Elazar Berkovitch

The Design of Bankruptcy Law: A Case for Management Bias in Bankruptcy Reorganizations

In an incomplete contracting environment, bankruptcy is considered to be a renegotiation of the firms financial contracts. An optimal bankruptcy law is derived as optimal restrictions on the environment within which the claimants to a distressed firm bargain. The law is used as a commitment device to ensure actions that are ex ante optimal but not subgame perfect. We show that the bankruptcy court can use two types of mechanisms to implement the optimal bankruptcy outcome: direct restrictions on the bargaining game between the claimants, and the use of a “restricted auction.” In both cases, the restrictions prevent the strategic use of bankruptcy by firms not in financial distress, provide for truthful revelation of information so that distress results in an ex post efficient allocation of resources, and establish a bias toward the manager in reorganizations that provides correct ex ante decision making incentives.

The Loan Commitment as an Optimal Financing Contract

This paper provides an imperfect information explanation for the existence of bank loan commitments when both the bank and the potential borrower are risk neutral. The borrower is assumed to have access to a two-stage investment project wherein the investment required in the second stage is not known at the outset. The unknown investment requirement is revealed to the borrower, but not to the bank, at the beginning of the second stage. If the investor borrows at the beginning of the first stage, the realization at the beginning of the second stage might prompt a default in a situation where the project yields positive net present value. The reason is that the borrower does not regard the first-stage investment as a sunk cost. We show that a two-stage contract resembling a loan commitment can solve this under-investment problem.

Managerial Compensation and Capital Structure

We investigate the interaction between financial structure and managerial compensation and show that risky debt affects both the probability of managerial replacement and the managers wage if he is retained by the firm. Our model yields a rich set of predictions, including the following: (i) The market values of equity and debt decrease if the manager is replaced; moreover, the expected cash flow affirms that retain their managers exceeds that affirms that replace their managers, (ii) Managers affirms with risky debt outstanding are promised lower severance payments (golden parachutes) than managers affirms that do not have risky debt. (Hi) Controlling for firms size, the leverage, managerial compensation, and cash flow of firms that retain their managers are positively correlated, (iv) Controlling for the firms size, the probability of managerial turnover and firm value are negatively correlated, (v) Managerial pay‐performance sensitivity is positively correlated with leverage, expected compensation, and expected cash flows.

Optimal bankruptcy law and firm-specific investments

In this paper we characterize an optimal bankruptcy law that takes into consideration the incentives of managers to invest in firm-specific human capital. We show that the optimal bankruptcy law is biased towards the management team, and may be implemented by the use of a ‘restricted auction’ mechanism, in which creditors have the right to refuse bankruptcy, but are not allowed to bid for the firm. The bankruptcy law is needed as a commitment device to implement the optimal outcome.

Why the NPV Criterion Does Not Maximize NPV

This article presents a theory of capital allocation that shows how the use of net present value (NPV) as an investment criterion leads to inefficient capital budgeting outcomes and how this criterion may be dominated by other capital budgeting criteria, like the internal rate of return and the profitability index. The essence of our theory is rooted in the mainstream paradigm of corporate finance: while firms use NPV to measure the addition to firm value from prospective projects, classical informational and agency considerations prevent it from implementing the optimal capital budgeting outcome. Our theory also identifies conditions when alternative criteria should be used. Finally, we characterize when direct monitoring through capital budgeting dominates compensation contracts in alleviating the agency problem. Copyright 2004, Oxford University Press.

A Double Moral Hazard Model of Organization Design

We develop a theory of organization design in which the firms structure is chosen by trading off ex post efficiency in the implementation of projects against ex ante efficiency in the selection of projects. Using our framework, we derive a novel set of empirical predictions regarding differences between firms with a functional structure and firms with a divisional structure. We examine how the overall profitability of the two structures is affected by various factors like size, complexity, and asymmetry in the importance of tasks and also explore the desirability of adopting a narrow business strategy.

The Boundaries of the Firm: The Choice Between Stand-Alone and Integrated Firms

This study presents a theory of corporate structure selection. It outlines when economic units should be structured as stand-alone firms versus an integrated firm (conglomerate). The theory suggests that an integrated firm better controls agency problems through yardstick competition between managers for project acceptance. However, this structure reduces the ability to receive division-specific project information from the market. Based on this trade-off, we show that divisions within a conglomerate have different characteristics and, thus, different valuations than similar stand-alone firms. Our theory also explains differences in the required rate of return between stand-alone firms and conglomerates and how they relate to relative valuations of conglomerates and similar stand-alone firm. It also predicts when stock price reaction to divestiture and merger announcements will be positive or negative. Copyright 2006, The Author(s) Journal Compilation (c) 2006 Blackwell Publishing.

The Innovation Process and Financial Decisions

The literature has identified two different processes by which innovation of new products presents itself. The first, the Technology Push process, occurs when the innovation of a new product is spurred by a technology that the entrepreneur possesses. The second, the Market Pull process, occurs when demand for products that do not yet exist motivates the innovation. The premise of this article is that the type of the innovation process - Technology Push or Market Pull - is not exogenous, but endogenously determined by the corporation. Moreover, the innovation process is related to and jointly determined with financial decisions in the corporation, such as diversification decisions, going public decisions, compensation practices, governance structure, and ownership structure.