TCF - set 2 - Princeton University Press

Report
MULTISTAGE FINANCING




LIQUIDITY RATIOS
RISK MANAGEMENT
SOFT BUDGET CONSTRAINT
FREE CASH FLOW
2th set of transparencies for ToCF
CORPORATE LIQUIDITY DEMAND
HOARDING OF LIQUIDITY
Asset side : – securities
– credit lines and loan commitments
Future promises to lend
(maximum amount, lending terms, duration, commitment
fee, option to convert into term loan at maturity?,…)
Over 75% of commercial and industrial loans at large US
banks = take-downs under loan commitments.
Liability side : – long term debt and equity
WHY?
Concern about refinancing (Thakor-Hong-Greenbaum 1981, Froot2
Scharfstein-Stein 1993).
CORPORATE RISK MANAGEMENT
TECHNIQUES
• forward/futures markets (raw materials, agricultural products),
• swap  FX
•
 interest rate,
• securitization,
• insurance against theft, fire, death of key employee,
• trade credit insurance,
• geographical plant diversification.
…
•Yet limited hedging (Culp-Miller). Large companies make much
greater use of derivatives.
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WHY?
• reduction in volatility for claimholders : No!
• cut tax bill? (Stulz),
• insure managers by filtering out exogenous noise (Stulz, FitePfleiderer)? Alternative : virtual hedging.
• reduce probability of bankruptcy?
AGENCY BASED EXPLANATIONS
• unability to get funds when one needs them (Froot et al,
Stulz),
• avoid ancillary damages such as gambling behavior.
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CORPORATE LIQUIDITY DEMAND
"Cash poor firm"
overruns/reinvestment
Cash need
shortfall in earnings
0
Financing
1
continue
2
Outcome
Liquidation,
downsizing
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• How to meet these needs?
2 options
Date 1
go to capital market :
new debt, new equity
DILUTION
Date 0
hoard liquidity
SECURITIES
CONTRACT
• credit line (ST)
• revolving credit
(often option to
convert into LT loan)
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BASIC INSIGHT:LOGIC OF CREDIT RATIONING APPLIES AT
DATE 1 AS WELL  WANT TO HOARD
LIQUIDITY
CASH RICH FIRM: flip side of same coin.
Jensen 1986
ST debt
Easterbrook 1984
Dividend
pump out money
steel, tobacco, chemical, broadcasting,...
Security design also regulates liquidity
Equity, LT debt: little cash draining
ST debt: drains cash
Preferred stocks...
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I. LIQUIDITY RATIO AND CORPORATE RISK MANAGEMENT
I. FIXED INVESTMENT VERSION
Optimal policy: continue iff
for some
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(IC)
9
10
(i)
(first best)
(ii)
Then
[Third case (iii)
no funding ]
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CASH-RICH FIRM:
Theory of maturity structure:
Weak balance sheet
short maturity structure.
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CASH-POOR FIRM:
Example: r = 0.
"Wait-and-see" policy suboptimal
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II. VARIABLE INVESTMENT VERSION
2.1 Two-shock case
Timing
1
0
•
•
2
Investment
I
Borrows
I-A
MH
(choice
pH or pL )
“INTACT”
(no
reinvestment
needed)
“DISTRESSED”
(reinvestment 
per unit of
investment)
Outcome
RI
p
1-p
0
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Assumptions
(1) There exists store of value ( 1
(2)
1)
remember
(3)
Interpretation
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Policy #1 : abandon in case of distress
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Policy #2: pursue project in case of distress
Minimize cost :
policy #2
1    
1
Policy #2 when  low
 high
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2.1 Continuum-of-shocks case
0
Contract.
Investment I.
External
financing
I-A.
1
Need for
cash infusion
realized.
Distribution
pay
2
Outcome
MH
No
money
to pay
pH
pL
p
1-p
RI
0
on
Project abandoned
(liquidation)
Yields 0
(later : yields LI)
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a) OPTIMAL CONTRACT (later: implementation)
• Only investors can cover I .
• Suppose for the moment one can contract on continuation rule
 Optimum:
continue: needs
liquidate (nothing for entrepreneur)
Pledgeable income after continuation
0I

