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Corporate finance articles

MM Proposition (1958)
I.
II.

III.

The market value of any firm is independent of its capital structure and is
given by capitalizing its expected return at the rate k appropriate to its class.
The expected yield of a share of stock is equal to the appropriate
capitalization rate pk for a pure equity stream in the class, plus a
premium related to financial risk equal to the debt-to-equity ratio times the
spread between k and r.
The cut-off point for investment in the firm will in all cases be k and will be
completely unaffected by the type of security used to finance the
investment

J. Scott (1976) presented a multipored model of debt, equity, and firm valuation.
Under the assumption that the market for real assets was imperfect, the model
implied that the value of the non-bankrupt firm was a function not only of
expected future earnings but also of the liquidating value of its assets. His
comparative statics analysis yielded three clear cut results. The optimal level of
debt was an increasing function of the liquidation value of the firms
assets, the corporate tax rate, and the size of the firm.
Bris, Welch, and Zhu (2006) find that Chapter 7 cases are systematically
different from Chapter 11 cases along with a number of dimensions such as firm
size. After controlling for self-selection (which is important and effective), Chapter 7
seems to offer few advantages: It takes almost as long to resolve, requires similar
fees, and in the end provides creditors with lower recovery rates (often zero) than a
comparable Chapter 11 procedure.
Rajan and Zingales (1995) 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. They 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.
1) Tangibility : is measured as the ratio of fixed to total assets. The rationale
underlying this factors is that tangible assets are easy to collateralize and
thus they reduce the agency costs of debt. Berger and Udell (1994) show that
firms with close relationships with creditors need to provide less collateral.
They argue this is because the relationship substitutes for physical collateral.
If so, we should find tangibility mattering less in bank oriented countries.
2) Market to book : The theory predicts that firms with the high market to
book ratios have higher costs of financial distress which is why we expect the
negative correlation. There may be other reason for this negative
correlations. For instance, the shares of firms in financial distress (high
leverage) may be discounted at a higher rate because distress risk is priced
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( Fama and French (1992)). If this is the dominant explanation, the negative
correlation should be driven largely by firms with the low market to book
ratios. In fact, the negative correlation appears to be driven by firms with the
high market to book ratios rather than by firms with the low market to book
ratios.
Another reason for the market to book ratio to be negatively correlated with
book leverage stems from the tendency for firms to issue stock when their
stock price is high relative to earnings or book values. This would imply that
correlation between the market to book ratio and leverage was driven by
firms who issue lots of equity which are proved by empirical analysis in the
paper.
3) Size
: could be proxy for the (inverse) probability of default. If so, it
should not be strongly positively related to leverage in countries where costs
of financial distress are low.
Another argument for size is that information asymmetries between insiders
in a firm and the capital markets are lower for a large firm. So large firms
should be more capable of issuing informationally sensitive securities like
equity, and should have lower debt. Unfortunately, this neither squares with
the negative correlation between size and leverage observed for most
countries, nor is it true that large firms issue more. They concluded that they
do not really understand why size is correlated with leverage.
4) Profitability
: finally profitability is negatively correlated with leverage.
if is the short run, dividends and investments are fixed, and debt financing is
the dominant mode of external financing, then changes in profitability will be
negatively correlated with changes in leverage. As large firms tend to issue
less equity, the negative influence of profitability on leverage should become
stronger as firm size increases. Firms that are profitable and have few
investment opportunities (i.e., large firms) will reduce equity issues
drastically. These firms will have a more positive correlation between
leverage and profitability. By contrast, if profitability is also correlated with
investment opportunities small firms have, then an increase in profitability
may lead to greater equity issuances, reducing the correlation between
profitability and leverage.
Lemmon, Roberts, and Zender (2008) 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.
Akerlof (1970) provides a thorough treatment of the effects of asymmetric
information on trading in markets (quality of products in market, size, and existence
of market). He uses the automobiles market (specifically the used car market) for its
concreteness and ease in understanding. An individuals new car may be good or it
may be a lemon (bad quality car), the individual does not know when initially
purchasing the new car. The good and bad cars are being traded at the same price
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in the market because buyers can't distinguish between good and bad so the seller
of the good cars will not get the fair price of their products and soon will leave the
market and market will be left only with bad cars.
Ross (1977) argues that a signaling mechanism arises naturally in the market to
signal information to market participants which allows them to separate or
determine which firms have good future prospects and which dont.
Ross suggests that MMs assumption that all market participants know what future
firm cash flows will be is wrong. There exists asymmetry of information because
managers know more than investors but they know only about their firm and not
about other firms.
Assume managers cant trade their own stock but they can use their firms capital
structure to signal.
Assumptions
1. There are two types of firms, a successful type A and an unsuccessful type B,
and the value of type A greater than the value of type B. V a > Vb
2. F* is the maximum amount of debt that an unsuccessful firm can carry
without going bankrupt.
3. F > (<) F* means management signals it is type A (B).
For a signaling equilibrium, management compensation must be such that
managers of type A firms and type B firms make more if they truthfully signal their
firms type.
1. Clearly, managers of firms of type A will tell the truth by choosing F > F*
because they earn more compensation if they do because V b < Va.
2. Managers of type B firms dont necessarily have the same incentives.
Compensation must be set such that they earn more by correctly choosing F
< F* to signal that they are type B.
This condition says that the management compensation gain from lying must be
less than the management compensation loss. The LHS is the management share of
gain from initially fooling the market that it is a type A when it is really a type B. The
RHS is the penalty due to bankruptcy.
Unsuccessful firms dont have enough cash to avoid bankruptcy if F >F*
and lying managers will earn less, therefore, a signaling equilibrium
accurately separates firms into high-priced (P = Va ) and low-priced (P =
Vb) .
Without this signaling, all of the firms will trade at the same price because
investors cannot distinguish one from another.
Myers and Majluf (1984)
1. It is generally better to issue safe securities than risky ones. Firms
should go to bond markets for external capital, but raise equity by

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2.

