TILBURG UNIVERSITY

Summary Capital Structure

Wouter Theloosen
21-12-2011

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Content
Part II: How does capital structure affect corporate strategy? ................................................................. 3
Bolton & Scharfstein (1990) ................................................................................................................. 3
Chevalier (1995a) ................................................................................................................................ 3
Chevalier (1995b) ................................................................................................................................ 4
Zingales (1998) .................................................................................................................................... 5
Part III: Why do firms go public? .............................................................................................................. 6
Barath and Dittmar (2010) ................................................................................................................... 6
Bodnaruk, Kandel, Massa, and Simonov (2008).................................................................................... 8
Pagano & Roel (1998) .......................................................................................................................... 8
Pagano, Panetta & Zingales (1998)....................................................................................................... 9
Part IV: Capital structure and property rights........................................................................................... 9
Hart (2001) .......................................................................................................................................... 9
Kaplan & Stromberg (2003) ............................................................................................................... 10
Roberts & Sufi (2009)......................................................................................................................... 11
Part V: Dynamic models of capital structure .......................................................................................... 12
Lemmon, Roberts & Zender (2008) .................................................................................................... 12
Brav (2009) ........................................................................................................................................ 13
Part VI: How do companies choose between internal and external finance? .......................................... 14
Hubbard (1998) ................................................................................................................................. 14
Petersen & Faulkender (2006) ........................................................................................................... 15
Gorton (2008) .................................................................................................................................... 16
Ashcraft et al. (2010) ......................................................................................................................... 16
Part VII: Topics in financial development ............................................................................................... 17
Booth, Aivazian, Demirguc-Kunt, Maksimovic (2001) ......................................................................... 17
King & Levine (1993) .......................................................................................................................... 20
Levine & Zervos (1998) ...................................................................................................................... 20
Dyck and Zingales (2004) ................................................................................................................... 21
La Porta, Silanes, Shleifer & Vishny (1998) ......................................................................................... 23
Part VIII: Going private .......................................................................................................................... 24
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Lehn, Poulsen (1989) ......................................................................................................................... 24
Kaplan (1989) .................................................................................................................................... 25

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Part II: How does capital structure affect corporate strategy?

Bolton & Scharfstein (1990)
A theory of predation based on agency problems in financial contracting
The authors analyze the optimal finance contract in light of the predatory threat. They argue that the
commitment to terminate a firms funding if its performance is poor ensures that the firm does not
divert resources to itself at the expense of investors. This termination threat, however, is costly in a
competitive environment. Rival firms then have an incentive to ensure that the firms performance is
indeed poor. This increases the likelihood that investors cut off funding and induces premature exit. To
counter this, the optimal response is to lower the sensitivity of the refinancing decision to firm
performance. There are two ways of doing this:
1. One is to increase the likelihood that the firm is refinanced if it performs poorly;
2. The other is to lower the likelihood that the firm remains in operation even if it performs well.
Both strategies reduce the benefit of predation by lowering the effect of predation on the likelihood of
exit.
There is a tradeoff between deterring predation and mitigating incentive problems; reducing the
sensitivity of the refinancing decision discourages predation, but exacerbates the incentive problem.
The central argument of this paper is that agency problems in financial contracting can give rise to
rational predation. The financial contract minimizes agency problems and also maximizes rivals
incentives to prey. As a result there is a tradeoff between deterring predation and mitigating incentive
problems: reducing the sensitivity of the refinancing decision to the firms performance discourages
predation, but exacerbates the incentive problem.
In addition, their model suggests that certain types of product-market competition can increase
managerial incentive problems within the firm. Reliance on external funds can discipline (and thus
reduce agency costs) managers, but may also lead to predation.

Chevalier (1995a)
Do LBO supermarkets charge more?
This article examines changes in supermarket prices in local markets following supermarket LBOs. The
author finds that prices rise following LBOs in local markets in which the LBO firms rivals are also highly
leveraged, and that highly leveraged LBOs have higher prices than relatively less leveraged LBOs.
However, it is also found that prices fall following LBOs in local markets in which rival firms have low
leverage and are concentrated. These price drops are associated with LBOs firms exiting the local
market, suggesting predation.
Empirical evidence suggests switching costs for supermarket shoppers. Setting low prices can thus be
seen as an investment to lure new customers. If pricing is viewed as an investment, then two strands of
literature predict that a firms leverage will affect its pricing behavior. First, Jensen (1989) argues that
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managers of firms like to build empires and over-invest the firms resources. Thus, agency theory
suggests that managers will set prices too low. When an LBO is undertaken, the incentives of managers
and investors are aligned, and the firm raises prices. On the other hand, the literature of liquidity
constraints suggests that high leverage may lead firms to be cash-constrained, and that a cashconstrained firm may be forced to cut investment, even if the firm has positive net present value
investment opportunities. Chevalier and Scharfstein (1994) suggest that these firms increase prices. The
authors model therefore suggests that prices increase after an LBO.
The results suggest that price decreases following an LBO are likely when the LBO firms rivals have low
leverage, and one of the low-leverage rivals has a very large market share. Evidence is found that the
probability of exit increases. Price increases are likely if the LBO firms rivals are highly leveraged, and no
single rival with low debt has a large market share. Evidence is found that these price increases increase
the probability of entry and that LBO firms are the high-priced firms in their cities. The results support
both models of predation and the hypothesis that leverage increases an incentive to raise prices.

Chevalier (1995b)
Capital structure and product market competition
This paper establishes an empirical link between firm capital structure and product-market competition
using data from local supermarket competition. Two classes of theoretical models are tested, by
examining the share price response of supermarket chains to the announcement of rival chains
leveraged buyout and by examining the entry, exit, and expansion behavior of supermarket chains. The
first class of models predicts that increases in firm leverage tend to soften product-market competition.
The second class of models, predicts that increase in firm leverage tend to toughen product-market
competition.
The findings of this paper are consistent with the group of theoretical models of capital structure and
product-market competition that suggest that product-market competition becomes softer (which
means that more local stores can compete within a location) when leverage increases.
The principal results of this paper are that the announcement of an LBO increases the expected future
profits of a firms product-market rivals and that the presence of LBO firms encourages local entry and
expansion by rivals. Both sets of results are suggestive that leverage makes product-market competition
less tough.
The basic finding, that markets in which LBOs have occurred attract entry and expansion, is consistent
with the alternative hypothesis that LBO firms were simply underperformers prior to their LBOs.
While these results cannot prescribe an optimal capital structure based on product-market outcomes,
the results make clear that product-market effects of capital-market decisions must be considered a
component of the choice of optimal capital structure.

