Ivan E. Brick

Interest Rate Uncertainty and the Optimal Debt Maturity Structure

As demonstrated by Boyce and Kalotay (1979) and Brick and Ravid (1985), the use of long-term debt may be preferred because of tax-related advantages. Brick and Ravid show that if there exists a tax advantage to debt and nonstochastic interest rates, long-term debt will increase the present value of the tax benefits of debt if the term structure of interest rates, adjusted for risk of default, is increasing. A decreasing term structure, on the other hand, calls for short-term debt. The present paper extends the tax-induced argument of Brick and Ravid to allow for the presence of stochastic interest rates. Once interest rates are uncertain, pricing even under risk neutrality becomes a complex issue. We analyze the debt maturity decision under two competing pricing equations: the return to maturity expectations hypothesis and the local expectations hypothesis. (This terminology is used in Cox, Ingersoll, and Ross (1981) and Campbell (1986).) Under uncertainty, a debt capacity factor will create an additional incentive to issue long-term debt. Our other results may be interpreted to indicate that if the term premium, the difference between the implied forward interest rate and the future expected spot rate, is positive (sufficiently negative) then long-term (short-term) debt maturity strategy is optimal.

Asymmetric Information concerning the Variance of Cash Flows: The Capital Structure Choice

This paper assumes that a higher valued firm is distinguished from its lower valued counterpart by having a cash flow distribution with a lower variance. A separating (sequential) Nash equilibrium signaling model is developed in which firms use the levels of debt and dividends to convey information to the market regarding the variance of their underlying cash flow. In contrast to most, if not all, debt signaling models, the higher quality firm signals its value by issuing new equity (decreasing the leverage) while simultaneously offering cash dividends. Copyright 1998 by Economics Department of the University of Pennsylvania and the Osaka University Institute of Social and Economic Research Association.

Leasing and Financial Intermediation: Comparative Tax Advantages

In the past two decades, leasing has developed into an important method of asset-based financing. Spurred by the tax concessions granted in the early 1980s, operating leases have become prime vehicles for financial intermediation. As a result, legal owners of assets may in fact be pure financial agents intermediating between manufacturers and operators of assets. In the past, the academic literature focused primarily on the question of valuation assuming a two party transaction namely, the lessor and the lessee. No distinction was made between the manufacturer and the pure leasing intermediary. (See, for example, [1], [2], [7], and [8].) It is, therefore, unclear if the same analysis holds for both types of lessor. Broadly speaking, the advantages of leasing as a form of financial intermediation stem from two sources reduction in taxes and lower financing costs. Many large leasing transactions have elements of both. The former arises primarily due to differences between the marginal tax rates of the lessor and the lessee. There are many aspects of the latter, but the most important one is related to the transactions cost of adjusting the debt-equity mix of a firm. In this paper, we concentrate on tax considerations. In particular, we examine the conditions under which a pure financial intermediary benefits from entering the leasi g business as a lessor. Obviously, in order to justify the creation of a leasing financial intermediary, between an equipment manufacturer and the user, base on a tax rationale, it must be demonstrated that the tax benefits of the arrangement exceed those when the manufacturer serves directly as the lessor. This may be true because the base for depreciation differs depending on whether the lessor is an intermediary or is the manufacturer of the asset. In a competitive market, it may pay a manufacturer to share the benefits of a higher depreciation base through selling the asset to an intermediary who, in turn, can act as the lessor. Note that in an otherwise identical lease contract, the manuAn earlier version of this paper was presented at the Financial Management Association meetings in Toronto, Canada, 1984. The first author acknowledges the financial support he received from Rutgers. The authors gratefully acknowledge the comments of Robert Taggart, Charles Upton, and the anonymous referees.

Effects of Classifying Equity or Debt on the Value of the Firm under Tax Asymmetry

This paper examines the effect of classifying a firms equity or debt into subclasses of unequal seniority on the total expected tax burden of the firm and its security holders in a world with no agency and no bankruptcy costs. It is shown that, when positive income is taxed at a higher rate than that allowed on realized capital losses, expected taxes are min? imized and the value of the firm is maximized if the firm has only one class of equity and, at most, one class of debt. This result helps to explain the common practice of issuing corporate bonds under open indentures. In fact, our empirical results indicate that before the advent of a differentiated capital gains tax in 1921, a great majority of publicly traded long-term industrial bonds were issued under closed indentures. By 1951, nearly all such debt was issued under single indentures (i.e., there was only one class of creditor).

The Relative Tax Benefits of Alternative Call Features in Corporate Debt

This paper examines the differential tax treatment of the borrower and lender at the time debt is called as a potential explanation for the widespread existence of call provisions in corporate debt. This tax effect alone cannot explain the standard call feature because greater tax benefits may be derived for bonds callable at market prices. The equilibrium implications of the model allowing for tax arbitrage opportunities both at the corporate level and the individual level also are considered.

