A real options approach for evaluating the implementation of a risk-sensitive capital rule in banks

I evaluate a bank's incentives to implement a risk-sensitive regulatory capital rule. The decision making is analyzed within a real options framework where optimal policies are derived in terms of threshold levels of credit risk. I provide a numerical example for the implementation of internal ratings based models for credit risk (the IRB approach) under the new Basel Accord (Basel II).     

The influence of firm financial position and industry characteristics on capital structure adjustment

We extend Byoun's (2008) modelling of the relationship between deficits and surpluses and adjustment speed, to demonstrate how industry characteristics identified by Kayo and Kimura (2011), including industry concentration, industry munificence and industry dynamism, impact on speed of adjustment. Using New Zealand firms as a case study, we find significant evidence that, as well as firm financial position, industry characteristics also impact on adjustment speed. The firm financial position results are the most robust, and we recommend further research to confirm the nature of the relationship between industry characteristics and the speed at which firms adjust towards target capital structures.     

Internal capital networks as a source of MNC competitive advantage: Evidence from foreign subsidiary capital structure decisions

This paper documents multinational company (MNC) strategic advantages arising from its internal financial network. Using data from US multinational company affiliates in 62 countries, we show that MNC affiliates in countries with low credit availability, poor creditor protections, high political risks, and high inflation are found to bear high interest costs and multinational affiliate debt ratios are high in high tax countries. In addition, affiliates in countries with high (low) credit availability, a high (low) corruption index, low (high) political risks and high (low) currency depreciation are found to carry high external (parent) debt ratios. We also find that currency depreciation, credit availability, and location in common law countries are negatively associated with the use of parent (relative to external) debt. Thus, our findings suggest that affiliates substitute external debt with parent debt using internal capital markets to overcome weak external financial markets and institutional environments. This is important evidence of the strategic competitive advantage based on financial networks enjoyed by MNCs.     

Modeling capital structure decisions in a transition market: empirical analysis of firms in Egypt

It has been realized that none of the three basic theories of capital structure presents a complete answer to the actual determinants of corporate financing decisions. This study attempts to model the practice of capital structure decisions according to the basic premises of each theory of capital structure: trade-off theory, pecking-order theory and free cash flow theory. The methodology addresses modeling long-term and short-term debt financing decisions based on ten different statistical criteria using data from Egypt stock market. The empirical evidence indicates that four models of corporate financing are influenced by the trade-off theory relatively. The contributions of this paper are as follows. First, this study offers a more refined and comprehensive methodology for modeling firms’ capital structure decisions. Second, the results of this study compare to those of previous studies of other developing countries and thus add an element of external validity. Mohamed A. Ismail is currently working as a consultant for the Information and Decision Support Center (IDSC), the Egyptian Cabinet-Egypt. He would like to acknowledge the financial support provided by the IDSC.     

A model of dynamic compensation and capital structure

This paper studies the optimal compensation problem between shareholders and the agent in the Leland (1994) capital structure model, and finds that the debt-overhang effect on the endogenous managerial incentives lowers the optimal leverage. Consistent with data, our model delivers a negative relation between pay-performance sensitivity and firm size, and the interaction between debt-overhang and agency issue leads smaller firms to take less leverage relative to their larger peers. During financial distress, a firm's cash flow becomes more sensitive to underlying performance shocks due to debt-overhang. The implications on credit spreads and debt covenants are also considered.     

The role of credit ratings on capital structure and its speed of adjustment: an international study

Using an international dataset, we examine the role of issuers’ credit ratings in explaining corporate leverage and the speed with which firms adjust toward their optimal level of leverage. We find that, in countries with a more market-oriented financial system, the impact of credit ratings on firms’ capital structure is more significant and that firms with a poorer credit rating adjust more rapidly. Furthermore, our results show some striking differences in the speed of adjusting capital structure between firms rated as speculative and investment grade, with the former adjusting much more rapidly. As hypothesized, those differences are statistically significant only for firms based in a more market-oriented economy.     

The capital structure of multinational corporations: Canadian versus U.S. evidence

Contrary to the U.S. evidence, we show that Canadian multinational corporations (MNCs) display higher leverage than domestic firms (DCs). This higher leverage is due to lower agency costs of debt associated with MNCs' U.S. operations. We also find that the Canadian firms with international bond market access have higher leverage than firms without such access. Comparison with a U.S. matched sample shows that the sensitivity of leverage to firm-specific factors differs between the two countries, especially for the MNCs samples. Our evidence indicates that capital structures of MNCs are a complex interaction of both home and host country factors and differences in leverage determinants across countries.     

