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EXOGENOUS FINANCIAL LIABILITIES

EXOGENOUS FINANCIAL LIABILITIES. Session 2A Doctoral Seminar National Taiwan University June 29, 2011 Utpal Bhattacharya (Indiana University). Pre-1958. Only two types of liabilities exist – debt (obligated fixed payoff in all states, except during insolvency) and equity (the residue)

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EXOGENOUS FINANCIAL LIABILITIES

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  1. EXOGENOUS FINANCIAL LIABILITIES Session 2A Doctoral Seminar National Taiwan University June 29, 2011 Utpal Bhattacharya (Indiana University)

  2. Pre-1958 Only two types of liabilities exist – debt (obligated fixed payoff in all states, except during insolvency) and equity (the residue) History Private debt: Two banks in Mesopotamia (3000 B.C.) Public debt: The “Grand Parti” (France, 1555) Equity: The Russia Company (U.K., 1553) Research question: What is the optimal D/E ratio? Before 1958, finance was obsessed with this question. The techniques used to answer it: • Linear programming (minimize financing cost, given constraints) • EOQ models (cash management) • Markov chains (credit losses)

  3. Post-1958 Modigliani and Miller Irrelevance Proposition (158, AER): Given assumptions of frictionless markets, firm value does not depend on its debt-equity ratio. This was a paradigm shift. From “guilty unless shown otherwise” (capital structure matters unless shown otherwise), we shift to “innocent unless shown otherwise” (capital structure is irrelevant unless shown otherwise). The theory stood on the shoulder of giants – Fisher (1930, the Separation Theorem) and Arrow-Debreu (1954, Spanning). It was the first time that arbitrage arguments were used. Ironically, arbitrage arguments are now more popular in asset pricing than in corporate finance. ILLUSTRATION 1

  4. 1960s and 1970s: Taxes Focus: Explaining why capital structure matters using the trade-off theory with taxes as the only friction. • Deductibility of interest from pre-tax income, but not dividends from pre-tax income, makes the use of debt save taxes. So debt is a tax shelter. 2) Not true, if one also considers the personal tax advantage of equity (capital gains taxes are lower). Miller (1977, JF) 3) Miller (1977, JF) not true given tax rates today. Debt has a net tax advantage

  5. Operating Income ($1.00) Or paid out as equity income Paid out as interest Corporate Tax None Tc Income after Corp Taxes $1.00 $1.00 – Tc Personal Taxes . TpI TpE(1.00-Tc) Income after All Taxes $1.00 – TpI $1.00–Tc-TpE (1.00-Tc) =(1.00-TpE)(1.00-Tc) To bondholders To stockholders

  6. So (C D ) is the maximum tax shield of debt, and (* D ) is the effective tax shield of debt, where C >* > 0. With personal taxes,

  7. 1960s and 1970s: Taxes (Contd) 4) Though debt does have a net tax advantage on average, it will have a disadvantage for agents with high personal income tax brackets. These folks will prefer equity; the others will prefer debt. All of them will be satisfied by the menu of products being offered in equilibrium. A firm, being small, cannot affect this menu set, and so can gain no advantage or disadvantage by changing its D/E ratio. ILLUSTRATION 2 5) Increasing debt does increase debt tax shields, but it also increases the probability of not availing of other tax shields (like accounting depreciation, etc.) As the latter cost of debt is firm-specific, there is a firm-specific optimal D/E. DeAngelo and Masulis (1980, JFE)

  8. 1960s and 1970s: Taxes (Contd) Insight of the trade-off theory: the net tax advantage of debt is traded off by the financial distress costs of debt. But what are the financial distress costs of debt? Direct costs of bankruptcy – the legal costs – are small as a percentage of value. Warner (1977, JF). Moreover, out of court settlements between bondholders and shareholders can avoid this cost. Remember that bankruptcy is just a transfer of wealth between bondholders and shareholders, and need not involve any deadweight leakage, and so value of firm should not change.

  9. 1980s: Indirect Costs of Debt The allocation between shareholders and bondholders may itself affect the firm’s NOI. This will arise if • It is costly or impossible to verify actions and/or outcomes • It is impossible to verify firm or manager type • Control and ownership rights are important • Other reasons The firm is now viewed as a web of contractual relationships. If you change allocations, you change incentives, which in turn affects NOI.

  10. 1980s: Indirect Costs of Debt (Contd) 1) Agency (hidden action) Jensen and Meckling (1976, JFE); Jensen (1986, AER) ILLUSTRATION 3 Myers (1977, JFE) INTUITION Equityholders versus managers Harris and Raviv (1990, JF); Stulz (1990, JFE) INTUITION Equityholders versus debtholders Diamond(1989,JPE);Hirshleifer and Thakor (1992,RFS) INTUITION

  11. 1980s: Indirect Costs of Debt (Contd) 2) Adverse Selection (hidden type) Ross (1977, BJE) ILLUSTRATION 4 Myers and Majluf (1984, JFE) ILLUSTRATION 5 Leland and Pyle (1977, JF) ILLUSTRATION 6 3) Corporate Control Considerations Harris and Raviv (1988, JFE) ILLUSTRATION 7 Stulz (1988, JFE) ILLUSTRATION 8

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