Executive Summary:
Dynamic Model Reflects Complexity of Corporate Financing and Investment Decisions
Nearly 100 years later, the math behind Einstein’s 1905 paper on Brownian motion is being used in the creation and development of a dynamic model that can predict a wide array of interactions between investment and financing decisions. The importance of this research comes not only from the creation of the model—one which has been in evolution for roughly 30 years—but in the usefulness to corporations in determining optimal levels of initial debt, debt maturities, flexibility in adjusting debt levels at maturity dates, and asset structures in general. Underlying the numerous issues addressed by the model, stockholder-bondholder conflicts of underinvestment and overinvestment, decisions of asset substitution versus asset expansion, and the agency costs related to decisions are analyzed. The paper “Interactions of Corporate Financing and Investment Decisions: The Effects of Agency Conflicts” by Chair of Finance David Mauer, Paul Childs of the University of Kentucky, and Steven Ott of the University of North Carolina is forthcoming in the Journal of Financial Economics.
Interactions and the Feedback from Corporate Misdeeds
There are two major types of stockholder-bondholder conflicts that arise—decisions which result in underinvestment and overinvestment. Managers acting on behalf of equityholders often end up rejecting good investments if too much of the investment’s benefit would go to the bondholders. An example of this would be a significant office maintenance expense of say $10,000,000. If the business environment looks volatile, it is easy for firms to not make the investment that may cost handsomely; and if there is a potential for bankruptcy looming, the creditors or bondholders would get the assets. As a result of this dynamic, firms choose to underinvest, which happens all too often. Because bondholders realize underinvestment occurs, and depending on the probability of a firm getting into trouble, then a premium gets built into the cost of financing.
The other conflict of overinvestment arises when managers of firms choose overly risky investments. This happens because equityholders capture all of the upside potential but are cushioned on the downside because they have limited liability. Once lenders catch wind of these management practices, even if it’s once, a premium is then built into the cost of financing. The resulting feedback loop can become a vicious cycle for a firm. As Mauer explained, “That feedback then returns in the form of higher costs of financing. Now decent investments cannot be funded because of the information of prior risky actions feeding back into the system with the resultant higher cost of capital. Dynamically over time, the firm will end up rejecting some good investments because of higher financing costs.”
Corporate extravagance has been one form of misdeed which shows up in the feedback chain and is a form of overinvestment. One way to prevent manager misdeeds is to use shorter debt maturities. This allows lenders to monitor a firm. Previously, there wasn’t widespread recognition that outside financiers adjusted to compensate for corporate misdeeds like lavish perks. But in reality the cost of outside financing rises to compensate for the loss in value from these sub-optimal investments (agency costs). “It’s in everybody’s interest to wring out these costs and prevent inappropriate actions because in the end it is the corporation’s shareholders who pay,” Mauer commented.
Given underinvestment and overinvestment, there are consequences and influences on capital structure, debt maturity structure, and the amount of financing that is optimal for a corporation. With the flexibility in the future to adjust the debt level, how does that feed back into investment decisions but also into initial financing decisions? The model developed allows for predictions under different investment options about optimal leverage, optimal debt maturity structures and the value of financial flexibility.
Financial Flexibility
Prior to this research, academics had trouble establishing that firms optimally use short-term debt to resolve this agency conflict, although empirically academics could show this solution. Mauer continued, “Myers, who wrote one of the key papers about these issues was right—that agency problems can be mitigated if not completely eliminated by shortening up the maturity of debt. Firms that have these problems do use short-term debt. However, nobody was able to show this theoretically in a realistic dynamic model.”
In prior research, it was easy to demonstrate that as you shorten debt maturities, the agency costs go away. The problem was that extant theoretical models predict that firms optimally shun short-term debt. One reason was the transactions costs of rolling over debt, but also the liquidity risk. “The solution which is obvious is that corporations can hedge the liquidity risk,” Mauer elaborated. “If you have financial flexibility and even minimal foresight that things could get bad, you will reduce your debt to be less levered.” The model allows corporations to choose the level of debt and maturity, but also give them the financial flexibility to hedge liquidity risk.
Today corporations issue a variety of short-term debt instruments. “Corporations have long-term debt, but over the years the long-term debt that they are issuing is getting shorter and shorter,” Mauer explained. “Corporations now have the expertise to dynamically manage agency costs, liquidity, and debt structures.” In the model, because liquidity risk gets reduced and because short-term debt is taken, both the agency costs of overinvestment and underinvestment are driven down. They can be reduced to zero. The ability to use dynamic models leads to results that closer reflect business reality. Thus the question: Are these agency costs driven to zero in the real world?
In reality, a corporation’s investment opportunity set drives interactions between financing and investment decisions. Another set of findings in the research proved counterintuitive. In cases where future investment options increase risk, the firm will actually choose a higher level of debt when it has financial flexibility than when it does not. Alternatively, when expanding the asset base is the goal, this is when a firm will choose a lower initial level of debt. “These findings are counterintuitive and provide testable predictions that empiricists can use to either support or reject the model, “ Mauer said.
Conclusion
With equityholders’ desire to either shift wealth from debtholders (overinvestment) or prevent the enhancement of debtholder wealth (underinvestment), the research shows that short-term debt can mitigate, if not completely resolve these conflicts. But the firm will only choose short-term debt when it has the financial flexibility to adjust the debt level in the future. The reason is that short-term debt exposes the firm to liquidity risk, which it can hedge by reducing the debt level when business conditions sour.
Dynamic models that allow for interactions between flexible financing and investment decisions are rare. Even more rare are dynamic models allowing for agency costs as well. The influence of financial flexibility—the ability to dynamically adjust capital structure in the future—can be analyzed in conjunction with a firm’s initial financial policy choices. Although financial flexibility encourages the firm to choose shorter-term debt, the resulting decrease in agency costs may not encourage the firm to simultaneously choose a higher initial debt level. The firm’s initial debt level choice also depends on the characteristics of the firm’s investment opportunities—that of asset substitution or asset expansion and whether a firm intends to maximize the value of equity or the total value of the firm.
Note: This summary is a general conceptual overview of the research. It is a simplistic representation of the original paper. Great detail exists in the research for real financial connoisseurs.
Written by Jennifer Warren. |
