How to finance the firm?
The theory of corporate finance.
Finance:
• asset pricing
• corporate finance
Why is corporate finance important?
The importance of providing capital to business
How does the capital market perform?
Nilssen, ”Hvordan skaffe kapital til næringslivet? Bank
kontra aksjemarked”, Norsk Økonomisk Tidsskrift 109
(1995), 27-50.
Economics of the firm - Tore Nilssen – Lecture 7: Corporate Finance I - page 1
Two sources of capital:
• banks
• stock market
Two types of capital:
• debt
• equity
• banks vs. bonds
• many vs. few owners
Which is better?
• response from old theory: doesn’t matter
• the Modigliani-Miller theorem
• taxation, bankruptcy, information
• response from policy advisers: equity / stock market
• response from modern theory: it all depends
Financial systems around the world:
• bank-dominated: Germany, Japan
• market-dominated: US, UK
• What is dominance?
Economics of the firm - Tore Nilssen – Lecture 7: Corporate Finance I - page 2
Starting point
• the forgotten source of capital: retained earnings
• policy issue: tax on profit vs. tax on dividend
• Retained earnings are more important than debt and
equity in many countries.
Corbett and Jenkinson, ”The Financing of Industry,
1970-1989: An International Comparison”, Journal of the
Japanese and International Economies vol 10 (1996).
• A higher tax rate on dividend than on profit makes equity
even more expensive
• This will shift firms towards
• retained earnings
• bank loans
• Is it wise to have firms use retained earnings?
• Retained earnings the cheapest capital
• Who have the best incentives to find the best
investment projects – managers or investors?
• What about entrepreneurs?
Economics of the firm - Tore Nilssen – Lecture 7: Corporate Finance I - page 3
The three concerns
• Do firms get as much capital as they need?
- Are profitable projects put aside because of lack of
capital?
- Norway: Johansen, Discussion Paper SSB 1994
• Is the capital well looked after?
• How does the source of capital affect the
possibilities to monitor the firms’ use of it?
• Is financial distress treated efficiently?
• Are genuinely weak firms turned bankrupt while
viable firms are brought through the difficulties?
The three informational problems
• hidden information – adverse selection
• hidden action – moral hazard
• non-verifiability – incomplete contracts
Economics of the firm - Tore Nilssen – Lecture 7: Corporate Finance I - page 4
Hidden information
• The firm’s management has better information about its
future profitability than outside investors.
• External finance is more expensive for the good firms
than if outside investors had been informed.
• Good firms stay out of the capital market.
• Bank vs. market:
• Economies of scale in collection of information:
• Banks
• Financial analysts?
• Storing information for later use
• Bank/customer relationships
Economics of the firm - Tore Nilssen – Lecture 7: Corporate Finance I - page 5
Hidden action
The firm’s management is unable to verify to outsiders
- its efforts
- the information it obtains about the
profitability of the firm’s operations
Solution: trade-off incentives / risk-sharing
Which outsider is the best at monitoring the firm’s
operations?
Banks:
• delegated monitoring
• But: does the bank get on the inside?
• not allowed to be a board member
Stock market:
monitoring done by:
• financial analysts
• institutional investors
(pension funds, etc.)
• speculators
Should banks be allowed to hold equity positions?
• makes banks’ monitoring easier
• decreases banks’ solidity
• increases banks’ power
• Germany
Economics of the firm - Tore Nilssen – Lecture 7: Corporate Finance I - page 6
Non-verifiability
Information is sometimes known to both the firm’s
management and outside investors but cannot be verified
by third parties, like courts.
• An incomplete contract between the firm and its
investors
An infeasible contract:
”The firm pays the creditor 1 million if it has enough
funds to do so”
A feasible contract:
” The firm’s management keeps control of the firm if
the firm pays as agreed. If not, then creditors take control.”
This contract does not specify what should be done, only
who has the right to decide (authority).
Debt/equity vs. allocation of control rights:
Debt → Financial distress → Transfer of control rights
According to this view, the debt/equity ratio should be high
if:
(i)
investors are good managers
(ii)
the firm’s assets are liquid
(iii)
transfer costs are low
- costs of coordinating creditors
- costs of the bankruptcy process
- Japan
Economics of the firm - Tore Nilssen – Lecture 7: Corporate Finance I - page 7
The big concern: Short-termism
Is business sufficiently long-term in its decisionmaking?
