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I examine the effects of information asymmetry–driven mispricing on security issuance. Using predisclosure changes in purchase obligations as a proxy for information asymmetry–driven mispricing, I find that managers avoid (prefer) issuing securities when they perceive their firms to be undervalued (overvalued). The effects of information asymmetry–driven mispricing are stronger on equity issuance than debt issuance. Consequently, undervaluation (overvaluation) causes an increase (decrease) in leverage. These effects are more pronounced for firms, periods, and securities associated with greater information asymmetry. The stock‐trading patterns that managers follow suggest that their perceived mispricing is an important factor in both private and firm‐level decisions.

We estimate real losses arising from the cross‐sectional misallocation of financial liabilities. Extending a production‐based framework of misallocation measurement to the liabilities side of the balance sheet and using manufacturing firm data from the United States and China, we find significant misallocation of debt and equity in China but not the United States. Reallocating liabilities of firms in China to mimic U.S. efficiency would produce gains of 51% to 69% in real value‐added, with only 17% to 21% stemming from inefficient debt‐equity combinations. For Chinese firms that are large or in developed cities, we estimate lower distortionary financing costs.

This paper studies how a financial system that is organized to efficiently create safe assets responds to macroeconomic shocks. Financial intermediaries face a cost of bearing risk, so they choose the least risky portfolio that backs their issuance of riskless deposits: a diversified pool of non-financial firms’ debt. Non-financial firms choose their capital structure to exploit the resulting segmentation between debt and equity markets. Increased safe asset demand yields larger and riskier intermediaries and more levered firms. Quantitative easing reduces the size and riskiness of intermediaries and can decrease firm leverage, despite reducing borrowing costs at the zero lower bound.

Optimal dynamic capital structure choice is fundamentally a problem of commitment. In a standard trade‐off setting with shareholder‐debtholder agency conflicts, full commitment counterfactually predicts the firm would rely almost exclusively on debt financing. Conversely, absent commitment a Modigliani‐Miller‐like value irrelevance and policy indeterminacy result holds. Thus, the content of dynamic trade‐off theory must depend on the commitment technology. In this context, collateral is valuable as a low‐cost commitment device. Because ex ante optimal commitments are likely to be suboptimal ex post, observed capital structure dynamics will exhibit hysteresis and depart significantly from standard predictions.

We show that sovereign debt impairments can have a significant effect on financial markets and real economies through a credit ratings channel. Specifically, we find that firms reduce their investment and reliance on credit markets due to a rising cost of debt capital following a sovereign rating downgrade. We identify these effects by exploiting exogenous variation in corporate ratings due to rating agencies' sovereign ceiling policies, which require that firms' ratings remain at or below the sovereign rating of their country of domicile.

We argue that corporate bond yields reflect fears of debt deflation. When debt is nominal, unexpectedly low inflation increases real liabilities and default risk. In a real business cycle model with optimal but infrequent capital structure choice, more uncertain or procyclical inflation leads to quantitatively important increases in corporate log yields in excess of default-free log yields. A panel of credit spread indexes from six developed countries shows that credit spreads rise by 14 basis points if inflation volatility or the inflation-stock correlation increases by one standard deviation.

Leverage cross-sections more than a few years apart differ markedly, with similarities evaporating as the time between them lengthens. Many firms have high and low leverage at different times, but few keep debt-to-assets ratios consistently above 0.500. Capital structure stability is the exception, not the rule, occurs primarily at low leverage, and is virtually always temporary, with many firms abandoning low leverage during the post-war boom. Industry-median leverage varies widely over time. Target-leverage models that place little or no weight on maintaining a particular ratio do a good job replicating the substantial instability of the actual leverage cross-section.

Rating agencies have become more conservative in assigning corporate credit ratings over the period 1985 to 2009; holding firm characteristics constant, average ratings have dropped by three notches. This change does not appear to be fully warranted because defaults have declined over this period. Firms affected more by conservatism issue less debt, have lower leverage, hold more cash, are less likely to obtain a debt rating, and experience lower growth. Their debt spreads are lower than those of unaffected firms with the same rating, which implies that the market partly undoes the impact of conservatism on debt prices. This evidence suggests that firms and capital markets do not perceive the increase in conservatism to be fully warranted.

Contrary to recent accounts of off-balance-sheet securitization by financial firms, we show that asset securitization by nonfinancial firms provides a valuable form of financing for shareholders without harming debtholders. Using data from firms� SEC filings, we find that securitization is attractive to firms in the middle of the credit quality distribution, which are the firms with the most to gain. Upon initiation, firms experience positive abnormal stock returns and zero abnormal bond returns, and largely use the securitization proceeds to repay existing debt. Securitization minimizes financing costs by reducing expected bankruptcy costs and providing access to segmented credit markets.

We show that peer firms play an important role in determining corporate capital structures and financial policies. In large part, firms' financing decisions are responses to the financing decisions and, to a lesser extent, the characteristics of peer firms. These peer effects are more important for capital structure determination than most previously identified determinants. Furthermore, smaller, less successful firms are highly sensitive to their larger, more successful peers, but not vice versa. We also quantify the externalities generated by peer effects, which can amplify the impact of changes in exogenous determinants on leverage by over 70%.

Private equity funds pay particular attention to capital structure when executing leveraged buyouts, creating an interesting setting for examining capital structure theories. Using a large, international sample of buyouts from 1980 to 2008, we find that buyout leverage is unrelated to the cross-sectional factors, suggested by traditional capital structure theories, that drive public firm leverage. Instead, variation in economy-wide credit conditions is the main determinant of leverage in buyouts. Higher deal leverage is associated with higher transaction prices and lower buyout fund returns, suggesting that acquirers overpay when access to credit is easier.

