Robert A. Haugen

Bankruptcy and Agency Costs: Their Significance to the Theory of Optimal Capital Structure

We support and generalize our original results (1978) in light of potential impediments to a pure market solution to agency problems and potential causal links between liquidation and bankruptcy. In the case of bankruptcy costs, market impediments are easily eliminated through the inclusion of simple provisions in corporate charters and bond indentures. Further, we demonstrate that recent attempts to link liquidation costs to capital structure are without merit. If the firm is to be liquidated on the basis of a rule other than one that maximizes the total value of all the claimants, arbitrage profits arise, and informal reorganization will discipline management to follow the liquidation rule that is optimal for existing securityholders. Also, we find that the pure market solution is not readily generalizable to other classes of agency problems, particularly the risk incentive problem. However, the alternative solution of the risk incentive problem through complex financing contracting may be useful in explaining complexities in contemporary financial contracts.

Risk and the Rate of Return on Financial Assets: Some Old Wine in New Bottles

Strides have been made recently in the discovery and refinement of theoretical models which purport to describe the relationship between asset prices and their risk attributes. (See especially Lintner [13,14,15], Sharpe [19], Mosin [17,18] and Fama [7,8.9].) The models have gained widespread acceptance because of their intuitive appeal and because most reported empirical evidence [1,4,5,11,20,21] allegedly supports their predictive value. It is our purpose to analyze critically one aspect of the nature of this evidence, reveal its inherent weakness, and to design an alternative test to examine the risk-return function. After observing the performance of an extremely large number of issues over long periods of time, we find little support for the notion that risk premiums have, in fact, manifested themselves in realized rates of return.

Corporate Finance and Taxes: A Review

ferential returns, the relatively favorable treatment of interest expenditures leads to a preference for debt financing by firms. In terms of the personal income tax, the taxation of capital gains under the new tax law is deferred until realization. In the absence of either desirable distributional properties of dividend payments that are not replicable on personal account [28] or costless tax shelters [46], investors will prefer that dividend payments are minimized unless the returns are commensurately higher on high dividend paying

The Value of the Tax Subsidy on Risky Debt

The effect of corporate taxes on the market value of a levered firm continues to be a central issue in recent contributions in finance theory (e.g., Miller 1977; DeAngelo and Masulis 1980; Kim 1982; Modigliani 1982). In these and other studies (e.g., Krause and Litzenberger 1973; Scott 1976; Brennan and Schwartz 1978; Kim 1978), the relationship between market value and capital structure is established by formulating a tax subsidy function that specifies the partial effect of debt on the expected tax savings at the corporate level under the existing U.S. tax code. A working assumption in most of these studies is that both principal and interest are tax deductible. This assumption is made in the spirit of the original Modigliani and Miller (1963) formulation in which debt is taken to be perpetual and riskless. Indeed, it is well known that the tax shield provided by the deduction of principal in a singleperiod framework has the same value as the tax shield from interest deductions in the case of perpetual and riskless debt. Under this assumption, it is shown that in the absence of non-debtThis paper examines the relationship between leverage and the value of the firm, when non-debt-related tax shields are available and the corporate tax is levied as an income tax. In a previous paper, De Angelo and Masulis argue that, in the presence of nondebt-related tax shields, the relationship between debt and firm value is concave, resulting in an interior optimal capital structure when there is a tax-induced differential in the cost of corporate debt. Their result derives from the fact that they assume the payment of debt principal and non-debt-related depreciation charges are deductible. However, the former deduction is consistent with a wealth tax, while the latter is consistent only with an income tax. We show that if the interest alone is deductible, the debt-firm value function is convex, resulting in corner solutions to the capital structure problem. * The authors wish to thank Richard Castanias, Richard Green, Lemma Senbet, and especially an anonymous referee for helpful comments, and Richard Green and Robert Dammon for computational assistance.

