silver anniversary commemoration || executive summaries

Executive SummariesSource: Financial Management, Vol. 24, No. 2, Silver Anniversary Commemoration (Summer,1995), pp. 126-132Published by: Wiley on behalf of the Financial Management Association InternationalStable URL: http://www.jstor.org/stable/3665540 .

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Executive Summaries

Corporate Finance Over the Past 25 Years This paper traces developments in the theory of corporate

finance over the past 25 years. From one perspective, the development can be thought of in terms of a shift from exploring the valuation implications of alternative ways of allocating given cash flow streams to exploring the implications for the cash flow stream itself of the allocation mechanism used to distribute it: in other words, in terms of the relaxation of the major ceteris paribus assumptions underlying the MM propositions concerning dividend and, particularly, capital structure policy. In particular, there has been increasing concern with the effect of the structure of claims on the incentives of the individuals whose decisions affect the income stream. Increased recognition of the importance of the structure of claims to the firm's cash flows has led to a renewed attention to the roles of different types of security issue; under the MM paradigm, these were for the most part a "mere detail" and therefore not amenable to serious analysis. At the same time, recognition that contracts are necessarily incomplete and fail to constrain future decisions completely has led to analysis of the allocation of control or decision rights across claimholders. On the asset side of the balance sheet, there has been a corresponding shift in focus, from

asking what investment decision rule investors would unanimously support to asking what rules decision makers are likely to follow, given their incentives. Finally, whereas the old approach was essentially comparative static in nature, comparing corporations with different financial structures, the modern theory has a much more dynamic flavor to it, with analysis focused on particular events or transactions in the life of the corporation, such as initial public offerings, subsequent financings of debt and equity, repurchases of securities and exchange offers, takeover, and bankruptcy.

From a second perspective, the fundamental change has been the recognition of the decisive role of individually motivated agents, both those within the corporation and those with whom the corporation must deal. The corporation

of financial theory in the early 1970s ignored individual agents within the corporation. Similarly, it rendered the individuals with whom the corporation must deal--investors, bankers, underwriters, bidders, customers, employees, and others--essentially uninteresting, by treating them as price takers who suffered from no informational disadvantage and had no relevant aims beyond expanding their budget sets. In economic analysis, agents are described by their tastes and their opportunities, and the new theories that have been developed have relied on more careful description of both tastes and opportunities; important features of the opportunity set that have been newly recognized include the informational endowments of agents, their discretionary powers, and the nature of the implicit and explicit contracts that link their actions to their rewards. Newly recognized aspects of tastes include perquisite consumption, control benefits and other non-pecuniary benefits, reputation, and effort aversion. These new concepts have provided richer explanations for

newly recognized phenomena. From a third perspective, the shift can be seen in

large part as one of technique. The new technology of games under incomplete information has replaced the price-taking assumption throughout much of the corporate finance literature.

From a fourth perspective, the shift can be seen as a move from analyzing the implications of existing institutional arrangements to that of justifying such arrangements as

optimal responses to particular problems, then to considering alternative institutions. In parallel to this, efforts have shifted from the development of normative rules for

corporate decision makers to the development of normative propositions about such institutional arrangements as insider trading rules, disclosure, the payment of greenmail, and the erection of other takeover defenses.

Michael J. Brennan

Financial Management, Vol. 24, No. 2, Summer 1995, pages 9-22.

126



FM EXECUTIVE SUMMARIES 127

A Functional Perspective of Financial Intermediation New financial product designs, improved computer and

telecommunications technology, and advances in the

theory of finance have led to dramatic and rapid changes in the structure of global financial markets and institutions. This paper offers tentatively a conceptual framework for analyzing the dynamics of institutional changes in financial intermediation. The key element in this framework is its focus on functions instead of institutions as the conceptual "anchor." This functional perspective rests on the basic

premises that financial functions are more stable than financial institutions (both over time and across

geopolitical borders) and that innovative and competitive forces tend to drive institutional change in the direction of greater efficiency in the performance of financial system functions. The perspective can be applied whether the unit of analysis is the system, institution, activity, or product. Financial intermediaries serve to complete markets, reduce transactions costs, and minimize agency problems.