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Zingales (1998)
Survival of the fittest or the fattest?
This paper studies the impact that capital market imperfections have on the natural selection of the
most efficient firms by estimating the effect of the pre-deregulation level of leverage on the survival of
trucking firms after the Carter deregulation. Highly leveraged truck firms are less likely to survive the
deregulation shock.
In perfect capital markets, competition and exit assure that only the most efficient firms survive.
However, in the presence of market imperfection, efficient firms may be forced to exit due to lack of
funds.
Evidence is found that more efficient firms are more likely to survive after deregulation, but also
evidence is found that their leverage at the beginning of the deregulation period has an impact on the
probability of survival eight years later. Therefore, both the fittest and the fattest firms survive. It is
most pronounced in the segment that remains imperfectly competitive even after deregulation, and the
effect is zero in the segment that becomes fully competitive.
This paper addresses two related questions. First, how does leverage affect a firms ability to respond to
unexpected changes in the competitive environment? Second, what are the sources of these effects?
To answer the first question, three main reasons are given. First, the initial level of debt may negatively
affect survival because highly indebted firms may be unable to finance large new investments (Myers,
1977). This problem is more likely to arise when investments cannot be collateralized easily. Second, the
initial level of debt may negatively affect survival because it directly affects a firms ability to compete
(Bolton and Scharfstein, 1990). Alternatively, a high level of leverage may affect a firms competitiveness
because customers avoid dealing with a company that is likely to go bankrupt (Titman, 1984). Third, the
initial level of debt may negatively affect survival, because it forces inefficient firms to liquidate.
On the other hand, there are two main reasons why the pre-deregulation level of leverage may
positively impact a motor carriers survival during deregulation. First, debt might force firms into
restructuring sooner (Jensen, 1989) maximizing their chance of survival. Second, a highly leveraged firm
may compete more aggressively because of the option-like payoff of leveraged equity (Brander and
Lewis (1986).
The results of the study suggest that firms which are highly leveraged at the beginning of deregulation
are less likely to survive afterward, even when controlling for some measures of efficiency and for the ex
ante probability of default. Also, evidence is found that the initial level of leverage has a negative impact
on the ability of a motor carrier to invest in the years following deregulation.
Second, evidence is found that the pre-deregulation level of leverage negatively impacts the price that a
carrier charges during the price war which follows deregulation.

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Part III: Why do firms go public?

Barath and Dittmar (2010)
Why do firms use private equity to opt out of public markets?
The authors investigate how firms weigh the costs and benefits of being public in the decisions to opt
out of the public market and go private. Their empirical results provide strong support for the
importance of information and liquidity considerations in being a public firm. The factors are evident at
the IPO, on average thirteen years before the going private decision. Access to capital and control
considerations become increasingly important in the choice of going private over the public life of the
firm.
The goal of this study is to understand the economic forces that drive a firm to go from public to private
markets. The authors show that firms are more likely to go private when it is more costly to produce
information, and thus, they have less information available about them in the public market. Specifically,
firms are more likely to go private if they have less analyst coverage and lower institutional ownership.
Additionally, they document the importance of liquidity to a public firm. They find that firms are more
likely to go private when they are less liquid relative to the comparison sample. They also find strong
support for the importance of high levels of free cash flow in determining who goes private, but only in
the 1980s. They find evidence that financially constrained firms are more likely to remain public
(supporting the importance of access to capital) and that firms that go private engage in fewer
acquisitions over their public life, suggesting support for the role of control considerations in the publicprivate choice. The theory on why firms go public or go private is categorized into five groups:
information considerations, access to capital, control, liquidity, and agency and other considerations.
Information considerations
Adverse selection: investors are less informed than the issuers about the true value of the companies
going public. This adversely affects the share price at the IPO. Leland and Pyle (1977) show that
entrepreneurs can signal the quality of their projects by investing more of their wealth into these
projects. This adverse selection cost is a more serious obstacle to young, small companies that have low
visibility (low analyst following and low institutional ownership) and concentrated ownership; thus,
these firms will be more likely to go private to avoid the adverse selection costs.
Duplicative monitoring: these costs can be mitigated by the availability of a public price that conveys
information to all investors so that only a fraction of the investors will incur the information production
cost. The authors therefore predict that firms where information is more costly, or less available and
firms with low liquidity will be more likely to go private.
Serendipitous information production: Subrahmanyam and Titman (1999) discuss how the public market
provides a trade-off between costs of duplication of information and the benefits of serendipitous
information (defined in their model as the information that stock market investors by chance come
across in their day-to-day activities). Serendipitous information, though noisy, is likely to be diverse
across market participants; thus, when aggregated across many investors, it can provide a useful signal.
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They predict that firms prefer to be public when the benefit of this signal outweighs the cost of
duplication. This logic suggests that as the cost of generating serendipitous information increase, firms
would choose to go private.
Investor recognition: Merton (1987) provides an extension to CAPM that relaxes the assumption of
efficient information for all investors and show that expected returns decrease with the size of investors
base, which he characterizes as the degree of investor recognition. Thus, the benefit of being public is
diminished for firms with high ownership concentration or lower investor recognition, and these firms
are more likely to opt to be private.
Access to capital
The opportunity to tap public markets for equity capital is appealing for high growth firms with large
current and future investments that may have limited access to other financing alternatives due to high
leverage or high transactions costs and is a leading reason why firms go public. Thus, firms that do not
have large investments and future growth opportunities are more likely to go private. A related
motivation for going and being a public firm is to minimize the cost of capital for the firm and thus
maximize the value of the company. The lower the cost of capital in the public versus the private
market, the greater the incentive to be a public firm. The above suggests that financially constrained
firms would prefer to be public to fund their investment opportunities since (i) visibility in the public
markets can be a prerequisite to raise further (even non-equity) capital, and (ii) their public status allows
them to enjoy competition among suppliers of finance and to negotiate private capital at better rates
than they would be otherwise.
Liquidity
Liquidity is therefore a benefit to being a public firm that is considered in the choice between public and
private ownership. Further, share trading on an exchange is cheaper compared to bilateral trades, and
this liquidity benefit (which is an increasing function of the trading volume) leads companies to go
public. The authors predict that, as the liquidity benefit in the market deteriorates, firms are more likely
to go private.
Control considerations
Zingales (1995) argues that an IPO can serve as the first step toward selling a company at an attractive
price through a takeover. In going public, the initial owner sells a portion of his cash flow and control
rights. It suggests that if the firm is not very active in the market for corporate control, it will more likely
to go private.
Agency considerations
The literature on going private suggests that LBOs lead to efficiency gains because of higher debt
payments and alignment of the management incentives by increase equity positions (Jensen, 1986).
Thus, one motive for going private is to improve the incentive alignment and governance structure of

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the firm. This motivation is particularly important for high free cash flow firms, which can more easily
destroy value by wasting accessible cash flow.
First, the authors find support for the importance of many of the costs and benefits of being a public
firm. Particularly, they find strong support for the importance of theories that stress information and
liquidity considerations. They also find support for the role of free cash flow, primarily in the pre-1990s
period and support for control and access to capital considerations.

Bodnaruk, Kandel, Massa, and Simonov (2008)

Shareholder diversification and the decision to go public
This paper studies the effects of the controlling shareholders portfolio diversification on the IPO
process. Less diversified shareholders have more to gain from taking their firm public, and are more
willing to accept a lower price for shares. The authors show that the less diversified individual
shareholders, especially those with lower wealth, sell more of their shares at the IPO. Firms held by less
diversified controlling shareholders are more likely to go public, and exhibit higher undervaluation.
However, the diversification of non-controlling shareholders has no effect. Their findings also suggest
that diversification of controlling shareholders plays a prominent role in the IPO process. It is also shown
that firms whose only goal is going public is to raise capital do not exhibit any relation between the
degree of their shareholders diversification and the undervaluation.

