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Corporate finance
In this section, the reports deal with articles on corporate finance: capital structure, corporate financial policy, IPOs, share buybacks, CEO compensations, stock options, managerial incentives, debt issuance, tax issues, the empirical studies etc..

How and When Do Firms Adjust Their Capital Structures toward Targets

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How and When Do Firms Adjust Their Capital Structures toward Targets

Soku Byoun

The two competing theories of pecking order and trade off behavior have been largely evaluated in isolation from one other. This study combines the basic intuition of the pecking order theory with the observation that imbalances in cash flows (financial deficits /surpluses) will likely incur capital structure adjustments.

The study examines:
a) The capital structure adjustment conditional on the required external capital changes as measured by a financial deficit/surplus.
b) Firms’ propensities to use financial deficits/surpluses to capital structure adjustments conditional on above and below-target debt.
c) The effects of financial constraints on capital structure adjustments.

According to the pecking-order theory, adverse selection costs are the dominant factor in capital structure decisions. The most apparent effect of adverse selection costs is a firm's preference for internal funds. Accordingly, in the presence of adverse selection costs, firms may have target debt levels and still prefer internal funds over costly external ones. Adjustments toward a target can be asymmetric in the sense that firms weigh differently positive and negative deviations of leverage ratio from a target.

A typical target adjustment model is developed in which the firm and industry characteristics related to costs and benefits of operating with various leverage ratios are regressed on the observed debt ratio. The initial sample consisted of all available US firms from the annual Compustat files for the period 1971-2003.

The results suggest that most adjustments occur when firms have above-target debt with a financial surplus or when they have below-target debt with a financial deficit. Firms with above-target debt use all of their financial surpluses to pay off debt, whereas firms with below-target debt retire both debt and equity with their financial surpluses.

Firms appear to preserve their debt capacity for future financing needs in order to avoid the higher costs of repurchasing and re-issuing equity. Controlling for the disparity between the deviation from the target and the financial deficit/surplus, the study finds that the changes in capital structure are impressively consistent with the target adjustment model: the adjustment coefficient is close to 100% when firms have above-target debt with a financial surplus and around 80% when firms have below-target debt with a financial deficit, which may reflect that the adjustment costs of reducing debt are lower than those of increasing debt and/or the costs of having above-target debt are higher than those of having below-target debt.

The results seem to suggest that there are fewer “endogenous components" in the financial surplus (related to a positive cash flow shock) than in the financial deficit (related to a negative cash flow shock). Accordingly, capital structure adjustments appear to occur in direct response to available surpluses, whereas the slower adjustments observed in response to financial deficits appear to reflect the interaction between investment and financing decisions by constrained firms.

In conclusion, adverse selection costs associated with information asymmetry influence
firms' capital structure adjustment decisions but not in the manner hypothesized by the
traditional pecking-order theory. Thus, adverse selection costs, along with other costs and benefits, must be part of a unified theory of capital structure.



Growth vs. Margins: Destabilizing Consequences of Giving (...)

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Growth vs. Margins: Destabilizing Consequences of Giving the Stock Market What It Wants

Many firms face a fundamental problem of the choice to either emphasize growth or margins. The limits on managerial time and resources forces firm to focus more on one dimension in relation to others. Anecdotal evidence suggests that, just as a firm can change its strategic orientation over time, so too can investors shift the emphasis that they place on various performance measures.
This paper focuses on interplay between firms’ strategies and the way that the stock market goes about evaluating them. The study develops a model in which a firm can devote effort either to increasing sales growth, or to improving per-unit profit margins. The assumptions made are that if the market conjectures that the firm is pursuing a growth strategy, its valuation will tend to put more weight on realized growth, which will in turn encourage the manager to stick with the growth strategy so long as this is not too inefficient. On the other hand, if the market conjectures that the firm is pursuing a cost-cutting strategy, its valuation will tend to emphasize margins, which will reward the manager for staying with the cost-cutting strategy. For as long as the market continues to value it as a growth firm, any change in strategy will lead it to disappoint the market on the growth dimension, thereby damaging its stock price.
The static model which aims to maximize expected managerial utility includes variables of first period profit which is the sum of two components (sales volume and margin component), stock price at the end of first period. The market is modeled as fully rational, albeit imperfectly informed about managerial ability. The assumption for generating first period sales and margins respectively include technologies like size of market, variables for sales shock and random variable for marginal shock.
If the market perceives that a firm is trying hard to generate sales growth, it will tend to react more strongly to news about growth, because such news is more informative about managerial ability. In contrast, if the market thinks that the firm is focusing its efforts on improving margins, it will tend to react more strongly to news about profitability. In either case, a manager who is concerned about stock prices will tend to give the market what it is looking for, which creates the scope for multiple equilibria.
The central implication of the work is that a firm’s investment and sales growth will be higher when its stock price is more sensitive to growth-oriented metrics; and conversely, a firm’s investment and sales growth will be lower and profit margins higher when its stock price is more sensitive to measures of costs and margin
If the firm’s manager cares about the current stock price, he will favor the growth strategy when the market pays more attention to growth numbers. Conversely, it can be rational for the market to weight growth measures more heavily when it is known that the firm is following a growth strategy. This two-way feedback between firms strategies and the market’s pricing rule can lead to excess volatility in real variables, even absent any external shocks.

