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67 Cards in this Set
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Briefly summarize the paper by Modigliani & Miller (1958) |
Back in 1958, Modigliani and Miller showed capital structure was irrelevant to a firm’s cost of capital and hence to investment decisions. Their main assumptions were that there are (i) no taxes,(ii) no transaction costs, (iii) no bankruptcy costs, and (iv) no agency costs. |
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Briefly summarize the paper by Fama & French (1998) |
Fama and French use cross-sectional regressions to study how a firm’s value is related to dividends and debt. With a good control for profitability, the regressions can measure how the taxation of dividends and debt affects firm value. Simple tax hypotheses say that value is negatively related to dividends and positively related to debt. The authors find the opposite.They infer that dividends and debt convey information about profitability(expected net cash flows) missed by a wide range of control variables. This information about profitability obscures any tax effects of financing decisions. |
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Briefly summarize the paper by Graham (2008) |
Graham investigates the size of the tax shield on debt. A key insight is that tax savings are less than the one implied by statutory tax rates due to the fact that: (i) companies may not be able to fully offset interest against taxable income (other tax shields or loss making years), and (ii) personal income taxation. The author finds that the average benefit of the tax deductibility of interest payments adds up to 9.7% of total market value. Graham does not include the costs of distress in his analysis as he feels they are hard to estimate, most presumably are small and have low explanatory power. According to him, firms leave on average 15.7% of firm value of the table from not using an optimal capital structure. When personal taxes are taken into account the effect decreases to the point where firms forego a benefit of 7.3% of firm value. |
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Briefly summarize the paper by Korteweg (2010) |
Korteweg estimates the market’s valuation of the net benefits to leverage using panel data from 1994 to 2004, identified from market values and betas of a company’s debt and equity. The median firm captures net benefits of up to 5.5% of firm value. Small and profitable firms have high optimal leverage ratios, as predicted by theory, but in contrast to existing empirical evidence. Companies are on average slightly underlevered relative to the optimal leverage ratio at refinancing. This result is mainly due to zero leverage firms. Korteweg also looks at implications for financial policy.
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Briefly summarize the paper by Andrade & Kaplan (1998) |
Andrade and Kaplan investigate why ‘highly leveraged transactions’ such as LBOs or MBOs have entered into distress, as well as the consequences of that distress. A key challenge when measuring cost of financial distress is that financial distress is typically caused by bad economic performance. In order to measure the pure effect of financial distress,one has to strip out the impact of bad economic performance. All firms studied have positive operating margins; hence the reason why they defaulted probably was not rooted in economic problems. The authors find that the net costs of financial distress in their sample appear to be in the 10-20% of total firm value range. The distinction between financial and economic distress is important, because economic distress is more costly due to the fact that such firms with low or negative profitability have less incentive to survive.Financial distressed firms can usually restructure (apply a different capital structure) and have good profitability overall. In addition, economic distress tends to be something that the entire economy faces, affecting all firms. |
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Briefly summarize the paper by Van Binsbergen et al. (2010) |
Van Binsbergen et al. use exogenous (having an external cause) variation in tax benefit functions to estimate firm-specific cost of debt functions that are conditional on company characteristics such as collateral,size, and book-to-market. This paper is written in the style of the trade-off theory, meaning firms balance the pros of debt financing (e.g. tax savings,lenders monitoring) against the cons (e.g. cost of financial distress, personal taxes). |
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Briefly summarize the paper by James & Kizilaslan (2014) |
James & Kizilaslan investigate to what extent asset specificity results in fire sale discounts, and what is the subsequent impact on financing. The main idea is that if a particular industry is in distress, then highly specific assets cannot be readily deployed to industry outsiders without a significant drop in value. In other words, firms with highly specific assets face fire sale prices when trying to sell their assets in industry downturns. This relates to loan pricing in that loan pricing and the evaluation of credit risk involve both an assessment of them likelihood of default as well as the loss given default (LGD). All else equal, the higher the expected LGD, the higher the credit spread and thus the higher the expected cost of borrowing under lines of credit. Overall, the results suggest that the potential for fire sale discounts affects the ex-ante pricing and structure of bank loans. In addition the authors suggest that the increased exposure to industry risk as a result of the highly specific asset leads to an increase in covenant intensity in an attempt to mitigate some of that risk. In an imperfect world one might argue that the increase in cost of the borrowing as described by James & Kizilaslan could lead to a shift in capital structure toward equity. |
