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The article develops supply and demand functions for the commercial paper market. Between 1965 and 1968 the value of short-term debt issued by corporations more than tripled. The author estimates equations for supply and demand using quarterly data for the period 1954-1968. Results for several different industries are presented and discussed. Although the model worked will within the sample time frame, it performed less well for the two subsequent quarters, owing to structural changes in the market.

We present the first evidence that initial ratings of commercial paper influence common stock returns. Highly-rated industrial issues of commercial paper, unaccompanied by bank letters of credit, are associated with significantly positive abnormal returns; lower-rated issues are not. The stock price effects of changes in commercial paper ratings also demonstrate the relevance of ratings to the financing of firms. Rating downgrades, especially those that imply an exit from the commercial paper market, produce significantly negative abnormal returns; upgrades have no effects. Initial commercial paper ratings and subsequent reratings appear to help investors sort firms by their future prospects. [ABSTRACT FROM AUTHOR]

It is rather unusual to find all the papers presented in one of these sessions adhering so closely to the session title. I am taking note of this point to emphasize the unusual commonality of the two papers. Namely, both papers use the two parameter CAPM as their basic framework, and both papers investigate (or better, reinvestigate) classic, fundamental corporate finance issues. These are not trivial or second order issues undertaken in the two papers--capital budgeting, capital structure and dividend policy have always been at the core of corporation finance. But there is even a third similarity between these two papers; and that is, they both use numerical examples and solutions to illustrate some very difficult conceptual and analytical problems and to draw general conclusions. In many of the topics or cases studied in the two papers, analytical solutions were extremely complex or impossible, so that the usefulness of numerical examples was clearly demonstrated. [ABSTRACT FROM AUTHOR]

There have been several studies reported in the literature dealing with the valuation and the determinants of the premium on convertible bonds, see [1,2,3,5]. The phenomenon of liquidation of the convertible bonds seems to have received relatively scant attention and the theorists and practitioners alike are hard pressed to find cogent rationale for the voluntary conversion of convertible bonds. Once the share price exceeds the conversion price the holder of the convertible bond faces the decision either to convert it into shares or hold on to it until a later date. The paper by Mehta attempts to offer a rationale for this voluntary conversion of the convertible bonds taking place gradually over a period of time. He provides empirical data to indicate that voluntary conversion of convertible bonds does take place in the market and that it is gradual over time. After analyzing a number of possible reasons for voluntary conversion of the convertible bonds the author concludes that because of uncertain growth in share prices, the (convertible bond) CB holders hedge their position by selling the call option and where the price subsequently goes up they close their position by converting the CB assuming that this would be cheaper than the alternative of selling the CB and buying the shares in the market with the associated transaction costs and tax considerations taken into account. The paper rules out other motives of CB conversion such as the interest/dividend differential on the CB and its underlying equity on the grounds that it would be inconsistent with the gradual voluntary conversion of the CBs over time. The paper argues that voluntary conversion of CB can best be explained in terms of market imperfections and two of these imperfections considered by the author are taxes and transaction costs. [ABSTRACT FROM AUTHOR]

Employing a comprehensive database on transactions of commercial paper issued by domestic U.S. nonfinancial corporations, we study the determinants of very short-term corporate yield spreads. We find that liquidity plays a role in the determination of spreads but, somewhat surprisingly, credit quality is the more important determinant of spreads, even at horizons of less than 1 month. These results are robust across a variety of proxies for liquidity and credit risk, and have important implications for the literature on the modeling of corporate bond prices. [ABSTRACT FROM AUTHOR]

In two papers and in a recent book I have presented theory and evidence which lead to the conclusion that a corporation's share price (or its cost of capital) is not independent of the dividend rate. As you may know, MM (Modigliani and Miller) have the opposite view, and they argued their position at some length in a recent paper.3 Moreover, the tone of their paper made it clear that they saw no reasonable basis on which their conclusion could be questioned. Since they were so sure of their conclusion, it would seem advisable for me to review carefully my thinking on the subject, and this meeting appears to be a good time and place to do so. [ABSTRACT FROM AUTHOR]

The article presents commentary about a paper written by E. Han Kim entitled "Miller's Equilibrium, Shareholder Leverage Clienteles, and Optimal Capital Structure," which was published in the May, 1982 edition of the "Journal of Finance." The author regards Kim's paper as a survey of research on optimal capital structure inspired by Merton Miller's article "Debt and Taxes." He discusses the portion of Kim's paper that contrasted complete and incomplete capital market environments, and notes the importance of tax arbitrage restrictions in understanding them.