Pagano & Roel (1998)

The choice of stock ownership structure: agency costs, monitoring, and the decision to go public
This paper analyzed the optimal design of the ownership structure of a company. The initial viewpoint is
taken that an owner behaves opportunistically, once he has given up a stake in his firm to outside
investors in return for investment funds. Since ex ante he internalizes all relevant agency costs, he must
design shareholders stake sizes so as to induce them to do the right amount of costly monitoring. He
will not choose an ownership structure so concentrated that it maximizes firm value net of monitoring
costs, because he takes into account his own future private benefits. Instead, the share must be
sufficiently dispersed to ensure the optimal degree of monitoring.
This has interesting implications for the decision to go public. If a controlling shareholder wants to sell a
minority stake to external shareholders without listing the company, he cannot aim for a large and
disperse shareholder base, and as a result, may have to accept more stringent monitoring. If the
company goes public instead, he can fine-tune the stakes of external shareholders to ensure that they
monitor optimally. First, listing a company on the stock exchange involves some direct costs, with a large
fixed component. Second, it entails losing control over the identity of the external shareholders, with
potentially adverse consequences for the controlling shareholder. So the initial owner of the company
faces a trade-off between the costs of over-monitoring and the costs of going public.
The model has a number of empirical predictions.

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First, the incentive to go public is an increasing function of the amount of external finance to be
raised, of the inefficiency of monitoring and of the value of the private benefits of control. All
these factors limit the degree to which monitoring is worthwhile.
Second, companies are more willing to list if public companies are subject to tighter accounting
and disclosure standards than private companies: this set of rules enables them to pre-commit
to fair play.
Third, if external shareholders are able to cooperate in their monitoring activity, going public
tends to become a more attractive option relative to staying private.
Finally, if minority shareholders receive so little legal protection that the managing shareholder
can bribe large shareholders to monitor less, there is no incentive to go public.

Pagano, Panetta & Zingales (1998)

Why do companies go public?
This paper analyzes the determinants of initial public offerings (IPOs). The likelihood of an IPO is
increasing (by 25%) in the companys size and the industrys market-to-book ratio. Two reasons may
support this statement:
1. A high market-to-book ratio implies a high expected growth in value.
2. The attempt to exploit sectoral mispricing (which means an overvaluation of the sector)
The paper supports the last argument.
Companies appear to go public not to finance future investments and growth, but to rebalance their
accounts after high investment and growth. IPOs are also followed by lower costs of credit and
increased turnover of the controlling group.
Among the post-IPO effects that were found is a reduction in profitability a phenomenon consistent with
findings by various authors in the US. Also, an effect is found that independent companies experience a
reduction in the cost of bank credit after the IPO.

Part IV: Capital structure and property rights

Hart (2001)
Financial contracting
Modigliani Miller assumes a perfect world. Agency problems do take into account market imperfections.
Financial Contracting Literature also takes into account market imperfections. The literature takes as a
starting point the idea that the relationship between an entrepreneur or manager and investors is
dynamic rather than static. Researchers have focused on how the allocation of control rights affects the
trade-off between cash flows and private benefits once the relationship is underway. This research takes
into account patronage and diversion (the managers puts money in other firms, than the one financed
by an investor).
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The agency approach, is a theory of optimal incentive schemes, rather than capital structure; while the
control rights models helps to explain the optimal allocation of control between insiders and outsiders,
but not why, given a particular level of control by insiders (in this case, zero), outsiders hold
heterogeneous claims, i.e., some are shareholders while others are creditors. In fact, ones first thought
would be that diversity is bad since it creates conflicts of interest between different investors.
Moreover, it is not clear why management should be affected by diversity: why does it matter to them
that in good states of the world shareholders have control, while in bad states creditors have control
(given that management never has control).
One idea that supports the argument of diversity of investors is that creditors discipline management.
When the firm is not able to repay their debts, creditors will seize assets, which may drive the firm into
bankruptcy.
Another idea behind diversity is that investors can put more pressure on management. Here follows the
explanation of this statement: suppose that a company has a single investor with 100% control rights.
This shareholder has the right and the ability to intervene at any time; but assume, in contrast to what
has gone before, that intervention is costly. Then this investor may choose not to act because the costs
of intervention exceed the benefits. In contrast, if the company has several investors with
heterogeneous claims, it is likely that for at least one investor the benefits of intervention exceed the
costs. If this investor also has the ability to intervene, management will be under pressure.

Kaplan & Stromberg (2003)

Financial contracting theory meets the real world
This paper compares the financial contracting theory with empirical evidence. The distinguishing
characteristic of VC (Venture Capital) financings is that they allow VCs to separately allocate cash flow
rights, board rights, voting rights, liquidation rights, and other control rights. These rights are often
contingent on observable measures of financial and non-financial performance. In general, board rights,
voting rights, and liquidation rights are allocated such that if the firm performs poorly, the VCs obtain
full control. As performance improves, the entrepreneur retains/obtains more control rights. If the firm
performs very well, the VCs retain their cash flow rights, but relinquish most of their control and
liquidation rights. The authors also report that it is common for VCs to include non-compete and vesting
provisions that make it more expensive for the entrepreneur to leave the firm, thus mitigating the
potential hold-up problem between the entrepreneur and the investor. Finally, the cash flow incentives,
control rights and contingencies in these contracts are used more as complements than as substitutes.
Ventures in which the VCs have voting and board majorities are also more likely to make the
entrepreneurs equity claim and the release of committed funds contingent on performance milestones.
The results have the following implications. First, cash flow rights matter in a way that is consistent with
the principal-agent theories. For example, the entrepreneurs equity compensation function is more
sensitive to performance when incentive and asymmetric information problems are more severe.
Second, the allocation of control rights between the VC and the entrepreneur is a central feature of the
financial contracts. This strongly suggests that despite the prevalence of contingent contracting,
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contracts are inherently incomplete. Third, cash flow rights and control rights can be separated and
made contingent on observable and verifiable measures of performance. This is most supportive of
theories that predict shifts of control to investors in different states. Fourth, the widespread use of noncompete and vesting provisions indicates that VCs care about the hold-up problem explored in Hart and
Moore (1994).

Roberts & Sufi (2009)

Control rights and capital structure
This article shows that incentive conflicts between firms and their creditors have a large impact on
corporate debt policy. Net debt issuing activity experiences a sharp and persistent decline following
debt covenant violations, when creditors use their acceleration and termination rights to increase
interest rates and reduce the availability of credit. The effect of creditors actions on debt policy is
strongest when the borrowers alternative source of finance is costly. In addition, despite the less
favorable terms offered by existing creditors, borrowers rarely switch lenders following a violation.
A fundamental question in financial economics is: how do firms choose their financial policies. Extant
empirical research on this question has focused primarily on the presence of taxes and bankruptcy costs,
information asymmetry, and more recently, market timing behavior. However, beginning with Jensen
and Meckling (1976), a large body of theoretical research examines how incentive conflicts between
managers and external investors affect corporate financial policies. In particular, theoretical research on
financial contracting shows that in the presence of incentive conflicts, optimal debt contracts will
allocate certain rights to creditors after negative performance in order to help firms secure financing ex
ante. Thus in the context of the capital structure debate, financial contracting theory raises two
important empirical questions: first, to what extent do inventive conflicts and creditor rights impact
corporate financial policies? The goal of this study is to answer these questions by examining the
response of corporate financial policies to covenant violations.
Theory and hypothesis development
The foundation of this literature is Jensen and Meckling (1976), who analyse how risk-shifting
tendencies of managers acting on behalf of shareholders influence debt contracts. Given incentive
conflicts introduced by managers convex payoff functions, creditors will attempt to mitigate riskshifting through covenants restricting firm investment and financial policy. Covenants emerge
endogenously in recent theoretical research that derives debt with control rights as an optimal financial
contract. For example, Aghion and Bolton (1992) use an incomplete contracting framework in which a
wealth constrained owner-manager seeks capital to finance projects that produce both cash profits and
managerial private benefits. In their model, origination contracts allocate a decision right that depends
on an imperfect state signal. When the signal indicates that managerial private benefits are likely to
distort the manager into inefficient decisions, the decision right is transferred to creditors. Dewatripont
and Tirole (1994) assume the existence of an ex ante managerial moral hazard problem, and they find
that optimal financial contracts with concave cash flow rights encourage debt-holders to interfere with
firm policy after signs of poor performance.
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Part V: Dynamic models of capital structure