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Briefly summarize the paper by Myers & Majluf (1984) |
Myers & Majluf consider a firm that must issue common stock to raise cash to undertake a valuable investment opportunity. Management is assumed to know more about the firm’s value than potential investors. Investors interpret the firm’s actions rationally. They develop an equilibrium model of the issue-invest decision under these assumptions. Their model shows that firms may refuse to issue stock, and therefore may pass up valuable investment opportunities. Among other things,they find that firms whose investment opportunities outstrip operating cash flows, and which have used up their ability to issue low-risk debt, may forego good investments rather than issue risky securities to finance them. However, stockholders are better off when the firm carries sufficient financial slack to undertake good investment opportunities as they arise. The authors define “slack” as:“the sum of cash on hand and marketable securities. Financial slack should also include the amount of default-risk-free debt the firm can issue.” Slack is useful because. Without slack, the firm is sometimes unwilling to issue new stock even though good investment opportunities are present (because stock may only be issued below the fair value because of adverse selection problems). Slack (free cash) avoids the need to go to the market when good opportunities arise, and hence has value. |
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Briefly summarize the paper by Frank & Goyal (2008) |
Frank & Goyal notice how financing patterns differ across various types of firms, in particular the differences between private firms, small public firms, and large public firms. The authors find that privately held (non-listed) firms appear to particularly use retained earnings and bank loans for their financing. The reason for this is that there is a lot of asymmetric information about value with these firms. As a result equity financing is sub-optimal. A bank may also be hesitant to provide funding(not easily) but that is the only other firm of financing possible for privately held firms. Small publicly held (listed) firms rely mostly on equity financing. They do so because they have high asset volatility. That is, if there is more asymmetric information about risk than about value. On the other hand, large publicly held firms rely mainly on retained earnings and corporate bonds. The reason for this is that large companies face lower cost of debt because they are more stable and have less default risk by definition. |
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Briefly summarize the paper by Warr et al. (2012) |
In the paper by Warr et al. they hypothesize that the rate of adjustment of a firm to its target leverage (TL) is dependent on equity mispricing. More specially, the authors expect that when equity is overvalued(undervalued) and a firm is overlevered, the rate of adjustment is faster(slower), and when equity is overvalued (undervalued) and a firm is underlevered, the rate of adjustment is slower (faster). They assume that managers are aware of any mispricing and use this to time equity issuance and buybacks when making capital structure adjustments.Overvalued firms adjust to their target in about 1.9 years,while undervalued firms take almost 3 years to adjust. |
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Briefly summarize the paper by Ross (1977) |
In his paper, Ross shows how the choice of a managerial incentive scheme and the choice of a leverage structure provide valuable information to the market that could be value-adding. The author analyzes how signaling can help to overcome informational problems. First referred to as the ‘lemons problem’ by George Akerlof, in this article Ross shows that—under information asymmetry—this classic adverse selection problem also applies to outside financiers. As investors are unable to distinguish a lemon from a fine firm, when choosing to finance one of two firms (firm A and firm B), they only settle for a price that ranges between that of firm A and firm B. |
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Briefly summarize the paper by Chemmanur et al. (2009) |
The basic premise of the paper by Chemmanur etal. is that better managers (with higher reputation and quality) are more able to communicate the intrinsic value of their firm to outsiders. Hence, these managers can (partially) overcome the information asymmetry in the equity problem. Since these managers are better able to convince investors, their firms would depend less on other signals (such as dividend payments). In addition, the premise is that these better managers are better at sourcing positive NPV projects and ultimately will also invest more. |
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Briefly summarize the paper by Leary & Roberts (2014) |
Leary & Roberts show that peer firms play an important role in determining corporate capital structures and financial policies. In large part, firms’ financing decisions are responses to the financing decisions and, to a lesser extent, the characteristics of peer firms.According to the authors, these peer effects are more important for capital structure determination than most previously identified determinants.Furthermore, smaller, less successful firms are highly sensitive to their larger, more successful peers, but not vice versa. |
