BRN482
Corporate Financial Policy
Clifford W. Smith, Jr.
Summer 2007 - Overhead 4
* Covers readings on course outline through Smith/Warner (1979)
Bond Contracts
Conflicts of Interest
 Dividend payouts
 Claim dilution
 Asset substitution
 Underinvestment
Bond Covenants
Restrictions on:
 Investment policy
 Dividend policy
 Financing policy
 Required bonding activities
Bond Covenants

Restrictions on Investment
–
Direct restrictions on investment of
physical assets seldom observed
–
Restrictions on financial investments
–
Restrictions on disposition of assets
–
Security provisions (i.e. mortgage loans)
–
Asset maintenance
–
Restrictions on mergers
Mergers
Under what circumstances are bondholders
made better off or worse off by a merger?
Mergers
 Under what circumstances are bondholders
made better off or worse off by a merger?
 Suppose bondholders in the old firms
receive bonds in the new firm with equal
priority and the same contract provisions as
before.
BA(V, F, T, σ2 , r, DIV) vs BAB(V, F, T, σ2, r, DIV)
Mergers
Benchmark Case:
VA + VB = VAB
FA / VA = FAB / VAB = FB / VB
TA = T B
σ2A = σ2AB = σ2B; ρAB = 1
DIVA = DIVAB = DIVB
In this benchmark case, the merger should leave the
value of the bonds roughly unchanged
Mergers
Deviations from the benchmark case.
Suppose:
BA
VA + VB < VAB
FA / VA < FAB / VAB < FB / VB
TA < TB
σ2A < σ2AB < σ2B
σ2A > σ2AB < σ2B
DIVA < DIVAB < DIVB
BB
Mergers
Deviations from the benchmark case.
Suppose:
BA
+
VA + VB < VAB
FA / VA < FAB / VAB < FB / VB
-
BB
+
+
TA < TB
+
-
σ2A < σ2AB < σ2B
-
+
σ2A > σ2AB < σ2B
+
+
DIVA < DIVAB < DIVB
-
+
Mergers
In what type of firms will bondholders be
most concerned about mergers?
 low debt
 low variance
 low dividend
 bonds with long maturity
Solutions to the
Underinvestment Problem
Restrictions on dividends
 Suppose I agree to a maximum
dividend payment of $25 per period
until the bond is repaid.
Dividend Restrictions
Time
Project
0
1
2
A
-50
100
50
B
–
-75
100
Bond
120
-20
-100
Max Div = 25
Dividend Restrictions
Time
Project
NVP
0
1
2
A
-50
100
50
B
–
-75
100
Bond
120
-20
-100
25
25
75
Max Div = 25
Div(A+B)
= 125
Dividend Restrictions
Time
Project
NVP
0
1
2
A
-50
100
50
B
–
-75
100
Bond
120
-20
-100
DIV(A+B)
25
25
75
= 125
DIV(A-)
25
25
50
= 100
Max Div = 25
Who Benefits from
Dividend Restrictions

Without Restriction
Bond
70
-20
-50
DIV
20
80
–

=
100
=
125
With Dividend Restriction
Bond
DIV
(A+B)
120
-20
-100
25
25
75
Bond Covenants
Restrictions on Dividends
Earnings and
Stock Sales
Dividend
Reservoir
Dividends
Dividend Restrictions
 Inventory for Dividends
 Dividend Constraint
Dt < max [ 0, Dt* ]
Dividend Restrictions
 Cash Flow Identity
Uses of Funds = Sources of Funds
Dt + Rt + Pt + It = CFt + St + Bt
Dividend Restrictions
 Cash Flow Identity
Uses of Funds = Sources of Funds
Dt + Rt + Pt + It = CFt + St + Bt
CFt = Et + DEPt + Rt + Lt
Dt = Et + DEPt + Lt + St + Bt - Pt - It
Dividend Restrictions
 Combining the cash flow identity with
the dividend constraint yields*
* Assuming the Dip, D = 0
Dividend Restrictions
 Combining the cash flow identity with the
dividend constraint yields
Dividend Restrictions
 Combining the cash flow identity with the
dividend constraint yields
Book Value   Book Value
of Debt
of Assets
Dividend Restrictions
 Combining the cash flow identity with the
dividend constraint yields
Book Value   Book Value
of Debt
of Assets
 Placing a ceiling on dividends effectively
places a floor on real investment
Dividend Restrictions
Dividend Restrictions
 Improve dividend payout problem
 Improve claim dilution problem
 Improve underinvestment problem
 May exacerbate asset substitution problem
Restrictions on Financing
 Option pricing analysis might lead you to
predict "me first" rules in bond contracts
 Instead, we observe restrictions on financial
ratios such as:
funded debt
net tangible assets
interest expense
earnings
Restrictions on Financing
Use of balance sheet vs
income statement for financing restrictions
Other Financing Issues
 Leasing
 Convertible Bonds
 Callable Bonds
 Sinking Funds
Solutions to the
Underinvestment Problem
Sinking fund provisions

A bond with a sinking fund provides
for the repayment of some of the
principle before expiration
Sinking Funds
Time
Project
0
1
2
A
-50
100
50
B
–
-75
100
120
-60
-60
Bond
Sinking Funds
Time
Project
0
1
2
A
-50
100
50
B
–
-75
100
120
-60
-60
Bond
DIVA+B=
35
+
0 +
90 = 125
Sinking Funds
Time
Project
0
1
2
A
-50
100
50
B
–
-75
100
120
-60
-60
Bond
DIVA+B =
35
+
0 +
90 = 125
DIV A- =
70
+
40 +
0 = 110
Bonding Activities
 All financial statements sent to stockholders
must also be sent to bondholders
 Specify accounting techniques (GAAP)
 Financial Reports Audited by Independent
Auditor
 Officers Certificate of Compliance
 Purchase of Insurance