Lemmon, Roberts & Zender (2008)
Back to the beginning
The authors examine the dynamic behaviour of corporate capital structures in order to determine the
empirical relevance of recent theories. They begin by showing that capital structure is highly persistent,
so much so that the cross-sectional distribution of leverage in the year prior to the IPO is largely
unchanged almost twenty years later. Moreover, their analysis suggests that market timing, and inertia
are unlikely explanations for the observed cross-sectional variation in capital structures, which exists
prior to firms IPOs. Rather, their results indicate that factors associated with debt policy have significant
and long lasting effects on capital structure, as opposed to factors associated with equity policy. Further,
analysis of capital structures at the time of and prior to the IPO reveal heterogeneity in private financing
decisions and debt contracts consistent with segmented capital markets. While suggestive, ultimately
their results suggest a critical need for understanding variation in corporate debt policies and the
determination of private firms capital structures in order to better understand public firms capital
structures, the latter of which are largely a reflection of the former.
A common theme among recent investigations into corporate capital structure is the extent to which
shocks to leverage have a persistent effect and the corresponding implication for the cross-sectional
distribution of leverage. At the heart of this debate lie the following questions. First, to what extent is
capital structure persistent? Specifically, persistence in leverage suggests that either deviations from an
optimal leverage are not costly, adjustment costs are important, and/or estimates of target leverage are
missing something important. Thus, the second question arising from this debate is which of these
explanations is behind the cross-sectional distribution of capital structures. The goal of this paper is to
address these questions by examining the evolution of capital structure and its corresponding crosssectional distribution.
Interestingly, the sorting of firms into high and low leverage categories precedes the IPO, so that high
(low) leverage firms were as such even before gaining access to the public equity market. This pre-IPO
sorting of firms casts doubt on theories attempting to explain heterogeneity in capital structure with
equity market timing considerations, or stock price variation, since neither of these considerations
present a plausible explanation for the development of the cross section of capital structures prior to
the IPO. It also suggests that the process of going public does little to ameliorate any market
imperfections that drive cross-sectional heterogeneity in capital structure. Rather, the results suggest
that factors associated with differences in debt policy are the more relevant source of the observed
heterogeneity in capital structures. The frequency of debt issues early in a firms public life, as well as
the relative amount of collateralizable assets, both have a significant impact on capital structures for
many years. Additionally, the fraction of assets that are tangible, and most easily collateralized, has a
significant effect on leverage even twenty years later. They also find that initially highly levered firms are
more than 60% more likely to issue short-term debt and 40% more likely to issue long term debt than
their initially low levered counterparts in almost every year during the two decades following the IPO.
Initially highly levered firms are less likely to use equity financing than initially low levered firms,
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however this difference is much less dramatic (14%). Thus, their evidence suggest that the key
determinants behind the cross-section of capital structures is more likely found in heterogeneity in
corporate debt policy, as opposed to equity policy the focus of recent hypotheses.
Second, estimates of target or optimal leverage relying on functions of firm characteristics (e.g. size,
book-to-market, industry, etc.) provide at best only a marginal improvement over a specification
consisting solely of initial leverage. Empirical results in conjunction with the high degree of persistence,
suggest that despite explaining a significant fraction of the cross-sectional distribution of capital
structure, existing studies leave much variation unexplained. This leads to their last set of analyses
aimed at understanding the determinants of firms initial pre-IPO capital structures. They find that highly
levered firms are: three times more likely to have previously been involved in a LBO, seven times more
likely to have a credit rating, almost half as likely to be back by a VC, and almost two year older at the
time of IPO than low levered firms. Additionally, highly levered firms tend to enter into term loans with
longer maturities offered by larger lending syndicates than low levered firms who are more likely to
enter into short-term revolving lines of credit from just one lender. The discussion of their results
suggest that segmented capital markets is, in part, responsible for these discrepancies and draws a
parallel to recent finding by Faulkender and Petersen (2004) and Leary (2005), who find that segmented
capital markets impact the capital structure of public firms.

Brav (2009)
Access to capital, capital structure, and the funding of the firm
The author finds that compared to their public counterparts, private firms rely almost exclusively on
debt financing, have higher leverage ratios, and tend to avoid external capital markets, leading to a
greater sensitivity of their capital structures to fluctuations in performance. The author argues that
these differences are due to private equity being more costly than public equity. Further, it is shown
that private equity is more costly than its public counterpart due to information asymmetry and the
desire to maintain control. The goal of this paper is to answer questions about differences in capital
structure of private and public firms. The differences are striking: private firms have leverage ratios that
are approximately 50% higher (33.7% vs. 22.7%), on average, than their public counterparts. A closer
look at private versus public firms capital structures reveals further differences in the maturity
structures of debt. The ratio of short-term debt to total debt is 64% for private firms, while the same
ratio for public firms is about half as large at 37%. While equity issues comprise approximately 50% of
the incidents in which public firms raise external capital, for private firms this figures is approximately
10%. These large differences, as well as the fact that these two groups of firms differ markedly in their
ability to access the public equity markets, provide an ideal setup to examine rational theories of capital
structure. Trade-off theory and pecking order hypothesis, offer several predictions with respect to
relative differences in the financial policies and capital structure between public and private firms. The
author classifies these predictions into two groups: the level effect and the sensitivity effect:
The level effect refers to consequences that arise from the fact that private firms relative cost of equity
to debt capital is higher than that of public firms. The sensitivity effect refers to consequences that arise
from the fact that private firm absolute costs of accessing the external capital market is, higher than
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that of public firms. The effect is that private firms are less likely the capital market. Since it is more
costly for private firms to rebalance their debt ratios, their leverage will exhibit larger sensitivity to
operating performance, smaller sensitivity to traditional trade-off theory determinants of capital
structure, a greater persistence. The authors empirical research is consistent with the hypothesis.
One fundamental difference between private and public firms is their ownership structure and hence
the degree to which control is valued by their shareholders. Where conflicts of interest exist, agency
problem can arise and control is valuable. Therefore, firms controlled by a major shareholder should be
reluctant to use equity financing when doing so causes the controlling shareholder to risk losing control.
Since private firms are held by at most a few shareholders, whereas public firms are held by many
atomistic shareholders, the cost of issuing equity (giving away control) is higher for private firms than for
public firms. In addition, given the separation between management and ownership that is more typical
of a public firm than a private firm, managers of public firms may rationally seek to dilute the control of
any single shareholder, further increasing the value of equity to managers of public firms relative to
managers of private firms (Morellec, 2004). Finally, given private firms do not tend to offer minority
shareholders the same disclosure an protections they would enjoy with public firms, minority
shareholders may be less willing to purchase private equity, contributing further to equity issuance
being more expensive for private firms than public firms. In sum, a security that gives away control
equity shoulder be much more costly to issue for the manager of a private firm than for the manager
of a public firm.
Another distinction between private and public firms is the level of information asymmetry between
insiders and outsiders at the time capital is raised. Because of this, the cost of equity will be much higher
for private firms than that of public firms.