The paper presents a series of examples on the dynamics of institutional change. For a variety of reasons-including differences in size, complexity, and available technology, as well as differences in political, cultural, and historical

backgrounds-the most efficient institutional structure for fulfilling the functions of the financial system generally changes over time and differs across geographic and political subdivisions. The institutional form serving a particular function often appears to oscillate between intermediaries and organized markets. This pattern is not seen as cyclical but instead as an innovation spiral. In this view, the process is one of both short-run, static competition and long-run, dynamic complementarity between markets and intermediaries in a secularly improving financial system.

Systematically declining transactions costs, together with the prospect of greater global competition, drive the magnitude and speed of institutional changes that are likely to occur.

From the external dynamics of institutional change, the paper next turns to the internal managerial issues for intermediaries with a discussion of the production process for financial-engineering products and services. The discussion centers on a hypothetical example with a focus on comparing two polar forms of production: underwriting versus synthesizing. The analysis concludes that a key factor in the relative efficiency of the two approaches is credit risk as perceived by the customers of the intermediary. This conclusion leads into an elaboration on the central role for risk management and on the determination of the optimal exposures of the intermediary to credit, market, and liquidity risks.

The last section of the paper addresses issues surrounding regulation and financial intermediation. The dynamics of institutional change apply not only to private-sector intermediaries but also to government intermediaries and regulatory bodies. The role of regulation is to improve the efficiency, integrity, and infrastructure of the financial system. To perform that role effectively in an environment of significant and rapid change, the regulatory structure itself needs a dynamic setting in which regulations both anticipate and respond to changes in financial structure. The case is argued that this is more likely to be achieved by a functional approach to regulation instead of the more traditional institutional one.

Robert C. Merton




128 FINANCIAL MANAGEMENT / SUMMER 1995

Financial Distress and Restructuring Models A variety of problems arise when a firm encounters

financial distress. This paper focuses on how financial restructuring and recontracting may contribute to the financial rehabilitation of the firm.

Our analysis suggests that the greatest concern to creditors is that the financially distressed firm will further dissipate its resources by making highly risky investments. If such investments turn out to be profitable, the managers and equity holders will benefit, possibly at the expense of creditors and other stakeholders. Since the managers and equity holders are in a favored position under U.S. bankruptcy law, they are likely to make decisions that will benefit them rather than protect the positions of creditors and other stakeholders. The higher the ratio of the firm's debt to its prospective liquidation value, the greater the likelihood of overinvestment in projects involving excessive risk.

Since the equity holders of a firm have an option to buy out the creditors at the face value of their claims, equity holders have an incentive to take on greater risks. Favorable outcomes do not increase the returns to debtholders, but they do improve the returns to shareholders. In financial distress, this conflict of interest is aggravated.

Within this broad framework, the paper discusses the role of debt maturity. When debt maturity is short, the repayment obligation acts as a tax that has to be paid before new investments can be made. If debt maturity is long, this extends the maturity of the option or right of the equity holders to buy out the creditors at a fixed price. An option that has a longer time to expiration is of greater value than a shorter-term option. Shorter maturities provide greater protection to the value of debtholder claims. In general, when debt maturity is shorter, shareholders must receive higher returns to offset the tax that must be paid to retire the short-term debt as a requirement for making further investments. Choosing the appropriate maturity structure of debt involves balancing the negative effects of meeting claims that have to be paid off early on the one hand and

providing equity holders with underpriced options when debt

maturity is long on the other.

Exchange offers can alter the priority status of debt. Since distressed public debt typically sells at only a fraction of its face value, debtholders may agree to a distressed restructuring in which the face value of their claims is

reduced. They may agree because a reduction in the face value of debt claims on the firm may facilitate financial restructuring that will make the firm once again profitable, thereby increasing the market value of debt claims.

Our analysis also provides a framework for understanding debtor relations with financial institutions. Banks and other financial institutions have characteristics that are different from other creditors. Direct negotiation between the debtor and a small number of banks or other financial institutions can facilitate the reorganization process because of the small number of parties involved.

Bank debt tends to be of relatively short maturity, which facilitates monitoring and recontracting. In a bank debt restructuring, the maturity of the debt may be extended, and the bank may provide the firm with the cash necessary for new profitable investments as well as paying off short-term public debt. Financing with banks may help avoid the

debt-repayment tax that tends to discourage the investment required to restore the firm to profitability.

