Determinants of Corporate Determinants of Corporate BorrowingBorrowing

Stewart C. MyersStewart C. MyersSloan School, M.I.T., Cambridge, MA 02139, U.S.A.Sloan School, M.I.T., Cambridge, MA 02139, U.S.A.

Received October 1976, Received October 1976, revised version received July 1977revised version received July 1977

Journal of Financial Economics 5 (1977) 147-175 Journal of Financial Economics 5 (1977) 147-175 North-Holland Publishing CompanyNorth-Holland Publishing Company

QF04 892615 QF04 892615 徐靜珊 徐靜珊 892617 892617 曾瓊萩曾瓊萩 892629 892629 賴書儀賴書儀

SummarySummary

Growth opportunity & call optionsGrowth opportunity & call options Issuing risky debt & present market valueIssuing risky debt & present market valueCorporate borrowing & the proportion of Corporate borrowing & the proportion of

market value accounted by real optionsmarket value accounted by real optionsOther aspects of corporate borrowingOther aspects of corporate borrowing

IntroductionIntroduction

BorrowingBorrowing -why not borrowing as much as possible-why not borrowing as much as possible -tradeoff between tax advantage of debt -tradeoff between tax advantage of debt and costs of the suboptimal future and costs of the suboptimal future investment strategyinvestment strategy -other factors-other factors

AssumptionsAssumptions

Most firms are valued as going concern and the value Most firms are valued as going concern and the value reflects an expectation of continued future investment reflects an expectation of continued future investment by the firm.by the firm.

The investment is discretionary. The amount invested The investment is discretionary. The amount invested depends on the net present values of opportunities as depends on the net present values of opportunities as they arise in the future.they arise in the future.

V = VV = VA A + V+ VGG There are no corporate taxes and no bankruptcy costs.There are no corporate taxes and no bankruptcy costs. The firm’s managers act in the shareholders’ interest. The firm’s managers act in the shareholders’ interest. Capital markets are perfect and completeCapital markets are perfect and complete

Case1Case1A firm with no assets in place (VA =0 ) and only

one future investment opportunity.

The firm is initially all-equity financed.

Balance sheet at t=0

Value of growth opportunity VG

0       Value of debt

VE Value of equity

Value of the firm V V

If it decides to invest, additional shares must be issued to raise the required investment I.

Balance sheet at t=1

Value of newlyacquired asset V (s)

0 Value of debt

VE Value of equity

Value of the firm V (s)

V(s)

Case2Case2

The debt matures before the investment decision is made,but after the true state of nature is revealed.

Balance sheet at t=0

Value of growth opportunity VG

VD Value of debt

VE Value of equity

Value of the firm V V

The firm raise the amount I and exercises its investmentoption.

Balance sheet at t=1, given x (s) =1

Value of newlyacquired asset V (s)

Min[V(s),P] Value of debt

Max[0,V(s)-P] Value of equity

Value of the firm V (s)

V(s)

There is a definite limit, VThere is a definite limit, VD D (max)(max) If the option exercised, min (V (s) ,P)=PIf the option exercised, min (V (s) ,P)=P V is a monotonically decreasing function of PV is a monotonically decreasing function of P

Trade-offTrade-off

Assets as call optionsAssets as call options

Bankruptcy costBankruptcy cost

˙̇renegotiating the debt contractrenegotiating the debt contract 1. 1. Incentive:Incentive: If bondholders and shareholders find themselves in If bondholders and shareholders find themselves in

the position where V<P, then it is in both interest to the position where V<P, then it is in both interest to renegotiate.renegotiate.

2. Disadvantages:2. Disadvantages: ‧‧ the direct costs of renegotiationthe direct costs of renegotiation ‧‧ a costly duplication-it is doubtful that bondholders a costly duplication-it is doubtful that bondholders could obtain an adequate estimate of V without could obtain an adequate estimate of V without

continual monitoring of the firm’s actions.continual monitoring of the firm’s actions.

Liquidation cost &Liquidation cost & reorganization cost reorganization cost

˙̇rewriting the contractrewriting the contract

There would rarely be any objective basis for There would rarely be any objective basis for judging whether the contract is breached, for judging whether the contract is breached, for example, V(s) which is not objectively example, V(s) which is not objectively

observed.observed.

Impaired ability to conduct businessImpaired ability to conduct business

˙̇mediationmediation 1. 1. incentive :incentive : When there are symptoms of financial distress When there are symptoms of financial distress and suspicion, bondholders would call for an and suspicion, bondholders would call for an impartial party to mediate.impartial party to mediate. 2. disadvantage :2. disadvantage : It is difficult to define when the mediator to be It is difficult to define when the mediator to be called in.called in.

