corporate finance- theory and empirics
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Empirics of Financial Markets
Patrick J. Kelly, Ph.D.
Theory and Empirics of Corporate Finance
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Firms and Project (Investment) Financing
Firms are economically productive organizations whichproduce streams of cash flows.
Coase (1937) firms as the nexus of contracts
How do firms finance the activities of the firm?
2010 Patrick J. Kelly 3
Financing Investment
Firms raise capital for investment by selling rights to theircash flows.
Debt1. Typically fixed payments2. Typically for a fixed amount of time3. Typically debt holders gain control rights
if the firm fails at (1) or (2) Equity
Control rights (ownership) Residual claimant: Get whatever cash is left over after all other
claimants are paid (such as debt holders)
2010 Patrick J. Kelly 4
The theory of capital structure
The mix of equity and debt, or rather the fraction of firmvalue attributed to debt and equity is calledthe Capital Structure of the firm
Why do we see that firms have the level of debt that theydo?
They should choose the capital structure that maximizes the valueof the firm!
2010 Patrick J. Kelly 5
Modigliani and Miller (1958)
The value of the firm is: Independent of its capital structure
Consider an Unlevered firm (U):
Investment Payoff
2011 Patrick J. Kelly 6
UUVS =
Equity Raised through Share Issuance
Value of Unlevered Firm
X
Fraction of Firm value
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Capital Structure Irrelevance
Unlevered firm (U):
Investment Payoff
Levered firm (L):
Investment Payoff
2011 Patrick J. Kelly 7
UUVS = X
LLLDSV += ( ) XrDrDX LL =+
Payoff to Equity orShare Holders inLevered Firm
Payoff to DebtHolders inLevered Firm
Same, so the firmvalue must be thesame
ULVV =
Irrelevance Enforced by Arbitrage
if < short sell debt and equity in
levered and buy unlevered
if > short sell equity in unlevered
buy debt and equity in levered
2011 Patrick J. Kelly 8
LLLUUDSVVS +===
1. Assumptions Needed for Capital Structure Irrelevance
1. Frictionless markets No taxes: personal or corporate Perfect divisibility of assets Costless information available to all
No bankruptcy
2. Individuals can mimic firms
Equal access to capital markets
Homemade leverage Can issue equity, just like firms
2010 Patrick J. Kelly 9
2. Assumptions Needed for Capital Structure Irrelevance
3. Perfect Competition4. Homogeneous expectations
Insiders and outsiders have the same information, i.e. no signalingopportunities.
5. Investors maximize wealth6. No wealth transfers (no agency costs)7. Investment decisions are given (fixed)8. Operating cash flows are unaffected by capital structure
2010 Patrick J. Kelly 10
The power of M&M58
Not that capital structure is irrelevant, but rather the assumptions needed to make capital structurerelevant are really strict.
Relaxing these assumptions has lead to a betterunderstanding of the nature of the firm
2010 Patrick J. Kelly 11
Miller (1963) Relaxing No Corporate Taxes Assumption
Often interest payments on debt can be deducted fromprofits, lowering the tax bill
Investment Payoff
Invest and Borrow Payoff
Same payoffs Same Price 2010 Patrick J. Kelly 12
( )( )CL
rDX 1~
LS
Homemadeleverage ( )CLU DS 1
Cleverly chosenamount to borrow
( ) ( )CLC
rDX 11~
( )( )CL
rDX = 1~
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Miller (1963)
By No Arbitrage rule: Same payoffs Same Price means
Investment in a Levered Firm = Investing in Unlevered plus borrowing
Implication: Borrow 100% the value of the firm! 2010 Patrick J. Kelly 13
( )CLU
DS 1=L
S
( )CLLU
DSS = 1
( )LCLLU
DDSS +=
LCLUDVV =
LCULDVV += Discounted Present
Value of Tax Shield
Empirical Findings: Gains to Leverage M&M(1966)
2011 Patrick J. Kelly 14
Miller and Modigliani, AER June 1966
Electric Utility Industry (63 Firms)
Graham (1996) in a sample of 10,000 firms from 1980-1992, finds thathigh tax rates are associated with higher debt.