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Briefly summarize the paper by Berger, Ofek, and Yermack (1997) |
Berger, Olef and their friend Yermack study associations between managerial entrenchment and firms’ capital structures. The results suggest that entrenched CEOs seek to avoid debt. In a cross-section alanalysis, they find that leverage levels are lower when CEOs do not face pressure from either ownership and compensation incentives or active monitoring. In an analysis of leverage changes, they find that leverage increases in the aftermath of entrenchment-reducing shocks to managerial security, including unsuccessful tender offers, involuntary CEO replacements,and the addition to the board of major stockholders. |
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Briefly summarize the paper by Mikkelson & Partch (1986) |
Mikkelson and Partch examine the stock price effects of straight debt, equity, and convertible debt offers. The authors use360 randomly-selected U.S. firms over a period ranging between 1972 and 1982.What they find is that equity offerings induce significantly negative abnormal returns around their announcement dates. Straight debt offerings induce non-significant abnormal returns around the announcement date, as is consistent with Myers and Majluf (1984). In cross-sectional regressions, security type is the only significant determinant of abnormal return. |
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Briefly summarize the paper by Bayless & Chaplinsky (1991) |
Bayless and Chaplinsky examine the market reaction to straight debt and equity offerings and how they are influenced by investors’ expectations on the type of security to be issued. This paper is the first to make a link between security choice expectations and stock price reactions. The authors show that an equity or debt offering issued by Firm A can trigger a different stock price reaction than an offering by Firm B. What matters are the prior expectations of the investors regarding the security choice. They conclude that stockholders reactions to straight and equity offering announcements are influenced by investors’ expectations about whether the firm will issue straight debt or equity. When an ‘equity-type’ firm issues straight debt instead, abnormal stock returns are significantly positive. When a ‘debt-type’ firm issues equity instead, abnormal returns are significantly negative (more negative than if equity-like firm would have issued equity). |
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Briefly summarize the paper by Bayless & Chaplinsky (1996) |
In another article by Bayless and Chapinsky the two happy fellows examine whether there are periods during which SEOs (Seasoned Equity Offerings) can be made at more favorable terms (i.e. with less negative announcement returns). The authors are one of the first to examine whether there are periods during which abnormal returns at SEO announcements are systematically less native. They find that, during high equity issue volume(“hot”) periods, the abnormal stock returns at SEO announcements is roughly 200basis points less negative than in low equity issue volume (“cold”) periods.The 200 basis point difference implies that a typical hot market issuer would forego approximately $13 to $16 million in additional equity value if it issued in a cold market instead. The authors hypothesize the potential existence of windows of opportunities, motivated by the model of asymmetric information. As believe that, the economy-wide level of asymmetric information, and hence of equity-related adverse selection costs, varies over time. During periods when the level of asymmetric information is low, investors have more information about firm value, and are less likely to interpret equity offerings as a signalof firm overvaluation. |
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Briefly summarize the paper by Baker & Wurgler (2002) |
Baker and Wurgler investigate how equity market timing affects capital structure. In particular, they examine whether equity market timing has a short-run or long-run effect on capital structure. By short-run they mean a mechanical effect, that is, leverage decreases if firm issue new equity when market value is high. By long-run they mean the standard theory, which suggests that the short-run effect fades out through rebalancing the capital structure. This paper is the first study that looks at the long-run impact of market timing on capital structure. The authors conclude that capital structure is the cumulative outcome of historical market timing efforts. Firms that exhibit a low leverage are those which raised funds when their market valuations were high. On the other hand, firms that exhibit a high leverage are those which raised funds when their market valuations were low. This means that fluctuations in market valuations have large effects on capital structure (the effects persist for at least 10 years). It would seem that managerial market timing decisions accumulate over time into the firm’s current capital structure,which is evidence for the market timing theory of capital structure”. |
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Briefly summarize the paper by Leary & Roberts (2005) |