If not, is the financing to blame?
• Hidden information: Projects with quick pay-off give
investors early information about profitability. But these
projects may not be the ones that maximize net present
value.
- Long-term bank financing may be helpful
• Hidden action: Investors intervene because they do not
trust the management when earnings are low in the short
term.
- Long-term bank financing may be helpful
- But: the threat of change of ownership may be
a good thing.
• The stock market: threats of acquisitions
- Management is concerned about today’s stock
price
- Management waste resources in order to keep
outside raiders at bay.
• Ownership structure (Bøhren et al., discussion paper BI, 2004)
- individual owners vs. institutional investors
- direct vs. indirect monitoring
Economics of the firm - Tore Nilssen – Lecture 7: Corporate Finance I - page 8
Is there a conclusion?
Banks score relative to stock market because of
- long-termism
- information storage
But:
• Can we trust the banks?
- the Norwegian bank crisis
- conflicts bank management / bank owners
- German banks
• Institutional investors are important
- monitoring
- long-term ownership
- indirect vs. direct monitoring
• Internationally, financial systems are becoming
increasingly similar …
- Germany:
- Japan
- USA:
stock market more important
banks more regulated
bond market
banks less regulated
• … and were perhaps not that different after all
- the propensity to change management following a
drop in stock price is more or less the same in
Germany, Japan, and the US.
Economics of the firm - Tore Nilssen – Lecture 7: Corporate Finance I - page 9
Financing the firm
• Hidden action and conflicts of interest
- owners vs. management
- owners vs. creditors
Jensen & Meckling
• Hidden information
- The firm knows more about its value than do
outside investors
Daniel & Titman
• Product market vs. capital market
- The debt/equity ratio may affect a firm’s
ability to compete successfully in the product
market
Brander & Lewis
• Control aspects
Hart, Ch. 5
Harris & Raviv, “The Theory of Capital
Structure”, Journal of Finance vol 46 (1991).
Economics of the firm - Tore Nilssen – Lecture 7: Corporate Finance I - page 10
Hidden action and conflicts of interest
(i) Owners vs. managers:
• Owners want managers to maximize expected profits but
do not observe managers’ efforts
• A manager chooses the action that maximizes his
expected utility
• Unless the manager owns 100% of the firm, there is a
conflict of interest.
What could managers be doing?
(a) Consuming perquisites (big offices, many employees)
How does the debt/equity ratio matter?
Suppose the manager has invested EM in the firm’s stock.
Total equity is E = EM + EO. Debt is D.
Total capital is
C = E + D = EM + EO + D.
An increase in D/E by increasing D and decreasing EO,
keeping constant C and EM, increases the manager’s share
of the firm’s stock, EM/E, and reduces the conflict of
interest.
Economics of the firm - Tore Nilssen – Lecture 7: Corporate Finance I - page 11
(b) Overinvestment (e.g., acquiring too many other firms)
• Can managers be trusted that they spend the capital they
have available in an efficient way?
• The Free Cash Flow Hypothesis
- an argument for low tax on dividends
Jensen (1986)
How does the debt/equity ratio matter?
Debt
- commits the firm to make down-payments
- reduces the amount of free cash flow available
for inefficient investments
If down payments are not made, then creditors may force
liquidation and most likely a change of management.
In both cases, debt ameliorates the conflict of interest
between owners and managers.
Economics of the firm - Tore Nilssen – Lecture 7: Corporate Finance I - page 12
(ii) Debt holders vs. equity holders: Creditors vs. owners
owners’ share
creditors’ share
D
gross profit
project A
project B
With debt, owners have incentives to invest in too risky
projects – the asset substitution effect.
This makes debt expensive for the firm.
The benefit of debt: the owner-management conflict
The cost of debt: the creditor-owner conflict
Combined: an optimum debt/equity ratio.
Economics of the firm - Tore Nilssen – Lecture 7: Corporate Finance I - page 13