Lecture 1: Introduction, Optimal financing contracts, Debt

Transcription

1 Corporate finance theory studies how firms are financed (public and private debt, equity, retained earnings); Jensen and Meckling (1976) introduced agency costs in corporate finance theory (not only the direct costs of compensation and monitoring the agent/manager/borrower, but also the indirect costs - welfare loss due to the inefficient decisions by the agent/manager/borrower); What kind of inefficient decisions? Private benefits; Empire-building (overinvestment); Debt overhang - underinvestment (borrower cannot raise new funding for profitable project, unless he renegotiates debt terms with initial investors); Asset substitution (take actions increasing risks);

2 Assets Accounts receivable Cash Inventories =Current Assets Fixed Assets Intangible Assets =Total Assets Liabilities Accounts payable Current Debt =Current Liabilities Long Term Debt =Total Liabilities Equity =Total Liabilities+Equity

3 Firms in bank-based financial systems (Germany, Japan) do not have higher debt ratios than in market-based systems (US, UK): Rajan and Zingales, 1995, JF; Adjusted Adjusted Total Liabilities Total Debt Total Liabilities Total Debt to Total Assets to Net Assets to Total Assets to Net Assets US Japan Germany France Italy UK Canada

4 Balance sheet entries are adjusted: Accounts receivable from 13 to 29% and Accounts payable from 12 to 17%; Pension liabilities included in the balance sheet in Germany; Consolidated vs non-consolidate balance sheet; Liquidity provisions and off-balance sheet arrangements; After adjustments (Table III, Panel B): UK and Germany have lowest debt ratios, and the rest of G7 countries have higher (and similar) values; UK and Germany also have the highest legal protection of creditor rights (US is other extreme, with law biased in favor of keeping-the-firm-running ); This suggests that UK and German law might result in too much liquidation (inefficient) and this leads to less debt;

5 Investors(claim holders) need to exert their control over the agent/borrower/manager. In addition, when ownership is dispersed, it rises additional conflicts of interests between claim holders; Corporate governance - how to balance limits on the managerial discretion, and small investor protection (concentrated control rights make it easier to control management, but might hurt small investors); Arrangements: one share - one vote; shareholder voting trusts; modern corporation: management(ceo)+board of directors (ALL stakeholders might be represented - shareholders, managers, workers, large lenders, local community);

6 Unlike leverage, control rights differ a lot across countries; La Porta et al. (1999): countries with good shareholder protection have more dispersed ownership (three largest shareholders concentration ratio is 0.19 in UK, 0.34 in France and 0.48 in Germany (listed firms)); Shleifer and Vishny (1986): among Fortune 500 firms the average holding of the largest shareholder is 15.4%; In Faccio and Lang (2002), the share of firms where the largest owner has less than 20% of control rights is 0.13 in Italy, 0.14 in France, 0.10 in Germany, 0.39 in Sweden, and 0.63 in UK;

7 Why standard debt contracts emerge Derive from the optimal incentive contract problem Different theories of debt (assumptions on how borrower can divert funds): verifiable cash flows (Innes, 1990): cashless borrower has profitable project; borrower exerts effort and increases the project cash flows (shifts the density of cash flow distribution); if the borrower is the residual claimant (there is debt financing), his marginal benefit from exerting effort increases; standard debt contract helps to achieve the first-best effort level; semi-verifiable cash flows (costly state verification models); unverifiable cash flows;

8 Cash flows are unverifiable (Bolton and Scharfstein, 1990; 1996) Borrower s cash flows cannot be verified by the audit; Might seem like an extreme assumption, but is relevant in many cases (small firms); Incentive to repay are provided by the threat of termination of the future projects financing; Simple two-period model of debt financing to demonstrate how the incentives to repay the debt are restored;

9 t = 0 : Borrower invests I in the 2-period project, funds are provided by the investor; t = 1 : Cash flows are R 1 with probability p, or 0 with probability 1 p; Borrower decides whether to repay D to the investor; Investor decides whether to terminate the contract and liquidate (sell) the assets-in-place for price L < I (investment is risky); t = 2 : If project was note terminated, cash flows are R 2 0; If terminated, R 2 = 0;

10 Assume liquidation is inefficient: L < R 2 and that R 1 > D; Other interpretation of L: savings on not investing in period t = 1, which could bring R 2 ; Debt contract specifies: Investment I, repayment D at t = 1, probability y 1 to continue the project if repayment is D,and probability y 0 to continue the project if repayment is lower than D;

11 Constraints: IC(b) : R 1 D + y 1 R 2 R 1 + y 0 R 2 or (y 1 y 0 )R 2 D IR(i) : pd + (1 p)(1 y 0 )L I max D,y 0,y 1 p(r 1 D + y 1 R 2 ) + (1 p)y 0 R 2 IR(i) is binding (otherwise could decrease D, and it would increase utility of the borrower); y 1 = 1, (otherwise if y 1 < 1, could increase y 1, this would relax IC(b) and would increase utility); IC(b) is binding also;