Optimal capital structure: A multi-period programming model for use in financial planning

Abstract This paper describes a multi-period, chance constrained mathematical programming model to compute for each period, the firms optimal debt to equity ratio and the optimal maturity distribution of its debt. The model assumes that the firms objective is to maximize total value of the firm, and that the firm operates in a world of uncertainty, with corporate income taxes and bankruptcy costs. Finally, the actual coupon rate paid by the firm which is commensurate to the risk of default is endogenously determined by the model.

Monopoly Price-Advertising Decision-Making under Uncertainty

THIS paper uses the Capital Asset Pricing Model (CAPM) to examine the joint price (quantity)-advertising decision for the monopolist under uncertainty. A generalized form of uncertainty is treated where the variability of sales volume (price) depends on the price (quantity)-advertising decision in a flexible manner. In contrast, previous models (Horowitz [6] and Dehez and Jacquemin [3]) assume that uncertainty is exogenous. The Dorfman-Steiner Theorem is generalized to the uncertainty case and the comparative statics properties of the model explored. Specifically, the results are shown to depend on: (a) the precise form in which uncertainty enters the random demand function; (b) the relationship between the risk-adjusted price (quantity) elasticity of demand and advertising, and (c) the covariance of the random cash flow with the random rate of return of the market portfolio. Unambiguous results are obtained in all cases for the additive and multiplicative uncertainty models. For the generalized uncertainty case, unambiguous results are obtained for exogenous shifts in demand. Determinate results are obtained for general changes in risk if the variance of sales volume (price) increases with price (sales volume).

Calculating the Cost of Capital of an Unlevered Firm for Use in Project Evaluation

The adjusted present value requires an estimate of the cost of equity of an unlevered firm. Traditional approaches for calculating this cost assume that firms maintain a constant market-value percentage of debt when in fact firms typically use a book-value percentage of debt. In this paper, we present an approach to correctly estimate the cost of equity of an unlevered firm whenever the firm fails to maintain a constant market-value-based leverage ratio. We also demonstrate that both the Modigliani and Miller (1963) and Miles and Ezzell (1980) approaches may yield substantial valuation errors when firms determine debt levels based on book-value percentages. In contrast our method makes no errors as long as managers know the marginal tax benefit of debt.

On the Relationship between Accounting Risk and Return: Is There a (Bowman) Paradox?

Bowmans (1980, 1982, 1984) finding of a negative relationship between the means and variances of accounting returns (the Bowman Paradox) spurred a considerable literature analyzing this phenomenon. The sign of the relationship between the mean return on equity (ROE) and its standard deviation remains unresolved. Concerns were raised about ROE measurement and statistical techniques used in establishing the paradox. The papers critiquing (and supporting) it were mostly limited in scope, studied only short periods of time and provided limited robustness checks. In addition, no paper considered the effect of issuances and repurchase of stocks on the measurement of ROE. This study revisits the Paradox and addresses the above mentioned deficiencies in prior research. We use data from longer periods, control for size and leverage and provide additional robustness checks. We conclude that a positive relationship between mean ROE and its standard deviation is far more likely than a negative one.

Utility Theory, Value Maximization and the Quality Decision under Uncertainty

This paper analyzes the quality decision of the competitive firm under uncertainty using two well-known valuation frameworks: the expected utility model and the Capital Asset Pricing Model CAPM (see Sharpe [1964], Lintner [1965] and Mossin [1966]). The former approach is in some ways more general because it imposes few restrictions on the form of the preference function. However, the paradigm is limited because it implicitly assumes that the firms decisions are independent of the financial market equilibrium (see Greenberg, Marshall and Yawitz [1978] and Brick and Jagpal [1980]). That is, the firm makes policy decisions regardless of their impact on market value and hence on the future wealth (utility) of the owner(s) (see Fama [1980]). This difficulty is dealt with in the CAPM by introducing additional assumptions about the behavior of investors and the distribution of returns from risky assets2. The main conclusions of our analysis are twofold. Firstly, for the competitive firm, the introduction of risk affects policy in the same manner as an increase in risk-aversion regardless of the valuation framework. As a special case, Sandmos conclusion that the competitive firm unambiguously reduces output in the presence of uncertainty is true for the expected utility model only when uncertainty is exogenous. Secondly, the comparative statics properties of the model for general parameter shifts are different for the expected utility and CAPM frameworks. Specifically, the CAPM results have a clear economic interpretation regardless of the type of uncertainty. In contrast, the expected utility results are well-defined only if uncertainty is exogenous.