Part VI: How do companies choose between internal and external

finance?
Hubbard (1998)
Capital-market imperfections and investment
This review concentrates on developments and challenges in the empirical research and uses advances
in models of information and incentive problems to motivate these developments and challenges.
Interest by contemporary researchers in links between internal funds and investment decisions reflects
two main concerns, one macro and one micro. The macro concern is that cyclical movements in
investment appear too large to be explained by market indicators of expected future profitability or the
use costs of capital. This had led some macroeconomists to identify financial factors in propagating
relatively small shocks, factors that correspond to accelerator models that explain investment data
relatively well. Indeed, the term financial accelerator has been used to refer to the magnification of
initial shocks by financial market imperfections. The micro concern relates to consequences of
informational imperfections in insurance and credit markets. In this line of inquiry, problems of
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asymmetric information between borrowers and lenders lead to a gap between costs of external
financing and internal financing. This notion of costly external financing stands in contrast to the more
complete-markets approach underlying conventional models of investment emphasizing expects future
profitability and the user cost of capital as key determinants of investment. The formal conclusions of
models of financial frictions in business investment decisions: (1) uncollateralized external financing is
more costly than internal financing; and (2) holding constant investment opportunities, a reduction in
net worth reduces investment for firms facing information costs. Theoretical models of imperfections in
capital markets imply that external financing is more costly than internal financing for many firms.
Hence, for given levels of investment opportunities, information costs, and market interest rates, firms
with higher net worth should invest more.
Empirical studies of firm investment provide strong support for the basic predictions of links between
changes in net worth and investment arising from information problems in financial markets. For many
firms in the economy, available evidence is consistent with: (1) a gap between the cost of external and
internal financing; and (2) a positive relationship between the borrowers spending and net worth,
holding constant underlying investment opportunities.

Petersen & Faulkender (2006)

Does the source of capital affect capital structure?
Prior work on leverage implicitly assumes capital availability depends solely on firm characteristics.
However, market frictions that make capital structure relevant may also be associated with a firms
source of capital. Examining this intuition, we find firms that have access to the public bond markets, as
measured by having a debt rating, have significantly more leverage. Although firms with a rating are
fundamentally different, these differences do not explain our findings. Even after controlling for firm
characteristics that determine observed capital structure, and instrumenting for the possible
endogeneity of having a rating, firms with access have 35% more debt.
Under the trade-off theory of capital structure, firms determine their preferred leverage ratio by
calculating the tax advantages, costs of financial distress, mispricing, and incentive effects of debt versus
equity. However, market frictions that make capital structure choices relevant determine its preferred
leverage. In this article, the authors investigate the link between where firms obtain their capital (the
private versus public debt markets) and their capital structure (leverage ratio).
In presence of information asymmetry, firms may not be able to raise sufficient capital to fund all of
their good projects. Such market frictions create the possibility for differentiated financial markets or
institutions to arise. These financial intermediaries are lenders who specialize in collecting information
about borrowers, which they then use in credit approval decision. By interacting with borrowers over
time and across different products, the financial intermediary may be able to partially alleviate the
information asymmetry that cause the markets failure. Financial intermediaries also may have an
advantage over arms length lenders (e.g. bond markets) after the capital is provided. If ex post
monitoring raises the probability of success (through either enforcing efficient project choice or the
expenditure of the owners effort), then they may be a preferred source of capital. This intuition is the
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basis for the empirical literature that examines firms choices of lenders. Firms that are riskier, smaller,
and about whom less is known are those that are most likely to borrow from financial intermediaries.
Larger firms, about which much is known, will be more likely to borrow from arms length capital
markets. However, this monitoring is costly. This cost must be passed back to the borrower. It means
that the cost of capital for firms in such an imperfect market depends not only on the risk of their
projects but also on the resources needed to verify the viability of their projects.

Gorton (2008)
The panic of 2007
How could a bursting of the house price bubble results in a systemic crisis. In this paper, the author tries
to answer this last question. The author develops the thesis that the interlinked or nested unique
security designs that were necessary to make the subprime market function results in a loss of
information to investors as the chain of structures - securities and special-purpose vehicles stretched
longer and longer. The chain of securities and the information problems that arose are unique to
subprime mortgages and that is an important message of this paper.

Ashcraft et al. (2010)

MBS rating and mortgage credit booms
The credit ratings on subprime and Alt-A mortgage-backed securities (MBS) deals issued between 2001
and 2007 is studied. The fraction of highly-rated securities in each deal is decreasing in mortgage credit
risk, suggesting ratings contain useful information for investors. However, they also find evidence of
significant time-variation in risk-adjusted credit ratings, including a progressive decline in standard
around the MBS market peak between the start of 2005 and mid-2007. Conditional on initial ratings,
they observe underperformance (high mortgage defaults and losses, and large rating downgrades)
amongst deals with a high fraction of opaque low-documentation loans.
The basic research question: how well did initial credit ratings summarize the variation in MBS default
risk across this sample of deals? The main unit of analysis is an MBS deal, which is a set of structured
bonds linked to a common pool (or pools) of mortgages. Ratings for an MBS deal are typically described
in terms of the subordination of each rating, which is the fraction of the deal junior to the bonds of that
letter rating. For example, if a deal consists of $1bn of mortgages, and only the most senior $850m of
bonds are rated triple-A, subordination below triple-A is 15%. The average unconditional subprime
subordination levels increase between 2001 and the end of 2004, and then is relatively flat until mid2007. A similar pattern, albeit less pronounced, is evident for Alt-A deals. Estimating a simple model of
ratings determination, they show that subordination is related in the expected directions to
fundamentals like the level of mortgage credit risk (based on a simple ex-ante default model), and the
strength of credit enhancement features in the deal. Controlling for these factors, they find a humpshaped pattern in initial subordination between 2001 and 2007. Namely, risk-adjusted subordination
increases between 2001 and 2004, but then declines significantly between the start 2005 and mid-2007.
During this latter period, the average riskiness of new MBS deals increases significantly, based either on
their default, or on other metrics such as early-payment defaults, house price appreciation, and
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mortgage underwriting characteristics. However, the fraction of highly-rated MBS in each deal remains
flat, rather than increasing in response to this greater risk.
If credit ratings are informative, mortgages underlying deals rated more optimistically (i.e. lower
subordination, or equivalently a larger fraction of highly-rated securities), should perform better ex-post
in terms of lower mortgage default and loss rates. Furthermore, prior information available when the
deal was initially rated should not be expected to systematically predict deal performance, after
controlling for credit ratings. This is because this prior information should already be reflected in the
ratings themselves, to the extent it is informative about default risk.
The authors find higher subordination is generally correlated with worse ex-post mortgage performance
as expected. However, conditional on subordination, time dummies and credit enhancement features,
they also find significant variation in performance across different types of deals. First, MBS deals
backed by loans with observably risky characteristics such as low FICO scores and high leverage perform
poorly relative to initial subordination levels. Moreover, deals with a high share of low- and nodocumentation loans (low doc), perform disproportionately poorly, even relative to other types of
observably risky deals. This suggests such deals were not rated conservatively enough ex-ante. They find
that underperformance of low-doc and observably high risk deals holds surprisingly robustly over the
entire sample period, including earlier deal vintages not significantly affected by the crisis.
The evidence does suggest that ratings are informative, and also rejects a simple story that credit ratings
standards deteriorate uniformly over the pre-crisis period. However, they find evidence of apparently
significant time-series variation in subordination levels; most robustly, they observe a significant decline
in risk-adjusted subordination levels between the start of 2005 and mid-2007.
The analysis also suggests MBS ratings did not fully reflect publicly available data. Observably high-risk
deals, measured by a simple ex-ante model, significantly underperform relative to their initial
subordination. Deals with a high share of low-documentation mortgages also perform
disproportionately worse compared to other types of risky deals. These two results are evident even for
earlier vintages, and can be identified even only using pre-crisis data.
The results are no conclusive about the role of explicit agency friction in the rating process. However,
two of our results appear consistent with recent theoretical literature modeling these friction: (i) the
poor performance relative to ratings of deals backed by opaque low-documentation loans, (i) the
observed decline in risk-adjusted subordination around the peak of MBS issuance, when incentive
problems are likely most severe.

