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Empirics of Financial Markets

Patrick J. Kelly, Ph.D.

Theory and Empirics of Corporate Finance

Firms and Project (Investment) Financing

Firms are economically productive organizations which produce streams of cash flows.
Coase (1937) firms as the nexus of contracts

Financing Investment
Firms raise capital for investment by selling rights to their cash flows. Debt
1. Typically fixed payments 2. Typically for a fixed amount of time 3. Typically debt holders gain control rights if the firm fails at (1) or (2)

How do firms finance the activities of the firm?

Equity
Control rights (ownership) Residual claimant: Get whatever cash is left over after all other claimants are paid (such as debt holders)
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The theory of capital structure

The mix of equity and debt, or rather the fraction of firm value attributed to debt and equity is called the Capital Structure of the firm Why do we see that firms have the level of debt that they do?
They should choose the capital structure that maximizes the value of the firm!

Modigliani and Miller (1958)

The value of the firm is:
Independent of its capital structure
Fraction of Firm value

Consider an Unlevered firm (U):

Investment Payoff

SU = VU
Equity Raised through Share Issuance Value of Unlevered Firm

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Capital Structure Irrelevance

Unlevered firm (U):
Investment Payoff

Irrelevance Enforced by Arbitrage

SU = VU = VL = S L + DL
X
Same, so the firm value must be the same

SU = VU
Levered firm (L):
Investment

if

<

short sell debt and equity in levered and buy unlevered short sell equity in unlevered buy debt and equity in levered

Payoff

if

>

VL = S L + DL

(X rDL ) + rDL = X
Payoff to Equity or Share Holders in Levered Firm Payoff to Debt Holders in Levered Firm

VL = VU
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1. Assumptions Needed for Capital Structure Irrelevance

1. Frictionless markets
No taxes: personal or corporate Perfect divisibility of assets Costless information available to all
No bankruptcy

2. Assumptions Needed for Capital Structure Irrelevance

3. Perfect Competition 4. Homogeneous expectations
Insiders and outsiders have the same information, i.e. no signaling opportunities.

2. Individuals can mimic firms

Equal access to capital markets Homemade leverage Can issue equity, just like firms

5. Investors maximize wealth 6. No wealth transfers (no agency costs) 7. Investment decisions are given (fixed) 8. Operating cash flows are unaffected by capital structure

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The power of M&M58

Not that capital structure is irrelevant, but rather the assumptions needed to make capital structure relevant are really strict.

Miller (1963) Relaxing No Corporate Taxes Assumption

Often interest payments on debt can be deducted from profits, lowering the tax bill
Investment Payoff

S L
Relaxing these assumptions has lead to a better understanding of the nature of the firm
Invest and Borrow
Homemade leverage

~ X rDL (1 C )

SU DL (1 C )
Cleverly chosen amount to borrow

X (1 C ) rDL (1 C )
~ = X rDL (1 C )

Payoff

Same payoffs Same Price

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Miller (1963)
By No Arbitrage rule:
Same payoffs Same Price means Investment in a Levered Firm = Investing in Unlevered plus borrowing

Empirical Findings: Gains to Leverage M&M(1966)

Electric Utility Industry (63 Firms)

SL =

SU DL (1 C )

SU = S L DL (1 C )
SU = (S L + DL ) CDL

VU = VL CDL VL = VU + CDL
Discounted Present Value of Tax Shield

Miller and Modigliani, AER June 1966

Implication: Borrow 100% the value of the firm!