Agency costAgency cost **case 1:case 1: shareholders may take a risk investmentshareholders may take a risk investment ˙̇Honesty is the best policy Honesty is the best policy 1.1.Cause and effect:Cause and effect: Stockholders can play at the short-run expense of Stockholders can play at the short-run expense of bondholders, but in the long run, shareholders bear bondholders, but in the long run, shareholders bear the costs.the costs. 2.Voluntary forbearance is the simplest and best 2.Voluntary forbearance is the simplest and best solution to the investment incentive problem. solution to the investment incentive problem.

*Case2:*Case2: Shareholders may reject an investment with Shareholders may reject an investment with positive NPV.positive NPV. ˙ ˙Honesty is the best policyHonesty is the best policy

**case 3:case 3: Shareholders may pay excess dividend.Shareholders may pay excess dividend. ˙̇Restrictions on dividendsRestrictions on dividends

Imperfections in Real Asset MarketsImperfections in Real Asset Markets

We think of the firm as composed of two We think of the firm as composed of two assets type: real assets, real option. And assets type: real assets, real option. And we assume the market is not perfect and we assume the market is not perfect and complete.complete.

Here, it is necessary that the value of a Here, it is necessary that the value of a growth option vanishes if it is not growth option vanishes if it is not exercised by the firm.exercised by the firm.

Case 1: if the real option is firm-specificCase 1: if the real option is firm-specific Case 2: if the real option is not firm-specific Case 2: if the real option is not firm-specific

Long-term borrowingLong-term borrowing

Assume a firm holding options wants to Assume a firm holding options wants to exercise one of its option, at the same exercise one of its option, at the same time, it has bonds outstanding which is time, it has bonds outstanding which is mature at mature at t t : : : the value of the firm: the value of the firm : an incremental investment on : an incremental investment on

the market value of equitythe market value of equity : the investment policy continues : the investment policy continues

investing.investing.

, ,t E t D tV V V E DdV dV dV

dI dI dI

1dV

dI

The value of the firm’s debt :The value of the firm’s debt :

Therefore:Therefore:

There is a transfer cost of value from There is a transfer cost of value from

stockholders to bondholder:stockholders to bondholder:

if , the investment exist. if , the investment exist. Assume ,what happened?Assume ,what happened?

21, , /tD t t t tV f V V V

2,

21E t t t t

t t t

dV f fdV

dI dI V I

2

0t

t

0tZ

2,

2

E tt t t tt

t t t

dVdV f fdVZ

dI dI dI V I

Fig 4.Fig 4.

Spillover EffectsSpillover Effects & & Shift in Asset RiskShift in Asset Risk

Spillover effects:Spillover effects: In brief, the investment at t will affect the In brief, the investment at t will affect the

value of the firm at t-1 and t+1.value of the firm at t-1 and t+1.

Shift in asset risk means that each Shift in asset risk means that each investment of the firm may face different investment of the firm may face different risk.risk. the impact of risky debt on the market value of the impact of risky debt on the market value of

the firm is less for firms holding investment the firm is less for firms holding investment options. In this sense we may observe risky options. In this sense we may observe risky firms borrowing more than safe ones. firms borrowing more than safe ones.

borrowing against a borrowing against a portfolio of assetsportfolio of assets

One advantage of corporate diversification One advantage of corporate diversification is that diversified firms can borrow more. is that diversified firms can borrow more. We take two firms We take two firms ii, , jj holding two real holding two real options.options.First, we take a numerical example:First, we take a numerical example:

case A: case A: VVii(s)+V(s)+Vjj(s)>P(s)>Pii+P+Pjj, it will be taken., it will be taken.

case B: case B: VVii(s)+V(s)+Vjj(s)<P(s)<Pii+P+Pjj, it will not be taken. , it will not be taken.

: the point to justify : the point to justify investing or not.investing or not.

: the present value of option : the present value of option ii in in portfolio with the other option portfolio with the other option jj

: diversification value : diversification value

i j i jV s V s P P

iV j

iV j

i i iDV V j V s

casecase

ConclusionsConclusions

This paper is presented:This paper is presented:The firm’s growth opportunities could be views The firm’s growth opportunities could be views

as call option.as call option. If the firm want to issue debt, what is the place If the firm want to issue debt, what is the place

to borrow? to borrow? We think that it’s case by case. Until now, we We think that it’s case by case. Until now, we

introduce many situations. Each has different a introduce many situations. Each has different a way doing. way doing.

The author thought that he’s still have many The author thought that he’s still have many things didn’t present yet. things didn’t present yet.