Effect of diversification on capital structure

Previous empirical financial studies have paid little attention to the role of diversification strategy on financial choices. This study analyses the financing strategies of multibusiness firms, suggesting the relevance of sorting the diversification phenomena into its related and unrelated components. The implications of our findings are important because they explain earlier contradictory results on capital‐structure determinants and offer an explanation of how the degree of product specialization/diversification and the direction of diversification (related or unrelated) translate into different corporate financial behaviours.     

Switching to a poor business activity: optimal capital structure, agency costs and covenant rules

We address the issue of modeling and quantifying the asset substitution problem in a setting where equityholders decisions alter both the volatility and the return of the firm cash flows. Our results contrast with those obtained in models where the agency problem is reduced to a pure risk-shifting problem. We find larger agency costs and lower optimal leverages. We identify the bankruptcy trigger written in debt indenture, which maximizes ex-ante firm value, given that equityholders will ex-post be able to risk-shift. Our model highlights the tradeoff between ex-post inefficient behavior of equityholders and inefficient covenant restrictions.      

The impact of changes in bank ownership structure on the allocation of capital: International evidence

A new wave of bank privatizations in the past decade has significantly changed the ownership structure of banking systems around the world. This paper explores how these changes affect the allocation of capital within countries. Increases in domestic blockholder ownership of banks adversely affect the allocation of capital through increased lending activity to less productive industries and to those with less dependence on external finance. This result is more pronounced in countries with higher levels of corruption. I find some evidence that foreign presence improves capital allocation efficiency by increasing lending to more productive industries, primarily in common law countries.     

Government ownership and the capital structure of firms: Analysis of an institutional context from China

Emerging economies provide interesting scenarios for examining how institutional context influences the financing behavior of firms. In this study, we examine the capital structure of Chinese listed firms following the Split-Share Structure Reform of 2005. This reform allowed a reduction of government ownership by making government shares tradable. We find that the impact of government ownership on leverage is dependent on whether the government is the largest shareholder in a firm and whether the government ownership is through a parent state-owned enterprise. In addition, we document that the largest non-government shareholder positively influences leverage. Overall, our results reveal that the largest controlling shareholder, either government or non-government, has a significant impact on the capital structure of Chinese firms.     

The effect of a decision aid on risk aversion in capital investment decisions

In this study we examine whether a decision aid is an effective means of reducing risk aversion within a capital investment decision context, and under what conditions. Participating in the experiment were 78 working adults (mid management) with a mean age 30 and enrolled in a leading U.S. MBA program. We predict and find that a decision aid will be most effective among individuals intolerance of ambiguity and exhibiting high negative affect.     

The cost of capital and optimal financing policy in a dynamic setting

This paper revisits the Modigliani–Miller propositions on the optimal financing policy and cost of capital in a dynamic setting. In an environment without taxes and bankruptcy costs, the results are generally consistent with the Modigliani–Miller Propositions 1 and 2. However, the first proposition should be presented and interpreted more carefully, as given firm characteristics, there is only one optimal capital structure. Thus, a firm’s capital structure is relevant. A relaxation of assumptions about either taxes or bankruptcy costs leads to conclusions that are generally different from those in Modigliani and Miller (1958). The model predicts that leverage and sales-to-capital ratios decrease but firm size and capital stock increase with the subjective discount factor of the firm’s manager if there are taxes and bankruptcy costs. The empirical analysis supports these predictions.     

Financial frictions on capital allocation: A transmission mechanism of TFP fluctuations

This paper provides a theory of financial frictions as a transmission mechanism for news shocks to drive aggregate TFP fluctuations. We show that in an economy calibrated to U.S. data, variations in financial frictions on capital allocation in response to news about future technology can generate aggregate TFP fluctuations and, thus, trigger business cycles before the actual technological change is realized. Using the COMPUSTAT dataset, we find that the relative capital productivity of financially constrained to unconstrained firms is highly countercyclical. Moreover, our VAR analysis shows that news shocks can account for a substantial fraction of the relative capital productivity fluctuations over business cycle frequencies.     