This article presents a discussion of a paper that examined the behavior of companies when dealing with foreign exchange. The author states that the paper follows a risky asset management hypothesis and examines several ways that foreign currency assets and liabilities can change. The author discusses several of the paper's strengths and also comments on various areas where it could be improved. The author discusses the conclusions reached in the paper and states that the strength of these points should be examined.

These are two excellent papers that view the Modigliani-Miller (MM) theorem from different perspectives. The Leland and Pyle (LP) paper considers what occurs when the financial claims of an entrepreneur convey information to the market about the type of project that is being financed. The Grossman and Stiglitz (GS) paper considers the financial decision when the market possesses full information about the returns of firms but where the market incompletely covers or markets claims in all contingencies. These are different approaches towards the same goal of developing a theory of corporate finance. The role of the MM theorem in these studies is analogous to that of Arrow's impossibility theorem in the theory of social choice. In both cases, to obtain an acceptable theory one must weaken the underlying assumptions. [ABSTRACT FROM AUTHOR]

The authors respond to comments by Professor Eugene Carter concerning their paper "A Simultaneous Equation Approach to Financial Planning." They state that while matrix inversions are utilized in solving linear simultaneous equations, their own model utilizes nonlinearities that prevent the use of a straight-forward matrix inversion technique. They suggest their own model does a more effective job of portraying financial decision making than other models. They comment on the accuracy of projections for Sears-Roebuck and mention a discussion about if the U.S. Securities and Exchange Commission should permit or require projections in equity prospecti, considering the method for making financial projections is well-developed.

The article presents a list of books received including "Determination: An Analysis of Wage Criteria," by Jules Backman, "Principles and Policy," by Royall Brandis, and "City Expenditures in the United States," by Harvey E. Brazer.

In recent months there has been no shortage of mergers in the U.S. We have seen numerous multibillion dollar takeovers and the issuance of new merger guidelines by antitrust authorities. In thinking about mergers, there are two large categories of issues. The first has to do with the owners and managers of the participating companies. Do shareholders of acquired firms benefit? Do shareholders of acquiring firms benefit? On net, is there value created by mergers? Or do many mergers simply carry out the whims of managers? The second large set of questions has to do with whether mergers improve the allocation of resources in the economy. Any value creation that might occur through merger could be as a result of real economic efficiency or as a result of the creation or exercise of monopoly power. Value creation to owners is not a sufficient basis for public policy decision on mergers since there are many competing theories about what might lead to such value. Richard Ruback's paper, in some sense, takes Paul Halpern's suggestion to the extreme. Halpern (1982) suggests that mergers are a theory of special cases. Ruback's paper is a paper about one and one case only. In discussing that paper there are three general areas on which I will focus. First, what should we expect to learn from a case study. Second, what methodological issues are raised in the paper. Third, what sort of interpretation can we make of the results of the paper. [ABSTRACT FROM AUTHOR]

This paper examines to what extent credit ratings directly affect capital structure decisions. The paper outlines discrete costs (benefits) associated with firm credit rating level differences and tests whether concerns for these costs (benefits) directly affect debt and equity financing decisions. Firms near a credit rating upgrade or downgrade issue less debt relative to equity than firms not near a change in rating. This behavior is consistent with discrete costs (benefits) of rating changes but is not explained by traditional capital structure theories. The results persist within previous empirical tests of the pecking order and tradeoff capital structure theories [ABSTRACT FROM AUTHOR]

If papers presented at our annual meetings are not addressed to the small group of academicians who attend the actual programs, but to a much larger audience that includes decision makers in the field, then Dr. Pellatt's paper on the analysis of real estate investment opportunities represents a significant contribution. He has done a competent, intelligent job of applying capital budgeting theory to the problem of real estate investment. Admittedly, there is nothing new or unique in the tools, techniques, or concepts employed in his paper, but he has produced a worthwhile marriage. He brings together a potentially fruitful union of capital budgeting, where we have had significant progress in the last decade, with the field of real estate evaluation where we have had little change in the last century. [ABSTRACT FROM AUTHOR]

This paper analyzes how mutual fund performance relates to past performance. These tests are based on a multiple portfolio benchmark that was formed on the basis of securities characteristics. We find evidence that differences in performance between funds persist over time and that this persistence is consistent with the ability of fund managers to earn abnormal returns. [ABSTRACT FROM AUTHOR]

