Dynamic Models of Investment Distortions

This paper studies the interaction between corporate financing decisions and investment decisions in a dynamic framework. When the production decision involves an expansion option, the firm trades off tax benefits of debt against two costs of debt financing, namely the investment distortion related to exercise of the expansion option and the loss of a valuable expansion opportunity if the firm defaults. The optimal capital structure is all equity for firms with more value in growth options (or intangible assets) and tends to involve debt financing for firms with more value in tangible assets. JEL Classification: D81, G13, G31, G32     

Investment opportunities and bankruptcy prediction

A firm's mix of growth options and assets in place is an important determinant of its optimal default strategy. Our simple model shows that shareholders of a firm with valuable investment opportunities would be able/willing to wait longer before defaulting on their contractual debt obligations than shareholders of an otherwise identical firm without such opportunities. More importantly, we show empirically using a dataset of recent corporate bankruptcies that measures of investment opportunities are significantly related to the likelihood of bankruptcy. Augmenting existing bankruptcy prediction models by these measures improves their out-of-sample forecasting ability.     

Corporate Insurance and Debt: The Case of China*

Finance theorists have long argued that corporate purchases of property insurance can reduce the probability and hence the expected costs of financial distress. And by so doing, the corporate use of insurance can reduce borrowing costs and/ or increase debt capacity, reduce the overall cost of capital, and increase firm value. This article attempts to apply this argument to the case of publicly traded companies in China, which provides a particularly interesting environment given the significant presence of both foreign direct investment and state shareholdings in its corporate sector. From their study of several hundred Chinese companies during the period 1997‐2003, the authors report the following conclusions: Companies with higher borrower costs tend to purchase more property insurance, which in turn has the effect of increasing their debt capacity. Smaller companies are more likely than larger firms both to insure their assets and to purchase more property insurance (as a percentage of assets), reflecting their greater vulnerability to financial shocks and larger potential benefit from insurers' real advisory services (such as loss prevention advice). Companies with more and larger growth opportunities are more likely to purchase insurance, reflecting their higher expected costs of financial distress (from possible underinvestment) than firms with limited growth opportunities. Companies with higher levels of state ownership tend to insure their assets to a greater extent, suggesting that the managers of such companies insure to protect their job security, particularly as the availability of state subsidies to the Chinese corporate sector has declined since market reforms were initiated in 1978.     

TAX-TIMING OPTIONS,LEVERAGE, AND THE CHOICE OF CORPORATE FORM

The tax-timing options associated with opportunities to trade corporate securities are examined. The availability of such options to both the firm and its securityholders is shown to create incentives for, and thereby to add to the possible explanation of, three empirically observed financial phenomena: (1) the existence of complex corporate capital structures; (2) the presence of debt in those capital structures; and (3) corporate spin-offs as vehicles to increase the total market value of a firm's assets. A set of symmetrical arguments also offers a reason to expect at least one negative effect on shareholder wealth from mergers of publicly traded companies.     

Asset Pricing Implications of Nonconvex Adjustment Costs and Irreversibility of Investment

This paper derives a real options model that accounts for the value premium. If real investment is largely irreversible, the book value of assets of a distressed firm is high relative to its market value because it has idle physical capital. The firm's excess installed capital capacity enables it to fully benefit from positive aggregate shocks without undertaking costly investment. Thus, returns to equity holders of a high book‐to‐market firm are sensitive to aggregate conditions and its systematic risk is high. Simulations indicate that the model goes a long way toward accounting for the observed value premium.     

Corporate debt issues and interest rate risk management: Hedging or market timing?

Apart from the obvious reasons for raising capital, a firm can hedge its interest rate exposure by issuing debt, the value of which moves in an opposite direction from the value of its assets as interest rate varies. We examine whether firms in the UK market make full use of debt issuances for hedging purposes or if they have other considerations. Our evidence shows that firms’ choices of debt issues are primarily driven by debt market conditions in an effort to lower their costs of capital rather than managing their firm-specific interest rate exposures. This suggests that market timing, as opposed to hedging, is the primary motivation behind corporate debt issuances.     