Leverage, imports, profitability, exchange rates, and capital investment: a panel data study of the textile and apparel industries 1974-1987

This paper explores the relationship between capital structure and import competition for the textile and apparel industries from 1974-1987. The level of import penetration should have an important effect on business risk and hence on financial leverage. We also examine the response of leverage to the interrelationships that may exist between import competition and three other factors: firm profitability, strength of the dollar, and investment in capital equipment.The evidence suggests that leverage for the textile firms increases with rising imports but that the effect is less marked if the imports are the result of a strengthening dollar. The textile firms also seem to have inaugurated a capital investment campaign in reaction to import competition. For apparel firms, the interrelationship between profitability and import penetration seems to have been the primary determinant of leverage.     

Capital structure and financing of SMEs: Australian evidence

This paper investigates the determinants of capital structure and use of financing for small and medium sized enterprises. Hypotheses utilising static trade-off and pecking order arguments are empirically examined using a series of firm characteristics including: size, asset structure, profitability, growth and risk. The hypotheses developed are tested using a large Australian nationwide panel survey. The results suggest that asset structure, profitability and growth are important determinants of capital structure and financing. For asset structure the direction of the influence is reliant upon the capital structure or financing measure employed. The results generally support static trade-off and pecking order arguments proposed by theoretical models.     

The performance of insolvency prediction and credit risk models in the UK: A comparative study

Theoretically-driven, market-based contingent claims models have recently been applied to the field of corporate insolvency prediction in an attempt to provide the art with a theoretical methodology that has been lacking in the past. Limited studies have been carried out in order directly to compare the performance of these models with that of their accounting number-based counterparts. We use receiver operating characteristic curves to assess the efficacy of thirteen selected models using, for the first time, post-IFRS UK data; and investigate the distributional properties of model efficacy. We find that the efficacy of the models is generally less than that reported in the prior literature; but that the contingent claims models outperform models which use accounting numbers. We also obtain the counter-intuitive finding that predictions based on a single variable can be as efficient as those which are based on models which are far more complicated – in terms of variable variety and mathematical construction. Finally, we develop and test a naïve version of the down-and-out-call barrier option model for insolvency prediction and find that, despite its simple formulation, it performs favourably compared alongside other contingent claims models.     

Budgeting, the individual and the capital market: A case of fiscal stress

Budgetary control is a major aspect of management control. It has undergone major shifts of emphasis in both the literature and practice in the later part of the 20th century. A significant influence on the changing practices of this aspect of control has been the growth of and increased influence of the capital market. This paper draws on a detailed field study focusing on the problematic nature of budgetary control in a changing operational environment that acknowledges both the importance, internally, of the organisation members and their contribution to continued growth—and externally the growing influence of shareholders on business operations. The focus of the paper is on the effects of the constant pressure of the share price on the case unit of analysis and how that changed the use of the budgetary control system. This change is illustrated both at a macro level of organisational accountability for predicted results and also as it is driven down the organisation to the level of the individual.     

The term structure of banking crisis risk in the United States: A market data based compound option approach

We use a compound option-based structural credit risk model to estimate banking crisis risk for the United States based on market data on bank stocks on a daily frequency. We contribute to the literature by providing separate information on short-term, long-term and total crisis risk instead of a single-maturity risk measure usually inferred by Merton-type models or barrier models. We estimate the model by applying the Duan (1994) maximum-likelihood approach. A strongly increasing total crisis risk estimated from early July 2007 onwards is driven mainly by short-term crisis risk. Banks that defaulted or were overtaken during the crisis have a considerably higher crisis risk (especially higher long-term risk) than banks that survived the crisis.     

Capital structure of multinational and domestic corporations – a cross‐country comparison

This study investigates whether the determinants of capital structure between multinational corporations (MCs) and domestic corporations (DCs) vary across Australia, U.S., Japan, U.K. and Malaysia. Results show (i) the debt holding capacity and majority of the explanatory factors vary between DCs and MCs and also across countries; (ii) Australia, Japan, U.K. and Malaysian MCs hold significantly less long‐term debt relative to U.S. firms; (iii) DCs and MCs that operate under an imputation tax system hold significantly less short‐ and long‐term debt; and (iv) DCs and MCs operating under common law have significantly less short‐term debt and significantly higher long‐term debt.