The paper has some important implications concerning how the bankruptcy process should operate. The automatic stay provision strengthens the position of the

debtor-in-possession (DIP). This facilitates DIP financing, which may provide the firm with the additional funds

required to reorganize profitably. Second, one of the

problems in reorganizing firms before the 1978 changes to the Bankruptcy Code was the strong position of dissenters. Under the new law, creditors are divided into classes with two-thirds in amount and one-half in number required for

approval. Third, the bankruptcy law provides for absolute

priority rules in establishing the order of claims under

reorganization. Frequent but small deviations from absolute priority occur in practice. This may facilitate approval of a reorganization plan earlier than would otherwise be possible.

This paper analyzes the cross currents of influences involved when a firm is in financial distress. Rules that are too stringent may delay financial restructuring. Rules that are too lenient may lead to investments with excessive risks. The key is to strike a proper balance.

Yehning Chen, J. Fred Weston, and Edward I. Altman





Corporate Capital Structure Decisions: Evidence from Leveraged Buyouts The financial marketplace in the United States during the

decade of the 1980s was characterized by three major developments: 1) a substantial increase in corporate leverage, 2) a high degree of innovation in the design of financial instruments, and 3) a significant amount of

corporate restructuring. Because they combined all three of these elements, the transactions that perhaps best epitomize the period are leveraged buyouts. In a leveraged buyout (LBO), a group of investors cooperates in acquiring the

public interest in a firm's common equity, primarily with borrowed funds, and takes the firm private. The volume of LBO transactions in the United States increased dramatically from a level of just $240 million in 1979 to a peak of $66 billion in 1989 and comprised a sizable fraction of all

corporate acquisition activity during the 1980s. The logic and consequences of LBOs, both for the

participants involved and for the economy as a whole, have been widely debated. We provide in our paper some further evidence on the nature of these transactions, with particular emphasis on the composition of the LBO financing package. Our goal is to attempt to explain why the observed financing choices were made-by examining the

relationships between the characteristics of the target firms and the types of financings that were employed in their

acquisition. Our sample consists of 107 LBOs undertaken over the period from 1981 through 1990, accounting for approximately two-thirds of the total dollar volume of all such transactions during that period.

The reasons why corporations choose to finance themselves as they do have, of course, been addressed

extensively at the level of theory and have been examined

empirically in a number of studies previously. Tax considerations, agency costs, and the risk of financial distress have been cited as likely major influences on the capital structure decision process. We revisit that decision process with our sample. In principle, the factors that should lead the

buyout group in an LBO to select a particular financing package should be little different from those that would

apply to the design of the capital structure for any other

corporation. The discrete and often dramatic nature of the event, the amount and variety of the debt instruments

typically employed, and the closeness of the connection between ownership and management that usually results, however, may well intensify the influence of those factors. Hence LBO transactions may be especially useful settings in which to observe these influences at work.

The post-buyout capital structure of an LBO generally resembles what can be described as an inverted

pyramid. At the top are large amounts of senior secured debt provided by banks. In the middle is the so-called "mezzanine" financing consisting of unsecured subordinated long-term debt securities, typically referred to as "junk" bonds. At the bottom of the pyramid are relatively small amounts of preferred and common equity. Thus, for the firms in our sample, bank financing provided just over 60% of the funds raised for the buyouts, sales of subordinated debt not quite 25%, preferred stock issues approximately 4%, and common equity slightly less than 7%. Within the sample, however, there is considerable cross-sectional variation in the composition of the individual financing packages chosen. These differences are what we seek to explain.

We do so by proposing a "balancing" model of the decision process. We argue that the LBO financing decision involves a trade-off between leverage-related costs and leverage-related benefits. The benefits include the motivating and disciplining effects of debt on management and the tax shields provided by the debt. The costs arise from the agency costs of high levels of debt and the effects of possible financial distress associated with excessive debt service obligations. These are consistent with suggestions from the prior literature.

A substantial proportion of the variations across our

sample firms in the makeup of the financing packages observed can be captured by a logit regression model that contains key features of the target firms as independent variables. We find evidence that the financing packages are designed systematically to reflect differences across firms in their future growth prospects, in the level and variability of their operating earnings rates, in their pre-buyout liquidity positions, and in their opportunities to restructure through post-buyout asset sales. We find further evidence that the prospective cash flow profile of the target firm is important to the financing decision. Average debt maturities are lengthened, and securities with interest-deferral provisions are relied on more heavily, when the target firm has low current liquidity and significant growth opportunities-and when the buyout financing package contains an especially large proportion of debt. The latter findings imply that default risk is in fact a central issue in the financing decision process.

