Professional Documents
Culture Documents
MM Proposition (1958)
I.
II.
III.
The market value of any firm is independent of its capital structure and is
given by capitalizing its expected return at the rate k appropriate to its class.
The expected yield of a share of stock is equal to the appropriate
capitalization rate pk for a pure equity stream in the class, plus a
premium related to financial risk equal to the debt-to-equity ratio times the
spread between k and r.
The cut-off point for investment in the firm will in all cases be k and will be
completely unaffected by the type of security used to finance the
investment
J. Scott (1976) presented a multipored model of debt, equity, and firm valuation.
Under the assumption that the market for real assets was imperfect, the model
implied that the value of the non-bankrupt firm was a function not only of
expected future earnings but also of the liquidating value of its assets. His
comparative statics analysis yielded three clear cut results. The optimal level of
debt was an increasing function of the liquidation value of the firms
assets, the corporate tax rate, and the size of the firm.
Bris, Welch, and Zhu (2006) find that Chapter 7 cases are systematically
different from Chapter 11 cases along with a number of dimensions such as firm
size. After controlling for self-selection (which is important and effective), Chapter 7
seems to offer few advantages: It takes almost as long to resolve, requires similar
fees, and in the end provides creditors with lower recovery rates (often zero) than a
comparable Chapter 11 procedure.
Rajan and Zingales (1995) investigate the determinants of capital structure
choice by analyzing the financing decisions of public firms in the major
industrialized countries. At an aggregate level, firm leverage is fairly similar across
the G-7 countries. They find that factors identified by previous studies as correlated
in the cross section with firm leverage in the United States are similarly correlated
in other countries as well. However, a deeper examination of the U.S. and foreign
evidence suggests that the theoretical underpinnings of the observed correlations
are still largely unresolved.
1) Tangibility : is measured as the ratio of fixed to total assets. The rationale
underlying this factors is that tangible assets are easy to collateralize and
thus they reduce the agency costs of debt. Berger and Udell (1994) show that
firms with close relationships with creditors need to provide less collateral.
They argue this is because the relationship substitutes for physical collateral.
If so, we should find tangibility mattering less in bank oriented countries.
2) Market to book : The theory predicts that firms with the high market to
book ratios have higher costs of financial distress which is why we expect the
negative correlation. There may be other reason for this negative
correlations. For instance, the shares of firms in financial distress (high
leverage) may be discounted at a higher rate because distress risk is priced
1 | Page
( Fama and French (1992)). If this is the dominant explanation, the negative
correlation should be driven largely by firms with the low market to book
ratios. In fact, the negative correlation appears to be driven by firms with the
high market to book ratios rather than by firms with the low market to book
ratios.
Another reason for the market to book ratio to be negatively correlated with
book leverage stems from the tendency for firms to issue stock when their
stock price is high relative to earnings or book values. This would imply that
correlation between the market to book ratio and leverage was driven by
firms who issue lots of equity which are proved by empirical analysis in the
paper.
3) Size
: could be proxy for the (inverse) probability of default. If so, it
should not be strongly positively related to leverage in countries where costs
of financial distress are low.
Another argument for size is that information asymmetries between insiders
in a firm and the capital markets are lower for a large firm. So large firms
should be more capable of issuing informationally sensitive securities like
equity, and should have lower debt. Unfortunately, this neither squares with
the negative correlation between size and leverage observed for most
countries, nor is it true that large firms issue more. They concluded that they
do not really understand why size is correlated with leverage.
4) Profitability
: finally profitability is negatively correlated with leverage.
if is the short run, dividends and investments are fixed, and debt financing is
the dominant mode of external financing, then changes in profitability will be
negatively correlated with changes in leverage. As large firms tend to issue
less equity, the negative influence of profitability on leverage should become
stronger as firm size increases. Firms that are profitable and have few
investment opportunities (i.e., large firms) will reduce equity issues
drastically. These firms will have a more positive correlation between
leverage and profitability. By contrast, if profitability is also correlated with
investment opportunities small firms have, then an increase in profitability
may lead to greater equity issuances, reducing the correlation between
profitability and leverage.