This paper surveys capital structure theories based on agency costs, asymmetric information, product/input market interactions, and corporate control considerations (but excluding tax-based theories). For each type of model, a brief overview of the papers surveyed and their relation to each other is provided. The central papers are described in some detail, and their results are summarized and followed by a discussion of related extensions. Each section concludes with a summary of the main implications of the models surveyed in the section. Finally, these results are collected and compared to the available evidence. Suggestions for future research are provided. [ABSTRACT FROM AUTHOR]

This paper relates the value of additional information to asset prices in a pure exchange setting. The price structure of interest revolves around a "pricing-hypothesis": the prices in an economy with less information are unbiased estimators of the prices that would obtain in a more informative economy. Two basic results are developed. First, if the incremental information is useless then the pricing-hypothesis applies. Second, if the pricing hypothesis is assumed valid, then the information is valuable in a weak sense. The results are also considered in the context of empirical research. The case is made for viewing statistical tests of association between prices and signals as tests of the social value of information. [ABSTRACT FROM AUTHOR]

This paper answers the comments of readers of our earlier paper. Additional insight is gained by adding recent data to show the effect of following Value Line Investment Service recommendations in active stock market trading over the years 1974-81. We show that Value Line makes a statistically significant contribution, which cannot be explained by the Beta risk factor. We offer our results as an unexplained divergence from the Efficient Market Hypothesis, but with the tentative hypothesis that investment timing (i.e., the fact that the Efficient Market Hypothesis does not operate instantaneously) may explain much of the abnormality. [ABSTRACT FROM AUTHOR]

Our understanding of why corporations pay dividends is currently unsatisfactory. On the one hand, received theory tells us that dividends are irrelevant (in the sense that any two arbitrarily chosen dividend policies have equivalent consequences), both in the absence of taxes (Miller and Modigliani) and in their presence (Miller and Scholes). On the other hand, dividends continue to flood the empirical world with cash as regularly and as consistently as the sun scorches the desert, and one is hard put to characterize this pattern (currently at an annual rate of about $63 billion) as being founded on irrelevance. Not surprisingly, the attendant anomaly has led some, notably Black, to suggest that we really don't know why companies pay dividends. Something is clearly amiss. The present paper will look to the information content of dividends as a substantive (although not necessarily complete) explanation for the prevalence and persistence of positive dividend policies in market economies. The notion that dividends may constitute a source of information is, of course, not new (see e.g., Miller and Modigliani, Black, Stern). The basic idea is that the raising and lowering of dividends communicates information over and beyond what is provided by (mandated and nonmandated historical cost-based) earnings reports, forecasts, and other announcements. By in effect merging extant dividend theory with the theory of public information, the present paper generates several noteworthy consequences. [ABSTRACT FROM AUTHOR]

In a previous paper it was shown that the traditional rule that the allowed return on the equity of a regulated firm should be set equal to its cost of equity capital was conceptually deficient. This deficiency arises because the cost of equity capital of a regulated firm depends upon its risk, which depends in turn upon the regulatory policy that will be followed in the future, including the allowed rate of return. It was argued therefore that this traditional rule should be replaced by the requirement that the regulatory policy be consistent. A consistent regulatory policy achieves what the traditional rule only attempts: it ensures that at the time of a regulatory hearing the market value of the firm equity is equal to the equity financed portion of the rate base. To devise a consistent regulatory policy, it is necessary to have a valuation model which takes explicit account of regulatory policy. Such a model was developed in the above-mentioned paper. In this paper we generalize the earlier valuation model so that the investment policy of the regulated firm is determined by the value maximizing decisions of the management instead of being taken as exogenous. To the extent that investment policy is discretionary, its endogeneity must be taken into account in devising a consistent regulatory policy, and this is made possible by the generalized model. In reality it seems unclear to what extent the investment policies of regulated firms are predetermined by the requirement that they meet demand, and to what extent they are discretionary. Since the model presented here easily accommodates constraints on the investment policy it is the more appropriate model so long as there exists any element of discretionary investment behaviour, and permits a more adequate approach to the determination of consistent regulatory policies. [ABSTRACT FROM AUTHOR]