Bankruptcy
Borrowing 100% is not real Bankruptcy costs
Warner (1977) 11 railroad bankruptcies 1933-55 Direct cost 5.3% of value 1 month prior to filing (avg. not MC) 1% of value 7 years prior Directed costs are trivial
2010 Patrick J. Kelly 15
Indirect Costs of Bankruptcy
Indirect costsTrade CreditValue of warrantiesValidity of contracts Litigation costs Cash flow may drop due to bankruptcy
Altman (1984) Opportunity costs are 8.1% of firm value 3 years prior 10.5% 1 year prior
Opler and Titman (1994) During downturns, high leverage firms from 26% in market value
2010 Patrick J. Kelly 16
Bankruptcy costs affect the level of Debt
Cost of Debt
Taxes Paid
FinancialDistress Cost ofDebt
$ PV
D
D+S
Optimal CapitalStructure
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Implications
Bankruptcy costs reduce the benefits of debt Capital Structure IS relevant
VL
Debt
VU
Miller6
3
MM58
Warner (1977) andothers BankruptcyCosts
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Empirical Findings: Gains to Leverage
Mackie and Mason (1990): the propensity to issue debt is: Negatively related to
existence of other tax shieldsA one standard deviation increase in non-debt tax shields leads to a 10% lower
probability of debt issuance
Probability of distress Positively related to
Level of Free Cash Flow Asset Tangibility
Frank and Goyal (2003) add (+) size, median industry leverage, top corporate tax rate (-) dividends, loss carry forwards, profitability, and interest rates Suggests: Trade-off theory
2010 Patrick J. Kelly 19
Relaxing M&M58s Assumptions
If we introduce personal taxes andTaxes on capital gains < tax on interest income
Gains to leverage are less than when the taxes on interest and capital gainsdont exist or are the same
+=
)1(
)1)(1(1
PB
PSC
LULDVV
Gains to Leverage
GL
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Relaxing M&M58s Assumptions
M&M58: c=ps=pb=0 GL=0
Miller (1963): c> 0 but ps=pb=0 GL= cDL
Miller (1977): c> 0 and ps (1 - pb ) or
(1 - c) (1 - ps) < (1 - pb)
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Supply and Demand for Bonds
For simplicity lets assume: ps=0
and corporate tax the same for all corporations.
%
$ amount of all bonds
j
C
S rr
=
1
1
0
r0is the effective, aftertax interest rate thecorporation pays
i
pb
D rr
=
1
1
0
Demand: order individuals by tax rate
+1
0i
pb
i
pb
Tax Exempt Bonds
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Implications
1. High tax individuals buy tax exempt bonds Once those run out low tax individuals supply capital to the
corporate debt market
2. There is an optional economy-wide debt levelBUT each firm is exactly indifferent
Why? Costs the same.
Implies capital structure is irrelevant
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De Angelo and Masulis (1980)
Heterogeneous Corporate TaxesWith different tax rates:
Low tax firms are less interested in debt (and high more) Resulting in a downward sloping supply curve of debt
Currently, in the US, the corporate tax rate is 35% How do corporations get different tax rates?
They substitute, depreciation, investment tax credits Even with the same rate, corporations may have different effective
tax rates
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Debt Market Equilibrium
%
$ amount of all bonds
j
C
S rr
=
1
1
0
i
pb
D rr
=
1
1
0
Tax Exempt Bonds
FirmswithHighc
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Differences in Tax Rates
Cordes and Sheffrin (1983) using Treasury Data to calculate effective tax rates
Differences in Effective tax rates ranging from 45% for tobacco 16% for transportation and agriculture
Differences due to:Tax carry-backs and carry-forwards Foreign and domestic tax credits Investment tax credits Difference in taxes on capital gains vs. earnings Minimum tax rules
2008 Patrick J. Kelly 28
An Example
Consider a world where return is sufficiently volatile thatsome times the tax shield won
t be valuable.
r0=10% c=50% ps=0% pb=20% Assume all investors have the same tax rate:
Required return on taxable Debt:
125.2.1
1.