The paper by Leary and Roberts re-examines the market timing theory of capital structure. It provides an alternative explanation for the persistent effects of shocks to capital structure. The authors show that the presence of adjustment costs results in shocks having a persistent effect on leverage. A finding that is not consistent with Baker and Wurgler (2002) but is consistent with dynamic rebalancing. When adjustment is costly, it may be sub-optimal for firms to respond immediately to capital structure shocks. If the costs of adjustments are higher than its benefits,firms will wait to recapitalize. This can result in periods of financing inactivity that will have implications for the dynamic behavior of capital structure. They find that for firms for which adjustment costs is relatively lower, leverage is less persistent in the context of Baker and Wurgler’s model.This result is counter to the implications of market timing but consistent with dynamic rebalancing. The persistent effect of shocks on leverage is more likely due to optimizing behavior in the presence of adjustment costs, as opposed to indifference toward capital structure. |
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Briefly summarize the paper by Flannery & Rangan (2006) |
In their paper Flanner and Rangan provide the first comprehensive evidence on the dynamic nature of capital structure. The goal if this paper is to determine whether firms have target capital structures, and if so, what is the speed with which they move toward their targets. The key findings of this paper are not consistent with previous studies. However, the findings of this paper are consistent with earlier papers that implicitly indicate rapid adjustment of leverages. The authors argue that many previous studies impose unwarranted assumptions about the dynamic nature of leverage targets which materially affect the estimation results. Hence, this paper identifies empirically why previous studies provide mixed evidence on leverage targets and adjustment. In their research the authors add a lagged dependent variable to the specification. This allows for partial adjustment of the firm’s initial capital ratio toward its target within each time period.Earlier research assumes a perfect adjustment model, which Flannery and Rangan show is strongly rejected by the data. To conclude, they find strong and robust evidence that firms have target capital structures and that they adjust the actual capital structure to achieve their targets. Such a dynamic capital structure can be reasonable measured by means of a partial adjustment model with firm fixed effects. The annual adjustment speed is roughly 30%, i.e. the average firm closes on-third of the gap between actual and target leverage. |
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Briefly summarize the paper by Kisgen (2006) |
Kisgen published the first paper looking at how the manager’s concern for credit ratings affects the firm’s capital structure in 2006. Credit ratings (agencies) have substantially gained in importance over the last 10 years. Their role as a catalyst for credit risk transfer in the global financial crisis has been heavily debated (ratings for securitized mortgages and loans, sovereign ratings). Kisgen proposes the “Credit Rating –Capital Structure” (CR-CS) hypothesis. He suggests that firms which are close to rating changes (near upgrade or downgrade) issue relatively less debt(compared to equity) than those that are not close to rating changes (in the middle of rating class). If the firm is near an upgrade, then a relatively large debt issue might prevent the upgrade while an equity issue would increase the chance of an upgrade. If the firm is near a downgrade, then a relatively large debt issue might trigger the downgrade while an equity issue would decrease the chance of a downgrade. |
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Briefly summarize the paper by Kisgen (2009) |
In another paper by Kisgen he analyzes whether managers target credit ratings (or leverage levels) when making capital structure decisions. He finds that managers target minimum credit rating levels over time when making capital structure decisions. Downgraded firms are: (i)more likely to reduce debt, (ii) less likely to issue debt, and (iii) less likely to reduce equity. This behavior exists beyond target leverage behavior,distress concerns, market timing and business cycle effects. |
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Briefly summarize the paper by Fazzari, Hubbard and Petersen (1988) |
The three giants write the first comprehensive empirical test of firm’s financial constraints. The paper provides evidence that financial factors do affect corporate investment. Financial factors are important for all firms but the sensitivity of investment to cash flow and liquidity is grater for firms that mainly rely on internal finance. The findings are consistent with corporate financial constraints arise from capital market imperfections. |
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Briefly summarize the paper by Kaplan & Zingales (1997) |
Kaplan and Zingales attempt to determine whether investment-cash flow sensitivities provide useful measures of financial constraints.The paper shows that investment-cash flow sensitivities are not useful measures. The authors identify that the relation between investment and internal funds is non-monotonic. The most successful and least constrained firms rely primarily on internal cash flow to invest despite of the availability of additional low cost external funds. |
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Briefly summarize the paper by Lamont, Pol and Saa-Requejo (2001) |