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Graham (1996) in a sample of 10,000 firms from 1980-1992, finds that high tax rates are associated with higher debt.
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Bankruptcy
Borrowing 100% is not real
Bankruptcy costs

Indirect Costs of Bankruptcy

Indirect costs
Trade Credit Value of warranties Validity of contracts Litigation costs Cash flow may drop due to bankruptcy

Warner (1977)
11 railroad bankruptcies 1933-55 Direct cost 5.3% of value 1 month prior to filing (avg. not MC) 1% of value 7 years prior Directed costs are trivial

Altman (1984)
Opportunity costs are 8.1% of firm value 3 years prior 10.5% 1 year prior

Opler and Titman (1994)

During downturns, high leverage firms from 26% in market value
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Bankruptcy costs affect the level of Debt

Cost of Debt
$ PV

Implications
Bankruptcy costs reduce the benefits of debt Capital Structure IS relevant

Financial Distress Cost of Debt

VL

Mille

r6 3
Warner (1977) and others Bankruptcy Costs MM58

Taxes Paid D D+S VU

Optimal Capital Structure

Debt
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Empirical Findings: Gains to Leverage

Mackie and Mason (1990): the propensity to issue debt is:
Negatively related to
existence of other tax shields
A one standard deviation increase in non-debt tax shields leads to a 10% lower probability of debt issuance

Relaxing M&M58 s Assumptions

If we introduce personal taxes and

Taxes on capital gains < tax on interest income
Gains to leverage are less than when the taxes on interest and capital gains don t exist or are the same

Probability of distress

Positively related to
Level of Free Cash Flow Asset Tangibility

(1 C )(1 PS ) VL = VU + DL 1 (1 PB )
Gains to Leverage GL

Frank and Goyal (2003) add

(+) size, median industry leverage, top corporate tax rate (-) dividends, loss carry forwards, profitability, and interest rates Suggests: Trade-off theory
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Relaxing M&M58 s Assumptions

VL = VU + GL

When will investors prefer equity and when debt?

(1 C )(1 PS ) GL = DL 1 (1 PB )
$1 from Equity GL=0 (1 - c ) (1 - ps ) $1 from Debt

M&M58:
c= ps= pb=0

Miller (1963):
c > 0 c > 0 but and

= < >

(1 - pb )

ps= pb=0 ps< pb

GL= cDL

Miller (1977):

(1 C )(1 PS ) GL = DL 1 (1 PB )

GL<0 GL>0 GL=0

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therefore minimize leverage therefore maximize leverage therefore indifferent to leverage

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In equilibrium
In equilibrium it must be that for the marginal investor: (1 - c ) (1 - ps ) = (1 - pb ) Why? What would happen if ?
(1 - c ) (1 - ps ) > (1 - pb ) (1 - c ) (1 - ps ) < (1 - pb ) or

Supply and Demand for Bonds

For simplicity let s assume: ps= 0 and corporate tax the same for all corporations. Demand: order individuals by tax rate %
+1 0 ipb ipb

rD = r0

1 1 ipb 1 rS = r0 1 Cj
r0 is the effective, after
tax interest rate the corporation pays

Tax Exempt Bonds

$
23

amount of all bonds

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Implications
1. High tax individuals buy tax exempt bonds
Once those run out low tax individuals supply capital to the corporate debt market

De Angelo and Masulis (1980)

Heterogeneous Corporate Taxes

With different tax rates:
Low tax firms are less interested in debt (and high more) Resulting in a downward sloping supply curve of debt

2. There is an optional economy-wide debt level BUT each firm is exactly indifferent
Why?
Costs the same.

Currently, in the US, the corporate tax rate is 35% How do corporations get different tax rates?
They substitute, depreciation, investment tax credits Even with the same rate, corporations may have different effective tax rates
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Implies capital structure is irrelevant

Debt Market Equilibrium

Differences in Tax Rates

Cordes and Sheffrin (1983)
using Treasury Data to calculate effective tax rates

%
Firm s with High

Differences in Effective tax rates ranging from

c

rD = r0

1 1 ipb

45% for tobacco 16% for transportation and agriculture

Differences due to:

rS = r0
Tax Exempt Bonds

1 j 1 C
$
amount of all bonds

Tax carry-backs and carry-forwards Foreign and domestic tax credits Investment tax credits Difference in taxes on capital gains vs. earnings Minimum tax rules
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An Example
Consider a world where return is sufficiently volatile that some times the tax shield won t be valuable. r0=10%

