corporations creditors november 28, 2006. corporations creditors set of cost minimizers set of...

CORPORATIONS Creditors

November 28, 2006


Set of Cost Minimizers

Set of Profit Maximizers


Firm Size

CORPORATIONS Creditors – Firm Size

• The previous lectures emphasized the efficiency and optimality of the form of business that a firm might adopt.

• For example, sole proprietorships carry the most flexibility, in the extreme, but sacrifice

• the advantages of distributing the risks of long term investment over many individuals,

• the economies of scale and • specialization offered by incorporating the firm.


• V

F

Vs E

Us

Fs

Sole Shareholder Corporation


V

F

Expansion Path of Firm at agency costs = 0

Expansion path with optimal mix of credit and equity

CORPORATIONSCreditors – Firm Size

• V

F

Vs E

Us

Equity Expansion Path

Fs

Point where corporation becomes too big for owner and owner can start buying additional needs on the open market

EBoundary

Slope = -1


V

F

Agency costs = A

E*


Expansion Path of Firm at agency costs = A

Slope = -1

Slope = -


V

F

Agency costs = A

E*


Expansion path with optimal mix of credit and equityExpansion Path of Firm at agency costs = A


InsiderTrading

CORPORATIONS Creditors – Insider Trading

• In the previous lectures, the two major “investors” in the firm were “insiders” and “outsiders”


V

F

Utility Curve of Insider – Insider Trading Restricted Utility Curve of Insider – Insider Trading Unrestricted

Slope = -1

Slope = -


V

F

Vs E

E* Us

Fs

Impact of manager shareholder on outside shareholders


CompetingCreditors


• Now what happens when one introduces a third party – the lender or creditor?


• .

Secured Creditors

Preferred Creditors

Unsecured Creditors

Shareholders

BanksDebenturesBonds


• Why can the failure of the entrepreneur or manager to maximize the value of the firm be perfectly consistent with efficiency?

• Why is the sale of common stock a viable source of capital even though managers do not maximize the value of the firm?

• Why is debt relied upon as a source of capital before debt financing irregardless of tax advantages?

• Why do companies issue preferred stock?


• Modigliani and Miller (1958) argued that in the absence of bankruptcy costs and tax subsidies on the payment of interest, the value of the firm is independent of the financial structure.

• Modigliani and Miller later (1963) argued that the existence of tax subsidies on interest payments would cause the value of the firm to rise with the amount of debt financing by the amount of the capitalized value of the tax subsidy.

• This line of argument implies that the firm should be financed almost entirely with debt.


• Jensen and Meckling argue that as long as the "agency cost“ of debt financing (issuing bonds to creditors) remains below the "agency cost" of equity, then more debt is optimal.

• The optimality of expanding debt for the firm ceases when the two types of "agency costs" become equal.

• [Jensen and Meckling at 339-340]


Limited Liability

CORPORATIONS Creditors – Limited Liability

• Limited liability is a form of insurance to the shareholders.

• A firm is hit with a sudden downturn, or worse, an unforeseeable catastrophe, like Bhopal, India, in 1984, that causes the firm's liability to greatly exceed the total investment the shareholders made in the firm.

• Limited liability is a rule of law that attaches to the corporate firm of business association.


• Imperfect Information•Decreasing Marginal Costs Due to Precaution

•Increasing Marginal Costs Due To Production

Strict Liability Rule –MC1

Contracted Liability Rule – MC1

Expected Liability – MC1

a1

$C1


• Limited liability insures total liability to the shareholders will not exceed their total investment.

• Such a rule does not attach to sole proprietors or partners.

• In those firms total liability not only may exceed the investment, but may attach to the personal assets of the investors.


• Imperfect Information•Decreasing Marginal Costs Due to Precaution

•Increasing Marginal Costs Due To Production

Limited Liability Rule

Expected Liability – MC1

a1

$C1


• Imperfect Information• New Expectation Damages Rule Subject To The Limited Liability Rule

Limited Liability Rule

a1

$C1


• As with other forms of insurance, limited liability poses a "pooling problem".

• Pooling equilibria" emerge where different agents are expected to perform the same action under the same law.

• Different agents will do different actions, although they may "strategically" change their behaviour to act more uniformly.

• The group that performs below expectation commit a "moral hazard".


• The agency costs of unlimited liability would be much higher than simply paying a premium in the form of higher interest rates to the creditors of the corporation in return for their acceptance of a contract which grants limited liability to the shareholders.

• The creditors would then bear the risk of any non-payment of debts in the event of the corporation’s bankruptcy. (Jensen and Meckling, p. 331)


• Limited liability does not mean that every firm will take irrational risks, but some might.

• In these cases, limited liability, like other forms of insurance creates moral hazards.

• The most frequently discussed moral hazard of limited liability is bankruptcy.


Rules of Liability

CORPORATIONS Creditors – Liability Rules

• At common law, suits by creditors against debtors for unpaid debts were technically complex, drawn out and expensive.

• Those businesses that needed their money quickly sought other remedies, through their guilds, trade fairs or private "for hire" enforcers.

Secured Creditors

Preferred Creditors

Unsecured Creditors

Shareholders

BanksDebenturesBonds

Revenue Canada, Judgments

Employees, Suppliers


• In Italy, lenders adopted a custom of breaking (rupto) the selling stall (banco)of a defaulting debtor so that customers would know to pay the lenders directly instead of the debtor


• The agency cost of debt financing appreciates significantly when the firm does not have sufficient net worth to pay all classes of creditors.

• The probability and cost of potential bankruptcy adversely effects the value of the firm.


• Another drawback of bankruptcy is its finality. Bankruptcy kills the business.

• In an economy without a relatively costless bankruptcy procedure, competing creditors might seize assets critical to the corporation's operation and worsen an already suboptimal situation


• What would be the main motivation for this kind of legislation?

• Difficulties of recontracting debts at common law» Foakes v. Beer» Gilbert Steel

• Prisoners Dilemna – The Uncooperative Game» Without the prioritization or hierarchy of creditors,

there is a “suboptimal” Nash equilibrium


• The common law also recognized the right of lenders to "contract" their own remedies in the agreement that accompanied the loan.

• Usually such agreements provided that legal title to the firm's assets be transferred to the lender for the duration of the loan.

• Railways and large manufacturing concerns were frequently controlled in this matter. Such lenders are treated as "secured lenders" with the highest priority over other creditors.


• In the 1930’s, both Canada and the United States passed legislation that enabled corporations to request “breathing space” to freeze creditor action while reorganization

• United States – Chapter 11• Canada – Corporation Creditors Arrangement Act


• Stelco case – latest in a long line of cases that included

• Eaton’s• Consumers Distributors• Dylex• Many others

corporations creditors november 28, 2006. corporations creditors set of cost minimizers set of...

Documents