Lamont and friends look at the impact of financial constraints on shareholder value. Their main goal is to determine if financially constrained firms share common variation in their stock returns.Why should we expect a common variation in stock returns of financially constrained firms you say? If constraints are purely firm-specific, stock returns should not move together. Also, if constrained firms are subject to common shocks, there should be a co-movement of their stock returns. The authors test whether financial constraints result from a common shock to firms(controlling for a variety of other determinants of stock returns). The paper provides first evidence for financial constraints factor in stock returns (“stock returns of constrained firms move together”). Surprisingly, constrained firms earn lower stock returns than unconstrained firms (which cannot be explained with existing asset pricing models). Constrained firms do not have stock returns that are more cyclical than average, i.e. the source of common shocks are not macro-economic factors. |
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Consider two firms that operate in the same industry and hence have thesame cash-flows at t = 1. At t = 0, firm A has debt of 25 and thevalue of its equity is 75. Firm B has debt of 50 and the value of its equity is60. The interest rate on debt for both firms is 10%. Assume that theassumptions of Modigliani and Miller 1958 (MM) hold. Show that this situationis not arbitrage-free, that is, an investor who can trade in the securities ofboth firms without costs (both long and short) can generate a riskless return. |
Consider that the investor goes long in 1% of both parts of the capital structure (equity plus debt) of firm A and 1% short in the capital structure of firm B. Denoting the cash-flow of the firms with pi, the investor thus obtains cash-flows at t = 1 from the long-position of 1%pi and -1%pi on the short-position. His pay-off at t = 1 is thus zero. However, at t = 0 the investor makes a profit of 1%(-25-75+50+60) = 0.1. He thus makes a risk-free profit, hence the situation is not arbitrage-free. |
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Consider the equation ij= pk + (pk - r) Dj/Sj on p.271in MM. Describe in your own words what is the effect of an increase in Dj on ij and explain the intuition behind this effect. |
The equation states that, for a given level of equity, an increase in the amount of debt (thus increase in leverage) raises the expected return on equity. The reason for this is that higher leverage means that equity becomes riskier - risk-averse investors will hence require a higher return on holding it. |
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Explain why "slack" is useful in Myers and Majluf! |
Without slack, the firm is sometimes unwilling to issue new stock even though good investment opportunities are present (because stock may only be issued below the fair value because of adverse selection problems). Slack (free cash) avoids the need to go to the market when good opportunities arise, and hence has value. |
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Why would active shareholders be indifferent about the financingstructure of the firm, based on Myers and Majluf. |
If capital markets are friction less, and all traders understand what is going on, then the capital structure becomes irrelevant. Shareholders should be able to buy and sell their shares, and buy or sell debt. |
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Based on the paper by Myers and Majluf, explain (in words) why management becomes less inclined to issue newequity when a is high, but moreinclined when b is high. |
High a: In this case the existing value of the firm (the value of legacy assets) is high. Due to informational asymmetry, outsiders do not know about this. Hence the price new shareholders are prepared to pay will not reflect the true value of the firm (they will undervalue the firm). If management cares about old shareholders, it will thus not sell equity as it would dilute the value of their claims. High b: High b means that the value of the new opportunity is high. In this case, the benefits from issuing equity is also high as otherwise the project cannot be financed. |
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Explain in words why it is possible to have a separating (signaling)equilibrium in Ross (1977) where managers reveal their firm's type! Why domanagers of bad firms not just mimic the behavior of the managers of goodfirms? |
Managers of bad firms (type B) know that when they choose F > F*, they will default. The same is not true for good firms (type A). Thus managers of bad firms have higher costs of using the signal. There can thus be situations where the signal is optimal for good managers, but not for bad managers. Bad managers are prevented from misleading the markets through their incentive structure. |
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Based on Ross (1977),If l increases, does this makeit more or less likely that we get a separating equilibrium, or is thelikelihood of a separating equilibrium unaffected? |
If l increases, ceteris paribus, it is more likely that we get a separating equilibrium, as this means the liquidation costs increase. The signaling equilibrium holds as long as the liquidation costs outweigh the margin gains from mimicking another firm. As these costs increase so does the likelihood that they are higher than the margin gains. |