Aghion, Philippe and Stein, Jeremy C., "Growth vs. Margins: Destabilizing Consequences of Giving the Stock Market What it Wants" (December 2004). Available at SSRN:


The Dynamics of Large and Small Chapter 11 Cases

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The Dynamics of Large and Small Chapter 11 Cases:
An Empirical Study
Douglas Baird, Arturo Bris, Ning Zhu

The Chapter 11 reorganization is run for the benefit of the business’s general creditors. The unsecured creditors who are entitled to whatever remains after secured creditors are paid off are the ones who benefit if Chapter 11 works well and suffer the loss if it works poorly.

This paper shows that the dynamics of Chapter 11 turn dramatically on the size of the business. Large cases consist of contending groups of sophisticated institutional investors. By contrast, in the small cases, there are few specialized assets beyond the human capital of the owner manager and it is not tied to the legal entity that is in bankruptcy.
The sample for this study consists of the corporate Chapter 11 bankruptcies in the District of Arizona and the Southern District of New York between 1995 and 2001. The data information on firm characteristics, public status, creditor characteristics, judge   characteristics and behavior, expenses, duration of proceedings, creditor recovery rates, and case outcome was extracted from PACER.

The study had two measures of information on asset value - prebankruptcy book values and post bankruptcy payout values. The post bankruptcy assets are calculated using actual recovery by secured creditors and hence they reflect the true value of the firm .The study also uses information on total liabilities; liabilities to secured and unsecured creditors and liabilities to priority vs. non-priority unsecured creditors. The information on compensation to professional services during the bankruptcy was also collected. These data are then used to explore the dynamics of Chapter 11 basically by exploring the differences between large and small business.

Twelve percent of all the businesses in the sample have assets less than $200,000. About one third of firms (45 firms) have assets greater than $200,000 but smaller than $1 million. The study on the relationship between liabilities and assets reflects that businesses with more than $5 million in assets average 5 secured creditors (median=3) and more than 400 general creditors (median=132). In most businesses when the assets are less than $200,000, nonpriority general creditors receive less than 50% of their claim, on average, with even lower medians. . In about 40% of these firms, nonpriority, unsecured creditors cannot recover anything unless APR is violated, because remaining assets are negative. For businesses with more than $5 million in assets, tax liabilities entitled to priority accounted for only 2.1% of all debt and most businesses owed none at all.

 The vast majority of the assets administered in Chapter 11 are concentrated in a handful of large cases, but most of the businesses in Chapter 11 are small, and the smaller the business, the smaller the distribution to general unsecured creditors. For businesses with assets above $5 million, unsecured creditors typically collect half of what they are owed. Where the business’s assets are worth less than $200,000, ordinary general creditors usually recover nothing. In the typical small Chapter 11 case, the tax collector is the central figure. In small business bankruptcies, priority tax liabilities are the largest unsecured liabilities of the business. Given the large shadow tax claims cast over small Chapter 11 reorganizations, accounts of small Chapter 11 must focus squarely on them.

Baird, Douglas G., Bris, Arturo and Zhu, Ning, "The Dynamics of Large and Small Chapter 11 Cases: an Empirical Study" (January 2007). Yale ICF Working Paper No. 05-29 Available at SSRN:



Which CEO Characteristics and Abilities Matter?

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Which CEO Characteristics and Abilities Matter?
Steven N. Kaplan, Mark Klebanov, and Morten Sorensen

A lot of extensive research has taken place about CEO compensation and turnover and their relation to firm performance. But there exist a gap on studies involving which types of CEOs affect firm performance and behavior.

This paper study how CEO characteristics and abilities relate to hiring decisions, PE investment decisions, and subsequent firm performance using a dataset of assessments of 300 CEO candidates for companies involved in private equity transactions (PE) – buyout (BO) and venture capital (VC).

CEOs are assessed in seven general areas – leadership, personal, intellectual, motivational, interpersonal, technical and functional. The assessments are based on four-hour structured interviews that were performed from 2000 to 2005 by a firm that assesses top management candidates for PE firms. The typical assessment is a 20 to 40-page document that includes detailed biographical information on the candidate from childhood through current job experience. The data include quantitative and qualitative information about the manager’s education and employment history as well as assessments of a rich range of personal skills and attributes such as “team player,” “aggressive,” “attention to detail” and so forth. The determinants of hiring and investment decisions are focused upon. The relation of the CEO ratings to subsequent success is also considered. The characteristics that matter for hiring and investment relative to those related to success for the BO firms are also examined.