3.

4.

5.

6.

retention if possible. That is, external financing using debt is better


than financing by equity.
Firms whose investment opportunities outstrip operating cash flows, and
which have used up their ability to issue low-risk debt, may forego
good investments rather than issue risky securities to finance them.
This is done in the existing stockholders interest. However, stockholders
are better off ex ante - i.e., on average - when the firm carries
sufficient financial slack to undertake good investment opportunities as
they arise. The ex-ante loss in value increases with the size of the
required equity issue. Thus, increasing the required investment or
reducing slack available for this investment also increases the ex-ante
loss. In addition, numerical simulations indicate the loss decreases when
the markets uncertainty about the value of assets in place is reduced,
or when the investment opportunitys expected NPV is increased.
Firms can build up financial slack by restricting dividends when
investment requirements are modest. The cash saved is held as
marketable securities or reserve borrowing power. The other way to
build slack is by issuing stock in periods when managers information
advantage is small; firms with insufficient slack to cover possible future
investment opportunities would issue in periods where managers have
no information advantage. However, we have not derived a generally
optimal dynamic issue strategy.
The firm should not pay a dividend if it has to recoup the cash by
selling stock or some other risky security. Of course dividends could
help convey managers superior information to the market. Our model
suggests a policy under which changes in dividends are highly
correlated with managers estimate of the value of assets in place.
When managers have superior information, and stock is issued to
finance investment, stock price will fall, other things equal. This action
is nevertheless in the (existing) stockholders interest. If the firm issues
safe (default-risk-free) debt to finance investment, stock price will not
fall.
A merger of a slack-rich and slack-poor firm increases the firms
combined value. However, negotiating such mergers will be hopeless
unless the slack-poor firms managers can convey their special
information to the prospective buyers. If this information cannot be
conveyed (and verified), slack-poor firms will be bought out by tender
offers made directly to their shareholders.

Myers (1984) Capital Structure puzzle


1. A static tradeoff framework, in which the firm is viewed as setting as
target debt to value ratio and gradually moving towards it, in much the same
way that a firm adjusts dividends to move towards a target payout ratio.
2. An old fashioned pecking order framework, in which the firm prefers
internal to external financing, and debt to equity if it issues securities. In the
pure pecking order theory, the firm has no well-defined target debt to value
ratio.
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Cost of financial distress:


The literature on costs of financial distress supports two qualitative statements
about financing behavior
1. Risky firms ought to borrow less, other things equal. Here risk would
defined as the variance rate of the market value of the firms assets. The
higher the variance rate, the greater the probability of default on any given
package of debt claims. Since costs of financial distress are caused by
threatened or actual default, safe firms ought to be able to borrow more
before expected costs of financial distress offset the tax advantages of
borrowing.
2. Firms holding tangible assets in place having active second hand markets will
borrow less than firms holding specialized, intangible assets or valuable
growth opportunities. The expected cost of financial distress depends not just
on the probability of trouble, but the value lost if trouble comes. Specialized,
intangible assets or growth opportunities are more likely to lose value in
financial distress.
The advantages of debt over equity issues. If the firm does seek external
funds, it is better off issuing debt than equity securities. The general rule is, Issue
safe securities before risky ones.
This second point is worth explaining further. Remember that the firm issues and
invests if y, the NPV of its investment opportunity, is greater than or equal to N,
the amount by which the new shares are undervalued (ifN>0) or overvalued (if
N<0). For example, suppose the investment requires N=$10 million, but in order
to raise that amount the firm must issue shares that are really worth $12 million. It
will go ahead only if project NPV is at least $2 million. If it is worth only $1.5 million,
the firm refuses to raise the money for it; the intrinsic overall value of the firm is
reduced by $1.5 million, but the old shareholders are $0.5 million better off.
The manager could have avoided this problem by building up the firm's cash
reservesbut that is hindsight. The only thing he can do now is to redesign the
security issue to reduce N. For example, if N could be cut to $0.5 million, the
investment project could be financed without diluting the true value of existing
shares. The way to reduce N is to issue the safest possible securitiesstrictly
speaking, securities whose future value changes least when the manager's inside
information is revealed to the market.
Of course, N is endogenous, so it is loose talk to speak of the manager controlling
it. However, there are reasonable cases in which the absolute value of N is always
less for debt than for equity. For example, if the firm can issue default-risk free
debt, N is zero, and the firm never passes up a valuable investment opportunity.
Thus, the ability to issue default-risk free debt is as good as cash in the bank. Even
if default risk is introduced, the absolute value of N will be less for debt than for
equity if we make the customary assumptions of option pricing models.13 Thus, if
the manager has favorable information (N>0), it is better to issue debt than
equity.
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This example assumes that new shares or risky debt would be underpriced. What if
the managers' inside information is unfavorable, so that any risky security issue
would be overpriced? In this case, wouldn't the firm want to make N as large as
possible, to take maximum advantage of new investors? If so, stock would seem
better than debt (and warrants better still). The decision rule seems to be, Issue
debt when investors undervalue the firm, and equity, or some other risky security,
when they overvalue it.
The trouble with this strategy is obvious once you put yourself in investors' shoes. If
you know the firm will issue equity only when it is overpriced, and debt otherwise,
you will refuse to buy equity unless the firm has already exhausted its debt
capacitythat is, unless the firm has issued so much debt already that it would
face substantial additional costs in issuing more. Thus investors would effectively
force the firm to follow a pecking order.
Leary and Roberts (2010) quantify the empirical relevance of the pecking order
hypothesis using a novel empirical model and testing strategy that addresses
statistical power concerns with previous tests. While the classificatory ability of the
pecking order varies significantly depending on whether one interprets the
hypothesis in a strict or liberal (e.g., modified pecking order) manner, the pecking
order is never able to accurately classify more than half of the observed financing
decisions. However, when we expand the model to incorporate factors typically
attributed to alternative theories, the predictive accuracy of the model increases
dramaticallyaccurately classifying over 80% of the observed debt and equity
issuances. Finally, we show that what little pecking order behavior can be found in
the data is driven more by incentive conflicts, as opposed to information
asymmetry.
Graham, Leary and Roberts (2014) examine the determinants of aggregate
corporate capital structure using a novel dataset of accounting and market
information that spans most publicly traded firms over the last century. We show
that the stability of nonfinancial aggregate leverage over this period reflects two
opposing forces. First, regulated sectors, such as railroads, delivered and contracted
in size. Second, unregulated sectors experienced a threefold increase in their debtto-asset ratio from 8% in 1946 to 27% in 1970. This increase occurred in all
unregulated sectors and was systemic, affecting firms of all sizes. The median firm
in 1946 had no debt in its capital structure, but by 1970 had a debt-to-asset ratio in
excess of 25%. Our analysis reveals that competition for investors funds between
the public and private sectors played an important role in explaining the increase in
debt usage. Taxes, economic uncertainty, and financial market development play
less important roles in driving this secular increase in leverage.
Choe, Masulis, and Nanda (1993)
It is well known that historically a larger number of firms issue common
stock and the proportion of external financing accounted for by equity is
substantially higher in expansionary phases of the business cycle. We show
that this phenomenon is consistent with firms selling seasoned equity when
they face lower adverse selection costs, which occurs in periods with more
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promising investment opportunities and with less uncertainty about assets in


place. Thus, firm announcements of equity issues are predicted to convey
less adverse information about equity values in such periods.
I.

II.

Proposition. As the business conditions improve, (i.e. increases,) holding


every-thing else constant, a firm is more likely to issue equity rather
than debt and the negative price reaction associated with an equity
offering announcement is smaller.
Proposition. As market uncertainty over the value of a firms assets in
place increases, holding everything else constant, the adverse selection
effect increases, so the number of firms issuing equity will decrease, the
number of firms issuing debt will increase, while the negative price
reaction associated with the equity offering announcement will be
greater.

Korajczyk, Lucas and McDonald (1991)


With the time varying adverse selection in the market for new equity issues, firms
will prefer to issue equity when the market is most informed about the quality of the
firm. This implies that equity issues tend to follow credible information releases. In
addition, if the asymmetry in information increases over time between information
releases, the price drop at the announcement of an equity issue should increase in
the time since the last information release.
Predictions:
I.
II.

A clustering of issues following information releases and few issues preceding


information release;
A larger price drop at announcement and issue the longer the time since the
last information release; and

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III.

Usually positive and informative information releases preceding equity issues

Baker and Wurgler (2002)


It is well know 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.
Trade-off theory:
The tradeoff theory predicts that temporary fluctuations in the market to
book ratio or any other variable should have temporary effects. Market-tobook is an indicator of investment opportunities, risk, agency, or some other
determinant of the optimal tradeoff between equity and debt. (Inconsistent)
Pecking order theory:
Firms with upcoming investment opportunities may reduce leverage to avoid
issuing equity in the future. (Inconsistent)
Managerial entrenchment theory:
High market valuations allow managers to add equity but also allow them to
become entrenched, resisting the debt finance necessary to restore debt to
the optimum. (Consistent)
Market timing theory:
Capital structure is the cumulative outcome of attempts to time the equity
market. (Consistent)
Baker, Greenwood and Wurgler (2003)
The maturity of new debt issues predicts excess bond returns. When the share of
long-term debt issues in total debt issues is high, future excess bond returns are
low. This predictive power comes in two parts. First, inflation, the real short-term
rate, and the term spread predict excess bond returns. Second, these same
variables explain the long-term share and together account for much of its own
ability to predict excess bond returns. The results are consistent with survey
evidence that firms use debt market conditions in an effort to determine the lowestcost maturity at which to borrow.
Jensen (1986)
The interests and incentives of managers and shareholders conflict, over such
issues as the optimal size of the firm and the payment of cash to shareholders.
These conflicts are especially severe in firms with large free cash flowsmore

