Summary Flashcards
Describe the main papers on Corporate Financing
(1) Modigliani and Miller 1958 and 1962: This paper is the one that argued that in a perfect world, the capital structure of the firm does not matter. Thus, when you finance a new project by increasing debt, your cost of equity will increase. However, when there is a tax shield, then firms will only use taxes.
(2) Myers and Majluf 1984: This paper proposes the pecking order theory. There are information asymmetries between managers and investors such that managers only find it worthwhile to raise capital with bad projects. Thus, you should use internal capital, then debt financing (which has contracting options) and only issue equity as a last resort.
(3) Baker and Wurgler (2002) argue that capital structure actually is behavioral and managers raise equity whenever they think that their stock is overvalued.
(5) Finally, there is a static tradeoff theory (e.g. Jensen and Meckling, 1976), that takes into account the distress cost of raising too much debt.
(4) Jensen 1986: This is the paper on why debt can actually increase value of the firm. When firms have a lot of free cash flow, managers have incentives to invest that capital at below the WACC. Debt can overcome this agency problem because managers must pay interest.
Literature Results: US corporations have debt ratios that are usually lower than in other countries and certainly do not hold 100% debt. This could also be related to the fact that the interest shield is just a cap on how much value could be created. Other tax things, missing profits can mitigate the benefit. There is also some work on issuing capital by selling non-care assets. There is some empirical evidence for distress costs in that companies complete projects early at a discount to avoid liquidation or re-organization. Firms also choose debt levels as a cushion to signal that they can push back if trade secrets are lost.
Describe the main papers on Behavioral Corporate Finance
(1) Malmendier and Tate 2005: They show that overconfident managers are too optimistic about projects and too pessimistic about external interest rates. Thus, when they have a lot of cash they invest too much and when they need more cash from external financing then they invest too little.
(2) Baker and Wurgler (2005): Companies try to pay dividends whenever investors put a premium on that. Thus, when dividend paying firms are over-valued, other firms start paying dividends.
Describe the main papers on Compensation and Incentives
(1) Core et al 1999: Less independent outsiders is associated with higher CEO compensation (e.g. when CEO has more power). Whenever the CEOs are overpaid, future performance of the company is bad. Either because of bas oversight by bad board or because incentives are not good for the CEO.
(2) Gabaix and Lanider (2008): The main reason for increases in CEO compensation is the increase in average firm size and compensation structure. CEOs have higher incentive pay and cannot diversify this risk: thus they must be paid more in expectation.
(3) Jensen and Murphy (1990): For some reason there is not a very strong relationship between CEO pay and firm performance. This could be because of contracting differences, risk aversion, and lack of CEO commitment to pay in cases of bad outcomes. (maybe this could get into the culture idea)
(4) Yermack 2006: There is also evidence that CEOs have been able to indulge in rent extraction (e.g. private jets) and that firms have negative stock returns when such benefits are granted.
(5) Morck, Shleifer, and Vishny (1988): For small ownership, incentives work and lead to better performance. But for median ownership, the managers become entrenched and too difficult to fire and hence performance incentives stop working until ownership is so high that the gains from shirking are reduced and the marginal gains from ownership are high enough to offset this.
Finally, there is a view that compensation may be guided by the legal system.
In general, CEOs in the US make more, but this can be explained by higher risk of compensation (i.e. more incentive based) and by larger firm size. The Jensen and Meckling paper is important here because of the agency costs. Incentive based compensation reduces the marginal benefit of shirking as a manager.
Describe the main papers on New Issues
(1) Baron 1982: When investment banks have information that issuers do not have, the issuer must forego some profit for the banker to put in effort in selling and reveal their private information.
(2) Rock 1986: There are uninformed and informed traders in the market. If informed traders would only engage in the market when they have good information, the uninformed would leave. But this would be back for both so there is underpricing.
(3) Benveniste and Spind (1989): Outsiders have information that investment bankers want to get during bookbuilding. Thus, they accept underpricing to get that information.
(4) Loughran and Ritter 1995: Show that the low performance after an IPO CANNOT be explained by risk exposures. It seems like there is just a mis-valuation. This is related to Baker and Wurgler that show that companies raise money when they are overvalued.