To produce significant net present value, an entrepreneur has to differentiate her enterprise from the ordinary. To take collaborators with her, she needs to have substantial ownership, and thus financing. But it is hard to raise finance against differentiated assets. So an entrepreneur has to commit to undertake a second transformation, standardization, that will make the human capital in the firm, including her own, replaceable, so that outside financiers obtain control rights that will allow them to be repaid. A vibrant stock market helps the entrepreneur commit to these two transformations. The nature of firms and financing are intimately linked. ONE OF THE CORNERSTONES of modern corporate finance is the Modigliani-Miller Theorem, which essentially says that, in a world where investors can borrow and lend as easily as corporations, the value of a firm is determined by the present discounted value of its expected cash flows, and not by how these cash flows are allocated to various claimholders. A firm's capital structure is therefore irrelevant to its value, or taken literally, much of what corporate finance spends its time on is of second-order importance. Corporate finance researchers have spent the years since Modigliani and Miller (1958) trying to prove the value of their field by challenging one as- sumption after another of the near-perfect world that Modigliani and Miller postulate. Modigliani and Miller themselves acknowledge the tax deductability of interest, which would imply that firm value should increase with leverage. Seminal contributions by Jensen and Meckling (1976) and Myers (1977) show that capital structure choices affect the firm's investment decisions. These con- tributions have been followed by Myers and Majluf (1984), who suggest that information asymmetries between management and investors also influence the choice of securities that are issued, and hence corporate investment, and by Jensen (1986), who proposes that debt disciplines managerial waste. Corpo- rate finance has thus responded well to the challenge posed by Modigliani and

This paper studies the presence of hedge funds in the Chapter 11 process and their effects on bankruptcy outcomes. Hedge funds strategically choose positions in the capital structure where their actions could have a bigger impact on value. Their presence, especially as unsecured creditors, helps balance power between the debtor and secured creditors. Their effect on the debtor manifests in higher probabilities of the latter’s loss of exclusive rights to file reorganization plans, CEO turnover, and adoptions of key employee retention plan, while their effect on secured creditors manifests in higher probabilities of emergence and payoffs to junior claims. THIS PAPER EXAMINES THE roles of hedge funds in Chapter 11 and the effects of their presence on the nature and outcome of the bankruptcy process. Hedge funds’ participation in the bankruptcy process takes a variety of forms, including investing in debt claims, buying equity stakes, serving on the unsecured creditors or equity committee, and pursuing a “loan-to-own” strategy, whereby a hedge fund acquires the debt of a distressed borrower with the intention of converting the acquired position into a controlling equity stake upon the firm’s emergence from Chapter 11. Using a comprehensive sample of 474 Chapter 11 cases from 1996 to 2007 formed by merging a variety of data sources, we show that hedge fund presence

Discount-rate variation is the central organizing question of current asset-pricing research. I survey facts, theories, and applications. Previously, we thought returns were unpredictable, with variation in price-dividend ratios due to variation in expected cashflows. Now it seems all price-dividend variation corresponds to discount-rate variation. We also thought that the cross-section of expected returns came from the CAPM. Now we have a zoo of new factors. I categorize discount-rate theories based on central ingredients and data sources. Incorporating discount-rate variation affects finance applications, including portfolio theory, accounting, cost of capital, capital structure, compensation, and macroeconomics.

We use exogenous variation in tax benefit functions to estimate firm-specific cost of debt functions that are conditional on company characteristics such as collateral, size, and book-to-market. By integrating the area between the benefit and cost functions, we estimate that the equilibrium net benefit of debt is 3.5% of asset value, resulting from an estimated gross benefit (cost) of debt equal to 10.4% (6.9%) of asset value. We find that the cost of being overlevered is asymmetrically higher than the cost of being underlevered and that expected default costs constitute only half of the total ex ante costs of debt. HUNDREDS OF PAPERS investigate corporate financial decisions and the factors that influence capital structure. Much theoretical work characterizes the choice between debt and equity in a trade-off context in which firms choose their optimal debt ratio by balancing the benefits and costs. Traditionally, tax savings due to the deductibility of interest have been modeled as a primary benefit of debt (Kraus and Litzenberger (1973)). Other benefits include committing managers to operate efficiently (Jensen (1986)) and engaging lenders to monitor the firm (Jensen and Meckling (1976)). The costs of debt include financial distress (Scott (1976)), personal taxes (Miller (1977)), debt overhang (Myers (1977)), and agency conflicts between managers and investors or among different groups of investors. For the most part, these theoretical predictions have been tested using reduced form regressions that attempt to explain variation in capital structure policies based on estimated slope coefficients for factors such as firm size, tax status, asset tangibility, profitability, and growth options (Rajan and Zingales (1995), Frank and Goyal (2009), Graham, Lemmon, and Schallheim (1998)).

I build a dynamic capital structure model that demonstrates how business-cycle variations in expected growth rates, economic uncertainty, and risk premia influence firms’ financing and default policies. Countercyclical fluctuations in risk prices, default probabilities, and default losses arise endogenously through firms’ responses to the macroeconomic conditions. These comovements generate large credit risk premia for investment grade firms, which helps address the “credit spread puzzle” and “under-leverage puzzle” in a unified framework. The model generates interesting dynamics for financing and defaults, including “credit contagion” and market timing of debt issuance. It also provides a novel procedure to estimate state-dependent default losses., Katherine Dusak Miller Ph.D. Fellowship in Finance

I analyze the strategic use of debt financing to improve a firm's bargaining position with an important supplier?organized labor. Because maintaining high levels of cor porate liquidity can encourage workers to raise their wage demands, a firm with external finance constraints has an incentive to use the cash flow demands of debt service to improve its bargaining position with workers. Using both firm-level collec tive bargaining coverage and state changes in labor laws to identify changes in union bargaining power, I show that strategic incentives from union bargaining appear to have a substantial impact on corporate financing decisions.

The notion that firms have debt ratio targets and that this is a primary determinant of financing behavior is influential in finance. Yet, how definitive is the available evidence? We examine this question by benchmarking the dynamics of actual debt ratios and the pattern of financing after major leverage-changing events against what is observed when samples are generated through simulations in which no target behavior is assumed. We find that the collective evidence that has been interpreted as indicative of target behavior is much weaker than is generally recognized. Specifically, the simulated data show similar reversal of the debt ratio and patterns of debt and equity issuance after major issuance activities or shocks to stock returns as in the actual data. We attribute the former to a mechanical reversal that exists on average, even with random financing, if the debt ratios are above or below a cut-off, and the latter to persistence of the financing deficit around major issuance activities. Some of the evidence in the actual data, however, can only be replicated if the simulation samples are modified to accommodate a specific type of "market timing" behavior. emmon, Roberts, and Zender (2006) find that differences in initial leverage ratios persist over time; remarkably, the simulated data exhibits similar persistence. Our results show that a firm-specific component in the time-series of the financing deficit and change in retained earnings contributes to this persistence. On the whole, however, our results indicate that there is not much to be learnt from the behavior of the debt ratios as to firms' motives for different types of financing.