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cash than profitable investment opportunities. The theory developed here


explains
1. The benefits of debt in reducing agency costs of free cash flows,
2. How debt can substitute for dividends,
3. Why diversification programs are more likely to generate losses than
takeovers or expansion in the same line of business or liquidationmotivated takeovers
4. Why the factors generating takeover activity in such diverse activities as
broadcasting and tobacco are similar to those in oil, and
5. Why bidders and some targets tend to perform abnormally well prior to the
takeover.
Stulz (1990) analyzes financing policies in a firm owned by atomistic
shareholders who observe neither cash flows nor managements investment
decisions. Management derives perquisites from investment and invests as much
as possible. Since it always claims that cash flow is too low to fund all
positive net present value projects. its claim is not credible when cash flow
is truly low. Consequently, management is forced to invest too little when
cash flow is low and chooses to invest too much when it is high. Financing
policies, by influencing the resources under managements control, can reduce
the costs of over and underinvestment.
Lehn and Poulsen (1989) investigate the source of stockholder gains in going
private transactions. We find support for the hypothesis advanced by Jensen
that a major source of these gains is the mitigation of agency problems
associated with free cash flow.
We empirically examine the "free cash flow" hypothesis by addressing two
questions:
1. Do firms that go private have significantly greater undistributed free cash
flow than similar firms that have not gone private?
2. Is undistributed free cash flow an important determinant of premiums paid in
going private transactions?
Our results indicate that the ratio of a firm's undistributed cash flow to its
equity value is a marginally significant determinant of a firm's decision to go
private between 1980 and 1987.
Sources of Stockholder Gains in Going Private Transactions
(1) Tax savings; (2) redistribution from bondholders; (3) asymmetric information;
and (4) mitigation of agency problems.
Edgerton (2012) uses novel data to examine the fleets of corporate jets operated
by both publicly traded and privately held firms. In the cross-section, firms owned
by private equity funds average 40% smaller fleets than observably similar public
firms. Similar fleet reductions are observed within firms that undergo leveraged
buyouts. Quantile regressions indicate that these results are driven by firms in the
upper 30% of the conditional jet distribution. The results thus suggest that
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executives in a substantial minority of public firms enjoy excessive perquisite and


compensation packages.
Jung, Kim and Stulz (1996) find strong support for agency model and said firms
often depart from pecking order due to agency consideration. Further they failed to
find any support for timing model.
Why it is that few firms raise new funds by issuing equity and others issue debt?
There are three important explanations for this choice in the literature;
1. The Pecking order model is based on the view that information
asymmetries between new investors and managers who maximize the wealth
of existing shareholders make equity issues more costly than debt issues and
therefore imply a financing hierarchy.
2. The agency model relies on the argument that mangers sometimes pursue
their own objectives such as firm growth at the expense of shareholders. If
management pursues growth objectives equity issues are valuable for
shareholders when undertaken by firms that have good investment
opportunities, but not otherwise.(better explain the cross sectional variation)
3. The timing model has evolved from the striking finding of Loughran and
Ritter (1995) and Spiess and Affleck-Gaves (1995) that firms experience
long-term underperformance after they issue equity. As argued by Stein
(1995) if equity is overpriced and the market underreacts to equity issues,
then management maximizes the wealth of existing shareholders by issuing
equity.
Fama and French (2002) confirm predictions shared by the trade off and pecking
order models, more profitable firms and firms with fewer investments have higher
dividend payouts. Confirming the pecking order model but contracting the tradeoff
model, more profitable firms are less levered. Firms with more investments have
less market leverage, which is consistent with the tradeoff model and a complex
pecking order model. Firms with more investments have lower long term dividend
payouts, but dividends do not vary to accommodate short term variation in
investment. As the pecking order predicts short-term variation in investment and
earnings is mostly absorbed by debt.

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Faulkender and Petersen (2006) Prior work on leverage implicitly assumes


capital availability depends solely on firm characteristics. However, market
frictions that make capital structure relevant may also be associated with
a firms source of capital. Examining this intuition, we find firms that have
access to the public bond markets, as measured by having a debt rating,
have significantly more leverage. Although firms with a rating are
fundamentally different, these differences do not explain our findings. Even after
controlling for firm characteristics that determine observed capital structure, and
instrumenting for the possible endogeneity of having a rating, firms with access
have 35% more debt.
Fama and French (2005) Financing decisions seem to violate the central
predictions of the pecking order model about how often and under what
circumstances firms issue equity. Specifically, most firms issue or retire equity each
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year, and the issues are on average large and not typically done by firms under
duress. We estimate that during 19732002, the year-by-year equity decisions of
more than half of our sample firms violate the pecking order.
Leary and Roberts (2005) empirically examine whether firms engage in a
dynamic rebalancing of their capital structures while allowing for costly adjustment
and find that firms actively rebalance their leverage to stay within an optimal range.
Their results also suggests that the persistent effects of shocks on leverage
observed in previous studies is more likely due to adjustment costs than
indifference towards capital structure.
Welch (2004) shows that U.S. corporations do little to counteract the influence of
stock price changes on their capital structures. As a consequence, their debt-equity
ratios vary closely with fluctuations in their own stock prices. The stock price effects
are often large and last a longtime, at least several years. He finds that stock
returns can explain about 40 percent of debt ratio dynamics over one to five year
horizons.
Dividend theories:
Signaling: Dividend signaling is a theory suggesting that when a company
announces an increase in dividend payouts, it is an indication it possesses positive
future prospects. The thought behind this theory is directly tied to game theory;
managers with good investment potential are more likely to signal. Miller and Rock
(1985) and Guay and Harford (2000) findings support dividend signaling theory.
Dividend Clientele: Sets of investors who are attracted to certain types of
dividend policy. The theory that changes in a firm's dividend policy will cause loss of
some clientele who will choose to sell their stock, and attract new clientele who will
buy stock based on dividend preferences. Market imperfections, such as transaction
costs, taxes, and institutional investment constraints, cause traditional dividend
clienteles. Black and Scholes (1974) and Allen, Bernardo, and Welch (2000)
develop clientele theories.
Life cycle theory: Dividends tend to be paid by mature, established firms,
plausibly reflecting a financial life cycle in which young firms face relatively
abundant investment opportunities with limited resources so that retention
dominates distribution, whereas mature firms are better candidates to pay
dividends because they have higher profitability and fewer attractive investment
opportunities. Fama and French (2001), Grullon et al. (2002), and DeAngelo and
DeAngelo (2006) all advance life-cycle explanations for dividends that rely,
implicitly or explicitly, on the trade-off between the advantages (e.g., flotation cost
savings) and the costs of retention (e.g., agency costs of free cash flow). DeAngelo
and DeAngelo and Stulz (2006) find consistent evidence for fraction of publicly
traded industrial firms that pay dividends is high when retained earnings are a large
portion of total equity (and of total assets) and falls to near zero when most equity
is contributed rather than earned.

