the 1995–2015 sample period. Our findings show that that serial SEO firms have higher leverage ratios than single issuers, implying that the additional equity funds are not used to pay down debt. Moreover, they indicate that serial issuer cash holdings are sensitive to debt changes, but this is not the case with single issuers. Our findings highlight that serial SEO issue activity is an important determinant of changes in debt and cash holdings.     

Liquidity and bank capital structure

Bank capital requirements reduce the probability of bank failure and help mitigate taxpayers’ sharing in the losses that result from bank failures. Under Basel III, direct capital requirements are supplemented with liquidity requirements. Our results suggest that liquidity provisions of banks are connected to bank capital and that changes in liquidity indirectly affect the capital structure of financial institutions. Liquidity appears to be another instrument for adjusting bank capital structure beyond just capital requirements. Consistent with Diamond and Rajan (2005), we find that liquidity and capital should be considered jointly for promoting financial stability.     

Complex ownership and capital structure

This paper explores pyramidal firms and their motivations for the use of debt financing. We find that pyramids have significantly higher leverage than non-pyramids and that the use of debt in pyramids is associated with the risk of expropriation. We do not find evidence for the control-enhancing, disciplining, tax-reduction, and risk-sharing explanations for the use of debt financing. Our results indicate that the capital structure of pyramids is affected by the expropriation activities of ultimate owners that have excess control rights.