We show 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 creditor actions on debt policy is strongest when the borrower’s alternative sources of finance are 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 (e.g., Scott (1976)), information asymmetry (e.g., Myers and Majluf (1984)), and more recently, market timing behavior (e.g., Baker and Wurgler (2002)). 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 (e.g., Aghion and Bolton (1992) and Dewatripont and Tirole

This paper explores the relevance of capital market supply frictions for corporate capital structure decisions. To identify this relationship, I study the effect on firms' financial structures of two changes in bank funding constraints: the 1961 emergence of the market for certificates of deposit, and the 1966 Credit Crunch. Following an expansion (contraction) in the availability of bank loans, leverage ratios of bank-dependent firms significantly increase (decrease) relative to firms with bond market access. Concurrent changes in the composition of financing sources lend further support to the role of credit supply and debt market segmentation in capital structure choice.

We find that the majority of variation in leverage ratios is driven by an unobserved time-invariant effect that generates surprisingly stable capital structures: High (low) levered firms tend to remain as such for over two decades. This feature of leverage is largely unexplained by previously identified determinants, is robust to firm exit, and is present prior to the IPO, suggesting that variation in capital structures is primarily determined by factors that remain stable for long periods of time. We then show that these results have important implications for empirical analysis attempting to understand capital structure heterogeneity.

We derive the optimal dynamic contract in a continuous-time principal-agent setting, and implement it with a capital structure (credit line, long-term debt, and equity) over which the agent controls the payout policy. While the project’s volatility and liquidation cost have little impact on the firm’s total debt capacity, they increase the use of credit versus debt. Leverage is nonstationary, and declines with past profitability. The firm may hold a compensating cash balance while borrowing (at a higher rate) through the credit line. Surprisingly, the usual conflicts between debt and equity (asset substitution, strategic default) need not arise. IN THIS PAPER, WE CONSIDER A DYNAMIC CONTRACTING ENVIRONMENT in which a riskneutral agent or entrepreneur with limited resources manages an investment activity. While the investment is profitable, it is also risky, and in the short run it can generate arbitrarily large operating losses. The agent will need outside financial support to cover such losses and continue the project. The difficulty is that while the probability distribution of the cash flows is publicly known, the agent may distort these cash flows by taking a hidden action that leads to a private benefit. Specifically, the agent may (i) conceal and divert cash flows for his own consumption, and/or (ii) stop providing costly effort, which would reduce the mean of the cash flows. Therefore, from the perspective of the principal or investors that fund the project, there is the concern that a low cash flow realization may be a result of the agent’s actions, rather than the project’s fundamentals. To provide the agent with appropriate incentives, investors control the agent’s wage, and may also withdraw their financial support for the project and force its early termination. We seek to characterize an optimal contract in this framework and relate it to the firm’s choice of capital structure. We develop a method to solve for the optimal contract, given the incentive constraints, in a continuous-time setting and study the properties of the credit line, debt, and equity that implement the contract as in the discrete-time model of DeMarzo and Fishman (2003). The continuous-time setting offers several ∗ Peter M. DeMarzo is from Stanford University and Yuliy Sannikov is from U.C. Berkeley. We

We examine the cross-sectional variation in the marginal value of corporate cash holdings that arises from differences in corporate financial policy. We begin by providing semi-quantitative predictions for the value of an extra dollar of cash depending upon the likely use of that dollar, and derive a set of intuitive hypotheses to test empirically. By examining the variation in excess stock returns over the fiscal year, we find that the marginal value of cash declines with larger cash holdings, higher leverage, better access to capital markets, and as firms choose greater cash distribution via dividends rather than repurchases. WHAT VALUE DO SHAREHOLDERS PLACE ON THE CASH THAT FIRMS HOLD, and how does that value differ across firms? While an extensive literature attempts to estimate the value of adding debt to a firm’s capital structure, the search for estimates of the value of additional cash has not received nearly as much attention. This is a non-trivial oversight considering that corporate liquidity enables firms to make investments without having to access external capital markets, and to thereby avoid both transaction costs on either debt or equity issuance and information asymmetry costs that are often associated with equity issuances. Moreover, corporate liquidity reduces the likelihood of incurring financial distress costs if the firm’s operations do not generate sufficient cash flow to service obligatory debt payments. Corporate liquidity comes at a cost, however, since interest earned on corporate cash reserves is often taxed at a higher rate than interest earned by individuals. Furthermore, cash may provide funds for managers to invest in projects that offer non-pecuniary benefits but destroy shareholder value (Jensen and Meckling (1976)). Given the extent to which the literature examines the effect of these same frictions on capital structure, it is surprising that the value implications of holding cash in the presence of these frictions have not been similarly explored. 1

This paper examines the capital structure implications of market timing. I isolate timing attempts in a single major financing event, the initial public offering, by identifying market timers as firms that go public in a hot issue market. I find that hot-market IPO firms issue substantially more equity than cold-market firms. The difference represents a genuine timing effect, as it cannot be explained by firm-level characteristics. Market timing depresses the leverage ratio substantially in the very short-run. However, the timing effect on leverage quickly reverses. Immediately after going public, hot-market firms start increasing their leverage ratios by issuing more debt and less equity relative to cold-market firms. This active reversal policy is strongly visible for two years. At the end of the second year following the IPO, the market timing impact on leverage completely vanishes. The results contrast with recent findings that suggest high persistence of market timing effects on capital structure.