Lemmon, Roberts, and Zender (2008) find that the majority of variation in leverage
ratios is driven by an unobserved time-invariant effect that generates surprisingly
stable capital structures: High (low) levered firms tend to remain as such for
over two decades. This feature of leverage is largely unexplained by previously
identified determinants, is robust to firm exit, and is present prior to the IPO,
suggesting that variation in capital structures is primarily determined by factors
that remain stable for long periods of time.
Akerlof (1970) provides a thorough treatment of the effects of asymmetric
information on trading in markets (quality of products in market, size, and existence
of market). He uses the automobiles market (specifically the used car market) for its
concreteness and ease in understanding. An individuals new car may be good or it
may be a lemon (bad quality car), the individual does not know when initially
purchasing the new car. The good and bad cars are being traded at the same price
2 | Page
in the market because buyers can't distinguish between good and bad so the seller
of the good cars will not get the fair price of their products and soon will leave the
market and market will be left only with bad cars.
Ross (1977) argues that a signaling mechanism arises naturally in the market to
signal information to market participants which allows them to separate or
determine which firms have good future prospects and which dont.
Ross suggests that MMs assumption that all market participants know what future
firm cash flows will be is wrong. There exists asymmetry of information because
managers know more than investors but they know only about their firm and not
about other firms.
Assume managers cant trade their own stock but they can use their firms capital
structure to signal.
Assumptions
1. There are two types of firms, a successful type A and an unsuccessful type B,
and the value of type A greater than the value of type B. V a > Vb
2. F* is the maximum amount of debt that an unsuccessful firm can carry
without going bankrupt.
3. F > (<) F* means management signals it is type A (B).
For a signaling equilibrium, management compensation must be such that
managers of type A firms and type B firms make more if they truthfully signal their
firms type.
1. Clearly, managers of firms of type A will tell the truth by choosing F > F*
because they earn more compensation if they do because V b < Va.
2. Managers of type B firms dont necessarily have the same incentives.
Compensation must be set such that they earn more by correctly choosing F
< F* to signal that they are type B.
This condition says that the management compensation gain from lying must be
less than the management compensation loss. The LHS is the management share of
gain from initially fooling the market that it is a type A when it is really a type B. The
RHS is the penalty due to bankruptcy.
Unsuccessful firms dont have enough cash to avoid bankruptcy if F >F*
and lying managers will earn less, therefore, a signaling equilibrium
accurately separates firms into high-priced (P = Va ) and low-priced (P =
Vb) .
Without this signaling, all of the firms will trade at the same price because
investors cannot distinguish one from another.
Myers and Majluf (1984)
1. It is generally better to issue safe securities than risky ones. Firms
should go to bond markets for external capital, but raise equity by
3 | Page
2.
3.
4.
5.
6.
This example assumes that new shares or risky debt would be underpriced. What if
the managers' inside information is unfavorable, so that any risky security issue
would be overpriced? In this case, wouldn't the firm want to make N as large as
possible, to take maximum advantage of new investors? If so, stock would seem
better than debt (and warrants better still). The decision rule seems to be, Issue
debt when investors undervalue the firm, and equity, or some other risky security,
when they overvalue it.
The trouble with this strategy is obvious once you put yourself in investors' shoes. If
you know the firm will issue equity only when it is overpriced, and debt otherwise,
you will refuse to buy equity unless the firm has already exhausted its debt
capacitythat is, unless the firm has issued so much debt already that it would
face substantial additional costs in issuing more. Thus investors would effectively
force the firm to follow a pecking order.