Describe the main papers on Agency Theory
(1) Jensen and Meckling 1976: This is the main agency paper. It says that if a owner-manager loses ownership, he will engage in more shirking at the expense of shareholders, but ultimately these costs are borne just by him. The costs include monitoring costs, bonding costs, and residual costs. The manager will agree to monitoring and bonding costs if they reduce residual costs more than they cost him.
(2) Fama and Jensen 1983 (2 papers): This is about the governance structure of firms. There exists decision management and decision control. For non-complex organizations those can be in the same person who can then also hold the residual claims. However, in large complex institutions, those should be split and so should the residuals. Splitting residual claims increase value but also introduces agency costs.
(3) Jensen 1986: This is the paper on why debt can actually increase value of the firm. When firms have a lot of free cash flow, managers have incentives to invest that capital at below the WACC. Debt can overcome this agency problem because managers must pay interest.
(4) Diamond 1991: This isn’t really only a paper on signaling, but it does fit in here and in the new issues and capital raising literature. Banks can significantly reduce information asymmetries because they can fund small and medium sized businesses. This can reduce the underpricing.
Describe the main papers on signaling
(1) Akerlof 1970: When there are strong information asymmetries, the size of the market tends to shrink and you need some sort of warranty to get the market to work again (i.e. some signal)
(2) Gragam et al 2005: This paper shows that there is a lot of signaling in financial statements. Think for example about earnings management.
(3) Sensoy 2009: this paper is the one on mutual fund benchmarking and shows that mutual funds change their benchmarks to attract higher returns.
Describe the main papers on Corporate Investment
(1) Myers 1977: This paper introduces the debt overhang problem. This problem arises when firms have too much debt to raise more capital. In that case, these firms must forego positive NPV projects.
(2) Ersahin, Irani, and Le 2020: This paper shows that once debt holders get involved (e.g. when a covenant is violated) firms because better managed, close more inefficient plants.
One of the main questions here is whether markets allocate capital well across firms and within a firm when there exist information asymmetries (e.g. cite the Akerlof 1970 and Myers 1977 papers). The literature finds that there are many agency problems with regard to corporate investment. For example, managers tend to overinvest because of overconfidence (baker and wurgler 2005) and for empire building.
Similarly, culture, law, education, and many other factors also play a role when it comes to innovation. It may be harder for very innovative firms to raise capital because of information asymmetries. Because of these asymmetries, conglomerates MIGHT MAKE SENSE. This is because the CEO knows better about the different divisions and could better allocate capital than outside investors. The dark side is that over over-investment and empire building. Because of that, conglomerates usually trade at a discount (Stein, 1997). The other pro-conglomerate camp talks about the diversification benefits. This makes no sense in efficient capital markets: in fact, the relative allocations are fixed and so not optimal.
What are the pros and cons of family firms?
Cons:
(1) The family firms are hard to acquire so many external governance channels are missing
(2) They are loyal to each other and hence incompetent people can run companies (e.g. a son)
(3) There are many intra-family feuds that add additional agency problems
(4) There are also more feuds between family and minority shareholders since families may want to also boos their image and reputation and not just shareholder value
(5) They use more dual class stock which can also make it more difficult to monitor (but there is extra value in splitting up ownership and control rights)
Pros:
(1) The families can often mitigate agency problems between shareholders and managers
(2) Families will monitor more closely and has a longer term horizon (founders want the firm to persist and not boost next month’s earnings)
(3) They have lower costs of debt because they have more debt like preferences: they mind bankruptcy a lot more
Describe the main papers on Mergers and Acquisitions
(1) Grossman and Hart 1980: This paper introduces the free-rider problem. The free rider problem can occur in general with corporate governance if there exists no blockholder because no agent wants to invest the entire cost of monitoring but only get the small gains. In M&A, the free rider problem causes shareholders to hold their shares during an attempted takeover to gain from the upside instead of selling.
(2) Shleifer and Vishny 2003: This paper shows that companies use over-valued stock to engage in acquisitions. This is yet another reason why the acquirers have on average lower returns during M&A transactions.
In general, know that short-run CARs may not be good predictors of long-run performance of mergers. (consider changes in factor exposures as drivers)`