Firms in more concentrated industries earn lower returns, even after controlling for size, book-to-market, momentum, and other return determinants. Explanations based on chance, measurement error, capital structure, and persistent in-sample cash flow shocks do not explain this finding. Drawing on work in industrial organization, we posit that either barriers to entry in highly concentrated industries insulate firms from undiversifiable distress risk, or firms in highly concentrated industries are less risky because they engage in less innovation, and thereby command lower expected returns. Additional time-series tests support these risk-based interpretations.

This paper examines the impact of credit ratings on capital structure decisions. I find that firms near a change in credit rating issue (retire) annually up to 1.5% less (more) debt relative to equity as a percentage of total assets than firms not near a change in rating, reflecting managers' desire to obtain upgrades and avoid downgrades of the firm's credit rating. These results are shown to be distinct from financial distress concerns. The results are robust to several model specifications and inclusion of control variables. I further show how credit rating effects complement the pecking order and tradeoff capital structure theories, and find that dummy variables, indicating firms are near a change in rating, remain predictive when nested in previous empirical tests of these theories. The results of this paper do not appear to be explained with traditional theories of capital structure, and thus this paper enhances the capital structure decision theoretical and empirical frameworks. To my knowledge, this is the first paper to show that credit ratings directly affect capital structure decision-making.

We empirically examine whether firms engage in a dynamic rebalancing of their capital structures while allowing for costly adjustment. We begin by showing that the presence of adjustment costs has significant implications for corporate financial policy and the interpretation of previous empirical results. After confirming that financing behavior is consistent with the presence of adjustment costs, we find that firms actively rebalance their leverage to stay within an optimal range. Our evidence suggests that the persistent effect of shocks on leverage observed in previous studies is more likely due to adjustment costs than indifference toward capital structure. A TRADITIONAL VIEW IN CORPORATE FINANCE is that firms strive to maintain an optimal capital structure that balances the costs and benefits associated with varying degrees of financial leverage. When firms are perturbed from this optimum, this view argues that companies respond by rebalancing their leverage back to the optimal level. However, recent empirical evidence has led researchers to question whether firms actually engage in such a dynamic rebalancing of their capital structures. Fama and French (2002), among others, note that firms’ debt ratios adjust slowly toward their targets. That is, firms appear to take a long time to return their leverage to its long-run mean or, loosely speaking, optimal level. Moreover, Baker and Wurgler (2002) document that historical efforts to time equity issuances with high market valuations have a persistent impact on corporate capital structures. This fact leads them to conclude that capital structures are the cumulative outcome of historical market timing efforts, rather than the result of a dynamic optimizing strategy. Finally, Welch (2004) finds that equity price shocks have a long-lasting effect on corporate capital structures as well. He concludes that stock returns are the primary determinant of capital structure changes and that corporate motives for net issuing activity are largely a

This paper presents an equilibrium model of industry dynamics and capital structure decisions. The unique stationary equilibrium is derived in closed-form. The analysis reveals that the interaction between capital structure and production decisions influences the stationary distribution of surviving firms and their survival probabilities. Under reasonably calibrated parameter values, the model predicts a low industry average leverage ratio which is in line with that observed in practice. Comparative static analysis demonstrates that the model can generate the relation between capital structure and firms¡¯ entry, exit and production decisions documented in the evidence. The model also provides a number of new predictions regarding industry dynamics and capital structure.

Our model assumes that creditors need to expend resources to collect on claims. Consequently, because diffuse creditors suffer from mutual free-riding (Holmstrom (1982)), they fare worse than concentrated creditors (e.g., a house bank). The model predicts that measures of debt concentration relate positively to creditors’ (aggregate) debt collection expenditures and positively to management’s chosen expenditures to resist paying. However, collection activity is purely redistributive, so social waste is larger when creditors are concentrated. If borrower quality is not known, the best firms choose the most concentrated creditors and pay higher expected yields. COORDINATION FAILURE AMONG MULTIPLE CLAIMANTS ,b ethey creditors or owners, is a subject well studied in the academic literature. Such coordination failure can lead to takeover failures (Grossman and Hart (1980)) or bank-runs (e.g., Diamond and Dybvig (1983), Morris and Shin (1999)), or can generally reduce the probability of successful renegotiation to a proposed reorganization plan when renegotiation requires simultaneous assent by many claimants (e.g., �

This study documents that managerial stock ownership plays an important role in determining corporate debt maturity. Controlling for previously identified determinants of debt maturity and modeling leverage and debt maturity as jointly endogenous, we document a significant and robust inverse relation between managerial stock ownership and corporate debt maturity. We also show that managerial stock ownership influences the relation between credit quality and debt maturity and between growth opportunities and debt maturity. THE IMPORTANCE OF LEVERAGE AND DEBT MATURITY STRUCTURE CHOICE in alleviating manager‐shareholder agency conflicts is well recognized in the finance literature. These vital decisions are at the discretion of top managers who are expected to make optimal (value-maximizing) financing choices on behalf of the shareholders. However, given the separation of ownership and control, managers cannot be expected to voluntarily choose the optimal debt maturity structure or leverage and self-impose monitoring unless there is an incentive mechanism to align managerial and shareholder interests. It is clear, therefore, that these decisions themselves are subject to an agency problem of managerial discretion. Managerial stock ownership can be effective in aligning the interests of managers and shareholders to mitigate such agency problems (see, e.g., Jensen and Meckling (1976)). We argue that the conflict between managers and shareholders over the maturity structure of debt arises from the inherent preference of self-interested managers for less monitoring. Our study adds a new dimension to the recently growing body of literature on capital structure choice in the presence of agency conflicts. By examining how managerial stock ownership determines corporate debt maturity structure, we provide evidence on an important, yet unaddressed, issue that is at the confluence of the capital structure and corporate governance literatures. Earlier capital structure studies emphasize the role of debt in reducing agency problems between managers and shareholders (see, e.g., Jensen and

