Financial contracting
What is missing in MM’s irrelevance result?
Rajan and Zingales (1995): Systematic factors determine D/E
ratio.
Mayers and Majlof (1984): managers have better information
about the assets in place than investors. If the manager acts
on behalf of old shareholders, he will not want to raise
capital by issuing new shares since the new shares will be
sold at a discount relative to their true values.
Pecking order theory of capital structure. (See 2B)
Aghion and Bolton (1992): Income rights and control rights can
be separated in an incomplete contract model. (See 5B)
Tirole (2001): Corporate governance with a choice of effort.
(See 3B)
Corporate Finance
© Professor Ho-Mou Wu
5A-1
Spring 2004
Summary: Choices of Capital Structures
Empirical Studies with International Data*:
Leveragei =α+β1 Tangibility of Assetsi +β2 Market to Book
Ratioi +β3 Log Salesi +β4 Profitabilityi
Tangibility of Assets = ratio of fixed assets to the book value of
total assets.
Market to Book Ratio = market value of equity and debt divided
by book value of assets.
Log Sales = logarithm of net sales.
Profitability = EBIT divided by book value of assets.
Q: What should be the signs of theseβ’s?
*Reference: Rajan and Zingales, “What do we know about capital structure?” Journal of Finance, Dec. 1995.
Corporate Finance
Spring 2004
© Professor Ho-Mou Wu
2A-30
Diversity of Outside Claims
5A-2
Spring 2004
Corporate Finance
© Professor Ho-Mou Wu
Dewatripont and Tirole (1994): The manager receives private
benefits from choosing some preferred action. The claim-holder
has the right to intervene (stop, S).
Consider a simplified framework allowing multiple claim holders:
At , the manager pays out and a claim-holder can
intervene with a cost of overcoming liquidity shocks . By
retaining , the manager maximizes his chances of surviving
till date 3. The investors get income if the firm survives.
Investor Optimum
The firm is worth saving if and only if . At date 2 the firm can borrow up to 90 against date 3 earnings.
This outcome can be achieved as the firm pays out all its earning at date 1, . The firm’s present value (with zero interest rate) at date 0 is
Since the value of investor’s optimum , the firm will be set up at date 0 if the manager can commit to the investor optimum.
5A-3
Spring 2004
Corporate Finance
© Professor Ho-Mou Wu
Manager Optimum
Once the firm is set up, the manager has a quite different goal from that of the investors: he wants the firm to survive to date 3 (private benefits). The manager wants to retain as much earning at date 1 as possible: ,retained .
If the manager has full control, he will never pay out anything at date 1. The firm’s present value at date 0 is
Since , the manager’s optimum is not feasible. If the manager has full control, the investors will not finance the firm at date 0.
Corporate Finance
© Professor Ho-Mou Wu
5A-4
Spring 2004
Shareholder Control (S)
In order to finance this project, the manager gives out some control to investors.
Suppose that the control right is given to a single shareholder (or a group of homogeneous shareholders). He can intervene, but with a cost F=18 (which is absent in Aghion and Bolton).
The manager will pay out just enough to make the shareholder indifferent between intervention and not. The equilibrium value of :
Note that , which is the intervention cost.
Moving backward in time, we find that . Total shareholder control is not enough to get the firm financed at data 0!
© Professor Ho-Mou Wu
5A-5
Corporate Finance
Spring 2004
Shareholder and Creditor Control (SC)
Introduce a short-term creditor who is owned 20 at date 0. If the creditor is not fully paid, she can choose to intervene at a cost of 18. Assume that once she seize , she can get reimbursed for the intervention costs. If the creditor decides not to intervene, her remaining debts are canceled.
The manager makes a payment at date 1 to the creditor first. The creditor decides whether or not to intervene. Then the manager makes a payment to the shareholder. The shareholder decides whether to intervene. (The shareholder can also get reimbursed for F, but it does not matter .)
Corporate Finance
© Professor Ho-Mou Wu
Spring 2004
5A-6
Shareholder and Creditor Control (SC)
The equilibrium is for the manager to pay 20 to the creditor and nothing to the shareholder and for neither party to intervene.
If the manager pays to the creditor, the creditor will choose to intervene. The manager loses 38 in funds altogether, so it is better for the manager to pay 20 to the creditor.
There is no need to pay the shareholder since the firm is now worth at date 1.
If the shareholder intervenes by seizing the remaining 30, the firm is worth
But the gain is only , which is less than F=18.
Corporate Finance
Spring 2004
5A-7
© Professor Ho-Mou Wu
Shareholder and Creditor Control (SC)
With short term debt (20) and equity (36), the firm at date 0 is worth
The firm can be financed at date 0.
A single shareholder is not tough enough on management. The reason is that intervention is costly and the gains from seizing the retained earnings are not that high. Issuing debt can reduce the amount of free cash flow available to the manager (See 2A-27).
Corporate Finance
Spring 2004
5A-8
© Professor Ho-Mou Wu