Example: Diminishing Value of Tax Shield

Tax Shield available up to $500 in interest payments

S1 .25

S2 .25

S3 .25

S4 .25 E[After Tax Income]

Pr

10% 10% = = 1 C 1 .5
Effective Tax Rate Highest Rate Willing Next $

c =50%

ps =0%

pb =20%
Debt Debt Interest Debt Interest Debt

But, over $500 in interest no taxes are paid in one state of the world: .75 x .50 = .375

Taxable Income
0 4000 500 8000 1000 12000 1500 16000 2000 500 0 0 0 0 1000 500 0 0 0 1500 1000 500 0 0 2000 1500 1000 500 0

625 375 187.5 125 0

50% 37.5% 25% 12.5% 0%

20%
.1/(1-.375)

Assume all investors have the same tax rate:

Required return on taxable Debt:

16%
.1/(1-.25)=

13.3%
.1/(1-.125)

rD =

r0 .1 = = .125 1 pb 1 .2
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Interest Debt Interest

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Example: Diminishing Value of Tax Shield

Between $0 and $500 in debt payments Between $500 and $1000 in debt payments

Debt Supply
Downward sloping because effective tax rate drops and Cannot deduct interest in all states of the world %

Taxable Income
500 250 50%
125

E[After Tax Income]

Effective Tax Rate

Highest Rate Willing

Debt Debt Interest

0 2000 250

1000 750 50%

375

1500 1250 50%

625

2000 1750 50%

875

625

50%

20%

20% 16% 13.3% 11.4% 10%

Tax rate After Tax Inc. Debt Interest 6000 750

.1/(1-.50)

500

50%

20%

0 0%
0

250 50%
125

750 50%
375

1250 50%
625
.1/(1-.375)

Tax rate After Tax Inc.

312.5

37.5%

16%

$4K

$8K

$12K $16K

amount of all bonds

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Downward Sloping Debt Supply

Implications
Many firms use leasing a non-debt tax shield
Leasing lowers the value of the debt tax shield
rD = r0 1 1 ipb

In a recession Debt Supply curve drops Capital Structure IS relevant

VL

r*

1 rS = r0 j 1 C
$
amount of all bonds

Mille

r6 3
DeAngelo and Masulis (1980) MM58

VU

r* =

(1 ) = (1 )
pb D* C

r0

r0

Effective Tax Rate at given level of debt

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Debt
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Relaxing more M&M58 Assumptions

Relaxing Assumptions of
No wealth transfers and Fixed Investments

Under Investment

Agency Problems
1. Under investment 2. Risk Sharing 3. Milking the firm

Under Investment: when the shareholders in a firm near bankruptcy instruct management not to invest in a positive NPV project because it will only benefit bond holders Consider an example
3 time periods 2 projects r = 0% Risk Neutral investors

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Under Investment Example

Two projects have the following cash flows:
A B Cash Flow to Equity t=0 -50 0 -50 t=1 100 -75 25 t=2 50 100 150 NPV 100 25 125

Under Investment Example

Consider if the firm takes the bond, but only project A:
t=0 120 -50 70 t=1 -20 100 80 t=2 -100 50 0 NPV

CF of Bond CF of A Cash Flow to Equity

150

Suppose there is a bond in the capital structure that matures at t=2

Bond A+B Cash Flow to Equity t=0 120 -50 70 t=1 -20 25 5 t=2 -100 150 50 NPV 0 25 125
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If bond holders pay $120 for bonds expecting projects A & B will be done, the bond holders are ripped off.
If they knew they d only be willing to pay $70 for the bond paying $120
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Under Investment Example

If they pay $70 for the bond paying $120:
CF of Bond CF of A&B Cash Flow to Equity t=0 70 -50 20 t=1 -20 25 5 t=2 -100 150 50 NPV -50

Under Investment Example

t=0 70 -50 20 t=1 -20 100 80 t=2 -50 50 0 NPV 0 100 100

CF of Bond Only A Cash Flow to Equity

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If instead they just commit to the $70 bond:

CF of Bond Only A Cash Flow to Equity t=0 70 -50 20 t=1 -20 100 80 t=2 -50 50 0 NPV 0 100 100
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Firm has no incentive to do both A & B If the firm cannot credibly commit to A & B then only A is sustainable. But this is not optimal: the NPV from taking both projects (if they could commit) is 125
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2) Risk shifting

Risk Shifting

Payoffs to bond and equity holders in a firm with debt:

$ Equity Pay Offs

Debt Pay Offs

With debt, riskier projects are better for equity holders Share holders especially prefer high risk projects near bankruptcy Potential bond holders anticipate this and are willing to pay less for debt Who loses out?

Vfirm

Payoffs to Equity like a call: = Vequity Payoffs to Bonds like writing a put
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The equity holders pay the cost of not being able to credibly commit

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3) Milking the property

Bond Holder wealth expropriation

Jensen and Meckling (1976)
Agency Cost of Debt

In financial distress pay more to shareholders:

CF Equity CF to Debt CF Equity CF to Debt t=0 $750 0 0 0 t=1 0 0 $100 $1,000 Take $$ and run Leave Assets in Place

$ Cost Agency Cost of Debt

Bond holders insist on covenants as a part of the contract to protect their wealth from expropriation by shareholders.
Optimal Capital Structure
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Agency Cost of Equity D D+S

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Jensen and Meckling (1976)

Typical Bond Indenture Provisions
1. 2. 3. 4. Restrictions on dividend payouts Restrictions on issuance of new debt Restrictions on merger activity Restrictions on the disposition of firm assets

Signaling
Firms choose their capital structure to communicate signals about the quantity of the projects/firm to the market Implicit in M&M58 is that the market knows the cash flows. But they don t.
The market values the perceived cash flows

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Ross (1977)

Ackerlof (1970): The market for Lemons

Capital structure may change the perception of risk w/o actual changes in return Example:
Suppose D* is the maximum debt a bad firm can take w/o going bankrupt Good firms can take on D* or more without the risk of bankruptcy

4 types of cars:
New/Used Good/Bad

When you buy a new car you don t know if it is good or bad. Over time an information asymmetry develops
Owners (sellers) know the quality - - Buyers don t

For equilibrium, signals must be

Unambiguous Managers must have the incentive to tell the truth
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Ackerlof (1970): The market for Lemons

Example: Costly Signaling Spence (1973)

Job seeker of one of two types:

Buyers can t tell the difference between good and bad cars
so they offer the same price for each type good or bad.

Productive Unproductive

Implication: Good cars are not traded only bad cars are. Costly signals can solve the problem.
Idea: find a signal that is too costly for the bad to use, but cheap for the good.

Suppose education is costly

Productive: Cost = x yrs Unproductive: Cost = 1 x yrs

Offer a high wage to those who get at least Y* years of education and a low (or no) wage to those that don t
But employers cannot offer so much that it is valuable for unproductive workers to get an education
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Pooling vs. Separating Equilibrium

Pooling vs. Separating Equilibrium

Suppose there are two types of firms: Hi & Lo Lo could not maintain a certain level of Debt, D*, because of
Low profits or high volatility (risking bankruptcy)

If wages, in the example, are too high we have a pooling equilibrium: you can t tell the good from the bad. If wages are set high enough to entice high productivity workers, but low enough to not make it worth while for low productivity, then we have a separating equilibrium: the bad choose not to get an education and the good do.