Leary and Roberts (2010) quantify the empirical relevance of the pecking order
hypothesis using a novel empirical model and testing strategy that addresses
statistical power concerns with previous tests. While the classificatory ability of the
pecking order varies significantly depending on whether one interprets the
hypothesis in a strict or liberal (e.g., modified pecking order) manner, the pecking
order is never able to accurately classify more than half of the observed financing
decisions. However, when we expand the model to incorporate factors typically
attributed to alternative theories, the predictive accuracy of the model increases
dramaticallyaccurately classifying over 80% of the observed debt and equity
issuances. Finally, we show that what little pecking order behavior can be found in
the data is driven more by incentive conflicts, as opposed to information
asymmetry.
Graham, Leary and Roberts (2014) examine the determinants of aggregate
corporate capital structure using a novel dataset of accounting and market
information that spans most publicly traded firms over the last century. We show
that the stability of nonfinancial aggregate leverage over this period reflects two
opposing forces. First, regulated sectors, such as railroads, delivered and contracted
in size. Second, unregulated sectors experienced a threefold increase in their debtto-asset ratio from 8% in 1946 to 27% in 1970. This increase occurred in all
unregulated sectors and was systemic, affecting firms of all sizes. The median firm
in 1946 had no debt in its capital structure, but by 1970 had a debt-to-asset ratio in
excess of 25%. Our analysis reveals that competition for investors funds between
the public and private sectors played an important role in explaining the increase in
debt usage. Taxes, economic uncertainty, and financial market development play
less important roles in driving this secular increase in leverage.
Choe, Masulis, and Nanda (1993)
It is well known that historically a larger number of firms issue common
stock and the proportion of external financing accounted for by equity is
substantially higher in expansionary phases of the business cycle. We show
that this phenomenon is consistent with firms selling seasoned equity when
they face lower adverse selection costs, which occurs in periods with more
6 | Page
II.
7 | Page
III.
8 | Page
10 | P a g e
year, and the issues are on average large and not typically done by firms under
duress. We estimate that during 19732002, the year-by-year equity decisions of
more than half of our sample firms violate the pecking order.
Leary and Roberts (2005) empirically examine whether firms engage in a
dynamic rebalancing of their capital structures while allowing for costly adjustment
and find that firms actively rebalance their leverage to stay within an optimal range.
Their results also suggests that the persistent effects of shocks on leverage
observed in previous studies is more likely due to adjustment costs than
indifference towards capital structure.
Welch (2004) shows that U.S. corporations do little to counteract the influence of
stock price changes on their capital structures. As a consequence, their debt-equity
ratios vary closely with fluctuations in their own stock prices. The stock price effects
are often large and last a longtime, at least several years. He finds that stock
returns can explain about 40 percent of debt ratio dynamics over one to five year
horizons.
Dividend theories:
Signaling: Dividend signaling is a theory suggesting that when a company
announces an increase in dividend payouts, it is an indication it possesses positive
future prospects. The thought behind this theory is directly tied to game theory;
managers with good investment potential are more likely to signal. Miller and Rock
(1985) and Guay and Harford (2000) findings support dividend signaling theory.
Dividend Clientele: Sets of investors who are attracted to certain types of
dividend policy. The theory that changes in a firm's dividend policy will cause loss of
some clientele who will choose to sell their stock, and attract new clientele who will
buy stock based on dividend preferences. Market imperfections, such as transaction
costs, taxes, and institutional investment constraints, cause traditional dividend
clienteles. Black and Scholes (1974) and Allen, Bernardo, and Welch (2000)
develop clientele theories.
Life cycle theory: Dividends tend to be paid by mature, established firms,
plausibly reflecting a financial life cycle in which young firms face relatively
abundant investment opportunities with limited resources so that retention
dominates distribution, whereas mature firms are better candidates to pay
dividends because they have higher profitability and fewer attractive investment
opportunities. Fama and French (2001), Grullon et al. (2002), and DeAngelo and
DeAngelo (2006) all advance life-cycle explanations for dividends that rely,
implicitly or explicitly, on the trade-off between the advantages (e.g., flotation cost
savings) and the costs of retention (e.g., agency costs of free cash flow). DeAngelo
and DeAngelo and Stulz (2006) find consistent evidence for fraction of publicly
traded industrial firms that pay dividends is high when retained earnings are a large
portion of total equity (and of total assets) and falls to near zero when most equity
is contributed rather than earned.
