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MULTISTAGE FINANCING LIQUIDITY RATIOS RISK MANAGEMENT SOFT BUDGET CONSTRAINT FREE CASH FLOW 2th set of transparencies for ToCF. CORPORATE LIQUIDITY DEMAND. HOARDING OF LIQUIDITY Asset side : – securities – credit lines and loan commitments. Future promises to lend

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slide1

MULTISTAGE FINANCING

  • LIQUIDITY RATIOS
  • RISK MANAGEMENT
  • SOFT BUDGET CONSTRAINT
  • FREE CASH FLOW2th set of transparencies for ToCF
slide2

CORPORATE LIQUIDITY DEMAND

HOARDING OF LIQUIDITY

Asset side : –securities

–credit lines and loan commitments

Future promises to lend

(maximum amount, lending terms, duration, commitment fee, option to convert into term loan at maturity?,…)

Over 75% of commercial and industrial loans at large US banks = take-downs under loan commitments.

Liability side : – long term debt and equity

WHY?

Concern about refinancing (Thakor-Hong-Greenbaum 1981, Froot-Scharfstein-Stein 1993).

slide3

CORPORATE RISK MANAGEMENT

  • TECHNIQUES
  • forward/futures markets (raw materials, agricultural products),
  • swap  FX
  •  interest rate,
  • securitization,
  • insurance against theft, fire, death of key employee,
  • trade credit insurance,
  • geographical plant diversification.
  • Yet limited hedging (Culp-Miller). Large companies make much greater use of derivatives.
slide4

WHY?

  • reduction in volatility for claimholders : No!
  • cut tax bill? (Stulz),
  • insure managers by filtering out exogenous noise (Stulz, Fite-Pfleiderer)? Alternative : virtual hedging.
  • reduce probability of bankruptcy?
  • AGENCY BASED EXPLANATIONS
  • unability to get funds when one needs them (Froot et al, Stulz),
  • avoid ancillary damages such as gambling behavior.
slide5

CORPORATE LIQUIDITY DEMAND"Cash poor firm"

overruns/reinvestment

Cash need

shortfall in earnings

0

continue

2

1

Financing

Outcome

Liquidation,

downsizing

slide6

How to meet these needs?

2 options

Date 0

Date 1

hoard liquidity

go to capital market : new debt, new equity

DILUTION

SECURITIES

CONTRACT

• credit line (ST)

• revolving credit

(often option to convert into LT loan)

slide7

BASIC INSIGHT: LOGIC OF CREDIT RATIONING APPLIES AT DATE 1 AS WELL  WANT TO HOARD LIQUIDITY

CASH RICH FIRM: flip side of same coin.

Jensen 1986

Easterbrook 1984

ST debt

Dividend

pump out money

steel, tobacco, chemical, broadcasting,...

Security design also regulates liquidity

Equity, LT debt: little cash draining

ST debt: drains cash

Preferred stocks...

slide8

I. LIQUIDITY RATIO AND CORPORATE RISK MANAGEMENT

I. FIXED INVESTMENT VERSION

Optimal policy: continue iff for some

slide11

(i)

(first best)

(ii)

Then

[Third case (iii) no funding ]

slide12

CASH-RICH FIRM:

Theory of maturity structure:

Weak balance sheet

short maturity structure.

slide13

CASH-POOR FIRM:

Example: r = 0.

"Wait-and-see" policy suboptimal

slide14

II. VARIABLE INVESTMENT VERSION

2.1Two-shock case

Timing

1

2

0

  • Investment
  • I
  • Borrows
  • I-A

MH

(choice

pH or pL )

Outcome

“INTACT”

(no

reinvestment needed)

RI

“DISTRESSED”

(reinvestment  per unit of investment)

p

1-p

0

slide15

Assumptions

(1) There exists store of value ( 1 1)

(2)

remember

(3)

Interpretation

slide17

Policy #2: pursue project in case of distress

Minimize cost :

policy #2

Policy #2 when

slide18

2.1Continuum-of-shocks case

pay

0

2

1

Need for

cash infusion

realized.

Distribution

on

Outcome

MH

Contract.

Investment I.

External

financing

I-A.