Dianne M. Roden and Wilbur G. Lewellen





Insider Trading and Long-Run Return Performance This paper examines the relationship between security

performance and the level of trading by "manager" insiders. Our emphasis is on measuring the pattern of insider transactions conditional on long-run periods of abnormal stock performance. In particular, we examine the pattern of insider trading before, during, and after one- and two-year intervals of stock performance. By analyzing longer investment intervals, we are able to characterize the extent to which insider trading is related to stock performance in spite of corporate and legal prohibitions on insider trading that raise the expected costs of detection around certain events. Moreover, since we analyze all NYSE and AMEX firms (even those with no insider transactions), we are able to evaluate the overall propensity, probability, and

profitability of insider trading in this marketplace. Both the number of insider transactions and the value of

those transactions are analyzed using virtually all 100,000 transactions undertaken over an eight-year period. All measures of individual firms' insider trading that we employ are adjusted for the "normal" level of insider transactions experienced by that firm. This permits us to characterize purchases, sales, and net purchases as above or below normal to better determine if manager-insiders affect the timing of their transactions in view of the costs of detection.

Our results show that insider trading is significantly affected by performance between one and two years in advance of the performance itself. There is a strong propensity for insider sales, but not purchases, to be abnormally large prior to both market-related and firm-specific returns that are below normal and to be abnormally small prior to returns that are above normal. There also is evidence in our results that managers tend to offset their previously created positions subsequent to the abnormal return interval. Thus, insider transactions seem to both anticipate long-time horizon returns and react after them. On average, over all firms, net sales were two to three times greater than normal prior to poor return performance for firms in the worst-performance group than they were

subsequent to the poor performance. The opposite effect is present for firms in the best-performance group. For corporations attempting to establish policy and monitor informational trading by their managers, the results suggest that such efforts must be concerned with assessing the patterns of abnormal sales in relation to long intervals of return.

R. Richardson Pettit and P.C. Venkatesh





Wharton Survey of Derivatives Usage by U.S. Non-Financial Firms In November 1994, the Weiss Center for International

Financial Research of the Wharton School, with the sponsorship of The Chase Manhattan Bank, sent a detailed questionnaire on derivatives usage to 2,000 non-financial corporations in the United States. To facilitate academic research on derivative usage, the firms were selected randomly from the set of firms on the 1993 COMPUSTAT database. The sample of firms spans a broad range of firm sizes as well as industries.

The survey consisted of a series of questions about derivatives usage, including the purposes for which derivatives are used, the organization of risk management activities, and reporting and control mechanisms. The participating firms were assured that only researchers at Wharton would have access to individual firm responses. Firms were given four weeks to respond with a single reminder postcard mailed out after two weeks. Of the 2,000 surveys mailed, we received 530 usable responses, which represents a respectable yield of 26.5%.

Of the 530 firms that responded to the survey, 183 or 35 % indicated that they use derivatives, defined in the survey as forwards/futures, options, and/or swaps. This percentage disguises some large differences across firms. While 65% of large firms use derivatives, just 30% of mid-sized firms and only 13% of small firms use them. The use of derivatives also varies considerably across industries. Commodity-based industries, such as agriculture, refining, and mining, show the highest usage at about 50%. Manufacturing industries report derivatives use around 40%, while about 30% of firms in the regulated industries (public utilities and transportation) use derivatives. Derivatives use is even less common in service industries. Only 29% of wholesale and retail trade firms, and just 14% of non-financial services firms use them.

The survey also sheds light on the use of derivatives by non-financial firms to manage four general types of exposures: foreign exchange, interest rate, commodity price, and equity price. From the responses, a clear pattern of specific instruments for specific exposures emerges. The standard forward contract is the most common

instrument for managing foreign currency risk, with OTC options and currency swaps also considered important. Swaps are far and away the most prevalent instrument for managing interest rate risk. There was no dominant instrument for hedging commodity or equity price risk.