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Catering theory of dividend: Baker and Wurgler (2004) propose that the decision
to pay dividends is driven by prevailing investor demand for dividend payers.
Managers cater to investors by paying dividends when investors put a stock price
premium on payers and by not paying when investors prefer non payers.
Fama and French (2001) The proportion of "firms paying cash dividends falls from
66.5% in 1978 to 20.8% in 1999, due in part to the changing characteristics of
publicly traded "firms. Fed by new listings, the population of publicly traded "firms
tilts increasingly toward small "firms with low profitability and strong growth
opportunities, characteristics typical of "firms that have never paid dividends. More
interesting, we also show that regardless of their characteristics, "firms have
become less likely to pay dividends. What we mean is that the perceived benefits of
dividends (whatever they are) have declined through time. This lower propensity to
pay is at least as important as changing characteristics in the declining incidence of
dividend-paying "firms.
LLSV (2000) Agency models of dividends:
1. Outcome model: Dividends are paid because of minority shareholders
pressure corporate insiders to disgorge cash. This model predicts that
stronger minority shareholder rights should be associated with higher
dividend payouts
2. Substitute model: Insiders interested in issuing equity in the future pay
dividends to establish a reputation for decent treatment of minority
shareholders. This model predicts the opposite.
Tests on a cross section of 4,000 companies from 33 countries with different levels
of minority shareholder rights support the outcome agency model of dividends.
IPO Underpricing: Beatty and Ritter (1986) develop and test two propositions.
They demonstrate that there is a monotone relation between the (expected)
underpricing of an initial public offering and the uncertainty of investors
regarding its value. We also argue that the resulting underpricing equilibrium
is enforced by investment bankers, who have reputation capital at stake. An
investment banker who cheats on this underpricing equilibrium will lose
either potential investors (if it doesnt underprice enough) or issuers (if it
underprices too much), and thus forfeit the value of its reputation capital.
Empirical evidence supports their propositions.
Ritter and Welch (2002) review the theory and evidence on IPO activity: why
firms go public, why they reward first-day investors with considerable underpricing,
and how IPOs perform in the long run. Their perspective is threefold:
1. First, they believe that many IPO phenomena are not stationary.
2. Second, they believe research into share allocation issues is the most
promising area of research in IPOs at the moment.
3. Third, they argue that asymmetric information is not the primary driver of
many IPO phenomena. Instead, they believe future progress in the literature
will come from non-rational and agency conflict explanations.
4. IPOs performs poorly in long run and reasons for this are investors behavior.
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IPO Activity: Choosing to Go Public


The first question must be why do firms go public? In most cases, the primary
answer is the desire to raise equity capital for the firm and to create a public
market in which the founders and other shareholders can convert some of their
wealth into cash at a future date. Nonfinancial reasons, such as increased
publicity, play only a minor role for most firms.
A. Life Cycle Theories
The first formal theory of the going public decision appeared in Zingales (1995). He
observed that it is much easier for a potential acquirer to spot a potential takeover
target when it is public. Moreover, entrepreneurs realize that acquirers can pressure
targets on pricing concessions more than they can pressure outside investors. By
going public, entrepreneurs thus help facilitate the acquisition of their company for
a higher value than what they would get from an outright sale. In contrast, Black
and Gilson (1998) point out that entrepreneurs often regain control from the venture
capitalists in venture-capital-backed companies at the IPO. Thus, many IPOs are not
so much exits for the entrepreneur as they are for the venture capitalists.
Chemmanur and Fulghieri (1999) develop the more conventional wisdom that IPOs
allow more dispersion of ownership, with its advantages and disadvantages. Pre-IPO
angel investors or venture capitalists hold undiversified portfolios, and, therefore,
are not willing to pay as high a price as diversified public-market investors. There
are fixed costs associated with going public, however, and proprietary information
cannot be costlessly revealedafter all, small investors cannot take a tour of the
firm and its secret inventions. Thus, early in its life cycle, a firm will be private,
but if it grows sufficiently large, it becomes optimal to go public.
B. Market timing theories
Lucas and McDonald (1990) develop an asymmetric information model where firms
postpone their equity issue if they know they are currently undervalued. If a bear
market places too low a value on the firm, given the knowledge of entrepreneurs,
then they will delay their IPOs until a bull market offers more favorable pricing. In
Choe, Masulis, and Nanda (1993), firms avoid issuing in periods where few other
good-quality firms issue. Other theories have argued that markets provide valuable
information to entrepreneurs (information spillovers), who respond to increased
growth opportunities signaled by higher prices (Subrahmanyam and Titman (1999),
Schultz (2000)).
IPO Pricing and Allocation
We know of no exceptions to the rule that the IPOs of operating companies are
underpriced, on average, in all countries. The offerings of non-operating companies,
such as closed-end funds, are generally not underpriced.
1. Theoretical Explanations of Short-run Underpricing
Ibbotson (1975) offered a list of possible explanations for underpricing, many of
which were formally explored by other authors in later work. One way of classifying
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theories of underpricing is to categorize them on the basis of whether asymmetric