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In the analysis of the effect of managerial entrenchment on leverage,Berger, Ofek and Yermack (1997) regress the level of leverage on managerial entrenchment proxies and other standard control variables. The authors note that it is difficult toascertain cause-and-effect relations from the estimated regressioncoefficients. Briefly explain why it is difficult (if not impossible) toestablish a causal effect of managerial entrenchment on leverage in theseregressions. |
In their paper, Berger, Ofek and Yermack (1997) find that leverage is lower when CEOs are entrenched. However, the authors also mention that, because variables are determined at the same time, it is very difficult to establish a causal relationship. In other words, it could very well be that leverage leads to entrenchment rather than entrenchment leading to more leverage. This is referred to as an endogeneity problem and makes it difficult,if not impossible, to establish a causal effect. |
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In their paper, Bayless and Chaplinsky (1991) investigate the stockmarket reaction to firms’ debt and equity offerings considering the investors’expectations as to the type of security to be issued. They document that, forequity issues, the most “debt-like” firms experience abnormal stock returns of-3.5%, and the most “equity-like” firms -2.0%. Moreover, for debt issues, themost “debt-like” firms experience abnormal stock returns of -0.4% and the most“equity-like” firms +1.0%. Please explain why the market reaction to an equityissuance is more negative as compared to a debt issuance in general(irrespective of investor expectations). |
[The basic adverse selection argument of Myers and Majluf (1984) strongly suggests that the market reaction to security offerings should be smaller the lower the risk that the security is overpriced. This implication is also a basic motivation for the financing pecking order of Myers (1984).] Given the predictable contractual payment stream embedded in a debt contract, protected by bankruptcy law, the risk of market mispricing is almost certainly lower for a corporate debt instrument than for common stock. Thus, the market reaction to debt issues should therefore be smaller than for equity. |
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Baker and Wurgler (2002) show that firms’ historical variation inmarket-to-book ratio has long lasting effects on their capital structures. Inparticular, they argue that firms that exhibit a low (high) leverage are thosewhich raised funds when their market valuations were high (low). Briefly explainwhether these findings are in accordance with the predictions of the trade-offtheory. |
The trade-off theory implies that there is an optimal level of debt, and that capital structure adjusts to changes in the market-to-book ratio.Accordingly, the trade-off theory predicts that temporary fluctuations in the market-to-book ratio or any other variable should have temporary effects.However, the authors find that variation in the ratio has a long-term impact on capital structure.They argue that it unlikely that their findings are in accordance with the trade-off theory, as this would imply that adjustment costs are large enough (or deviation from the optimum involves a small enough penalty) to make an adjustment within a 10-year span not worthwhile. This seems unlikely to Bakerand Wurgler. |
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In the analysis of determinants of leverage, Baker and Wurgler (2002) regress leverage ratio (i.e., D/At) on the external finance weighted-average market-to-book ratio (i.e., M/Befwa,t-1), the current market-to-book ratio (i.e., M/Bt-1), and other control variables. Briefly explain why the author simultaneously include both M/Befwa,t-1 and M/Bt-1 in the regression. |
The authors included both ratios to prevent a spurious link due to correlation between the timing measure and investment opportunities. This way, they try to control for the current investment opportunities and make sure that the historical within-firm variation more accurately identifies the market-timing opportunities. |
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Briefly explain MM Proposition I. |
Under their assumptions, Modigliani and Miller show thatdebt adds no value to a company. In other words, the value of the levered firmsequals the value of the unlevered firm. When taxes are introduced, debt doesadd value as interest payments on debt are tax-deductible. This propositionholds as due to the equivalence of pay-offs of firms with different capitalstructures. Any leverage applied by a firm can be mimicked by the investorsusing home-made leverage. |
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Briefly explain MM Proposition II. |
Their second proposition states that the return equityholders require increases with leverage. Since equity holders are exposed tomore risk when leverage increases, the cost of the firm’s equity should rise aswell (as more risk translates into more return). |
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Briefly explain MM Proposition III. |
Number three on the amazing list of propositions by the twofriends is dividend irrelevance. The authors claim that a firm’s total marketvalue is independent of its dividend policy. If we fix the firm’s investmentpolicy, then a change in dividend policy has to be met with a change infinancing policy (issue debt or issue equity). We know that financing policyhas no effect on firm value, therefore neither does a change in dividendpolicy. |
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Briefly explain MM Proposition IV. |
The fourth proposition states that, in a perfect capitalmarket, given the investment decision of a firm and given that the return onthe investment project exceeds the weighted average cost of capital, thefinancial policy of a firm is of no consequence. |