Part VII: Topics in financial development

Booth, Aivazian, Demirguc-Kunt, Maksimovic (2001)
Capital structures in developing countries

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This study assesses whether capital structure theory is portable across countries with different
institutional structures. The authors analyze capital structure choices of firms in 10 developing
countries, and provide evidence that these decisions are affected by the same variables as in developed
countries. However, there are persistent differences across countries, indicating that specific country
factors are at work.
The focus of the paper is on three questions: do corporate financial leverage decisions differ significantly
between developing and developed countries? Are the factors that affect cross-sectional variability in
individual countries capital structures similar between developed and developing countries? Are the
predictions of conventional capital structure models improved by knowing the nationality of the
company? This last question is particularly important, because different institutional factors, such as tax
rates and business risk, can result in different financing patterns, which then show up in firm data as
well as the aggregate flow of funds data.
The Static Trade off Model (STO) states that capital structure moves towards a target that reflect tax
rates, asset type, business risk, profitability, and the bankruptcy code. In the Agency Theory Framework
(ATF), potential conflict of interest between inside and outside investors determines an optimal capital
structure that trades off agency costs against other financing costs. The nature of the firms assets and
growth opportunities are important factors in the importance of these agency costs. In the Pecking
Order Hypothesis (POH), financial market imperfections are central. Transaction costs and asymmetric
information link the firms ability to undertake new investments to its internally generated funds. If the
firm must rely on external funds, then it prefers debts to equity due to the lesser impact of information
asymmetries.
Agency Costs and Financial Distress
Conflicts between principals and their agents can also affect capital structure choice. When
management pursues growth objectives, external common equity is valuable for firms with strong
investment opportunities, because management and shareholder interest coincide. In contrast, for firms
without strong investment opportunities, debt serves to limit the agency costs of managerial discretion.
Although the use of debt controls the agency costs of managerial discretion, it also generates its own
agency costs. A highly debt-financed firm might forgo good investment opportunities due to the debt
overhang problem. The problem is that with risky debt, the debt holders can share in any profitable
future investment returns, thereby extracting some of the net present value. This transfer of wealth can
cause the shareholders to turn down good investment opportunities. The value of the forgone
opportunities plus the costs of enforcing contractual provisions constitute the agency cost of debt.
Improvements in a firms growth opportunities lead to an increase in the agency costs of debt and a
reduction in the agency costs of managerial discretion.
Financing Hierarchies and the Pecking-Order Hypothesis
Myers and Majluf (1984) point out that high-quality firms can reduce the costs of informational
asymmetries by resorting to external financing only if financing cannot be generated internally. The
same argument implies that firms should issue debt before considering external equity. Informational
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asymmetries thus provide a justification for a financing-hierarchies approach. As a result, capital
structure choice depends on the firms investment opportunities and its profitability. High profitable
firms might be able to finance their growth by using retained earnings and by maintaining a constant
debt ratio. In contrast, less profitable firms will be forced to resort to debt financing.
The costs of financial distress in the STO model are closely related to the same factors that are
important from the ATF. For example, the costs of financial distress can be thought of as the product of
the probability of entering a distressed situation and the costs of resolving such a situation should it
occur. A high proportion of hard tangible assets then increases debt capacity, not only because of the
reduction in distress costs, but also because it can reduce the proportion of growth opportunities, and
as a result the agency costs of managerial discretion.
A consistent result in both the country and pooled data is that the more profitable the firm, the lower
the debt ratio, regardless of how the debt ratio is defined. This finding is consistent with the PeckingOrder Hypothesis. It also supports the existence of significant information asymmetries. This result
suggests that external financing is costly and therefore avoided by firms. However, a more direct
explanation is that profitable firms have less demand for external financing. This explanation would
support the argument that there are agency costs of managerial discretion. Also, this result does not sit
well with the static trade-off model, under which we would expect that highly profitable firms would use
more debt to lower their tax bill. We could argue, that such firms also have large growth options and
high market-to-book ratios, so that the agency costs of debt would imply low debt ratios. However, this
possibility relies on an argument that high market-to-book ratios are associated with high levels of
current profitability, which is not necessarily true. The importance of profitability also explains why the
average tax rate variable tends to have a negative effect on debt ratios, because rather than being a
proxy for debt tax-shield values, it seems to be an alternative measure of profitability.
There is also support for the role of asset tangibility in financing decisions. Clearly, asset tangibility
affects total and long-term debt decisions differently. The authors would expect this from the longstanding argument concerning matching and from the emphasis in bank financing on collateral for
shorter-term loans. Generally, the more tangible the asset mix, the higher the long-term debt ratio, but
the smaller the total-debt ratio. This indicates that as the tangibility of a firms assets increases, by say,
one percent, although the long-term debt ratio increases, the total-debt ratio falls; that is, the
substitution of long-term for short-term debt is less than one.
The answer to the first two questions posed in the introduction is: in general, debt ratios in developing
countries seem to be affected in the same way and by the same types of variables that are significant in
developed countries. However, there are systematic differences in the way these ratios are affected by
country factors, such as GDP growth rates, inflation rates, and the development of capital markets. The
answer to the third question is: knowing the country of origin is usually at least as important as knowing
the size of the independent variables for both the total and long term book-debt ratios. Only for the
market-debt ratio this is not true.

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King & Levine (1993)

Schumpeter might be right
The authors present evidence consistent with Schumpeters view that the financial system can promote
economic growth. Various measures of the level of financial development are strongly associated with
real per capita GDP growth, the rate of physical capital accumulation, and improvements in the
efficiency with which economies employ physical capital (measured both as an estimate of the per
capital growth rate of physical capital and the ratio of investment to GDP). Further, the predetermined
component of financial development is robustly correlated with future rates of economic growth capital
accumulation, and economic efficiency improvements.
In 1911 Schumpeter argued that the services provided by financial intermediaries mobilizing savings,
evaluating projects, managing risk, monitoring managers, and facilitating transactions are essential for
technological innovation and economic development. But numerous influential economists believe that
finance is a relatively unimportant factor in economic development. In this paper the authors study
whether higher levels of financial development are positively associated with economic development.
Specifically, they investigate whether higher levels of financial development are significantly and
robustly correlated with faster current and future rates of economic growth, physical capital
accumulation, and economic efficiency improvements.
The authors find that (1) indicators of the level of financial development the size of the formal financial
intermediary sector relative to GDP, the importance of banks relative to the central bank, the
percentage of credit allocate to private firms, and the ratio of credit issued to private firms to GDP - are
strongly and robustly correlated with growth, the rate of physical capital accumulation and
improvements in the efficiency of capital allocation; and (2) the predetermined components of these
financial development indicators significantly predict subsequent value of the growth indicators. The
data are consistent with the view that financial services stimulate economic growth by increasing the
rate of capital accumulation and by improving the efficiency with which economies use that capital.