Taxes affect capital budgeting under inflation in many ways. This note focuses on two of the most important—depreciation deductions and interest deductions. Because depreciation for tax purposes is based on historical costs rather than current values, investments in depreciable assets become less attractive under inflation. Because debtors can deduct nominal interest payments, not just real interest charges, debt-financed investments become more attractive under inflation. The impact of inflation and taxes on the value of potential investment projects depends on which factor dominates. In a recent paper in this journal, Gandolfi argued that the existence of a tax on corporate profits will not alter the real rate of return on the firm's marginal investment. In a subsequent paper, Jaffe exposed Gandolfi's error in ignoring the tax subsidy to debt-financed investments. Both authors assumed that the firm's investment takes the form of a non-depreciating machine—a special case, as Jaffe notes, among an infinite number of possible depreciation schedules. An extension of Jaffe's analysis to handle alternative depreciable lives confirms his assertion that investments which would be marginal in a world without taxes can become profitable in a world with taxes. However, the cutoff rate of return exceeds the rate calculated by Jaffe whenever the machines have finite lives. Moreover, in the limiting case of an asset which has a single period life, the required rate of return will be unaffected by a tax on profits. The section which follows introduces a depreciable asset into Jaffe's analysis; quantitative results of the impact of inflation and taxes on the firm's cutoff rate of return are calculated. Section three summarizes the main conclusions from the analysis. [ABSTRACT FROM AUTHOR]

This paper attempts to continue a line of attack on capital budgeting problems that was essentially begun by Myers and Turnbull. Their method was to use simple, tractable assumptions about cash flow stochastic processes and an intertemporal capital asset pricing relationship to investigate the accuracy of "cruder," traditional methods of valuation like discounting at a risk-adjusted cost of capital. We extend this approach to some prototypical mean-reverting cash flow processes which, we argue, are economically more relevant than the extrapolative, purely indeterministic processes used by Myers and Turnbull. In his discussion of the Myers and Turnbull paper, Hamada suggested that their results needed to be examined in the context of other types of cash flow processes; this paper is an attempt in that direction. It is our belief that, given the fact that risk-adjusted discount rate valuation (with project classes or divisions serving as surrogate measures of risk) is an important capital budgeting practice in many firms, asking questions of this type is a useful exercise in applied corporate finance. [ABSTRACT FROM AUTHOR]

The article comments on a paper published within the issue, "Elimination of the Double Taxation of Dividends and Corporate Financial Policy," by Robert H. Litzenberger and James C. Van Horne. The author summarizes the paper by claiming the authors' have clearly demonstrated the inability to separately analyze capital structure decisions and dividend policy in the presence of differential personal income taxes and dividend paying firms. He also discusses Litzenberger and Van Horne's development of a multi-period state-preference model. The model incorporates differential personal income taxes by introducing a time state claim on taxable ordinary income and a time state claim on nontaxable wealth. The author feels that Litzenberger and Van Horne carry out a thorough and careful analysis of two alternative ways to eliminate the double taxation of dividends.

This short paper had addressed the question of whether or not the stochastic nature of capitalization rates gives rise to a component of the risk of common stocks that we term systematic capitalization risk and whether corporate growth plays an important role in determining the magnitude of that risk. A second objective of the paper was to determine the most relevant definition of corporate growth for purposes of studying the determinants of systematic risk. Employing Cov[sub t-1](R[sub jt], R[sub mt])/Var[sub t-1](R[sub mt]) from the Sharpe-Lintner security market line as the appropriate measure of systematic risk for a stock we succeeded in deriving the underlying functions for R[sub jt] and R[sub mt] in terms of fundamental corporate characteristics such as the rate of return on investment, the rate of earnings retention, and the rate of stock financing. The result is that the systematic capitalization risk of common stocks is undoubtedly a positive function of the rate of growth of expected total corporate earnings. Moreover, retention policy, per se, appears to be neutral as a causal variable but is probably closely associated with systematic risk through its correlation with the rate of investment. Since the rate of growth of total expected earnings on equity is a positive multiplicative function of the investment rate and the rate of return on that investment it follows that an increase in either or both of these variables tends to increase systematic capitalization risk as well. The extension of capital market theory to include the notion that systematic risk is a positive function of total earnings growth promises to have profound implications for almost every type of economic decision. For example, Hamada, Myers, and others have shown with the use of stationary earnings distributions that the cost of capital for an investment project is a function of the covariance of return on the project with the return on the market portfolio. However, if we m... [ABSTRACT FROM AUTHOR]