12 | P a g e
Catering theory of dividend: Baker and Wurgler (2004) propose that the decision
to pay dividends is driven by prevailing investor demand for dividend payers.
Managers cater to investors by paying dividends when investors put a stock price
premium on payers and by not paying when investors prefer non payers.
Fama and French (2001) The proportion of "firms paying cash dividends falls from
66.5% in 1978 to 20.8% in 1999, due in part to the changing characteristics of
publicly traded "firms. Fed by new listings, the population of publicly traded "firms
tilts increasingly toward small "firms with low profitability and strong growth
opportunities, characteristics typical of "firms that have never paid dividends. More
interesting, we also show that regardless of their characteristics, "firms have
become less likely to pay dividends. What we mean is that the perceived benefits of
dividends (whatever they are) have declined through time. This lower propensity to
pay is at least as important as changing characteristics in the declining incidence of
dividend-paying "firms.
LLSV (2000) Agency models of dividends:
1. Outcome model: Dividends are paid because of minority shareholders
pressure corporate insiders to disgorge cash. This model predicts that
stronger minority shareholder rights should be associated with higher
dividend payouts
2. Substitute model: Insiders interested in issuing equity in the future pay
dividends to establish a reputation for decent treatment of minority
shareholders. This model predicts the opposite.
Tests on a cross section of 4,000 companies from 33 countries with different levels
of minority shareholder rights support the outcome agency model of dividends.
IPO Underpricing: Beatty and Ritter (1986) develop and test two propositions.
They demonstrate that there is a monotone relation between the (expected)
underpricing of an initial public offering and the uncertainty of investors
regarding its value. We also argue that the resulting underpricing equilibrium
is enforced by investment bankers, who have reputation capital at stake. An
investment banker who cheats on this underpricing equilibrium will lose
either potential investors (if it doesnt underprice enough) or issuers (if it
underprices too much), and thus forfeit the value of its reputation capital.
Empirical evidence supports their propositions.
Ritter and Welch (2002) review the theory and evidence on IPO activity: why
firms go public, why they reward first-day investors with considerable underpricing,
and how IPOs perform in the long run. Their perspective is threefold:
1. First, they believe that many IPO phenomena are not stationary.
2. Second, they believe research into share allocation issues is the most
promising area of research in IPOs at the moment.
3. Third, they argue that asymmetric information is not the primary driver of
many IPO phenomena. Instead, they believe future progress in the literature
will come from non-rational and agency conflict explanations.
4. IPOs performs poorly in long run and reasons for this are investors behavior.
13 | P a g e
Aggarwal, Prabhala, and Puri (2002) Institutions receive more hot IPOs than
book building suggests
Cornelli and Goldreich (2001) Underwriters use discretion to favor repeat
investors (bundling)
Hanley and Wilhelm (1995) Institutions are favored on hot IPOs, but bundling
occurs
Lee, Taylor, and Walter (1999) Institutions ask for more shares on hot IPOs,
but suffer discrimination
Ljungqvist and Wilhelm (2002a) Across countries, there is less underpricing if
institutions are favored
Ljungqvist, Jenkinson and Wilhelm (2003) examine the costs and benefits of
global integration of initial public offering (IPO) markets associated with diffusion of
U.S. underwriting methods in the 1990s. Book building is becoming increasingly
16 | P a g e
popular outside the United States and typically costs twice as much as a fixed price
offer. However, on its own, book building only leads to lower underpricing when
conducted by U.S. And/or targeted at U.S investors. For most issuers, the gain due
to lower underpricing outweighed the additional costs associated with hiring U.S
banks or marketing in the United States.
