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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
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
Concern about refinancing (Thakor-Hong-Greenbaum 1981, Froot-Scharfstein-Stein 1993).
shortfall in earnings
go to capital market : new debt, new equity
• credit line (ST)
• revolving credit
(often option to convert into LT loan)
BASIC INSIGHT: LOGIC OF CREDIT RATIONING APPLIES AT DATE 1 AS WELL WANT TO HOARD LIQUIDITY
CASH RICH FIRM: flip side of same coin.
pump out money
steel, tobacco, chemical, broadcasting,...
Security design also regulates liquidity
Equity, LT debt: little cash draining
ST debt: drains cash
I. FIXED INVESTMENT VERSION
Optimal policy: continue iff for some
[Third case (iii) no funding ]
Theory of maturity structure:
Weak balance sheet
short maturity structure.
Example: r = 0.
"Wait-and-see" policy suboptimal
pH or pL )
(reinvestment per unit of investment)
(1) There exists store of value ( 1 1)
Minimize cost :
Policy #2 when
(later : yields LI)
liquidate (nothing for entrepreneur)
Pledgeable income after continuation
Maximized at Explanation.
maximized at Intuition.
"expected unit cost of effective investment"
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.
(even worse if debt overhang, etc.)
* Nonrevocable credit line
no right to dilute
right to dilute
* Securities: same
(ex: foreign exchange risk).
Idea: obtain insurance so that does not mess up decision making.
For an arbitrary
Remark : could be a conditional credit line (less common).
Firm can withstand shocks such that
In contrast, manager ex post may or may not hedge if given the choice
"risk averse" w.r.t.
"risk loving" w.r.t.
Mean preserving spread
Firm better off
DIFFERENCE: "unavoidable"; option !
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
But "easier-refinancing effect": good news make it easier to return to the capital market.
(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
Short-term profit r in general is endogenous. Motivates investment-to-cash-flow sensitivity: see next section.
Basic idea: situation in which capital market is too soft: refinances when not ex ante optimal to do so.
signal (or realization)
want to punish if r small, etc.
KEY: Monetary punishments limited (especially if continuation!)
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:
at date 0
MLRP : increasing
over "relevant range" (small if B0 small).
Soft Budget Constraint
III. FREE CASH FLOW
exogenous (no SBC issue)
deterministic safe cash flow
Free cash flow assumption:
dividend (with ceiling)
Uncertainty not flexible enough, risk of liquidity problem
Rigid (ST debt): •liquidity risk
(see hedging stuff)
P1 high: good reinvestments not made
P1 low: free cash flow
Secret reinvestments just before r accrues.