1-p

p

No

money

to pay

pL

0

pH

RI

Project abandoned

(liquidation)

Yields 0

(later : yields LI)

slide19

a) OPTIMAL CONTRACT (later: implementation)

  • Only investors can cover I .
  • Suppose for the moment one can contract on continuation rule
  •  Optimum:

continue: needs

liquidate (nothing for entrepreneur)

Pledgeable income after continuation

slide20

 multiplier I = k A

Maximized at Explanation.

slide21

NPV per unit of investment:

maximized at Intuition.

Borrower’s utility

Optimum:

slide22

Optimal

"expected unit cost of effective investment"

slide23

Utility:

Utility =

slide25

CORPORATE DEMAND FOR LIQUIDITY

1

WAIT-AND-SEE POLICY IS SUBOPTIMAL

 even with "perfect" financial market, investors won\'t bring in more than at date 1.

 Conversely, initial investors willing to have their claims diluted.

Dilution only

(even worse if debt overhang, etc.)

HOARDING:

* Nonrevocable credit line

2

no right to dilute

or

right to dilute

* Securities: same

slide26

CORPORATE RISK MANAGEMENT

  • "Adverse" shocks with

(ex: foreign exchange risk).

  • Can get insurance at fair rate.

Modeling:

Idea: obtain insurance so that does not mess up decision making.

  • HEDGING

For an arbitrary

Remark : could be a conditional credit line (less common).

slide27

NO HEDGING

Firm can withstand shocks  such that

Hence:

where

Let

slide28

Lemma : H is more convex than F

convex

convex

Proof :

Arrow-Pratt:

In contrast, manager ex post may or may not hedge if given the choice

slide29

Firm

"risk averse" w.r.t. 

"risk loving" w.r.t. 

Mean preserving spread

Firm better off

DIFFERENCE: "unavoidable"; option !

slide30

OPTIMALLY INCOMPLETE HEDGING

 Full hedging is too stark a result.

 Transaction costs... and 5 other reasons for hedging incompletely.

(a) Market power

Forward sales and over-supply by monopolist or oligopolist.

(b) Several correlation of profits

Example:

  • random short-term income r (exogenous)
  • "attractive-reinvestment-opportunities effect": probability of success p +  (r) where \' > 0.

But "easier-refinancing effect": good news make it easier to return to the capital market.

slide31

Optimal policy:

(firm should keep some of its cash-flow as retained earnings)

(c) Aggregate risk

Like CAPM: economic agents share (in different proportions) the aggregate risk.

(d) Asymmetric information

(e) Incentives

Short-term profit r in general is endogenous. Motivates investment-to-cash-flow sensitivity: see next section.

slide32

II. SOFT BUDGET CONSTRAINT

Basic idea: situation in which capital market is too soft: refinances when not ex ante optimal to do so.

Date 0

Date 1

date 0

moral hazard

(or AS)

about

signal (or realization)

informative about

date-0 behavior

date-1

income

r

  • continuation
  • parameters
  • L
  • 2nd period
  • prospects
  • (R, pH…)

want to punish if r small, etc.

slide33

KEY: Monetary punishments limited (especially if continuation!)

  • Often liquidation (interference,…) only punishment or at least complementary punishment.
  • EXAMPLE: r endogenous
  • Perhaps even deterministic

Low date-0 effort

High date-0 effort

- monetary rewards

Private benefit B0I of shirking at date 0.

State-invariant continuation rule does not provide incentives. Two possibilities:

  • very small cost (2nd order) for B0 small
  • not credible if
slide34

Text:

if works

at date 0

if shirks

MLRP : increasing

Optimal policy:

over "relevant range" (small if B0 small).

no SBC

SBC

r

"retained-earnings policy"

Soft Budget Constraint

slide35

Jensen

Easterbrook

III. FREE CASH FLOW

exogenous (no SBC issue)

deterministic safe cash flow

  • r

(public utilities,

banks,

mature industries)

  • Generalized formulae:

Free cash flow assumption:

Payment:

ST debt

dividend (with ceiling)

slide36

CRITIQUES

Uncertainty not flexible enough, risk of liquidity problem

Ex:

Rigid (ST debt): •liquidity risk

(see hedging stuff)

P1 high: good reinvestments not made

P1 low: free cash flow

  • does not respond to news about L, future prospects  need to make use of market information !

Secret reinvestments just before r accrues.

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