Investment options with debt-financing constraints

A contingent claims model is used to study the impact of debt-financing constraints on firm value, optimal capital structure, the timing of investment and other variables, such as credit spreads. The optimal investment trigger follows a U shape as a function of exogenously imposed constraint. Risky, equity-financed R&D growth options increase firm value by increasing the option value on unlevered assets, while their impact on the net benefits of debt is small.     

A Theory of Debt Maturity: The Long and Short of Debt Overhang

Debt maturity influences debt overhang, the reduced incentive for highly levered borrowers to make real investments because some value accrues to debt. Reducing maturity can increase or decrease overhang even when shorter term debt's value depends less on firm value. Future overhang is more volatile for shorter term debt, making future investment incentives volatile and influencing immediate investment incentives. With immediate investment, shorter term debt typically imposes lower overhang; longer term debt can impose less if asset volatility is higher in bad times. For future investments, reduced correlation between assets‐in‐place and investment opportunities increases the shorter term debt overhang.     

THE IMPACT OF FINANCING SOURCES ON MULTINATIONAL PROJECTS

It is shown here that market imperfections, such as corporate taxes, are not a necessary condition for a firm to have a debt denomination preference. When the stochastic nature of project cash flows and exchange rates are explicitly considered, the risk of the project is affected by the source of borrowing used to finance the project. It is also shown that the existence of income taxes causes the expected net present value and risk of a foreign project to depend on the source of the firm's borrowing. The debt denomination preference in both cases depends on project- and country-specific variables.     

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.     

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.     

Debt overhang and non-distressed debt restructuring

In this paper, we analyse the restructuring of debt in the presence of debt overhang. The firm starts out with a debt liability and an investment opportunity. Then with unrestructured debt, the firm maintains the current borrowing payments until default or investment. If the creditors allow the parties to restructure the debt with exchange offers, then the borrowing payments change as well as the default and investment points. We find that there is a unique optimal restructuring path which maintains debt at positive levels but defers default indefinitely. This path is optimal regardless of whether the debt holders or the firm control the process through superior bargaining power. Moreover, a debt-for-equity exchange to remove all existing debt takes place just before investment that is followed by the issue of an optimal amount of new debt as part of the funding for the investment cost. The optimal investment trigger is higher along the optimal restructuring path than it is for an unlevered firm. We discuss the findings in the light of existing empirical evidence.     

Modigliani and Miller Again Revisited: The Cost of Capital with Unequal Borrowing and Lending Rates

The financial literature asserts that financial managers must borrow at least to some degree if they are to optimise the value of their companies. This result has been described in the literature as ‘perhaps the single most important result in the theory of corporate finance obtained in the last 30 years’ (Copeland and Weston, 1988, p. 443). Based on US tax systems, the value added to a company by debt has been estimated as high as 35 to 50% of the debt's market value. More recently in this journal, Ashton (1989b) has argued that under the present UK tax system, the theoretical tax advantage afforded by debt should be estimated at no more than 13% of the debt's market value. The contribution of this paper is to draw attention to an aspect of borrowing that has largely escaped attention, but which nevertheless affects the above conclusions: namely, that the market spread between borrowing and lending constitutes a ‘cost’ for corporate borrowing. This paper demonstrates that in the context of the present UK tax system, this ‘cost’ of borrowing is sufficient to nullify entirely the formerly perceived financial tax benefits of corporate borrowing. We conclude that, at present, corporate borrowing could imply a net disadvantage for the valuation of a company's equity by about 6 or 7% of the debt's market value.     

担保物权制度改革降低了企业债务融资成本吗?——来自中国《物权法》自然实验的经验证据

本文运用双重差分法考察以《物权法》出台为标志的担保物权制度改革是否降低了企业的债务成本。实证结果显示,《物权法》出台后,与固定资产占比较高的企业相比,固定资产占比较低企业的债务成本显著降低。进一步,与《物权法》出台通过扩大可抵押资产范围、加强债权人保护等渠道降低企业债务成本的经济直觉一致,三重差分检验结果表明,担保物权制度改革对企业债务成本的降低作用表现出丰富差异性:其一,与法律制度环境较好地区相比,《物权法》对企业债务成本的降低作用在法律制度环境较差地区相对更大;其二,与金融市场化程度较高地区相比,《物权法》对企业债务成本的降低作用在金融市场化程度较低地区相对更大;其三,与融资约束较弱企业相比,对于融资约束较强的企业而言,《物权法》对债务成本的降低作用相对更强。这些基于中国经济实践的经验证据识别并揭示出了担保物权制度改革促使企业债务成本下降的作用机理,从而对有效缓解企业融资难、融资贵等问题具有借鉴意义。     

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.     