But High can. Ross(1977) suggested that if E[profit] does not equal actual profit, then high quality firms can raise their value, by signaling their quality through choosing a level of Debt D*

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Pecking Order Hypothesis/Conjecture

Frank and Goyal (2003)

Pecking Order Hypothesis/Conjecture doesn t hold up so well

Myers and Majluf (1984) and Myers (1984) Managers know the true value of the firm. Outsiders don t
Adverse selection costs caused by information asymmetry

If a project comes along managers first use

1. Retained earnings
No adverse selection costs Debt is a costly commitment

1. Should work best for small high growth firms but in fact it best explains large low growth firms in the 70 s and 80 s 2. External financing is prevelant and large 3. Equity Capital is often larger than Debt in firms

2. Debt 3. External equity financing

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Dividends: How dividends are paid

Declaration date: date when the size of the dividend is stated Ex-dividend date: the first date the stock trades without the declared dividend Record date: the date, 2 days after the ex-dividend date, on which the company sees who owns their shares. Payable date: is the date the dividend checks are sent out.

Dividend Policy in Brief

Like M&M 58, Dividend Policy should be irrelevant to the value of the firm Given that dividends are tax disadvantaged (taxed as income at higher rates until 2003) they shouldn t be used.
Investors prefer repurchases (because of taxes)

Dividend policy cannot affect the present value of cash flows only when we receive them
Accelerating payments does NOT reduce uncertainty of cash flows and price drop on ex-dividend date will be larger

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Empirical Dividend Policy

Litner (1956) surveyed 28 companies, managers:
1. 2. 3. 4. Focus on the change in dividend, not the amount Avoid making dividend changes that have to be reversed Change dividends if earnings are out of line Pay little attention to need for investment

Empirical Dividend Policy

Brav, Graham, Harvey & Michaely (2003)
Cut dividends only under extra ordinary circumstances
Tend to smooth dividends Changes linked to long term changes in profitability

Repurchases are more flexible

Used for temporary earnings spikes after investment needs are met

Repurchase when stock prices are low Repurchase to improve EPS

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Optimal Dividend Policy?

Without taxes there is none.
If there are taxes choose the cheapest
<Pg 5 of notes>

The Bird in the Hand Fallacy [Bhattacharya (1979)]

Many have argued that when cash flows are uncertain paying dividends sooner reduces uncertainty
A bird in the hand is worth two in the bush

The Bird in the Hand Fallacy

Bhattacharya (1979) points out that dividend policy can t change the present value of cash flows received only the timing.
What is relevant is the riskiness of cash flows

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Optimal Dividend Policy?

Without taxes there is none.
If there are taxes choose the cheapest

Optimal Dividend Policy

Marsalis and Truman (1988):
Cost vs. Benefit of internal vs. external financing
Equilibrium is when after tax return is the same to reinvestment and dividends

Marsalis and Truman (1988) model personal taxes on dividends

Implication Cost of Internal capital is lower than external funds (if dividends are tax disadvantaged)

High tax individuals prefer reinvestment Low tax prefer dividends (tax clienteles) Firms with positive NPV projects will use up internally generated fund first Firms with fewer growth options will pay dividends Decreases in current earnings should leave investment unchanged in firms that use external capital and decrease investment in firms using internal capital Shareholder disagreement about investment policy will lead to the use of internal funds
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Evidence: Clientele Effects

Low tax investors buy high dividend yield stocks
Elton and Gruber (1970)
Ex-date price decline div

Dividends as Signaling
Ross (1977) Dividends are irrelevant in part because M&M61 assume investors know random returns
Capital structure can be used to signal the quality of the firm

Bhattacharya (1979)
Dividends can be a costly signal because less successful firms would have to finance externally Trade off between signaling benefit and Tax Consequences

Possible Caveat: Tax Arbitrage [Kalay, 1977, 1982]

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Repurchases
With tax dividends taxed at a higher rate, repurchases are a way to distribute cash to share holders at the lower capital gains tax rate
IRS is not dumb though: frequent repurchases will be taxed like dividends

Guay and Harford (2000)

When Dividends? When Repurchase?
Dividends: permanent cash flows Repurchase: transient cash flows

Open market repurchase

Buy back over time

Hypotheses: Why repurchase?