THIS YEAR MARKS the fiftieth anniversary of the publication of Harry Markowitz's landmark paper, "Portfolio Selection," which appeared in the March 1952 issue of the Journal of Finance. With the hindsight of many years, we can see that this was the moment of the birth of modern financial economics. Although the baby had a healthy delivery, it had to grow into its teenage years before a hint of its full promise became apparent. What has always impressed me most about Markowitz's 1952 paper is that it seemed to come out of nowhere. Compared to the work of his 1990 co-Nobel Prize winners (Sharpe primarily for his paper on the capital asset pricing model and Miller for his paper on capital structure), Markowitz's paper seems to have more of this flavor. In 1676, Sir Isaac Newton wrote his friend Robert Hooke, "If I have seen further it is by standing on the shoulders of giants" (Newton (1959)) and that is true of Markowitz as well, but, like Newton, he certainly saw a long distance given the height of those shoulders. Markowitz was hardly the first to consider the desirability of diversification. Daniel Bernoulli in his famous 1738 article about the St. Petersburg

It is well known that firms are more likely to issue equity when their market values are high, relative to book and past market values, and to repurchase equity when their market values are low. We document that the resulting effects on capital structure are very persistent. As a consequence, current capital structure is strongly related to historical market values. The results suggest the theory that capital structure is the cumulative outcome of past attempts to time the equity market. IN CORPORATE F INANCE, “equity market timing” refers to the practice of issuing shares at high prices and repurchasing at low prices. The intention is to exploit temporary f luctuations in the cost of equity relative to the cost of other forms of capital. In the efficient and integrated capital markets studied by Modigliani and Miller ~1958!, the costs of different forms of capital do not vary independently, so there is no gain from opportunistically switching between equity and debt. In capital markets that are inefficient or segmented, by contrast, market timing benefits ongoing shareholders at the expense of entering and exiting ones. Managers thus have incentives to time the market if they think it is possible and if they care more about ongoing shareholders. In practice, equity market timing appears to be an important aspect of real corporate financial policy. There is evidence for market timing in four different kinds of studies. First, analyses of actual financing decisions show that firms tend to issue equity instead of debt when market value is high, relative to book value and past market values, and tend to repurchase equity when market value is low. 1 Second, analyses of long-run stock returns fol

Many firms emerging from a debt restructuring remain highly leveraged, continue to invest little, perform poorly, and often reenter financial distress. The existing literature interprets these findings as inefficiencies arising from coordination problems among many creditors or an inefficient design of bankruptcy law. In contrast, this paper emphasizes that creditors lack the information that is needed to make quick and correct liquidation decisions. It can explain the long-term nature of financial distress solely as the result of dynamic learning strategies of creditors and suggests that it may be an unavoidable byproduct of an efficient resolution of financial distress. FINANCIAL DISTRESS IS OFTEN a long-term process and has an impact on the capital structure, investment policies, and performance of many firms even after they emerge from debt restructurings. James (1995) finds that many firms increase their investment expenditures only by very little in the first two years after a debt restructuring. Hotchkiss (1995) shows that in each of the first five years after emerging from bankruptcy, between 35 percent and 41 percent of all firms have negative operating income. According to Gilson (1997), more than 75 percent of firms that complete debt restructurings emerge with a leverage ratio that is higher than industry median and most are still significantly more highly leveraged than before the onset of financial distress. Furthermore, between one quarter and one third of all distressed firms

This study uses a new data set to assess whether capital structure theory is portable across countries with different institutional structures. We 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. Our findings suggest that although some of the insights from modern finance theory are portable across countries, much remains to be done to understand the impact of different institutional features on capital structure choices. OUR KNOWLEDGE OF CAPITAL STRUCTURES has mostly been derived from data from developed economies that have many institutional similarities. The purpose of this paper is to analyze the capital structure choices made by companies from developing countries that have different institutional structures. The prevailing view, for example Mayer ~1990!, seems to be that financial decisions in developing countries are somehow different. Mayer is the most recent researcher to use aggregate f low of funds data to differentiate between financial systems based on the “Anglo-Saxon” capital markets model and those based on a “Continental-German-Japanese” banking model. However, because Mayer’s data comes from aggregate f low of funds data and not from individual firms, there is a problem with this approach. The differences between private, public, and foreign ownership structures have a profound inf luence on such data, but the differences may tell us little about how profit-oriented firms make their individual financial decisions. This paper uses a new firm-level database to examine the financial structures of firms in a sample of 10 developing countries. Thus, this study helps determine whether the stylized facts we have learned from studies of developed countries apply only to these markets, or whether they have more general applicability. Our focus is on answering three questions

Banks can create liquidity precisely because deposits are fragile and prone to runs. Increased uncertainty makes deposits excessively fragile, creating a role for outside bank capital. Greater bank capital reduces the probability of financial distress but also reduces liquidity creation. The quantity of capital influences the amount that banks can induce borrowers to pay. Optimal bank capital structure trades off effects on liquidity creation, costs of bank distress, and the ability to force borrower repayment. The model explains the decline in bank capital over the last two centuries. It identifies overlooked consequences of having regulatory capital requirements and deposit insurance. DOES BANK CAPITAL STRUCTURE MATTER, and if so, how should it be set? Most work on the subject extrapolates an answer from prior work on the capital structure of industrial firms. But bank assets and functions are not the same as those of industrial firms. In fact, one strand of the banking literature suggests banks have a role precisely because they do not suffer the asymmetric information costs of issuance faced by industrial firms (see Gorton and Pennacchi (1990)). Therefore, to really understand the determinants of bank capital structure, we should start by modeling the essential functions banks perform, and then ask what role capital plays. Using this approach, we can see that a bank's capital structure affects its liquiditycreation and credit-creation functions in addition to its stability. The consequent trade-offs imply an optimal bank capital structure. Because customers rely to different extents on liquidity and credit, bank capital structure also determines the nature of the bank's clientele. Our approach will help us better understand the impact of regulations such as minimum capital requirements, and also help suggest the consequences of different recapitalization policies in a banking crisis. We start by describing the functions a bank performs. Consider a world where a number of entrepreneurs each has a project in need of funding. Each entrepreneur has specific abilities vis 'a vis his project so that the cash flows he can generate exceed what anyone else can generate from it. An entrepreneur cannot commit his human capital to the project, except on a

This paper extends the theory of non-cash auctions by considering the revenue and efficiency of using different securities. Research on bankruptcy and privatization suggests using non-cash auctions to increase cash-constrained bidder participation. We examine this proposal and demonstrate that securities may lead to higher revenue. However, bidders pool unless bids include debt, which results in possible repossession by the seller. This suggests all-equity outcomes are unlikely and explains the high debt of reorganized firms. Securities also inefficiently determine bidders' incentive contracts and the firm's capital structure. Therefore, we recommend a new cash auction for an incentive contract.