Buyout CEOs score higher on characteristics related to managerial or executive functions while the VC CEOs score higher on characteristics related to vision and strategy. Outside candidates score higher than incumbents on every summary measures. The differences are statistically significant for characteristics relating to leadership, interpersonal, and specifics.

On the individual characteristics, outside candidates score higher on hiring, developing people, removing under performers, efficiency, network, organization and planning skills, analytical skills, work ethic, setting high standards, listening skills, oral communication, holding people accountable, and achieving financial and non-financial targets. The outside candidates also report stronger academic backgrounds – SAT and high school performance.

These results suggest that

1) Outsiders have more talent than incumbents
2) PE firms upgrade the talent in the firms in which they invest
3) Outside candidates are considered when the internal candidates are not performing well.

More highly rated CEOs who are hired are more likely to be successful, particularly for buyout-funded companies. In comparing the characteristics that matter for hiring and investment relative to those related to success, the study find that the CEO characteristics related to managerial and executive functions – such as “moves fast,” “aggressive,” proactive,” and “sets high standards,” – appear undervalued, while CEO characteristics related to interpersonal skills – such as “teamwork,” “open to criticism,” and “develops people,” – appear overvalued.

The smaller number of negative ratings using public information suggests that it is likely that the public information provides a coarser measure of performance than the PE firm responses

The study also finds that talent is significantly related to subsequent success particularly in BO.
The principal component analysis reveals that talent is the most important component. The regressions indicate that incumbents are more likely to be hired by both buyout and VC funded companies, holding talent equal.

Kaplan, Steven N., Klebanov, Mark M. and Sorensen, Morten, "Which CEO Characteristics and Abilities Matter?" (March 2007). Swedish Institute for Financial Research Conference on The Economics of the Private Equity Market Available at SSRN:




Bankruptcy Codes and Innovation

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Bankruptcy Codes and Innovation
Viral V. Acharya, Krishnamurthy Subramanian

In the process of generation of sustainable long run growth rate, identifying government and private means is considered as a vital step. Legal institutions governing financial contracts are supposed to affect the nature of real investments in the economy.

 This paper develops a theory to show that debtor friendly bankruptcy codes encourage firm level innovation by promoting continuations upon failure. The nature of bankruptcy codes alters not only the financing mix of the firm but also the nature of its real activity.  A firm’s choice between innovative and conservative technologies is modeled as a two-armed bandit problem. The dead weight cost of bankruptcy is modeled as a function of the investment strategy followed by the firm (innovative or conservative), its capital structure (the debt-equity mix) and the bankruptcy code in place (creditor-friendly or debtor-friendly). The firm chooses simultaneously the nature of its real activity and the extent of its debt financing. This implication is tested by examining the intensity of patent creation and patent citation in industry level, cross country analysis (difference in difference approach) as well as around within country code changes in accordance of control rights to creditors (triple difference approach).

The data set is based on the patents issued by the USPTO to US and foreign firms over the period 1978-2002 The innovation intensity for an industry is measured by the median or mean number of patents issued in a given year in that industry, and by the median or mean number of (all subsequent) citations to these patents. A pooled cross section and time series regression is employed to test whether a higher creditor rights index for a country is associated with relatively lower intensity of innovation for industries that are more likely to innovate technologically. The measure of innovation is regressed against variables of creditor rights and patent intensity. The set of control variables include indicator variable for each country and industry categories. The relationship between leverage and creditor rights is studied with the focus on G 7 countries.    

On the basis of employing industry level cross country data, the study find that innovative industries exhibit greater intensity of patent creation and patent citation in countries with weaker creditor rights in bankruptcy. This finding is confirmed by within country analysis that exploits time series changes in creditor rights and finally weak creditor rights are shown to amplify the effect of financial development on innovation. The value of an optimally financed innovative firm reduces while the value of an optimally financed conservative firm increases when the code become more creditor-friendly. Innovative industries take on relatively less leverage compared to other industries when creditor rights are stronger. These results seem to suggest that legal institutions governing financial contracts like bankruptcy codes have a substantial effect on the nature of real activity in the economy, particularly on the extent of innovative pursuits by firms. Finally, while overall financial development measures like accounting standards, Total (stock market) capitalization to GDP, Domestic private credit to GDP, and Private credit to GDP per capita fosters innovation; strong creditor rights weaken this effect, especially for highly innovative industries.

Acharya, Viral V. and Subramanian, Krishnamurthy, "Bankruptcy Codes and Innovation" (April 2007). AFA 2008 New Orleans Meetings Paper Available at SSRN:



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