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What is the size of the gross tax shield on debt (Graham, 2000)? |
The author finds that the average benefit of thetax deductibility of interest payments adds up to 9.7% of total market value. |
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Why does Graham (2006) not include the costs of distress in his analysis? |
Graham does not include the costs of distress inhis analysis as he feels they are hard to estimate, most presumably are smalland have low explanatory power. |
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How much money do firms leave on the table according to Graham (2006)? |
According to Graham, firms leave on average 15.7%of firm value of the table from not using an optimal capital structure. Whenpersonal taxes are taken into account the effect decreases to the point wherefirms forego a benefit of 7.3% of firm value. |
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Why are the control variables used by Fama & French (1998) considered to be poor, and what is the information content (distortion) of these control variables? |
The reason for poor control variables is because all thecontrol variables in the full regressions (i) donot capture all the information in debt aboutprofitability, and (ii) cannot isolate the tax effects of debt (slopes are a mixture of tax agency, asymmetric information, bankruptcy, and proxy effects). |
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Explain the findings of Arthur Korteweg relating to the four research questions he addresses in his paper. |
XXX |
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According to Andrade & Kaplan (1998), what is the potential size of the costs of financial distress, and its distinction from the costs of economic distress. Explain why the two types of distress should be disentangled. |
The authors find that the net costs of financialdistress in their sample appear to be in the 10-20% of total firm value range.The distinction between financial and economic distress is important, becauseeconomic distress is more costly due to the fact that such firms with low ornegative profitability have less incentive to survive. Financial distressedfirms can usually restructure (apply a different capital structure) and havegood profitability overall. In addition, economic distress tends to besomething that the entire economy faces, affecting all firms. |
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Explain how asset specificity impacts loan pricing (incl. the intermediate steps of the reasoning) and the use of restrictive covenants for loans that finance these specific assets, based on James & Kizilaslan (2014). |
firms with highly specific assets face fire saleprices when trying to sell their assets in industry downturns. This relates toloan pricing in that loan pricing and the evaluation of credit risk involveboth an assessment of them likelihood of default as well as the loss givendefault (LGD). All else equal, the higher the expected LGD, the higher thecredit spread and thus the higher the expected cost of borrowing under lines ofcredit. Overall, the results suggest that the potential for fire sale discountsaffects the ex-ante pricing and structure of bank loans. In addition theauthors suggest that the increased exposure to industry risk as a result of thehighly specific asset leads to an increase in covenant intensity in an attempt tomitigate some of that risk. |
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Explain how asset specificity impacts on loan pricing may impact the optimal capital structure for a rm that holds these specific asset, based on James & Kizilaslan (2014). |
In an imperfect world one might argue that theincrease in cost of the borrowing as described by James & Kizilaslan couldlead to a shift in capital structure toward equity. |
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Based on Myers & Majluf, assuming shareholders are passive, what agency conflict is eliminated by slack? |
Slack (or having a lot of free cash) means that when apositive NPV project arises, the firm can invest right away. In other words, aproject can be undertaken without needing any external financing. Not needingexternal financing means avoiding the information asymmetry between managersand investors. Also, the conflicts of interest between the new and the oldstockholders will not be relevant any more. |
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Based on Myers & Majluf, assuming shareholders are passive, how can the value of slack disappear? |
The value of slack, however, could disappear if all‘special’ knowledge can be brought to the attention of new and old shareholderswithout incurring any costs (information costs). This is also called private communication.As a result slack will lose the value of being able to reduce agency problemssuch as information asymmetry. |
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Based on Myers & Majluf, why would active shareholders be indifferent about the financing structure of a firm? |
Active shareholders are indifferent about the financingstructure of a firm because they can always balance their portfoliosaccordingly to gain the optimal financial structure they wish to hold. Forexample, they can sell a part of their ownership to regain their investedmoney. For instance all investors could sell a part of their shares to buy morerisky debt issued by the firm (assuming this is sold to outsiders). |