Levine & Zervos (1998)

Stock markets, banks and economic growth
Do well-functioning stock markets and bank promote long-run economic growth? This paper shows that
stock market liquidity (as measured both by the value of stock trading relative to the size of the market
and by the value of trading relative to the size of the economy) and banking development (as measured
by bank loans to private enterprises divided by GDP) both positively predict growth, capital
accumulation, and productivity improvements when entered together in regressions, even after
controlling for economic and political factors. The results are consistent with the views that financial
markets provide important services for growth, and that stock markets provide different services from
banks. The paper also finds that stock market size, volatility, and international integration are not
robustly linked with growth, and that none of the financial indicators are closely associated with private
savings rates.

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Several students have derived models where more liquid stock markets markets where it is less
expensive to trade equities reduce the disincentives to investing in long-duration projects because
investors can easily sell their stake in the project if they need their savings before the project matures.
Enhanced liquidity, therefore, facilitates investment in longer-run, higher-return projects that boost
productivity growth. Also, greater international markets induces risk sharing through internationally
integrated stock markets induces a portfolio shift from safe, low-return investments to high-return
investments, thereby accelerating productivity growth. These liquidity and risk models, however, also
imply that greater liquidity and international capital market integration ambiguously affect saving rates.
In fact, higher returns and better risk sharing may induce saving rates to fall enough such that overall
growth slows with more liquid and internationally integrated financial markets. Moreover, theoretical
debate exists about whether greater stock market liquidity actually encourages a shift to higher-return
projects that stimulate productivity growth. Since more liquidity makes it easier to sell shares, some
argue that more liquidity reduces the incentives of shareholders to undertake the costly task of
monitoring managers. In turn, weaker corporate governance impedes effective resource allocation and
slows productivity growth.
The authors find that stock market liquidity and banking development both predict long-run growth,
capital accumulation and productivity improvements. The papers results are certainly consistent with
the view that the services provided by financial institutions and markets are important for long-run
growth. The result is consistent with the view that a greater ability to trade ownership of an economys
productive technologies facilitates efficient resource allocation, physical capital formation, and faster
economic growth. Furthermore, since measures of stock market liquidity and banking development both
enter the growth regressions significantly, the finding suggest that banks provided different financial
services from those provided by stock markets. The authors find no support for the contentions that
stock market liquidity, international capital market integration, or stock return volatility reduce private
saving rates, or hinder long-run growth. This paper finds a strong, positive link between financial
development and economic growth and the results suggest that financial factors are an integral part of
the growth process.

Dyck and Zingales (2004)

Private benefits of control
The authors estimate private benefits of control. On average the value of control is 14%. As predicted by
theory, higher private benefits of control are associated with less developed capital markets, more
concentrated ownership, and more privately negotiated privatizations. They also analyze what
institutions are most important in curbing private benefits. They find evidence for both legal and extralegal mechanisms. Media pressure and tax enforcement seem to be the dominating factors.
The benefits of control over corporate resources play a central role in modern thinking about finance
and corporate governance. From a modeling device the idea of private benefits of control has become a
centerpiece of the recent literature in corporate finance. In fact, the main focus of the literature on
investor protection and its role in the development of financial markets is on the amount of private

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benefits that controlling shareholders extract from companies they run. Two methods can be used to
quantify private benefits.
The first one focuses on privately negotiated transfers of controlling blocks in publicly traded
companies. The price per share an acquirer pays for the controlling block reflects the cash flow benefits
from his fractional ownership and the private benefits stemming from his controlling position in the
firm. By contrast, the market price of a share after the change in control is announced reflects only the
cash flow benefits non-controlling shareholders expect to receive under the new management. This
difference is the price paid for private benefits.
The second method relies on the existence of companies with multiple classes of stock with differential
voting rights. In this case, one can easily compute the market value of a vote. On a normal trading day
market transactions take place between non-controlling parties who will never have direct access to the
private benefits of control. Hence, the market value of a vote reflects the expected price a generic
shareholder will receive in case of a control contest. This in turn is related to the magnitude of the
private benefits of control. Thus, if one is willing to make some assumptions on the probability a control
contest will arise, the price of a voting right can be used to estimate the magnitude of the private
benefits of control.
In this paper the first method is applied. The authors find that on average corporate control is worth
14% of the equity value of a firm. Interestingly, the premium paid for control is higher when the buyer
comes from a country that protects investors less. This and other evidence suggest that the authors
estimates capture the effect the institutional environment has on private benefits of control. Next,
theory predicts that where private benefits of control are larger, entrepreneurs should be more
reluctant to go public and more likely to retain control when they do go public. In addition, where
private benefits of control are larger a revenue maximizing government should be more likely to sell a
firm through a private sale than through a share offering. Strong evidence is found in support of all
these predictions. A one standard deviation increase in the size of the private benefits is associated with
a 67% reduction in the ratio of external market capitalization of equity to GNP, an 11% reduction in the
percentage of equity held by non-controlling shareholders, and a 36% increase in the number of
privatized companies sold in private negotiations rather than through public listings. This evidence gives
support to the prominent role private benefits have in corporate finance.
While the existence of private benefits is not necessarily bad, their negative effect on the development
of security markets raises the question of what affects their average size across countries, Thus far, the
literature has emphasized the law as the primary mechanism to curb private benefits by giving investors
leverage over controlling shareholders. The right to sue management, for instance, limits the
discretionary power of management and, with it, the ability to extract private benefits. And so does any
righty attributed to minority shareholders. A common law legal origin is similarly argue to constrain
management by lowering that standard of proof in legal suits and increasing the scope of management
decisions subject to judicial review. Consistent with this literature, the authors analyse the effect the law
has on the size of private benefits. Besides the law, they also consider extra/legal institutions, which
have been mentioned in the literature as possible curbs for private benefits: competition, labour
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pressures, and moral norms. To these well-known mechanisms they authors add two: public opinion
pressure and corporate tax enforcement. Reputation is a powerful source of discipline, and being
ashamed in the press might be a powerful deterrent, especially where the press is more diffused.
Similarly, effective tax enforcement can prevent some transactions (such below market transfer prices)
that expropriate minority shareholders. They find that a high level of diffusion of the press, a high rate
of tax compliance, and a high degree of product market competition are associated with lower private
benefits of control. They find that many institutional variables, taken in isolation, seem to be associated
with a lower level of private benefits of control: better accounting standards, better legal protection of
minority shareholders, better law enforcement, more intense product market competition, a high level
of diffusion of the press, and a high rate of tax compliance. The possible role of tax enforcement in
reducing private benefits, and thus indirectly enhancing financial development, is probably the most
important new fact that emerges from the analysis.
However, what are private benefits? The theoretical literature often identifies private benefits of control
as the psychic value some shareholders attribute simply to being in control. Another traditional source
of private benefits of control is the perquisites enjoyed by top executives. The common feature of all the
above is that some value is not shared among all the shareholders in proportion of the shares owned,
but it is enjoyed exclusively by the part in control. Control does not only confer benefits: sometimes it
involves costs as well. Maintaining a controlling block, for instance, forces the largest shareholder to be
not well diversified. As a result, it might value the controlling block less. At the same time, a fledging
company might inflict a loss in reputation to the controlling party and, in some cases, even some legal
liabilities. For this reason, the authors do not necessarily expect all the estimates to be always positive.