1
0=
=
=
pb
D
rr
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Example: Diminishing Value of Tax Shield
S1 S2 S3 S4
Pr . 25 .25 .25 .25
Taxable Income
E[After TaxIncome]
EffectiveTax Rate
Highest RateWilling
Next $
Debt 0 500 1000 1500 2000 625 50% 20%
Debt 40000 500 1000 1500 375 37.5%
.1/(1-.375)
Interest 500 16%
Debt 80000 0 500 1000 187.5 25%
.1/(1-.25)=
Interest 1000 13.3%
Debt 120000 0 0 500 125 12.5%
.1/(1-.125)
Interest 1500 11.4%
Debt 160000 0 0 0 0 0% 10%
Interest 2000
Tax Shield available upto $500 in interestpayments
But, over $500 in interest no taxes are paid inone state of the world: .75 x .50 = .375
=
=
5.1
%10
1
%10
C
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Example: Diminishing Value of Tax Shield
Taxable Income
E[After TaxIncome]
Effective TaxRate
HighestRate
Willing
Debt 0 500 1000 1500 2000 625 50% 20%
Debt 2000250 750 1250 1750
Interest 250
Tax rate 50% 50% 50% 50%500 50%
.1/(1-.50)
After Tax Inc. 125 375 625 875 20%
Debt 60000 250 750 1250
Interest 750
Tax rate 0% 50% 50% 50%312.5 37.5%
.1/(1-.375)
After Tax Inc. 0 125 375 625 16%
Between $0 and $500 indebt payments
Between $500 and$1000 in debt payments
Debt Supply
%
$ amount of all bonds
Downward sloping because effective tax rate drops and
Cannot deduct interest in all states of the world
20%
16%
13.3%
11.4%10%
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$4K $8K $12K $16K
Downward Sloping Debt Supply
%
$ amount of all bonds
jC
S rr
=
1
1
0
i
pb
D rr
=
1
1
0
r*
( ) ( )*00*
11D
Cpb
rrr
=
=
Effective Tax Rate at givenlevel of debt
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Implications
Many firms use leasing a non-debt tax shield Leasing lowers the value of the debt tax shield
In a recession Debt Supply curve drops Capital Structure IS relevant
VL
Debt
VU
Miller6
3
MM58
DeAngelo and
Masulis (1980)
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Relaxing more M&M58 Assumptions
Relaxing Assumptions of No wealth transfers and Fixed Investments
Agency Problems1. Under investment2. Risk Sharing3. Milking the firm
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Under Investment
Under Investment: when the shareholders in a firm nearbankruptcy instruct management not to invest in a positive
NPV project because it will only benefit bond holders
Consider an example 3 time periods 2 projects r = 0% Risk Neutral investors
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Under Investment Example
Two projects have the following cash flows:
Suppose there is a bond in the capital structure thatmatures at t=2
t=0 t=1 t=2 NPV
A -50 100 50 100
B 0 -75 100 25
Cash Flow
to Equity -50 25 150 125
t=0 t=1 t=2 NPV
Bond 120 -20 -100 0
A+B -50 25 150 25
Cash Flow
to Equity 70 5 50 12537
Under Investment Example
Consider if the firm takes the bond, but only project A:
If bond holders pay $120 for bonds expectingprojects A & B will be done, the bond holders areripped off.
If they knew theyd only be willing to pay $70 for the bondpaying $120
t=0 t=1 t=2 NPV
CF of Bond 120 -20 -100
CF of A -50 100 50
Cash Flow
to Equity 70 80 0 150
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Under Investment Example
If they pay $70 for the bond paying $120:
If instead they just commit to the $70 bond:
t=0 t=1 t=2 NPV
CF of Bond 70 -20 -100 -50
CF of A&B -50 25 150
Cash Flow
to Equity 20 5 50 75
t=0 t=1 t=2 NPV
CF of Bond 70 -20 -50 0
Only A -50 100 50 100
Cash Flow
to Equity 20 80 0 100
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Under Investment Example
Firm has no incentive to do both A & B If the firm cannot credibly commit to A & B then only
A is sustainable.