12 Use two constraints { to solve} for y 0 : I 1 y 0 = min 1, pr 2+L(1 p) ; y 1 = 1; { } R D = min R 2, 2I pr 2+L(1 p) ; Characteristics of standard debt contract: if y 0 = 0 - bankruptcy filing; borrow I, repayment D; Threat of termination provides incentives for repayment Termination is less likely in case repayment is 0 in t = 1 if: (1) R 2 is higher (large stake to loose?); (2) L is higher;

13 Inefficiencies arise here because we terminate profitable projects (at least sometimes), and L < R 2 ; Model is also related to the sovereign debt literature;

14 Evidence on creditors control rights (interpreted as liquidation in the model) (Dahiya et al., 2003, JFE); For companies filing the bankruptcy ( enter Chapter 11 ), control rights are obtained by the major debt-holders(banks) (for example, incumbent CEO are replaced, special creditor rights, revolving credit, restrictive covenants); Same holds for the companies which use debtor-in-possession (DIP) financing; Recent evidence on substantial creditor control rights not only in the situation of defaults, but also in normal times (Chava and Roberts, 2008, JF; Nini et al., 2009, JFE); Creditors often impose restrictions on the borrowers investment, restrict credit availability, increase interest rates; BUT: This concerns ONLY private debt (banks, syndicated loan participants);

15 After the decision to terminate the project was taken, there is cake-at-the table (R 2 L); It is profitable to renegotiate: borrower bribes investor with L + ε and asks him not to terminate the project; Investor rationally excepts the bribe and never terminates; Understanding this, borrower never repays D (strategic defaults); Investor never invests (remember that L < I ); This contract is not renegotiation-proof if termination is not explicitly written in the contract (termination threat has to be credible);

16 Bolton and Scharfstein (1996) study this problem of renegotiation, and describe the impact of lender dispersion on the optimal contract (possibility for renegotiation might be different depending on the number of lender); Having more investors has positive and negative consequences for the borrower; Assets sold at liquidation to a single buyer are worth more than the collection of their parts sold to many buyers; (1) If there are many investors, and the borrower decided to default strategically, he has to pay more the investors in order to persuade them not terminate the project; This disciplines the borrower (manager), and prevents him from defaulting strategically, facilitates borrowing;

17 (2) But if the default is because of R 1 = 0 (borrower has no cash), investors have to look at the second-hand market to sell the assets; Because there are more investors, they are less likely to find a buyer (buyer would need to pay more), and have lower value from liquidation; As a result, borrower liquidates more often, and there is less financing; Debt contract renegotiation is very likely, 90% of loan contracts are renegotiated before maturity (Roberts and Sufi, 2009, JFE);

18 Cash flows are semi-verifiable (Townsend, 1979) Borrowers repay because of the threat of cash flow verification (audit) by outside investors; one-period project needs outside investment I ; project gross returns R [0, ), with density f (R); R is observed only by the borrower, contract cannot be written based on the realized R; there is a possibility of costly verification (cost K paid by the investor), which allows to learn true R; and the following condition is satisfied (project is profitable even if always verify): Rf (R)dR I + K; 0

19 Describe most general financing contract (terms of contract): Borrower has a strategy to report R(R) (reports truth or not); let w( R) be the repayment from the borrower to the investor as a function of reported R; y( R) is the probability of verification; If no verification, investor gets w( R); If verification, investor gets w( R, R); One possibility is to verify always: y = 1;

20 Standard debt contract: specify threshold D; - borrower reports R D, no verification, w( R) = D; - borrower reports R < D, verification, w( R, R) = min{r, D};

21 Optimal contract maximizes borrower s payoff: Borrower reports the truth: [R w(r)]f (R)dR max y( R),w( R),w( R,R) 0 IC(b) : w(r) = max{y( R)(R w( R, R)) + (1 y( R))(R w( R))} Investor breaks even: IR(i) : [w(r)]f (R)dR I + [Ky(R)]f (R)dR 0 min y( R),w( R),w( R,R) 0 [Ky(R)]f (R)dR minimize verification costs, s.t. two constraints 0

22 Show that standard debt contract is the solution to the maximization problem above: (1) Show that for any contract (A) satisfying IC(b), IR(i), there exists a contract (B) which pays more to the investors with smaller auditing costs; (2) For the contract (B) there exists a standard debt contract (C), where investors break-even and audit costs are even lower. (3) This proves that standard debt contract (C) is not worse (and may be better) than contract (A);

23 Start with any candidate contract (A)

24 For non-verification we can set the repayment to constant w(r) = D (if two different repayment levels w 2 (R) > w 1 (R) both result in no-verification, borrower would rather repay always w 1 (R), and never w 2 (R) )

25 Repayment in verification regions cannot be higher than in non-verification

26 This contract (B) below provides higher expected repayment to the investors than the contract before, and also lowers the auditing costs; IR(i) is not binding any more

27 No, we decrease the repayment to the investors and decrease further the audit costs so that IR(i) is binding again to obtain the standard debt contract (C) that satisfies constraints IR(i) and IC(b) This standard debt contract (C) provides not lower, and possibly even higher payoff to the borrower compared to the contract (A).

28 Interpretation of the state verification costs: (1) Auditing costs; (2) Bankruptcy costs (value of the firm decreases); (3) Legal penalties on borrowers (imprisonment? loss of reputation? time spent in courts?) - similar to the penalties in Diamond (1984);