We provide measures of absolute and relative equity agency costs for corporations under different ownership and management structures. Our base case is Jensen and Meckling’s ~1976! zero agency-cost firm, where the manager is the firm’s sole shareholder. We utilize a sample of 1,708 small corporations from the FRB0NSSBF database and find that agency costs ~i! are significantly higher when an outsider rather than an insider manages the firm; ~ii! are inversely related to the manager’s ownership share; ~iii! increase with the number of nonmanager shareholders, and ~iv! to a lesser extent, are lower with greater monitoring by banks. THE SOCIAL AND PRIVATE COSTS OF AN AGENT’S ACTIONS due to incomplete alignment of the agent’s and owner’s interests were brought to attention by the seminal contributions of Jensen and Meckling ~1976! on agency costs. Agency theory has also brought the roles of managerial decision rights and various external and internal monitoring and bonding mechanisms to the forefront of theoretical discussions and empirical research. Great strides have been made in demonstrating empirically the role of agency costs in financial decisions, such as in explaining the choices of capital structure, maturity structure, dividend policy, and executive compensation. However, the actual measurement of the principal variable of interest, agency costs, in both absolute and relative terms, has lagged behind. To measure absolute agency costs, a zero agency-cost base case must be observed to serve as the reference point of comparison for all other cases of ownership and management structures. In the original Jensen and Meckling agency theory, the zero agency-cost base case is, by definition, the firm owned solely by a single owner-manager. When management owns less than 100 percent of the firm’s equity, shareholders incur agency costs resulting from management’s shirking and perquisite consumption. Because of limitations imposed by personal wealth constraints, exchange regulations on the minimum numbers of shareholders, and other considerations, no publicly traded firm is entirely owned by management. Thus, Jensen and Meckling’s zero agency cost base case cannot be found among the usual sample of publicly

We estimate the internal rates of return earned by nonfinancial firms on (i) the initial market values of their securities and (ii) the cost of their investments. The return on value is an estimate of the overall corporate cost of capital. The estimate of the real cost of capital for 1950-96 is 5.95 percent. The real return on cost is larger, 7.38 percent, so on average corporate investment seems to be profitable. A by-product of calculating these returns is information about the history of corporate earnings, investment, and financing decisions that is perhaps more interesting than the returns. WHAT IS THE OVERALL COST of capital for U.S. nonfinancial corporations? Does the rate of return on investment exceed this cost of capital? How do firms finance investment? We address these questions. The standard textbook prescription calls for estimating a firm's cost of capital as a weighted average of the expected returns on its securities. Putting aside the difficult problem of estimating expected returns, this approach is straightforward for individual firms since the mix of securities in a firm's capital structure and the rates it pays on various forms of debt are known. But problems arise at the aggregate corporate level. For example, it is difficult to estimate aggregate quantities and returns for privately placed debt, and privately placed debt is a common form of corporate financing. We take a different approach, less fraught with measurement problems. In effect, we treat the entire nonfinancial corporate sector as an investment project. The cost of capital for the nonfinancial sector is estimated as the internal rate of return (IRR) that equates the initial market values of firms with the present values of their post-entry net cash flows and their terminal market values, all of which are estimated accurately. The IRR on value is a useful benchmark with many potential applications. For example, it is a starting point for cost of capital estimates for individual firms, which, of course, differ from the aggregate because of differences in

The joint determination of capital structure and investment risk is examined. Optimal capital structure reflects both the tax advantages of debt less default costs (Modigliani and Miller (1958, 1963)), and the agency costs resulting from asset substitution (Jensen and Meckling (1976)). Agency costs restrict leverage and debt maturity and increase yield spreads, but their importance is small for the range of environments considered. Risk management is also examined. Hedging permits greater leverage. Even when a firm cannot precommit to hedging, it will still do so. Surprisingly, hedging benefits often are greater when agency costs are low. THE CHOICE OF INVESTMENT FINANCING, and its link with optimal risk exposure, is central to the economic performance of corporations. Financial economics has a rich literature analyzing the capital structure decision in qualitative terms. But it has provided relatively little specific guidance. In contrast with the precision offered by the Black and Scholes (1973) option pricing model and its extensions, the theory addressing capital structure remains distressingly imprecise. This has limited its application to corporate decision making. Two insights have profoundly shaped the development of capital structure theory. The arbitrage argument of Modigliani and Miller (M-M) (1958, 1963) shows that, with fixed investment decisions, nonfirm claimants must be present for capital structure to affect firm value. The optimal amount of debt balances the tax deductions provided by interest payments against the external costs of potential default. Jensen and Meckling (J-M) (1976) challenge the M-M assumption that investment decisions are independent of capital structure. Equityholders of a levered firm, for example, can potentially extract value from debtholders by increasing investment risk after debt is in place: the "asset substitution" problem. Such predatory behavior creates agency costs that the choice of capital structure must recognize and control.