This paper analyses the movements in the total and the form of the external financing of the firms covered in the Nonfinancial Corporate Business Sector of the Flow of Funds Accounts over the period 1956 to 1973. It is centrally concerned with the determinants of the volume of short and long-term debt raised by these firms. On average, short-term debt issues accounted for about one-third of the total debt issues of these firms. The relative proportion of short and long-term debt varies significantly and has a marked cyclical pattern, however. Short debt expands very rapidly as the expansion approaches its peak and falls off dramatically in the subsequent recession. Long debt increases more slowly during the expansion and persists at relatively high levels well into the recession. The first issue to which the paper is addressed is that of whether there is any evidence that is consistent with the hypothesis that this variability arises in part because business firms manage the maturity of their debt issues in an attempt to lower the average cost of the debt they issue. If so, how important is this factor as opposed to a more straightforward attempt to finance short assets predominantly with short liabilities and long assets with long debt? A second issue of interest is whether the variability in the volume of long and short term debt issued in the period 1966 to 1973, and in particular around the time of the turmoil in the commercial paper market in mid 1970, was different from what one would have expected on the basis of earlier financing behavior. [ABSTRACT FROM AUTHOR]

This article presents the author's opinion on the article presented by Professors Brennan and Schwartz. The article distinguished between the book and market values of the assets and liabilities of a firm and financial constraints are posed in terms of plausible accounting ratios. The author discusses some concerns he had with the paper including that personal taxes are ignored and interest rates are assumed to be constant in their examination of the financial policy of an evolving firm.

The article presents commentary about a paper written by Nils H. Hakansson entitled "To Pay or Not to Pay Dividend," which appeared in the May, 1982 edition of the "Journal of Finance." The author believes Hakansson's paper raises several issues that could benefit from further research. Specifically, additional inquiry should be made into the questions of whether investors are rational, whether dividends are informative, and whether conclusions reached in Hakansson's paper hold within a multiperiod framework.

The article presents commentary from Uri Ben-Zion about an article written by Robert W. Resek, "Multidimensional Risk and the Modigliani-Miller Hypothesis," which appeared in the March, 1970 issue of the "Journal of Finance." In that paper Resek claimed to present a proof that the Modigliani-Miller proposition concerning the indifference of a firm's cost of capital to its capital structure was mistaken. In the current paper Ben-Zion argues that Resek himself is mistaken, and that the Modigliani-Miller proposition still holds.

The article presents commentary from Richard S. Bower about two papers contained in the current issue, "A Programming Approach to Corporate Financial Management" by Myers and Pogue, and "Debt Management and the Form of Business Financing" by White. He is disappointed that neither paper addresses such questions as whether financial managers should incorporate speculation about interest rates into their decisions about debt financing, what the optimal level of debt is, and whether dividends make sense when external equity is available as a source of funds. He doesn't believe White's paper backs up his hypothesis about rate speculation.

This paper develops a theory of capital structure in an international setting with corporate and personal taxes. We generalize the Miller analysis to an international equilibrium characterized by differential international taxation and inflation in otherwise perfect international capital markets. Our analysis highlights the key role that corporate tax arbitrage plays in generating an international capital structure equilibrium, and we set forth a number of mechanisms for tax arbitrage transactions. We close the paper by outlining some implications of our analysis for national differences in capital structure, the International Fisher Effect, and international tax effects on yield differentials. [ABSTRACT FROM AUTHOR]

This paper provides clear evidence of substantial tax effects on the choice between issuing debt or equity; most studies fail to find significant effects. The relationship between tax shields and debt policy is clarified. Other papers miss the fact that most tax shields have a negligible effect on the marginal tax rate for most firms. New predictions are strongly supported by an empirical analysis; the method is to study incremental financing decisions using discrete choice analysis. Previous researchers examined debt/equity ratios, but tests based on incremental decisions should have greater power. [ABSTRACT FROM AUTHOR]

This paper examined the returns earned by subscribing to initial public offerings of equity (IPOs). Rock (1986) suggests that IPO returns are required by uninformed investors as compensation for the risk of trading against superior information. We show that IPOs with more informed investor capital require higher returns. The marketing underwriter's reputation reveals the expected level of "informed" activity. Prestigious underwriters are associated with lower risk offerings. With less risk there is less incentive to acquire information and fewer informed investors. Consequently, prestigious underwriters are associated with IPOs that have lower returns. [ABSTRACT FROM AUTHOR]