But this is not optimal: the NPV from taking bothprojects (if they could commit) is 125
t=0 t=1 t=2 NPV
CF of Bond 70 -20 -50 0
Only A -50 100 50 100
Cash Flow
to Equity 20 80 0 100
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2) Risk shifting
Payoffs to bond and equity holders in a firm with debt:$
Vfirm
Payoffs to Equity like a call: = Vequity Payoffs to Bonds like writing a put
Equity PayOffs
Debt PayOffs
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Risk Shifting
With debt, riskier projects are better for equity holders Share holders especially prefer high risk projects near
bankruptcy
Potential bond holders anticipate this and are willing to payless for debt
Who loses out?The equity holders pay the cost of not being able to credibly
commit
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3) Milking the property
In financial distress pay more to shareholders:t=0 t=1
CF Equity $750 0CF to Debt 0 0CF Equity 0 $100CF to Debt 0 $1,000
Take $$and run
Leave Assetsin Place
Bond holders insist on covenants as a part of thecontract to protect their wealth from expropriation byshareholders.
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Bond Holder wealth expropriation
Jensen and Meckling (1976)Agency Cost of Debt
Agency Costof Equity
Agency Cost ofDebt
$Cost
D
D+S
Optimal CapitalStructure
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Jensen and Meckling (1976)
Typical Bond Indenture Provisions1. Restrictions on dividend payouts2. Restrictions on issuance of new debt3. Restrictions on merger activity4. Restrictions on the disposition of firm assets
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Signaling
Firms choose their capital structure to communicate signalsabout the quantity of the projects/firm to the market
Implicit in M&M58 is that the market knows the cash flows.But they dont.
The market values the perceived cash flows
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Ross (1977)
Capital structure may change the perception of risk w/oactual changes in return
Example: Suppose D* is the maximum debt a bad firm can take w/o going
bankrupt
Good firms can take on D* or more without the risk of bankruptcy For equilibrium, signals must be
Unambiguous Managers must have the incentive to tell the truth
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Ackerlof (1970): The market for Lemons
4 types of cars: New/Used Good/Bad
When you buy a newcar you dont know if it is good orbad.
Over time an information asymmetry develops Owners (sellers) know the quality - - Buyers dont
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Ackerlof (1970): The market for Lemons
Buyers cant tell the difference between good and bad cars so they offer the same price for each type good or bad.
Implication: Good cars are not traded only bad cars are. Costly signals can solve the problem.
Idea: find a signal that is too costly for the bad to use, but cheapfor the good.
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Example: Costly Signaling Spence (1973)
Job seeker of one of two types: Productive Unproductive
Suppose education is costly Productive: Cost = x yrs Unproductive: Cost = 1 x yrs
Offer a high wage to those who get at least Y* years ofeducation and a low (or no) wage to those that dont
But employers cannot offer so much that it is valuable forunproductive workers to get an education
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Pooling vs. Separating Equilibrium
If wages, in the example, are too high we have a poolingequilibrium: you cant tell the good from the bad.
If wages are set high enough to entice high productivityworkers, but low enough to not make it worth while for low
productivity, then we have a separating equilibrium: the bad
choose not to get an education and the good do.
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Pooling vs. Separating Equilibrium
Suppose there are two types of firms: Hi & Lo Lo could not maintain a certain level of Debt, D*, because
of Low profits or high volatility (risking bankruptcy)
But High can. Ross(1977) suggested that if E[profit] does not equal actual
profit, then high quality firms can raise their value, by
signaling their quality through choosing a level of Debt D*
52
Pecking Order Hypothesis/Conjecture
Myers and Majluf (1984) and Myers (1984)
Managers know the true value of the firm. Outsiders dont Adverse selection costs caused by information asymmetry
If a project comes along managers first use1. Retained earnings
No adverse selection costs2. Debt
Debt is a costly commitment3. External equity financing
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Frank and Goyal (2003)
Pecking Order Hypothesis/Conjecture doesnt hold up sowell
1. Should work best for small high growth firms but in fact itbest explains large low growth firms in the 70s and 80s
2. External financing is prevelant and large3. Equity Capital is often larger than Debt in firms
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Dividends: How dividends are paid
Declaration date: date when the size of the dividend isstated
Ex-dividend date: the first date the stock trades withoutthe declared dividend
Record date: the date, 2 days after the ex-dividend date, onwhich the company sees who owns their shares.