Pricing methods: auction, fixed pricing and bookbuilding.
Equity issuance timing: Alti and Sulaeman (2012) find equity issuance tend to
follow periods of high stock returns when coincide with strong institutional demand.
When not accompanied by institutional purchases, stock prices increase have little
impact on likelihood of equity issuance.
Bebhuk and Weisbach (2010) discuss seven important areas of corporate
governance. Shareholders, board of directors, executive compensation,
1. Shareholders and shareholder activismthe actions that shareholders
may take to protect their interests.
2. Corporate directors
3. Executives and their compensation.
Whereas Sections 13 focus on companies without controlling shareholders,
4. Considers companies with such controlling shareholders.
5. international corporate governance (cross country comparisons)
6. International corporate governance (considering cross-border investments
by foreign investors.
7. Political economy of corporate governance
Gompers, Ishii and Metrick (2003) uses the incidence of 24 governance rules to
constructed a Governance Index to proxy for the level of shareholder rights at
about 1500 large firms during the 1990s. They find that an investment strategy that
bought firms with strongest rights and sold firms with weakest rights would have
earned abnormal returns of 8.5 percent per year during the sample period. They
further find that firms with stronger shareholder rights had higher firm value, higher
profits, higher sales growth, lower capital expenditures, and made fewer corporate
acquisitions.
Jensen and Murphy (1990) analysis of performance pay and top-management
incentives for over 2,000 CEOs in three samples spanning five decades indicates
that the relation between CEO wealth and shareholder wealth is small and has fallen
by an order of magnitude in the last 50 years. Their estimates of the payperformance relation (including pay, options, stockholdings, and dismissal) for
chief executive officers indicate that CEO wealth changes $3.25 for every
$1,000 change in shareholder wealth. The largest CEO performance incentives
come from ownership of their firms' stock, but such holdings are small and
declining. Although the incentives generated by stock ownership are large relative
to pay and dismissal incentives, most CEOs hold trivial fractions of their firms' stock,
and ownership levels have declined over the past 50 years.
17 | P a g e
18 | P a g e
knowledge due to the technological fit between their parent firms and
entrepreneurial firms and CVCs greater tolerance for failure.
Devos, Kadapakkam and Krishnamurthy (2009). There is little evidence in the
literature on the relative importance of the underlying sources of merger gains. Prior
literature suggests that synergies could arise due to taxes, market power, or
efficiency improvements. Based on Value Line forecasts, we estimate the average
synergy gains in a broad sample of 264 large mergers to be 10.03% of the
combined equity value of the merging firms. The detailed data in Value Line
projections allow for the decomposition of these gains into underlying operating and
financial synergies. We estimate that tax savings contribute only 1.64% in
additional value, while operating synergies account for the remaining 8.38%.
Operating synergies are higher in focused mergers, while tax savings constitute a
large fraction of the gains in diversifying mergers. The operating synergies are
generated primarily by cutbacks in investment expenditures rather than by
increased operating profits. Overall, the evidence suggests that mergers generate
gains by improving resource allocation rather than by reducing tax payments or
increasing the market power of the combined firm.
Economists have accumulated considerable evidence and knowledge on the effects
of the takeover market. Most of the earlier work is well summarized elsewhere
(Jensen and Ruback, 1983; Jensen, 1984; Jarrell, Brickley and Netter in this
symposium). Here, I focus on current aspects of the controversy. In brief, the
previous work tells us the following:
1. Takeovers benefit shareholders of target companies. Premiums in hostile offers
historically exceed 30 percent on average, and in recent times have averaged about
50 percent.
2. Acquiring-firm shareholders on average earn about 4 percent in hostile takeovers
and roughly zero in mergers, although these returns seem to have declined from
past levels.