1. Signaling: Signal of increased cash flows OR exhausted investment opportunities 2. Tax shield: repurchase shares with new debt issue 3. Avoiding taxes: Section 302: Substantially disproportionate 4. Bond holder wealth expropriation: reduce asset base 5. Wealth transfer among share holders
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Tender offer:
number of shares, tender price, expiration of offer If over subscribed, repurchase on a pro rata basis If undersubscribed, extend or cancel

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Guay and Harford (2000): Findings

Evidence most consistent with
Tax shield Tax avoidance

Evidence of Dividends as a costly signal is mixed

Information about current dividends does not help forecast earnings [Watts (1973), Gonedes (1978), Penman (1983)]
Earnings changes predict dividend changes, but not the other way around [Benartzi, Michaely and Thaler (1997)]. Dividend decreases precede HIGHER earnings

But signals favorable information about future cash flows.

Market reaction to dividend changes larger when taxes are higher [Grullon and Michaely (2001)] Similar reactions in Germany, where dividends are tax favors (they are less of a signal) [Amihud and Murgia (1997)] Might signal changes in systematic risk [Grullon, Michaely and Swaminathan, 2002]
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Firm as a Nexus of Contracts

The firm is a set of contracting relationships Where there may exist externalities to the contracting process

Externalities

Externalities are the by product of a (productive) process that imposes harm (or benefits) to other agents
Pollution Cattle Rancher/Farmer Problem
A rancher trying to water his cattle tramples the field of a farmer
The externality is the destroyed crop

One agent maximizing profits imposes costs on another

Principle-Agent realm: one agent maximizing utility imposes costs on the principle

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Coase (1960)

Coase Theorem
Efficiency occurs regardless of the structure

Property Rights: The socially enforced right to select uses of goods Coase Theorem:
In the absence of transactions costs the allocation of resources does not depend on the initial disposition of property rights. Assuming
No transactions costs Trade-able property rights No income effects
Bottom p4 then p3
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The Coase Theorem is an Organizational Irrelevance Theorem

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Firm as the Nexus of Contracts: Coase (1937)

Boundaries of the Firm

Transactions costs help dictate the boundaries and structure of the firm Activities which are less costly to internalize are made part of the firm otherwise external The essence of Coase (1937)
It is in the interest of individuals to explore gains to trade It is in the interest of individuals to explore contracts to minimize costs

In market economies coordination of activity is does through the pricing mechnism Why do we have firms which entirely remove prices from the production coordination process? Answer: There are costs to using the price mechanism
Discovering Prices Negotiation Taxes

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If a research paper says

If a research paper says an organizational feature is important, you must ask:
What is the ill-defined property right? What is the transaction cost ? that makes this feature important?

Jensen and Meckling (1976)

Firm is a set of contracting relationships among individuals Imperfect contracting leads to agency problems

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Jensen and Meckling (1976)

Jensen and Meckling (1976)

If a owner/manager owns only 95%:
The manager expends effort to the point where the marginal utility of $1 of expenditure of firm resources equals marginal benefit of 95 cents purchasing power
Partial ownership leads to less vigorous effort Perquisite consumption

When owner/manager owns 100% of firm there are no agency costs. The manager maximizes his or her own utility.
Sets Marginal Utility derived from $1 of expenditure of firm resources = Marginal Utility of $1 in purchasing power (from dividends paid) Perquisite consumption not a problem

Agency costs arise because contracts cannot be written and enforced with no cost
Coase (1960):
Contracts define the rights, but There are significant transaction costs.

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Jensen and Meckling (1976)

Agency Costs are:
1. Costs of Structuring a set of contracts 2. Costs of Monitoring and Controlling the behavior of agents by principles 3. Costs of bonding to guarantee that agents make optimal decisions
Or that principles are compensated for suboptimal decisions

Jensen and Meckling (1976)

Agency costs affect the level of Debt
Bankruptcy liquidation is a hard tool against managers
$ Cost Agency Cost of Debt

4. Welfare loss arises from the divergence between agent s decisions and those which maximize the principle s welfare.

Agency Cost of Equity Optimal Capital Structure

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D D+S
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