information or symmetric information is assumed.
A.1. Theories Based on Asymmetric Information
If the issuer is more informed than investors, rational investors fear a lemons
problem: Only issuers with worse-than-average quality are willing to sell their shares
at the average price. To distinguish themselves from the pool of low-quality issuers,
high-quality issuers may attempt to signal their quality. In these models, better
quality issuers deliberately sell their shares at a lower price than the market
believes they are worth, which deters lower quality issuers from imitating. With
some patience, these issuers can recoup their up-front sacrifice post-IPO, either in
future issuing activity (Welch (1989)), favorable market responses to future dividend
announcements (Allen and Faulhaber (1989)), or analyst coverage (Chemmanur
(1993)). In common with many other signaling models, high-quality firms
demonstrate that they are high quality by throwing money away. One way to do this
is to leave money on the table in the IPO.
If investors are more informed than the issuer, for example, about the general
market demand for shares, then the issuer faces a placement problem. The issuer
does not know the price the market is willing to bear. In other words, an issuer faces
an unknown demand for its stock. A number of theories model a specific demand
curve.
One can simply assume that all investors are equally informed, and thus purchase
shares only if their price is below their common assessment. Observed (successful)
IPOs thus are necessarily underpriced. There are, however, some overpriced firms
going public, which would not be predicted because all investors are assumed to
know that these would be overpriced. A more realistic assumption is that investors
are differentially informed. Pricing too high might induce investors and issuers to
fear a winners curse (Rock (1986)) or a negative cascade (Welch (1992)).
All theories of underpricing based on asymmetric information share the
prediction that underpricing is positively related to the degree of
asymmetric information. When the asymmetric information uncertainty
approaches zero in these models, underpricing disappears entirely.
A.2. Theories Based on Symmetric Information
Tinic (1988) and Hughes and Thakor (1992) argue that issuers underprice to reduce
their legal liability and protect themselves from being sued. Drake and Vetsuypens
(1993) find that sued IPOs had higher, not lower underpricing, that is, that
underpricing did not protect them from being sued.
One popular related explanation for the high IPO underpricing during the Internet
bubble is that underwriters could not justify a higher offer price on Internet IPOs,
perhaps out of legal liability concerns, given the already lofty valuations on these
companies. One way of interpreting this is that underwriters were leaning against
the wind by not taking advantage of temporary over optimism on the part of some
investors. Although this argument has a certain plausibility, we find it unconvincing
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because investment banking firms were making other efforts to encourage


overvaluations during the Internet bubble, such as subsequently issuing buy
recommendations when market prices had risen far above the offer price. Boehmer
and Fishe (2001) advance another explanation for underpricing. They note that
trading volume in the aftermarket is higher, the greater is underpricing
2. Theories Focusing on the Allocation of Shares
In recent years, more attention has been drawn to how IPOs are allocated and how
their shares trade. Part of the reason for the increased academic attention on share
allocation is related to the increased public attention on perceived unfairness in how
shares are allocated, given the large amount of money left on the table in recent
years. Specifically, the allocation of shares to institutional investors versus
individuals has been a topic of interest.
Discrimination due to agency problems between underwriters and issuers

Loughran and Ritter (2002) State-contingent (uncertain) issuer psychology


boosts underwriter profits
Loughran and Ritter (2001) Allocations of hot issues boost underwriter
profits

Institutional versus individual investors

Aggarwal, Prabhala, and Puri (2002) Institutions receive more hot IPOs than
book building suggests
Cornelli and Goldreich (2001) Underwriters use discretion to favor repeat
investors (bundling)
Hanley and Wilhelm (1995) Institutions are favored on hot IPOs, but bundling
occurs
Lee, Taylor, and Walter (1999) Institutions ask for more shares on hot IPOs,
but suffer discrimination
Ljungqvist and Wilhelm (2002a) Across countries, there is less underpricing if
institutions are favored

Ownership structure: Monitoring and liquidity

Booth and Chua (1996) Allocations to many investors increase liquidity


Brennan and Franks ~1997! Underpricing results in many investors,
entrenching managers
Field and Sheehan (2001) empirically, there is no relation between
underpricing and blockholders
Mello and Parsons (1998) Allocate IPO shares diffusely with a separate offer to
blockholders
Stoughton and Zechner (1998) Underpricing allows creation of a blockholder,
inducing monitoring