3. Takeovers do not waste credit or resources. Instead, they generate substantial
gains: historically, 8 percent of the total value of both companies. Those value gains
represent gains to economic efficiency, not redistribution between various parties.
4. Actions by managers that eliminate or prevent offers or mergers are most
suspect as harmful to shareholders.
5. Golden parachutes for top-level managers do not, on average, harm
shareholders.
6. The activities of takeover specialists (such as Icahn, Posner, Steinberg, and
Pickens) benefit shareholders on average.
7. Merger and acquisition activity has not increased industrial concentration.
Indeed, over 1,200 divestitures valued at $59.9 billion occurred in 1986, also a
record level (Grimm, 1986).
8. Takeover gains do not come from the creation of monopoly power.
19 | P a g e
Bradley, Desai and kim (1988) document that a successful tender offer increases the
combined value of the target and acquiring firms by an average of 7.4%. They
also provide a theoretical analysis of the process of competition for control of the
target and empirical evidence that competition among bidding firms increases the
returns to targets and decreases the returns to acquirers, that the supply of
target shares is positively sloped, and that changes in the legal/institutional
environment of tender offers have had no impact on the total (percentage)
synergistic gains created but have significantly affected their division between
the stockholders of the target and acquiring firms.
RAJAN, SERVAES, and ZINGALES (2000). We model the distortions that internal
power struggles can generate in the allocation of resources between divisions of a
diversified firm. The model predicts that if divisions are similar in the level of their
resources and opportunities, funds will be transferred from divisions with poor
opportunities to divisions with good opportunities. When diversity in resources and
opportunities increases, however, resources can f low toward the most inefficient
division, leading to more inefficient investment and less valuable firms. We test
these predictions on a panel of diversified U.S. firms during the period from 1980 to
1993 and find evidence consistent with them.
Opler, Pinkowitz, Stulz and Williamson (1999). We examine the determinants
and implications of holdings of cash and marketable securities by publicly traded
U.S. firms in the 1971-1994 period. In time-series and cross-section tests, we find
evidence supportive of a static tradeoff model of cash holdings. In particular, firms
with strong growth opportunities and riskier cash flows hold relatively high ratios of
cash to total non-cash assets. Firms that have the greatest access to the capital
markets, such as large firms and those with high credit ratings, tend to hold lower
ratios of cash to total non-cash assets. At the same time, however, we find evidence
that firms that do well tend to accumulate more cash than predicted by the static
tradeoff model where managers maximize shareholder wealth. There is little
evidence that excess cash has a large short-run impact on capital expenditures,
acquisition spending, and payouts to shareholders. The main reason that firms
experience large changes in excess cash is the occurrence of operating losses.
1. The transaction costs model
Keynes' (1936) transaction motive for holding cash arises from the cost of
converting cash substitutes into cash. Transaction costs model implies that liquid
assets increase with (1) the volatility of cash flow divided by total assets, and (2)
the length of the cash conversion cycle. The model also implies that liquid asset
holdings decrease (1) with interest rates and the slope of the term structure, (2)
with the cost of raising debt, (3) with the ease of selling assets, (4) with the cost of
hedging risk, and (5) with the size of a firm's dividend. The inclusion of taxes has
the additional implication that the cost of holding liquid assets increases with the
firm's marginal tax rate.
2. Information asymmetries, agency costs of debt, and liquid asset holdings
3. Agency costs of managerial discretion
4. The financing hierarchy theory
20 | P a g e
Song and Lee (2012) We investigate the long-term effect of the Asian financial crisis
on corporate cash holdings in 8 East Asian countries. The Asian firms build up cash
holdings by decreasing investment activities after the crisis. We find that the
increase in cash holdings is not explained by changes in firm characteristics but by
changes in the firms demand function for cash, which indicates that the crisis has
systematically changed the firms cash-holding policies. Specifically, the firms
increased sensitivity to cash flow volatility is one of the main factors explaining the
higher level of their cash holdings in the post-crisis period.
21 | P a g e