Myers, S. (1977). Determinants of Corporate Borrowing. Journal of Financial Economics, no. 5, pp. 147-175. PDF

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Download Myers, S. (1977). Determinants of Corporate Borrowing. Journal of Financial Economics, no. 5, pp. 147-175. PDF

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ACF 2019 – Lecture 7

© Morten Hansen

9/23/2019

Determinants of Corporate Borrowing Source: Myers, S. (1977). Determinants of Corporate Borrowing. Journal of Financial Economics, no. 5, pp. 147-175. Lecture slides Notation:

t=0 variables

t=1 variables (if an investment is undertaken)

V =¿ V A =¿ V G=¿ V D =¿ V E =¿

s=¿ state of the world V ( s )=¿ new

value of the firm

assets and value of the firm

assets in place

V D ( s )=¿ debt V E ( s )=¿ equity I =¿ investment cost s a=¿ investment threshold under short-

future investment opportunities value of debt value of equity

term debt

s b=¿ investment threshold under longterm debt P=¿ promised payment q ( s) =¿ the current equilibrium price of a dollar delivered at period t=1 and only if the investment decision is carried out → in present value T =¿ corporate tax rate T s B =¿ investment threshold under tax-shield

Summary: The article by Myers show the consequence of debt in a firm’s capital structure. Especially, the effects of agency conflicts (credit rationing and debt overhang). In general, with no advantage to debt (taxdeduction) the original owners will not issue debt, otherwise there is a trade-off. Firms must therefore balance the tax-advantages of having debt, with bankruptcy cost and risk, when determining their capital structure. Value of the firm in the final and most imponent setting is the b

integral equation between s T and infinity. The equation (12) is given by a multiplier for a generic cost of borrowing variable, multiplied by the new value of the firm when undertaking investment, subtracted the investment costs, and added the value of the tax-shield of debt. The main conclusion of this article is heavily dependent on the existence of tax-benefits. Basic model: In the basis model we start by assuming no taxes and no bankruptcy cost. The firm's manager acts as to maximize shareholders value, there are perfect and complete capital markets. At

t=0 , the value of the firm, V

is given by

V =V A + V G where

1

(1)

ACF 2019 – Lecture 7

© Morten Hansen

9/23/2019

V A are the market value of assets in place. Initially the firm has no assets, i.e. V A =0 . V G are the market value of future investment opportunities. V D and V E respectively.

The market value of debt and equity are denoted

*Balance sheets are in market values

At time t=1 firm.

the state (of the economy) is

s ∈ (0 , ∞ ) , this state of

s also extents to the

At t=1 the firm have access/decides to a growth option (must likely a project). If the firm decide to invest I it receives assets worth V ( s ) which is increasing for higher states s , i.e. V ' ( s )>0 . If it does not invest then the investment opportunity expires and has no value to the firm or to anyone else.

*Balance sheets are in market values

CASE 1: Suppose debt is absent for now, i.e. the firm is an all-equity firm, then the firm will invest if and only if the new value of the firm is at least equal to the investment costs V (s)≥ I

(2)

At some point, investment becomes inefficient (no longer profitable for the firm), this “cut-off point” is denoted by s a .

Hence,

V ( s a )= I

The value of the all-equity firm is then given by

∞

∞

V E =∫ q ( s ) [ V (s) −I ] ds

V E =∫ q ( s ) max [ V ( s )−I , 0 ] ds

(3)

sa

0

where

q ( s)

is the present value of receiving a dollar if state s

prevails at time

t=1

The investment decision is shown in the figure 1. For states displayed to the right of s a (s ≥ s a ) , the investment is made (the yellow shaded area)

2

ACF 2019 – Lecture 7

© Morten Hansen

9/23/2019

Figure 1. The firm’s investment decision under all-equity financing as a function of the state of the world, s , at the decision point.

How does borrowing affect firm value? Since the growth options expires worthless if s < sa , the debt which is issued by the firm with a promised payment P is risky. I.e. it is NOT risk-free debt

CASE 2: Suppose the debt must be paid (matures) before the investment decision is made but after the true state is revealed. Then, if V (s)−I ≥ P , the firm will invest, and debt is repaid at value P as the value of the firm subtracted the investment costs is greater then the promised payment to the debt holders. However, if V (s)−I...