Ljungqvist, Jenkinson and Wilhelm (2003) examine the costs and benefits of
global integration of initial public offering (IPO) markets associated with diffusion of
U.S. underwriting methods in the 1990s. Book building is becoming increasingly
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popular outside the United States and typically costs twice as much as a fixed price
offer. However, on its own, book building only leads to lower underpricing when
conducted by U.S. And/or targeted at U.S investors. For most issuers, the gain due
to lower underpricing outweighed the additional costs associated with hiring U.S
banks or marketing in the United States.
Pricing methods: auction, fixed pricing and bookbuilding.
Equity issuance timing: Alti and Sulaeman (2012) find equity issuance tend to
follow periods of high stock returns when coincide with strong institutional demand.
When not accompanied by institutional purchases, stock prices increase have little
impact on likelihood of equity issuance.
Bebhuk and Weisbach (2010) discuss seven important areas of corporate
governance. Shareholders, board of directors, executive compensation,
1. Shareholders and shareholder activismthe actions that shareholders
may take to protect their interests.
2. Corporate directors
3. Executives and their compensation.
Whereas Sections 13 focus on companies without controlling shareholders,
4. Considers companies with such controlling shareholders.
5. international corporate governance (cross country comparisons)
6. International corporate governance (considering cross-border investments
by foreign investors.
7. Political economy of corporate governance
Gompers, Ishii and Metrick (2003) uses the incidence of 24 governance rules to
constructed a Governance Index to proxy for the level of shareholder rights at
about 1500 large firms during the 1990s. They find that an investment strategy that
bought firms with strongest rights and sold firms with weakest rights would have
earned abnormal returns of 8.5 percent per year during the sample period. They
further find that firms with stronger shareholder rights had higher firm value, higher
profits, higher sales growth, lower capital expenditures, and made fewer corporate
acquisitions.
Jensen and Murphy (1990) analysis of performance pay and top-management
incentives for over 2,000 CEOs in three samples spanning five decades indicates
that the relation between CEO wealth and shareholder wealth is small and has fallen
by an order of magnitude in the last 50 years. Their estimates of the payperformance relation (including pay, options, stockholdings, and dismissal) for
chief executive officers indicate that CEO wealth changes $3.25 for every
$1,000 change in shareholder wealth. The largest CEO performance incentives
come from ownership of their firms' stock, but such holdings are small and
declining. Although the incentives generated by stock ownership are large relative
to pay and dismissal incentives, most CEOs hold trivial fractions of their firms' stock,
and ownership levels have declined over the past 50 years.

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The lack of strong pay-for-performance incentives for CEOs indicated by our


evidence is puzzling. We hypothesize that political forces operating both in the
public sector and inside organizations limit large payoffs for exceptional
performance. Truncating the upper tail of the payoff distribution requires that
the lower tail of the distribution also be truncated in order to maintain levels
of compensation consistent with equilibrium in the managerial labor market.
The resulting general absence of management incentives in public corporations
presents a challenge for social scientists and compensation practitioners.
LLSV (2002) present a model of the effects of legal protection of minority
shareholders and of cash-flow ownership by a controlling shareholder on the
valuation of firms. They find evidence of higher valuation of firms in countries with
better protection of minority shareholders and in firms with higher cash flow
ownership by the controlling shareholder.
Gompers and Metrick (2003) analyzes institutional investors' demand for stock
characteristics and the implications of this demand for stock prices and returns.
They find that "large" institutional investors nearly doubled their share of
the stock market from 1980 to 1996. Overall, this compositional shift tends to
increase demand for the stock of large companies and decrease demand for the
stock of small companies. The compositional shift can, by itself, account for a nearly
50 percent increase in the price of large-company stock relative to smallcompany stock and can explain part of the disappearance of the historical smallcompany stock premium.
Gaspar, Massab and Matos (2005) investigates how the investment horizon of a
firms institutional shareholders impacts the market for corporate control. They find
that target firms with short-term shareholders are more likely to receive an
acquisition bid but get lower premiums. This effect is robust and economically
significant: Targets whose shareholders hold their stocks for less four months, one
standard deviation away from the average holding period of 15 months, exhibit a
lower premium by 3%. In addition, we find that bidder firms with short-term
shareholders experience significantly worse abnormal returns around the merger
announcement, as well as higher long-run underperformance. These findings
suggest that firms held by short-term investors have a weaker bargaining position in
acquisitions. Weaker monitoring from short-term shareholders could allow managers
to proceed with value-reducing acquisitions or to bargain for personal benefits (e.g.,
job security, empire building) at the expense of shareholder returns.
Chemmanur, Loutskina and Tian (2014) analyze how corporate venture capital
(CVC) differs from independent venture capital (IVC) in nurturing innovation in
entrepreneurial firms. We find that CVC-backed firms are more innovative, as
measured by their patenting outcome, although they are younger, riskier, and less
profitable than IVC-backed firms. Our baseline results continue to hold in a
propensity-score-matching analysis of IPO firms and a difference-in-differences
analysis of the universe of VC-backed entrepreneurial firms. We present evidence
consistent with two possible underlying mechanisms: CVCs greater industry