Merger and Stockholder Risk

In a world characterized by perfect and complete capital markets, the success (or failure) of a merger is judged by the mergers impact on stockholder wealth. With completeness, the mergers impact on the probability distribution generating stockholder returns is unimportant. The perfect market assumption guarantees that the stockholder not satisfied with the consolidated firms return distribution can frictionlessly sell his shares and reorder his portfolio; hence his only concern is the mergers impact on wealth. However, if we acknowledge the existence of commissions, taxes, and other frictions, or if markets are not complete, the mergers impact on the stockholder return distribution becomes relevant. In this study we will analyze 149 mergers involving large N.Y.S.E. firms. We will examine four different hypotheses related to the impact of merger on attributes of the stockholder return distribution. We focus our analysis on risk-related attributes including beta, total variance, residual variance, and several other risk-related attributes. In a companion paper, mergers impact on wealth is calculated for the same sample but will not be reported here.

New Perspectives on Informational Asymmetry and Agency Relationships

The two related problems of agency and informational asymmetry have received increasing attention in finance. In particular, prominent authors in this area (e.g., Jensen and Meckling [7], Ross [15, 16], Leland and Pyle [10], etc.) have demonstrably argued that the financial structure of the firm can be determined in the process of eliminating, or at least reducing, the costs associated with these problems.

Rate Regulation and the Cost of Capital in the Insurance Industry

We have discussed some of the effects of rate regulation in the property and casualty insurance industry. One consequence of the regulatory environment is that an optimal capital structure may clearly exist in this industry. If the rate of return to the insureds is generally deficient, we would expect that property and casualty stock companies would have an incentive to lever themselves to the maximum extent permissible by selling insurance. The classic monopoly of the economic literature finances its lucrative investment opportunities in a competitive capital market. The stock insurance company invests in that market, but the relative distribution of the return earned there may be less than equitable due to the process and standards of rate regulation.

Finance from a New Perspective

0 Academics and professionals in finance are reacting strongly to the publication and release of several new studies that call into question the validity of two major paradigms underlying much of what is taught in the classroom and practiced in corporations throughout the world. The first paradigm is the Capital Asset Pricing Model (CAPM). This theory assumes that all investors optimize without restriction in mean-variance space, and since aggregations of efficient portfolios are themselves efficient, it predicts the efficiency of the market aggregate. The second paradigm is the Efficient Market Model (EMM). This is more of a contention than a theory. The contention being that at any given time, stock prices accurately reflect what is knowable about economic and financial conditions as well as the relevant characteristics of the companies that issued the stocks.

Equilibrium in the Pricing of Capital Assets, Risk-Bearing Debt Instruments, and the Question of Optimal Capital Structure

After integrating risky debt instruments into the generalized asset pricing model developed by Sharpe and Lintner, we have demonstrated that the required return-to-equity capital in this model is a linear function of the debt-to-equity ratio with a slope equal to the difference between the unlevered cost of equity and the direct cost of debt. Consequently, we take the average cost of capital to be invariant with respect to leverage. The particular nature of the debt instrument issued by the firm does not affect this result.Our analysis supporting the net operating income valuation construct is of interest in that it takes into account not only the variance of the probability distribution of equity returns but also the covariance relationships between these returns and all other returns in the system. Further, we need not rely on assumptions of “equivalent return†classes or arbitrage possibilities to arrive at our solution. More important, our conclusion is quite general in that we demonstrate indifference toward finance with any instrument regardless of its inherent risk characteristics.

Rates of Return to Stockholders of Acquired Companies

This study has addressed itself to that group most immediately affected in corporate acquisition, the stockholders of acquired companies. We find that in the years observed, acquired company stockholders seem to have benefited from the acquisitions. This study differs from other studies of post-merger performance of the common stock of acquirors and not the performance of securities received by acquirees in exchange for their common stock. It should also be noted that most of the financial gain resulting from the acquisitions accrued at the time of merger because of substantial premiums paid by acquirors. While the stockholders of the acquired companies have, on average, benefited, these results tell us little of the effect of mergers on the welfare of society or, for that matter, of their effect on the stockholders of the acquiring firm. If the merger cannot be justified on the basis of some economy of scale or synergistic advantage, the newcomers reap their lucrative returns only at the expense of the old guard. If the acquiring firm pays a premium in acquisition on the basis of justifiably sound expectations of increased profits, social welfare is not necessarily enhanced. Increased profitability may not reflect increased efficiency; it may, for example, be a manifestation of decay in the competitive environment.