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 prederegulation level of leverage on the survival of trucking firms after the Carter deregulation. Highly leveraged carriers are less likely to survive the deregulation shock, even after controlling for various measures of efficiency. This effect is stronger in the imperfectly competitive segment of the motor carrier industry. High debt seems to affect survival by curtailing investments and reducing the price per tonmile that a carrier can afford to charge after deregulation. MOST ECONOMIC THEORIES ARE either implicitly or explicitly based on an evolutionary argument: Competition and exit assure that only the most efficient firms survive. This argument implicitly relies on the existence of perfect capital markets. In the presence of capital market imperfections, efficient firms may be forced to exit due to lack of funds. Although this argument is well understood in theory (Telser (1966) and Bolton and Scharfstein (1990)), its empirical relevance is much less clear. The crucial issue in trying to assess the effects of financing choices on the survival of firms and, thus, on the product market competition is the endogeneity of capital structure choices to the industry structure. If leverage affects a firm's competitive position, then the firm's financing decisions will take this into account. As a result, in the absence of a structural model we cannot determine whether it is the product inarket competition that affects capital structure choices or a firm's capital structure that affects its competitive position and its survival. This paper attempts to address the endogeneity problem by looking at the effects of leverage on the survival of trucking firms after the Carter dereg

We provide evidence that corporate tax status is endogenous to financing decisions, which induces a spurious relation between measures of financial policy and many commonly used tax proxies. Using a forward-looking estimate of before-financing corporate marginal tax rates, we document a negative relation between operating leases and tax rates, and a positive relation between debt levels and tax rates. This is the first unambiguous evidence supporting the hypothesis that low tax rate firms lease more, and have lower debt levels, than high tax rate firms. MANY THEORIES OF CAPITAL STRUCTURE imply that, all else equal, the incentive to use debt financing increases with a firm's marginal tax rate due to the tax deductibility of interest expense (e.g., Modigliani and Miller (1963), DeAngelo and Masulis (1980)). Conversely, leasing models generally predict that firms with low marginal tax rates employ relatively more leases than do firms with high marginal tax rates. The logic behind the leasinlg prediction is that leases allow for the transfer of tax shields from firms that cannot fully utilize the associated tax deduction (lessees) to firms that can (lessors) (e.g., Myers, Dill, and Bautista (1976), Smith and Wakeman (1985), Ross, Westerfield, and Jaffe (1996)). Despite these straightforward predictions, empirically testing for tax effects is difficult because a spurious relation exists between. the financing decision and many commonly used tax proxies. Specifically, both interest expense and lease payments are tax deductible. Thus, a firm that finances its operations with debt or leases reduces its taxable income, potentially lowering its expected marginal tax rate. If not properly addressed, this endogeneity of the tax rate can bias an experiment in favor of finding a negative

The paper develops a simple model of corporate ownership structure in which costs and benefits of ownership concentration are analyzed. The model cornpares the liquidity benefits obtained through dispersed corporate ownership with the benefits from efficient management control achieved by some degree of ownership concentration. The paper reexamines the free-rider problem in corporate control in the presence of liquidity trading, derives predictions for the trade and pricing of blocks, and provides criteria for the optimal choice of ownership structure. THE RECENT INCOMPLETE CONTRACTING approach in corporate finance has considerably improved our understanding of how small firms determine their capital structure. The basic setting considered in this line of research is one where a founder-manager seeks funding from one or several financiers. The main premise is that the founder-manager, in her dealings with the financiers, is primarily concerned with maintaining her private benefits of control. For small firms these are often quite large relative to the financial returns. Thus, for a small firm the problem of determining the financial structure often reduces to the problem of how to obtain fundingr while giving away as little control as possible to the financiers. Of course, most financiers insist on some form of protection, so that the final compromise reached in most financial contracts for small firms is one resembling a debt contract (or a venture capital contract), which protects the founder-manager's control as long as the firm is performing adequately.' This perspective for small firms does not extend naturally to large firms because the private benefits of control of the managers for large firms are likely to be small relative to the firm's monetary returns, so that protection of these benefits is not an overriding consideration. Moreover, large firms

We develop an option pricing model for calls and puts written on leveraged equity in an economy with corporate taxes and bankruptcy costs. The model explains implied Black-Scholes volatility biases by relating them to the firm's structural characteristics such as leverage and debt covenants. We test the model by comparing predicted pricing biases with biases observed in a large cross-section of firms with liquid exchange traded option contracts. Our empirical study detects leverage related pricing biases. The magnitudes of these biases correspond to those predicted by our model. We also find significant pricing biases for firms financed primarily by shortterm debt. This supports our model because short-term debt introduces net-worth hurdles similar to net-worth covenants. THE DIRECT LINK BETWEEN financing decisions at the firm level and the pricing of derivative securities has, with few exceptions, been ignored in the theoretical and empirical option pricing literature. Most finance literature treats the pricing of securities in the firm's capital structure and the pricing of options on these securities as separate research areas. Securities in the capital structure are priced using an assumption about the value process of the firm's assets; hedging arguments are invoked and the firm's debt and equity are priced as contingent claims.' Most equity option pricing literature, on the other hand, uses an exogenously specified equity price process as the basis for an option pricing formula.2

When firms experience financial distress, equity holders may act strategically, forcing concessions from debtholders and paying less than the originally-contracted interest payments. This article incorporates strategic debt service in a standard, continuous time asset pricing model, developing simple closed-form expressions for debt and equity values. We find that strategic debt service can account for a substantial proportion of the premium on risky corporate debt. We analyze the efficiency implications of strategic debt service, showing that it can eliminate both direct bankruptcy costs and agency costs of debt. THE CONTINGENT CLAIMS LITERATURE on corporate debt initiated by Merton (1974) interprets risky debt as a portfolio comprising the safe asset plus a short position in a put option written on the value of the firm's underlying assets. Under appropriate assumptions about asset return distributions, this interpretation implies simple, closed-form expressions for risky bond prices. However, empirical evidence suggests that risk premia on corporate debt significantly exceed those implied by Merton's model, except if one includes unrealistically high bankruptcy costs. Recent research has suggested two approaches whereby the high, observed risk premia may be rationalized. 1. Franks and Torous (1989) document the fact that, in many bankruptcy settlements, junior claimants including equityholders receive a greater share of residual value than is consistent with absolute priority. Longstaff and Schwartz (1995) incorporate such departures from absolute priority in a contingent claims model, taking the allocation of the bankrupt firm's residual value among stakeholders as exogenously given. They show that risk premia prior to bankruptcy may be significantly boosted by expectations of deviations from absolute priority. 2. An alternative approach takes as its starting point the observation that, in many cases, debtholders in distressed firms are persuaded by equityholders to accept concessions prior to formal bankruptcy proceedings. Bergman and Callen (1991) study the extraction of such concessions by equityholders in a static model of capital structure determination. Anderson and Sundaresan (1996) include such concessions in a binomial pricing model and examine the design of debt contracts.