Payable date: is the date the dividend checks are sent out.
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Dividend Policy in Brief
Like M&M 58, Dividend Policy should be irrelevant to the value of thefirm
Given that dividends are tax disadvantaged (taxed as income at higherrates until 2003) they shouldnt be used.
Investors prefer repurchases (because of taxes)
Dividend policy cannot affect the present value of cash flows onlywhen we receive them
Accelerating payments does NOT reduce uncertainty of cash flows and pricedrop on ex-dividend date will be l arger
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Empirical Dividend Policy
Litner (1956) surveyed 28 companies, managers:1. Focus on the change in dividend, not the amount2. Avoid making dividend changes that have to be reversed3. Change dividends if earnings are out of line4. Pay little attention to need for investment
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Empirical Dividend Policy
Brav, Graham, Harvey & Michaely (2003) Cut dividends only under extra ordinary circumstances
Tend to smooth dividends Changes linked to long term changes in profitability
Repurchases are more flexible Used for temporary earnings spikes after investment needs are met
Repurchase when stock prices are low Repurchase to improve EPS
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Optimal Dividend Policy?
Without taxes there is none. If there are taxes choose the cheapest
The Bird in the Hand Fallacy
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The Bird in the Hand Fallacy [Bhattacharya (1979)]
Many have argued that when cash flows are uncertain paying dividends sooner reduces uncertaintyA bird in the hand is worth two in the bush
Bhattacharya (1979) points out that dividend policy cantchange the present value of cash flows received only the
timing.
What is relevant is the riskiness of cash flows
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Optimal Dividend Policy?
Without taxes there is none. If there are taxes choose the cheapest
Marsalis and Truman (1988) model personal taxes ondividends
Implication Cost of Internal capital is lower than external funds (ifdividends are tax disadvantaged)
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Optimal Dividend Policy
Marsalis and Truman (1988): Cost vs. Benefit of internal vs. external financing
Equilibrium is when after tax return is the same to reinvestment and dividends High tax individuals prefer reinvestment Low tax prefer dividends (tax clienteles) Firms with positive NPV projects will use up internally generated
fund first
Firms with fewer growth options will pay dividends Decreases in current earnings should leave investment unchanged in
firms that use external capital and decrease investment in firms usinginternal capital
Shareholder disagreement about investment policy will lead to theuse of internal funds
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Evidence: Clientele Effects
Low tax investors buy high dividend yield stocks Elton and Gruber (1970)
Possible Caveat: Tax Arbitrage [Kalay, 1977, 1982] 2010 Patrick J. Kelly 63
Ex-date pricedecline div
Dividends as Signaling
Ross (1977) Dividends are irrelevant in part becauseM&M61 assume investors know random returns
Capital structure can be used to signal the quality of the firm Bhattacharya (1979)
Dividends can be a costly signal because less successful firmswould have to finance externally
Trade off between signaling benefit and Tax Consequences
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Repurchases
With tax dividends taxed at a higher rate, repurchases are away to distribute cash to share holders at the lower capitalgains tax rate
IRS is not dumb though: frequent repurchases will be taxed likedividends
Open market repurchase Buy back over time
Tender offer: number of shares, tender price, expiration of offer If over subscribed, repurchase on a pro rata basis If undersubscribed, extend or cancel
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Guay and Harford (2000)
When Dividends? When Repurchase? Dividends: permanent cash flows Repurchase: transient cash flows
Hypotheses: Why repurchase?1.Signaling: Signal of increased cash flows OR exhausted investment
opportunities
2.Tax shield: repurchase shares with new debt issue3.Avoiding taxes: Section 302: Substantially disproportionate4.Bond holder wealth expropriation: reduce asset base5.Wealth transfer among share holders
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Guay and Harford (2000): Findings
Evidence most consistent withTax shieldTax avoidance
But signals favorable information about future cash flows.