La Porta, Silanes, Shleifer & Vishny (1998)

Law and finance
This paper examines legal rules covering protection of corporate shareholders and creditors, the origin
of these rules, and the quality of their enforcement. The results show that common-law countries
generally have the strongest, and French-civil-law countries the weakest, legal protections of investors,
with German-and Scandinavian-civil-law countries located in the middle. They also find that
concentration of ownership of shares in the largest public companies is negatively related to investor
protections, consistent with the hypothesis that small, diversified shareholders are unlikely to be
important in countries that fail to project their rights.
The differences in legal protections of investors might help explain why firms are financed and owned so
differently in different countries. The content of legal rules in different countries may shed light on these
corporate governance puzzles. In general, commercial laws come from two broad traditions: common
law, which is English in origin, and civil law, which derives from Roman law. Within the civil tradition,
there are from French, German and Scandinavian. The French and the German civil traditions, as well as
the common-law tradition, have spread around the world through a combination of conquest,
imperialism, outright borrowing, and more subtle imitation. The authors show that laws vary a lot across
countries, in part because of differences in legal origin. Civil laws give investors weaker legal rights than
common laws do, independent of the level of per capita income. Common-law countries give both
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shareholders and creditors relatively speaking the strongest, and French-civil-law countries the
weakest, protection. German-civil-law and Scandinavian countries generally fall between the other two.
The quality of law enforcement is the highest in Scandinavian and German-civil-law countries, next
highest in common-law countries, and again the lowest in French-civil-law countries. A response to the
lack of legal protections is a high ownership concentration. Some concentration of ownership of a firms
shares is typically efficient to provide managers with incentives to work and large investors with
incentives to monitor the managers. However, some dispersion of ownership is also desirable to
diversify risk. Also, a very high ownership concentration may be a reflection of poor investor protection.
Poor investor protection in French-civil-law countries is associated with extremely concentrated
ownership. The data thus supports the idea that legal systems matter for corporate governance and that
firms have to adapt to the limitations of legal systems that they operate in. The quality of law
enforcement, unlike the legal rights themselves, improves sharply with the level of income. Third, the
data support the hypothesis that countries develop substitute mechanisms for poor investor protection.
Some of these mechanisms are statutory, as in the case of remedial rules such as mandatory dividends
or legal reserve requirements.

Part VIII: Going private

Lehn, Poulsen (1989)
Free cash flow and stockholder gains in going private transactions
The authors investigate the source of stockholder gains in going private transactions. They find support
for the hypothesis advance by Jensen (1986) that a major source of these gains is the mitigation of
agency problems associated with free cash flow. Using a sample of 263 going private transactions from
1980 through 1987, the results indicate a significant relationship between undistributed cash flow and a
firms decision to go private. In addition, they find that premiums paid to stockholders are significantly
related to undistributed cash flow. These results are especially strong for firms that went private
between 1984 and 1987 and also for firms whose managers owned relatively little equity before the
going private transaction.
Going private transaction create significant wealth gains for target stockholders. Four suggested source
of stockholder gains in these transaction include: tax savings (tax deductibility of interest payments on
corporate debt, increased depreciation deductions associated with step-up of assets in going private
transactions, and tax advantages of financing going private transaction with ESOPs), redistribution from
bondholders (asset-substitution as of increasing leverage ratio), asymmetric information, and mitigation
of agency problems (by LBO using debt which reduces free cash flow problem).
The results in this paper are consistent with the free cash flow hypothesis concerning the source of
stockholder wealth gains in going private transactions. By comparing firms that went private with a
control group, the authors find that the likelihood of going private is directly related to the ratio of
undistributed cash flow to equity value, and inversely related to the growth rate in sales. Furthermore,
they find that premiums paid to shareholders in going private transactions are positively and
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significantly related to undistributed cash flow. The results are strongest from 1984 to 1987 when the
threat of a hostile takeover was greater. If firms that went private were likely targets of hostile takeover
attempts, then managers may have strong incentives to preempt hostile bids by paying out the excess
cash flow. In addition, the positive relation between premiums paid to shareholders and cash flow is
especially strong among firms where managers owned relatively little equity prior to the going private
transactions, the firms where agency costs are expected to be highest. To some extent, the results are
consistent with other possible sources of wealth gains. For example, proponents of the tax savings
hypothesis could interpret our measure of undistributed cash flow as a proxy for debt capacity (and
potential tax benefits), confirming the tax savings hypothesis.

Kaplan (1989)
Management buyouts: evidence on taxes as a source of value
This paper estimates the value of tax benefits in 76 management buyouts of public companies
completed in the period 1980 to 1986. The median value of tax benefits, estimated at the time the
buyout company goes private, has a lower bound of 21% and an upper bound of 143% of the premium
paid to pre-buyout shareholders. The estimated value depends on the rate buyout debt is repaid and
the tax rate applied to the interest deductions. This paper also presents evidence on the actual taxes
paid and debt repayment rates by these companies after the buyout. The results suggest that tax
benefits are an important source of the wealth gains in MBOs.
Two major source of tax benefits available during sample period:
1. The large amount of debt used to finance the typical MBO generates large interest deductions.
2. Management could elect to increase the tax basis of the assets of their company from the
historical basis to the sum of the value of the purchased equity and the value of the firms
outstanding liabilities (step-up method, available before 1986).
The paper presents a range of estimates of the tax benefit from increased interest deduction based on
different assumptions for the (unobserved) marginal tax advantage to debt and the extent to which the
buyout debt increases are permanent. The median estimated value of interest deductions varies from
14.1% to 129.7% of the premium paid to pre-buyout shareholders. For those companies which elect to
step-up the basis of their assets, the median value of the asset step-up is 30.4% of the premium paid to
pre-buyout shareholders. The median value of the combined benefit from interest deductions and asset
step-up varies from 21.0% to 142.6%. The paper then examines the relationship between these
potential deductions and the premium paid (market adjusted) to pre-buyout shareholder. The results in
this section are consistent with the application of a longer repayment schedule and higher. These
exercises provide ex ante estimates of the value of the tax deductions. Finally, the paper examines the
actual post-buyout tax and debt repayment experience of 48 of the sample companies. The actual debt
repayment schedule is consistent with the maintenance of relatively high levels of debt. Consistent with
the ex ante analysis, the typical company in the sample pays little federal tax in the first two post-buyout
years. The typical company does pay taxes in the third post-buyout year. Together, the evidence on debt

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repayment and the strong correlation between total tax deductions and the premium paid are
consistent with tax benefits being an important source of the wealth gains in management buyouts.
The estimates in this paper are based on tax rates in effect prior to the Tax Reform Act of 1986 (TRA).
TRA lowered the maximum corporate rate from 46% to 34% and effectively eliminated the asset step-up
election. Clearly, this lowers the maximum tax benefit of interest deductions from 46% to 34%. When
personal taxes are considered, however, the net effect of TRA on the tax benefit of interest deduction
becomes unclear. TRA also lowered the effective maximum personal tax rate on debt and dividends to
28% and increased the tax rate on capital gains to 28%. Assuming a tax rate of 28% on debt, and 5% on
equity, the net tax advantage of debt is still 13%.

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