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knowledge due to the technological fit between their parent firms and
entrepreneurial firms and CVCs greater tolerance for failure.
Devos, Kadapakkam and Krishnamurthy (2009). There is little evidence in the
literature on the relative importance of the underlying sources of merger gains. Prior
literature suggests that synergies could arise due to taxes, market power, or
efficiency improvements. Based on Value Line forecasts, we estimate the average
synergy gains in a broad sample of 264 large mergers to be 10.03% of the
combined equity value of the merging firms. The detailed data in Value Line
projections allow for the decomposition of these gains into underlying operating and
financial synergies. We estimate that tax savings contribute only 1.64% in
additional value, while operating synergies account for the remaining 8.38%.
Operating synergies are higher in focused mergers, while tax savings constitute a
large fraction of the gains in diversifying mergers. The operating synergies are
generated primarily by cutbacks in investment expenditures rather than by
increased operating profits. Overall, the evidence suggests that mergers generate
gains by improving resource allocation rather than by reducing tax payments or
increasing the market power of the combined firm.
Economists have accumulated considerable evidence and knowledge on the effects
of the takeover market. Most of the earlier work is well summarized elsewhere
(Jensen and Ruback, 1983; Jensen, 1984; Jarrell, Brickley and Netter in this
symposium). Here, I focus on current aspects of the controversy. In brief, the
previous work tells us the following:
1. Takeovers benefit shareholders of target companies. Premiums in hostile offers
historically exceed 30 percent on average, and in recent times have averaged about
50 percent.
2. Acquiring-firm shareholders on average earn about 4 percent in hostile takeovers
and roughly zero in mergers, although these returns seem to have declined from
past levels.
3. Takeovers do not waste credit or resources. Instead, they generate substantial
gains: historically, 8 percent of the total value of both companies. Those value gains
represent gains to economic efficiency, not redistribution between various parties.
4. Actions by managers that eliminate or prevent offers or mergers are most
suspect as harmful to shareholders.
5. Golden parachutes for top-level managers do not, on average, harm
shareholders.
6. The activities of takeover specialists (such as Icahn, Posner, Steinberg, and
Pickens) benefit shareholders on average.
7. Merger and acquisition activity has not increased industrial concentration.
Indeed, over 1,200 divestitures valued at $59.9 billion occurred in 1986, also a
record level (Grimm, 1986).
8. Takeover gains do not come from the creation of monopoly power.
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Bradley, Desai and kim (1988) document that a successful tender offer increases the
combined value of the target and acquiring firms by an average of 7.4%. They
also provide a theoretical analysis of the process of competition for control of the
target and empirical evidence that competition among bidding firms increases the
returns to targets and decreases the returns to acquirers, that the supply of
target shares is positively sloped, and that changes in the legal/institutional
environment of tender offers have had no impact on the total (percentage)
synergistic gains created but have significantly affected their division between
the stockholders of the target and acquiring firms.
RAJAN, SERVAES, and ZINGALES (2000). We model the distortions that internal
power struggles can generate in the allocation of resources between divisions of a
diversified firm. The model predicts that if divisions are similar in the level of their
resources and opportunities, funds will be transferred from divisions with poor
opportunities to divisions with good opportunities. When diversity in resources and
opportunities increases, however, resources can f low toward the most inefficient
division, leading to more inefficient investment and less valuable firms. We test
these predictions on a panel of diversified U.S. firms during the period from 1980 to
1993 and find evidence consistent with them.
Opler, Pinkowitz, Stulz and Williamson (1999). We examine the determinants
and implications of holdings of cash and marketable securities by publicly traded
U.S. firms in the 1971-1994 period. In time-series and cross-section tests, we find
evidence supportive of a static tradeoff model of cash holdings. In particular, firms
with strong growth opportunities and riskier cash flows hold relatively high ratios of
cash to total non-cash assets. Firms that have the greatest access to the capital
markets, such as large firms and those with high credit ratings, tend to hold lower
ratios of cash to total non-cash assets. At the same time, however, we find evidence
that firms that do well tend to accumulate more cash than predicted by the static
tradeoff model where managers maximize shareholder wealth. There is little
evidence that excess cash has a large short-run impact on capital expenditures,
acquisition spending, and payouts to shareholders. The main reason that firms
experience large changes in excess cash is the occurrence of operating losses.
1. The transaction costs model
Keynes' (1936) transaction motive for holding cash arises from the cost of
converting cash substitutes into cash. Transaction costs model implies that liquid
assets increase with (1) the volatility of cash flow divided by total assets, and (2)
the length of the cash conversion cycle. The model also implies that liquid asset
holdings decrease (1) with interest rates and the slope of the term structure, (2)
with the cost of raising debt, (3) with the ease of selling assets, (4) with the cost of
hedging risk, and (5) with the size of a firm's dividend. The inclusion of taxes has
the additional implication that the cost of holding liquid assets increases with the
firm's marginal tax rate.
2. Information asymmetries, agency costs of debt, and liquid asset holdings
3. Agency costs of managerial discretion
4. The financing hierarchy theory
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Song and Lee (2012) We investigate the long-term effect of the Asian financial crisis
on corporate cash holdings in 8 East Asian countries. The Asian firms build up cash
holdings by decreasing investment activities after the crisis. We find that the
increase in cash holdings is not explained by changes in firm characteristics but by
changes in the firms demand function for cash, which indicates that the crisis has
systematically changed the firms cash-holding policies. Specifically, the firms
increased sensitivity to cash flow volatility is one of the main factors explaining the
higher level of their cash holdings in the post-crisis period.

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