B 

  p H  R 
I
p 





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IR  
 *

F (  * ) 0 I  I  A  
 f (  )d   I
 0


 multiplier I = k A
k( * )
1

1
Maximized at 
*
 0 .
*
0
 f (  )d   F (  * )  0
Explanation.
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NPV per unit of investment:
maximized at
Intuition.
Borrower’s utility
Optimum:
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Optimal
"expected unit cost of effective
investment"
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Utility:
Utility
=
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Generalization: liquidation value LI :
Intuition.
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CORPORATE DEMAND FOR LIQUIDITY
1 WAIT-AND-SEE POLICY IS SUBOPTIMAL
 even with "perfect" financial market, investors won't bring in
more than
at date 1.
 Conversely,
claims diluted.
initial investors willing to have their
Dilution only
(even worse if debt overhang, etc.)
2 HOARDING:
* Nonrevocable credit line
no right to dilute
or
* Securities: same
right to dilute
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CORPORATE RISK MANAGEMENT
with
Modeling: • "Adverse" shocks
(ex: foreign exchange risk).
• Can get insurance at fair rate.
Idea: obtain insurance so that
does not mess up decision making.
• HEDGING
For an arbitrary
Remark : could be a conditional credit line (less common).
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NO HEDGING
Firm can withstand shocks  such that
Hence:
where
Let
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Lemma : H is more convex than F
convex
convex
Proof :
Arrow-Pratt:
In contrast, manager ex post may or may not hedge if given the choice
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Firm
"risk averse" w.r.t. 
"risk loving" w.r.t. 
Mean preserving spread
Firm better off
DIFFERENCE:  "unavoidable";  option !
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OPTIMALLY INCOMPLETE HEDGING
 Full hedging is too stark a result.
 Transaction costs... and 5 other reasons for hedging incompletely.
(a) Market power
Forward sales and over-supply by monopolist or oligopolist.
(b) Several correlation of profits
Example:
• random short-term income r (exogenous)
• "attractive-reinvestment-opportunities effect": probability of
success p +  (r) where ' > 0.
But "easier-refinancing effect": good news make it easier to return
to the capital market.
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Optimal policy:
(firm should keep some of its cash-flow as retained earnings)
(c) Aggregate risk
Like CAPM: economic agents share (in different proportions) the
aggregate risk.
(d) Asymmetric information
(e) Incentives
Short-term profit r in general is endogenous. Motivates investment-tocash-flow sensitivity: see next section.
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II. SOFT BUDGET CONSTRAINT
Basic idea:situation in which capital market is too soft: refinances when not ex ante
optimal to do so.
Date 0
Date 1
date 0
signal (or realization)
moral hazard
informative about
(or AS)
date-0 behavior
about
date-1 continuation
income parameters
r
•
• L
• 2nd period
prospects
(R, pH …)
want to punish if r small, etc.
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• KEY: Monetary punishments limited (especially if continuation!)
Often liquidation (interference,…) only punishment or at least complementary punishment.
• EXAMPLE: r endogenous
Perhaps even deterministic
Low date-0 effort
High date-0 effort
- monetary rewards
Private benefit B0I of shirking at date 0.
State-invariant continuation rule does not provide incentives. Two possibilities:
• very small cost (2nd order) for B0 small
• not credible if
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Text:
if works
if shirks
MLRP :
at date 0
increasing
Optimal policy:
over "relevant range" (small if B0 small).
SBC
r
"retained-earnings policy"
Soft Budget Constraint
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III. FREE CASH FLOW
Jensen
Easterbrook
• r exogenous (no SBC issue)
deterministic safe cash flow (public utilities,
banks,
mature industries)
• Generalized formulae:
Free cash flow assumption:
Payment:
ST debt
dividend (with ceiling)
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CRITIQUES
Uncertainty
not flexible enough, risk of liquidity problem
Ex:
Rigid (ST debt):
• liquidity risk
(see hedging stuff)
P1 high: good reinvestments not made
P1 low: free cash flow
• does not respond to news about L, future prospects
market information !
 need to make use of
Secret reinvestments just before r accrues.
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