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Evidence of Dividends as a costly signal is mixed
Information about current dividends does not help forecastearnings [Watts (1973), Gonedes (1978), Penman (1983)]
Earnings changes predict dividend changes, but not the other wayaround [Benartzi, Michaely and Thaler (1997)]. Dividend decreases
precede HIGHER earnings
Market reaction to dividend changes larger when taxes arehigher [Grullon and Michaely (2001)]
Similar reactions in Germany, where dividends are tax favors(they are lessof a signal) [Amihud and Murgia (1997)]
Might signal changes in systematic risk [Grullon, Michaelyand Swaminathan, 2002]
2010 Patrick J. Kelly 68
Firm as a Nexus of Contracts
The firm is a set of contracting relationships Where there may exist externalities to the contracting
process
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Externalities
Externalities are the by product of a (productive) processthat imposes harm (or benefits) to other agents
Pollution Cattle Rancher/Farmer Problem
A rancher trying to water his cattle tramples the field of a farmerThe externality is the destroyed crop
One agent maximizing profits imposes costs on another Principle-Agent realm: one agent maximizing utility imposes costson the principle
70
Coase (1960)
Property Rights: The socially enforced right to select uses ofgoods
Coase Theorem: In the absence of transactions costs the allocation of resources
does not depend on the initial disposition of property rights.Assuming
No transactions costs Trade-able property rights No income effects
Bottom p4 then p371
Coase Theorem
Efficiency occurs regardless of the structure The Coase Theorem is an Organizational Irrelevance
Theorem
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Firm as the Nexus of Contracts: Coase (1937)
In market economies coordination of activity is doesthrough the pricing mechnism
Why do we have firms which entirely remove prices fromthe production coordination process?
Answer: There are costs to using the price mechanism Discovering Prices NegotiationTaxes
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Boundaries of the Firm
Transactions costs help dictate the boundaries and structure ofthe firm
Activities which are less costly to internalize are made partof the firm otherwise external
The essence of Coase (1937) It is in the interest of individuals to explore gains to trade It is in the interest of individuals to explore contracts to minimize
costs
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If a research paper says
If a research paper says an organizational feature isimportant, you must ask:
What is the ill-defined property right?What is the transaction cost ? that makes this feature important?
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Jensen and Meckling (1976)
Firm is a set of contracting relationships among individuals Imperfect contracting leads to agency problems
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Jensen and Meckling (1976)
When owner/manager owns 100% of firm there are noagency costs. The manager maximizes his or her own utility.
Sets Marginal Utility derived from $1 of expenditure of firmresources = Marginal Utility of $1 in purchasing power (fromdividends paid)
Perquisite consumption not a problem
77
Jensen and Meckling (1976)
If a owner/manager owns only 95%:The manager expends effort to the point where the marginal utilityof $1 of expenditure of firm resources equals marginal benefit of
95 cents purchasing power
Partial ownership leads to less vigorous effort Perquisite consumption
Agency costs arise because contracts cannot be written andenforced with no cost
Coase (1960): Contracts define the rights, but There are significant transaction costs.
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Jensen and Meckling (1976)
Agency Costs are:1. Costs of Structuring a set of contracts2. Costs of Monitoring and Controlling the behavior of agents by
principles
3. Costs of bonding to guarantee that agents make optimal decisions Or that principles are compensated for suboptimal decisions
4. Welfare loss arises from the divergence between agents decisionsand those which maximize the principles welfare.
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Jensen and Meckling (1976)
Agency costs affect the level of Debt Bankruptcy liquidation is a hard tool against managers
Agency Costof Equity
Agency Cost ofDebt
$Cost
D
D+S
Optimal CapitalStructure
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