Richard C. Green

Investment incentives, debt, and warrants

Abstract This paper models and characterizes investment incentive problems associated with debt financing. The decision problem of residual claimants is explicity formulated and their investment policies are characterized. The paper also analyzes the use of conversion features and warrants to control distortionary incentives. These claims reverse the convex shape of levered equity over the upper range of the firms earnings, and this mitigates the incentive to take risk. It is shown that, under certain conditions, such claims can be constructed to restore net present value maximizing incentives and simultaneously meet the financing requirements of the firm.

Ex-day behavior with dividend preference and limitations to short-term arbitrage: the case of Swedish lottery bonds ☆

Abstract Swedish lottery bonds offer a unique opportunity to study ex-day effects in an environment where cash distributions are tax-advantaged relative to capital gains. Thus, in the lottery bond market, we observe a reversal of the preference for capital gains that researchers have cited as an explanation for the ex-day behavior of U.S. equities. Further, in this market there are barriers to short-term arbitrage when prices do reflect the tax preferences of individual investors. We find the bonds are priced around the ex-day to reflect differential tax rates on income and capital gains consistent with the prevailing tax regimes. The bonds consistently experience negative returns over the coupon payment period, and in fact often sell at negative yields prior to the cash distribution, as one would expect given tax-motivated trading between high-tax investors, who buy prior to the distribution, and low-tax investors, who buy after the distribution.

Spanning and completeness in markets with contingent claims

Abstract We characterize financial markets that are “complete” or that contain portfolios which “span” all measurable functions of a particular asset payoffs, either finite and infinite dimensional. These results are then employed to describe the extent to which options trading is sufficient to complete markets, to investigate the existence of “efficient funds,” and to establish the extent of market completeness required to ensure the unanimity and irrelevance results of modern corporation finance.

The personal-tax advantages of equity ☆

We compute the value of a firm that pays its cash flows each period through share repurchases in a dynamic environment where personal taxes are paid on realized capital gains and dividends. These results provide a measure of the personal tax advantages of equity financing relative to debt financing, which are often cited as increasing the cost of debt. The initial price of the firm depends on the present value of the taxes paid, which, in turn, depends on the initial price. We solve this valuation problem in closed form in a deterministic setting and numerically in a stochastic setting. We find significant valuation effects from the tax protection afforded by the equity basis. The tax savings are on the order of 40-50% of the taxes paid by the shareholders of firm that distributes cash through dividends, and the cost of capital is reduced by approximately 1% through the use of repurchases relative to dividends.

The Personal-Tax Advantages of Equity

We compute the value of a firm that pays its cash flows each period through share repurchases in a dynamic environment where personal taxes are paid on realized capital gains and dividends. These results provide a measure of the personal tax advantages of equity financing relative to debt financing, which are often cited as increasing the cost of debt. The initial price of the firm depends on the present value of the taxes paid, which, in turn, depends on the initial price. We solve this valuation problem in closed form in a deterministic setting and numerically in a stochastic setting. We find significant valuation effects from the tax protection afforded by the equity basis. The tax savings are on the order of 40-50% of the taxes paid by the shareholders of firm that distributes cash through dividends, and the cost of capital is reduced by approximately 1% through the use of repurchases relative to dividends.

Expected utility maximization and demand behavior

Abstract This paper extends the non-parametric approach to consumer demand analysis to the case of expected utility maximization. We provide necessary and sufficient conditions for a set of price-quantity pairs to be consistent with expected utility maximization, and investigate their relationship to revealed preference conditions. Extensions to incomplete markets and intertemporal resolution of uncertainty are also considered.

Tax-Subsidized Underpricing: Issuers and Underwriters in the Market for Build America Bonds

Build America Bonds (BABs) were issued by states and municipalities for twenty months as an alternative to tax-exempt bonds. The program was part of the 2009 fiscal stimulus package. The bonds are taxable to the holder, but the federal Treasury rebates 35% of the coupon payment to the issuer. The stated purpose of the program was to provide municipal issuers with access to a more liquid market by making them attractive to foreign, tax-exempt, and tax-deferred investors. We evaluate one aspect of the liquidity of the bonds---the underpricing when the bonds are issued. We show that the structure of the rebate creates additional incentives to underprice the bonds when they are issued, and that the underpricing is larger for BABs than for traditional municipals, controlling for characteristics such as size of the issue or the trade. This suggests that the bonds are not more liquid, contrary to the stated purpose of the program, or that issuers and underwriters are strategically underpricing the bonds to increase the tax subsidy, or both. Several findings point to strategic underpricing. There is a negative correlation between the underwriters spread and the underpricing. The underpricing for BABs is quite evident for institutional and interdealer trades, while that for tax-exempts is primarily for smaller sales to customers. Counterfactuals for our estimated structural model also suggest strategic underpricing.

Report of the Editor of The Journal of Finance for the Year 2002

THE JOURNAL OF FINANCE IS THRIVING. Submissions continue to arrive at a record pace, we are attracting outstanding papers across the full range of topics in financial economics, and turnaround times are very good. During the past year, we completed the transition from the previous editor, and began the transition to the next editor. We published 89 papers, and could have published many more excellent ones. The Journal continues to provide the scholarly community in financial economics an outlet that is of high quality, that is widely visible, and that is broadly representative.