As for the purposes for which firms are making derivative transactions, the survey clearly indicates that firms are using derivatives to manage risk rather than to "take a view" on financial prices. The most common rationale for derivatives usage was to hedge well-defined exposures arising from firmly committed transactions or anticipated transactions less than a year away. These were cited as reasons for derivatives usage by approximately 80% of the firms using derivatives. Firms were less likely to use derivatives to hedge distant anticipated transactions or long-term competitive exposure, with less than half citing this as a reason. In contrast, a small percentage (9%) of firms indicated that they commonly use derivatives to "take a view" on the direction of market prices with another 34% indicating that they did so occasionally. If one equates "taking a view" with the speculative activities of several firms that made headlines in 1994, then it would appear that these cases are the exception rather than the norm.

With the large corporate derivatives losses in 1994, significant attention has been focused on management oversight of derivatives activity. The survey also asked questions about management and control of derivative activities. The responses indicate that only a minority of firms have internal pricing capabilities for options and swaps positions, with those that do relying primarily on internally developed systems. Finally with regards to reporting derivative activity to the board of directors, the majority of firms indicated that they had no set schedule for such reporting. Quarterly reporting is the most common among those firms with a set reporting schedule.

Gordon M. Bodnar, Gregory S. Hayt, Richard C. Marston, and Charles W. Smithson





1995 Derivatives Practices and Instruments Survey The significant publicity surrounding losses on

derivatives transactions, beginning in the Spring of 1994, prompted the Treasury Management Association (TMA) to undertake a study of derivatives practices and instruments among its members' organizations. Many of the surveys on derivatives usage conducted in the past year were sent to known samples of derivatives users. Since TMA membership is on an individual basis for those directly or indirectly engaged in the treasury profession, its membership represents a broad spectrum of employing organizations, including educational institutions, governmental units, and privately held corporations, as well as the publicly held corporations that are frequently surveyed. This broad membership base allows TMA to assess on a wider basis than previously reported the extent of derivatives practices among treasury professionals.

Careful analysis of the survey results, which is continuing, has thus far led to the following conclusions:

* Organizations of all sizes, from under $50 million to over $20 billion (sales or assets), face financial risk exposures. This implies a valuable opportunity for using risk management tools.

* Derivative usage for both managing financial risk and obtaining funding, while widespread across organizations of different sizes, increases with the size of the organization.

* Treasury professionals exhibit selectivity in their use of derivatives for risk management, as evidenced by the preponderance of OTC instruments used for hedging purposes.

* Smaller organizations, those under $250 million in sales/revenue, select 76% of their derivative investments from two categories: traditional securities with embedded options and asset-backed securities.

* The treasury professionals represented in this survey are conservative in their derivative choices. Among instruments chosen for obtaining funding, callable bonds, putable bonds, and securitized receivables are the three most preferred items.

Of the 657 respondents to the survey, 63.2% (415 respondents) reported engaging in some type of derivatives transaction, using derivative contracts, derivative securities, or both. In the view of those 415 respondents, their organizations face a variety of financial risks, including

interest rate risk, foreign exchange risk, and commodity price risk. Based on the responses of the 415 individuals,

* 90.4% of their organizations face interest rate risk.

* 75.4% of their organizations face foreign exchange risk.

* 36.6% of their organizations face commodity price risk.

As a result of these exposures, a significant proportion of the respondents at derivative-using organizations reported using derivatives for financial risk management purposes.

In addition to managing financial risk, organizations also use derivative instruments in two other ways. One is in conjunction with obtaining funding. The other is for investment purposes. Taking all three uses into consideration, the data reveal that

* 70.8% of respondents report their organizations use derivatives for financial risk management.

* 66.7% of respondents report their organizations use derivatives in conjunction with obtaining funding.

* 21.4% of respondents report their organizations use derivatives for investment purposes.

The TMA study is different from previous studies in that it encompasses a broader spectrum of derivative instruments. Many studies narrowly define derivatives as futures, forwards, options, or swaps, i.e., based on the type of derivative contract. Another major class of derivative instruments, called derivative securities, is equally important to treasury professionals. Derivative securities include 1) structured securities and deposits with embedded forwards and/or options, 2) traditional securities with embedded options, and 3) asset-backed securities. The TMA study covered the end use of derivative securities as well as derivative contracts for three major reasons:

* The study presents a comprehensive view of derivative practices among treasury professionals.

* Derivative securities represent a significant vehicle for obtaining funding and/or investing.

* A generic reference to derivatives has become common, but that reference fails to distinguish between derivative contracts and derivative securities.

Aaron L. Phillips




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