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Based on Frank & Goyal (2008), summarize how the three types of firms (private, small public, large public) finance their investments, and explain in your own words why these finance patterns occur the way the are. |
The authors find that privately held(non-listed) firms appear to particularly use retained earnings and bank loansfor their financing. The reason for this is that there is a lot of asymmetricinformation about value with these firms. As a result equity financing is sub-optimal.A bank may also be hesitant to provide funding (not easily) but that is theonly other firm of financing possible for privately held firms. Small publiclyheld (listed) firms rely mostly on equity financing. They do so because theyhave high asset volatility. That is, if there is more asymmetric informationabout risk than about value. On the other hand, large publicly held firms relymainly on retained earnings and corporate bonds. The reason for this is thatlarge companies face lower cost of debt because they are more stable and haveless default risk by definition. |
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Based on Warr et al. (2012), explain which types of firms can expect to see a high (low) adjustment speed towards their optimal capital structure. Explain the patterns for both debt and equity issues. |
Warr et al. expect that when equity isovervalued (undervalued) and a firm is overlevered, the rate of adjustment isfaster (slower), and when equity is overvalued (undervalued) and a firm isunderlevered, the rate of adjustment is slower (faster). They assume thatmanagers are aware of any mispricing and use this to time equity issuance andbuybacks when making capital structure adjustments. |
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Based on Chemmanur et al. (2009), explain how management quality is measured, and how it can impact both the financial policy of a firm, as well as its investment policy. |
Management team resources, management team structure, and management team reputation. |
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Based on Chemmanur et al. (2009), explain why/to what extent superior management quality may substitute for (other) signals as dividend payments, cash holdings, etc. |
The basic premise of the paper by Chemmanur etal. is that better managers (with higher reputation and quality) are more ableto communicate the intrinsic value of their firm to outsiders. Hence, thesemanagers can (partially) overcome the information asymmetry in the equityproblem. Since these managers are better able to convince investors, theirfirms would depend less on other signals (such as dividend payments). Inaddition, the premise is that these better managers are better at sourcingpositive NPV projects and ultimately will also invest more. |
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Based on Leary and Roberts (2014), explain why, and which types of firms (managers) are likely to imitate the financial policies of peer firms, and the impact of this copying on the optimality of capital structures. |
Leary & Roberts show that peer firms play an importantrole in determining corporate capital structures and financial policies. Inlarge part, firms’ financing decisions are responses to the financing decisionsand, to a lesser extent, the characteristics of peer firms. According to theauthors, these peer effects are more important for capital structuredetermination than most previously identified determinants. Furthermore,smaller, less successful firms are highly sensitive to their larger, moresuccessful peers, but not vice versa. |
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Explain equations (1) through (8) from Korteweg (2010). |
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Explain the methodology/approach Graham (2000) has taken. |
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How do Berger, Olef and Yermack (1997) measure leverage surplus? |
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Briefly summarize Figure 1 from Berger, Olef and Yermack. |
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Briefly summarize Table IV from Berger, Olef and Yermack. |
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Based on Bayless and Chaplinsky (1991), how do the asymmetric information proxies (RELSIZE, ROA, and PRICE) relate to information asymmetries? |
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Based on Bayless and Chaplinsky (1996),what are the potential drawbacks of using abnormal returns as a measure of information costs? |
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Based on Bayless and Chaplinsky (1996),what are the potential drawbacks of using aggregate equity issue volume as a means to identify the hot and cold periods? |
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Based on Leary and Roberts (2005), how do the estimated underwriter spread, Altman's Z-score, and debt credit rating proxy for adjustment costs? |
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Based on Kisgen (2009), why shouldn't ratings matter for the banks? |
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Based on Lamont, Polk and Saa-Requejo (2001), why should we expect a common variation in stock returns of financially constrained firms? |
If constraints are purely firm-specific, stockreturns should not move together. Also, if constrained firms are subject tocommon shocks, there should be a co-movement of their stock returns. Theauthors test whether financial constraints result from a common shock to firms(controlling for a variety of other determinants of stock returns). |