There is gathering evidence of insider trading around corporate announcements of dividends, capital expenditures, equity issues and repurchases, and other capital structure changes. Although signaling models have been used to explain the price reaction of these announcements, a usual assumption made in these models is that insiders cannot trade to gain from such announcements. An innovative feature of this paper is to model trading by corporate insiders (subject to disclosure regulation) as one of the signals. Detailed testable predictions are described for the interaction of corporate announcements and concurrent insider trading. In particular, such interaction is shown to depend crucially on whether the firm is a growth firm, a mature firm, or a declining firm. Empirical proxies for firm technology are developed based on measures of growth and Tobin's q ratio. In the underlying "efficient" signaling equilibrium, investment announcements and net insider trading convey private information of insiders to the market at least cost. The paper also addresses issues of deriving intertemporal announcement effects from the equilibrium (cross-sectional) pricing functional. Other announcement effects relate the intensity of the market response to insider trading, variance of firm cash flows, risk aversion of the insiders, and characteristics of firm technology (growth, mature, or declining). [ABSTRACT FROM AUTHOR]

This paper provides a test of whether capital structure decisions are at least in part motivated by managerial self-interest. It is shown that the debt ratio is negatively related to management's shareholding, reflecting the greater nondiversifiable risk of debt to management than to public investors for maintaining a low debt ratio. Unless there is a non managerial principal stockholder, no substantial increase of debt can be realized, which may suggest that the existence of large non managerial stockholders might make the interests of managers and public investors coincide. [ABSTRACT FROM AUTHOR]

This paper examines optimal corporate financing arrangements under asymmetric information for different patterns of temporal resolution of uncertainty in the underlying technology. An agency problem, a signalling problem and an agency-signalling problem arise as special cases. The associated informational equilibria and the optimal financing arrangements are characterized and compared. In the agency-signalling equilibrium the private information of corporate insiders at the time of financing is signalled through capital structure choices which deviate optimally from agency-cost minimizing financing arrangements, which in turn induce risk-shifting incentives in the investment policy. In the pure signalling cue the equilibrium is characterized by direct contractual precommitments to implement investment policies which are riskier than pareto-optimal levels. Empirical implications (or debt covenants and the announcement effect of investment policies and leverage increasing transactions on existing stock and bond prices are explicitly derived. [ABSTRACT FROM AUTHOR]

The development of organized markets for speculative-grade corporate debt has provided financial researchers with an opportunity to examine the pricing of default risk. By incorporating previous work on the default experience of low-rated corporate debt, this paper presents an introduction to risk-neutral models of risky-bond pricing and uses these to examine the relationship between the default premium embodied in bond yields and actual default rates. The contribution of macroeconomic information to the default premium is also examined. The author finds that holders of low-grade bonds have, on average, been compensated for losses due to default. [ABSTRACT FROM AUTHOR]

This paper examines differences in announcement day effects among firms engaged in voluntary sell-offs. While, on average, an initial sell-off announcement results in a significant positive excess return, not all divestiture announcements are accompanied by positive price movements. Dividing the sample into two subsamples based on whether the transaction price is announced shows that the announcement day effect is significantly positive for the price group but not statistically different from zero for the no-price group. In addition, a positive relation is found between the relative size of the sell-off and the announcement day return. [ABSTRACT FROM AUTHOR]

This paper has examined the moral hazard-cum-adverse selection problem in a corporate finance context via an analysis of the debt/equity financial market structure. The complex capital structure obtained from issuing debt and equity does a better job of resolving these combined problems than does an all-equity structure. We examined this market structure under the assumption that means and standard deviations are positively correlated. While the technical details make the equilibrium derivation difficult in general, we were able to establish a set of market-based conjectures that lead to an informationally consistent complete sorting equilibrium. These can be summarized as follows. Entrepreneurs with low variances of terminal value choose high ownership shares. Entrepreneurs with greater expected marginal productivity work less, but generate identical expected returns and increase their debt-promised payment levels accordingly. Outside investment is indeterminate under the constant returns to scale assumption; nevertheless, the difference between aggregate external investment and debt-promised payment is increasing in productivity, ceteris paribus. The end result is that capital structure leaves every firm with the same probability of defaulting on its bonds. Therefore, this model would predict that defaults on corporate debt are not failures of the informational efficiency of financial markets; rather, they are due to market-wide events that are outside the firm's control. [ABSTRACT FROM AUTHOR]

When capital market investors and firm insiders possess the same information about a company's prospects, its liabilities will be priced in a way that makes the firm indifferent to the composition of its financial liabilities (at least under certain, well-known circumstances). However, if firm insiders are systematically better informed than outside investors, they will choose to issue those types of securities that the market appears to overvalue most. Knowing this, rational investors will try to infer the insiders' information from the firm's financial structure. This paper evaluates the extent to which a firm's choice of risky debt maturity can signal insiders' information about firm quality. If financial market transactions are costless, a firm's financial structure cannot provide a valid signal. With positive transaction costs, however, high-quality firms can sometimes effectively signal their true quality to the market. The existence of a signalling equilibrium is shown to depend on the (exogenous) distribution of firms' quality and the magnitude of underwriting costs for corporate debt. [ABSTRACT FROM AUTHOR]