Real options,agency conflicts,and optimal capital structure

We examine the impact of a stockholder–bondholder conflict over the timing of the exercise of an investment option on firm value and corporate financial policy. We find that an equity-maximizing firm exercises the option too early relative to a value-maximizing strategy, and we show how this problem can be characterized as one of overinvestment in risky investment projects. Equityholders’ incentive to overinvest significantly decreases firm value and optimal leverage, and significantly increases the credit spread of risky debt. Numerical solutions illustrate how the agency cost of overinvestment and its effect on corporate financial policy vary with firm and project characteristics.     

Taxes,unequal access,public debt and corporate financial policy in the United Kingdom

The effect of corporate and personal taxes on the capital structure of the firm has been a subject of intense research in finance over several decades. However, specific features of tax systems are often overlooked in order to retain analytical tractability. The exclusion of public debt is another simplifying feature used in the modelling of the capital structure problem. In this paper we present a general equilibrium analysis of capital structure theory incorporating the impacts of the specific tax features of Government debt and financial intermediation in the United Kingdom. The implications of our model are shown to be consistent with the recent situation in the United Kingdom. That is, companies were not borrowing via the corporate debenture market; corporate borrowing was effected by the medium of bank loans.     

TOWARD A MORE COMPLETE MODEL OF OPTIMAL CAPITAL STRUCTURE

Most corporate finance practitioners understand the trade-off involved in making effective use of debt capacity while safeguarding the firm's ability to execute its business strategy without disruption. But quantifying that trade-off to arrive at an optimal level of debt can be a complicated and challenging task. This paper develops a simulation model of capital structure that starts by generating multiple estimates of market rates (LIBOR, currency rates) and corresponding company operating cash flows. To arrive at an optimal capital structure, the model then incorporates the shareholder value effects of alternative financing decisions by directly measuring the costs of financial distress, including the costs of missed investment opportunities and higher working capital requirements.
The model generates both a target credit rating and a lower fallback rating that permits a higher level of debt to maintain investments and dividends when operating cash flows are weak. As the model shows, companies with volatile cash flows and significant investment opportunities can add substantial shareholder value by establishing a fallback credit rating that is one or two notches below the target rating. The model also optimizes the mix of fixed versus floating debt, the maturity structure, and the currency composition. Another distinctive feature of the model is its ability to estimate the expected cost of alternative liability structures that can provide the liquidity insurance necessary to sustain the firm through periods of severe stress. This cost turns out to be quite small relative to the total market capitalization of the average firm.     

Managerial flexibility and the wealth effect of new product introductions

This paper examines whether investors recognize the value of managerial flexibilities, as proxied by real options, in their valuation of new product introductions. We define a firm’s real options portfolio as the difference between the firm’s market value and its assets in place. A firm’s strategic flexibilities are modeled as the ratio of its real option portfolio to its book value. Using a sample of new product introductions from 1998–2007, we find our real options measure is positively related to announcement period abnormal returns. This result holds after we control for other variables known to be correlated with the announcement effect in previous studies. Our result is robust to alternative measures of real options based on analysts’ earnings expectations and whether a firm has one or multiple segments. In summary, our results suggest that a firm’s perceived strategic and operating flexibilities are an important factor in the valuation of new products.     

CONVERTIBLE DEBT AND INVESTMENT INCENTIVES

In this paper we examine the effect of convertible debt on the investment incentives facing stockholders. The effect depends critically on the value of existing assets relative to the firm's investment requirements. With a restrictive dividend covenant, convertible debt mitigates the overinvestment incentive associated with risky debt but exacerbates the underinvestment incentive at higher values of existing assets. A less-restrictive dividend covenant exacerbates overinvestment under straight debt financing but reduces the underinvestment incentive induced by the conversion feature. In this context, a convertible debt contract with a less-restrictive dividend covenant maximizes firm value.