This article investigates the claim that debt finance can increase firm value by curtailing managers' access to "free cash flow." We first show that incentive contracts that tie the managers' pay to stockholder wealth are often a superior solution to the free cash flow problem. We then consider the possibility that the manager can trade on secondary capital markets. Liquid secondary markets are shown to undermine management incentive schemes and, in many cases, to restore the value of debt finance in controlling the free cash flow problem. THE FUNDAMENTAL INSIGHT OF the agency approach to corporate finance is that a firm's financial structure affects real decisions. While there is little doubt that financial policies have a variety of real effects, some classic agency models have recently been criticized for failing to allow management compensation to be jointly determined along with the firm's financial structure.1 The force of this critique is highlighted by analyses such as Dybvig and Zender (1991) and John and John (1993) in which management incentive contracts completely sever the link between a firm's real and financial policies, so that capital structure is either irrelevant or is determined solely by factors such as taxes. Management incentive schemes lead to capital structure irrelevance by motivating executives to make choices that maximize total firm value, regardless of the structure of claims on its cash-flows. Persons (1994) shows that this commitment role is undermined if shareholders are able to renegotiate man

This study provides evidence that transactions costs discourage debt reductions by financially distressed firms when they restructure their debt out of court. As a result, these firms remain highly leveraged and one-in-three subsequently experience financial distress. Transactions costs are significantly smaller, hence leverage falls by more and there is less recurrence of financial distress, when firms recontract in Chapter 11. Chapter 11 therefore gives financially distressed firms more flexibility to choose optimal capital structures. THIS STUDY INVESTIGATES the impact of transactions costs on leverage choices by financially distressed firms. The "transaction" that I examine is the reduction in corporate debt pursuant to a Chapter 11 bankruptcy reorganization or out of court restructuring. Analysis of sample firms shows that transactions costs are much higher when debt is restructured out of court. When firms recontract this way, financial distress can be chronic: less debt is extinguished, leverage remains higher, and relatively more firms have to go back to their creditors to restructure their debt again in the future. Transactions costs are much smaller, hence debt falls significantly more, when firms recontract in Chapter 11. Chapter 11 therefore gives financially distressed firms more flexibility to choose optimal capital structures. Transactions costs are central in the ongoing academic debate about whether firms have optimal leverage ratios. Those who believe in target

We document the determinants of the term to maturity of 7,369 bonds and notes issued between 1982 and 1993. Our main finding is that large firms with investment grade credit ratings typically borrow at the short end and at the long end and of the maturity spectrum, while firms with speculative grade credit ratings typically borrow in the middle of the maturity spectrum. This pattern is consistent with the theory that risky firms do not issue short-term debt in order to avoid inefficient liquidation, but are screened out of the long-term debt market because of the prospect of risky asset substitution. TRADITIONALLY, CAPITAL STRUCTURE RESEARCH has focused on how much of a firm's future cash flows should be paid out to debtholders instead of equityholders. An equally important issue is when future cash flows should be paid out to debtholders. A firm that finances its projects with short-term debt risks serious financial difficulty if the debt cannot be extended. Similarly, a firm that finances its activities with long-term debt can sacrifice profits by needlessly risking mismanagement of resources after cash flows are returned from investments, but before they are due to debtholders. This study investigates the factors that firms consider when choosing the maturity of their liabilities. We document the determinants of the maturity of 7,368 public debt issues made by U.S. corporations between 1982 and 1993. Our empirical tests are based on existing theoretical models that relate the maturity of a firm's borrowings to the riskiness of its cash flows, the time until investments pay off, the quality of information held by outsiders, the expected

This article examines the relation between bank debt forgiveness and the structure of public debt exchange offers in financial distress. I find that the structure of exchange offers and the likelihood of an offer's success are significantly related to whether the bank participates in the restructuring transaction. Exchange offers made in conjunction with bank concessions are characterized by significantly greater reductions in public debt outstanding and significantly less senior debt offered to bondholders. Overall, the results suggest that the structure of a firm's public and private claims significantly affects the firm's ability to modify its capital structure in financial distress. RECENT EMPIRICAL STUDIES PROVIDE apparently conflicting evidence on the relation between the mix of private and public debt in a firm's capital structure and the ability of the firm to restructure its debt outside of bankruptcy. For example, Gilson, John, and Lang (1990) find that the likelihood of a successful debt restructuring is positively related to a firm's reliance on bank borrowing. In contrast, Asquith, Gertner, and Scharfstein (1994) and James (1995) find that, for firms with public debt outstanding, banks rarely make unilateral concessions. Indeed, the latter two studies suggest that the avoidance of bankruptcy depends on the ability to restructure public, not private, debt claims.' Finally, Gilson (1994) finds less debt reduction in financial distress the higher the proportion of bank debt a firm uses. In this article, I examine the relation between bank debt restructurings and the composition of public debt exchange offers by financially distressed firms. The secured status of bank debt and institutional constraints on bank debt for equity swaps imply that banks are unlikely to provide debt forgiveness unless their claims are impaired; i.e., the face value of the bank's claim is greater than the value of the collateral net of transactions and bankruptcy costs.2 However, drawing on theoretical work by Gertner and Scharfstein (1991), I argue that bank participation in a restructuring can play an important role in resolving

The authors investigate the determinants of capital structure choice by analyzing the financing decisions of public firms in the major industrialized countries. At an aggregate level, firm leverage is fairly similar across the G-7 countries. The authors find that factors identified by previous studies as correlated in the cross-section with firm leverage in the United States are similarly correlated in other countries as well. However, a deeper examination of the U.S. and foreign evidence suggests that the theoretical underpinnings of the observed correlations are still largely unresolved. Copyright 1995 by American Finance Association.

The authors provide an empirical examination of the determinants of corporate debt maturity. Their evidence offers strong support for the contracting-cost hypothesis. Firms that have few growth options, are large, or are regulated have more long-term debt in their capital structure. The authors find little evidence that firms use the maturity structure of their debt to signal information to the market. The evidence is consistent, however, with the hypothesis that firms with larger information asymmetries issue more short-term debt. The authors find no evidence that taxes affect debt maturity. Copyright 1995 by American Finance Association.