This paper demonstrates that, contrary to the results of previous studies, the impact of inflation on the aggregate debt-asset ratio cannot be determined theoretically. However, it is shown that inflation is likely to increase this ratio when personal income tax schedules are indexed to the price level and/or when leverage-related costs are relatively high and the personal tax rate on income from holding common stocks is relatively low. [ABSTRACT FROM AUTHOR]

This paper provides a positive theory of voluntary disclosure by firms. Previous theoretical work on disclosure of new information by firms has demonstrated that releasing public information will often make all shareholders worse off, due to an adverse risk-sharing effect. This paper uses a general equilibrium model with endogenous information collection to demonstrate that there exists a policy of disclosure of information which makes all shareholders better off than a policy of no disclosure. The welfare improvement occurs because of explicit information cost savings and improved risk sharing. This provides a positive theory of precommitment to disclosure, because it will be unanimously voted (or by stockholders and will also represent the policy that will maximize value ex ante. In addition, it provides a "missing link" in financial signalling models. Apart from the effects on information production analyzed in this paper, most existing financial signalling models are inconsistent with a firm taking actions which facilitate future signalling because release of the signal makes all investors worse off. [ABSTRACT FROM AUTHOR]

In their seminal work Black and Scholes (1973) provide a significant insight which arguably is of more academic and practical value than their famous option pricing model. They demonstrate that corporate liabilities can be viewed as combinations of simple option contracts. This generalization of option pricing, as refined by Merton (1974, 1977), has become known as Contingent Claims Analysis (CCA). While CCA has subsequently been used by many researchers as a theoretical framework in which to view the pricing of corporate liabilities, its empirical validity remains an open question. Ingersoll (1976, 1977b) has tested the model's ability to predict prices for dual purpose funds and call policies for convertible bonds respectively. In a recent paper, JMR (1983), we tested CCA in one of its potentially most important applications, namely the valuation of debt in typical corporate capital structures. The objective of JMR (1983) was to test the predictive power of a prototypical model based on the usual set of assumptions in the CCA literature. The data base used in JMR (1983) was made up primarily of investment grade bonds, i.e. bond rating of BBB or higher. This paper extends that test of the prototypical model to a larger data base which includes a number of noninvestment grade, or “junk”, bonds. In addition, this paper demonstrates that in the multiple bond problem the value of callable debt need not be a monotonic function of firm value. [ABSTRACT FROM AUTHOR]

In this contribution, I propose to go once more over two “core issues” of corporate finance—how do leverage and dividend policy affect market valuation? These are issues that were supposed to have been settled in the two contributions that students often refer to as MoMi (Modigliani and Miller [1958]) and MiMo (Miller and Modigliani [1961]). The basic message in these papers, was that with rational investors, well functioning markets, and no taxes (or at most, only of a certain type), financial policy does not matter! [ABSTRACT FROM AUTHOR]

A corporation's capital structure is a means for partitioning its return stream among different classes of security-holders and across different states of nature. The primary thrust of capital structure theory has been to determine whether and how this partitioning affects the total value of the firm. For a firm subject to rate-of-return regulation, however, the capital structure decision may take on an additional dimension. Under such regulation, the firm's output price is set by an outside agency so as to yield a “fair” return to providers of capital, and, if effective, this process reduces monopoly profits. But if the regulator's price-setting rule depends on the firm's capital structure in some predictable way, the firm may be able to influence price and hence reap additional profits by judiciously choosing its financing mix. The purpose of this paper is to analyze possible “price-influence” effects of a regulated firm's capital structure and to illustrate regulators' attempts to combat them. The determinants of a regulated firm's capital structure have been touched upon in previous papers (Gordon, Elton and Gruber, Gordon and McCallum, Jaffe and Mandelker, Meyer and Sherman, for example), but that issue has not been their primary concern. The present paper differs from those mentioned above by focusing its attention more directly on the capital structure decision. This issue is of interest in its own right in view of the important position occupied by regulated firms' securities in the capital market, but the approach taken here also serves to highlight and extend some common threads in the previous papers. In particular the results of these papers emerge as straightforward applications of the price-influence principle, and differences among them can be attributed to differing perceptions of the regulator's price-setting behavior. [ABSTRACT FROM AUTHOR]

This paper discusses the implications of Miller's paper “Debt and Taxes” for the valuation of leases. It shows that if Miller's equilibrium holds, leasing is only likely to dominate debt and equity for companies in temporary non-tax-paying positions. [ABSTRACT FROM AUTHOR]

The agency costs of debt are introduced in this paper to explain the existence of complex financial instruments. Two areas of complexities are discussed in detail: the call provision and the maturity structure of debt. Their existence is rationalized as a means of resolving agency problems associated with informational asymmetry, managerial (stockholder) risk incentives, and foregone growth opportunities. It is also demonstrated that both features of corporate debt serve identical purposes in solving agency problems. Complex financial instruments are required because markets fail to provide complete and costless solutions to the agency problems discussed in the paper. [ABSTRACT FROM AUTHOR]

Since 1956, Federal Loan Guarantee Programs have expanded to the point where recipients of guarantees represent most segments of the economy. Considerable debate centers on the determination of the magnitude of the liability of the Federal Government that is represented by these programs. This paper illustrates how option pricing techniques may be used to obtain estimates of the purely pecuniary costs of loan guarantees, interest saving to the firm on senior and junior debt, and implicit present value profitability indices of projects. [ABSTRACT FROM AUTHOR]

This paper comments upon the article "Future Investment Opportunities and the Value of the Call Provision on a Bond" which was published in the "Journal of Finance" in September 1978. In this article, two economists argue that the existence of non-callable long-term debt in the firm's capital structure will have an adverse incentive effect on the firm's investment behavior in the presence of growth opportunities. This paper show that, any externalities generated by the existence of non-callable debt, when there are future investment opportunities, will be completely internalized prior to undertaking these investments. This internalization will, in turn, be reflected in the initial contractual agreements entered into by the claimants on the firm.

In the period following Modigliani and Miller's correction paper, it was generally agreed that where capital markets are perfect (taxes notwithstanding) there is an advantage to debt financing. In reaching this conclusion, Modigliani and Miller disregarded the effect of personal income taxes on the behavior of investors. When Miller introduced personal income taxes into the analysis, he was able to state that for a wide range of values of dividend, interest, and corporate tax rates "the gain from leverage vanishes entirely or even turns negative" (p. 267). In deriving this result Miller assumed the following: (1) all investors are taxed at the same rate; (2) the objective of the firm is to maximize its value; (3) no capital gains tax exists; (4) no bankruptcy risk exists; and (5) the firm pays all of its earnings in dividends. Later on in his paper Miller drops assumption (1) in order to reach the surprising result that there is no optimal capital structure for the individual firm but there is an economywide optimal capital structure. This paper argues that when individuals differ in the tax rates imposed on their interest income, value maximization is a meaningless dictum. Assumption (1) is therefore adopted throughout in order to investigate the impact of removing assumptions (3), (4), and (5). A short discussion of previous references to these assumptions is in order. [ABSTRACT FROM AUTHOR]

It has long been suggested that the financial structure of a firm communicates information about its returns, and in Ross [1977] some models were developed in which, at an equilibrium, managers would use finance to transmit and validate information about their firms. While these models have the virtue of describing a positive role for finance they are missing some important elements. Perhaps their principal limitation is that they assign no significant function to the manager beyond that of choosing the financial structure. This is in contrast to the neoclassical view of the manager as being concerned solely with activity choice, rather than with irrelevant financial matters. One of the purposes of this paper is to explore the relationship between these two functions. It is not unlikely that in some situations no incentive schedule can be found that simultaneously motivates that manager to make correct activity choices—efficient ones—and to signal the firm's type through the financial structure. Such a structure must reward the manager on the basis of competence while signalling, through finance, the framework of choice faced by the manager. The problem of assessing performance is further complicated by the inability to identify states. In the absence of a complete contingent description of the economy it will always be difficult to separate out the extent to which a particular firm's returns were the consequence of the manager's choices or nature's, i.e., skill or luck. The problems of moral hazard in such a situation are evident; if the manager's productive performance is positively rewarded it is in his interest to bias downward the market's perception of the activity set open to him. This evaluation problem is the second theme of this paper. The first section of the paper introduces the general incentive-signalling-financial (ISF) equilibrium model, and the following section specializes the model to a traditional state-space framework. Here... [ABSTRACT FROM AUTHOR]