MULTISTAGE FINANCING
LIQUIDITY RATIOS
RISK MANAGEMENT
SOFT BUDGET CONSTRAINT
FREE CASH FLOW
2th set of transparencies for ToCF
CORPORATE LIQUIDITY DEMAND
HOARDING OF LIQUIDITY
Asset side : – securities
– credit lines and loan commitments
Future promises to lend
(maximum amount, lending terms, duration, commitment
fee, option to convert into term loan at maturity?,…)
Over 75% of commercial and industrial loans at large
US banks = take-downs under loan commitments.
Liability side : – long term debt and equity
WHY?
Concern about refinancing (Thakor-Hong-Greenbaum 1981, Froot-
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Scharfstein-Stein 1993).
CORPORATE RISK MANAGEMENT
TECHNIQUES
• forward/futures markets (raw materials, agricultural products),
• swap FX
• interest rate,
• securitization,
• insurance against theft, fire, death of key employee,
• trade credit insurance,
• geographical plant diversification.
…
•Yet limited hedging (Culp-Miller). Large companies make much
greater use of derivatives.
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WHY?
• reduction in volatility for claimholders : No!
• cut tax bill? (Stulz),
• insure managers by filtering out exogenous noise (Stulz, Fite-
Pfleiderer)? Alternative : virtual hedging.
• reduce probability of bankruptcy?
AGENCY BASED EXPLANATIONS
• unability to get funds when one needs them (Froot et al,
Stulz),
• avoid ancillary damages such as gambling behavior.
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CORPORATE LIQUIDITY DEMAND
"Cash poor firm"
overruns/reinvestment
Cash need
shortfall in earnings
0 1 continue 2
Financing Outcome
Liquidation,
downsizing
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• How to meet these needs?
2 options
Date 1 Date 0
go to capital market : hoard liquidity
new debt, new equity
DILUTION
SECURITIES CONTRACT
• credit line (ST)
• revolving credit
(often option to
convert into LT loan)
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BASIC INSIGHT:LOGIC OF CREDIT RATIONING APPLIES AT
DATE 1 AS WELL WANT TO HOARD LIQUIDITY
CASH RICH FIRM: flip side of same coin.
Jensen 1986 ST debt
pump out money
Easterbrook 1984 Dividend
steel, tobacco, chemical, broadcasting,...
Security design also regulates liquidity
Equity, LT debt: little cash draining
ST debt: drains cash
Preferred stocks...
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I. LIQUIDITY RATIO AND CORPORATE RISK MANAGEMENT
I. FIXED INVESTMENT VERSION
Optimal policy: continue iff for some
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(IC)
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(i)
(first best)
(ii)
Then
[Third case (iii) no funding ]
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CASH-RICH FIRM:
Theory of maturity structure:
Weak balance sheet
short maturity structure.
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CASH-POOR FIRM:
Example: r = 0.
"Wait-and-see" policy suboptimal
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II. VARIABLE INVESTMENT VERSION
2.1 Two-shock case
Timing
0 1 2
• Investment MH Outcome
I (choice RI
• Borrows pH or pL ) p
I-A
1-p
“INTACT” “DISTRESSED” 0
(no (reinvestment
reinvestment per unit of
needed) investment)
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Assumptions
(1) There exists store of value ( 1 1)
(2) remember
(3)
Interpretation
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Policy #1 : abandon in case of distress
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Policy #2: pursue project in case of distress
Minimize cost :
policy #2 1 1
Policy #2 when low
high 17
2.1 Continuum-of-shocks case
0 1 pay 2
Contract. Need for MH Outcome
Investment I. cash infusion p 1-p
External realized. No
financing pH pL RI 0
Distribution money
I-A. to pay
on
Project abandoned
(liquidation)
Yields 0
(later : yields LI)
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a) OPTIMAL CONTRACT (later: implementation)
• Only investors can cover I .
• Suppose for the moment one can contract on continuation rule
Optimum:
continue: needs
liquidate (nothing for entrepreneur)
Pledgeable income after continuation
B
0I pH R I
p
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IR
*
F ( * ) 0I I A
0
f ( )d I
multiplier I = k A
Maximized at 0 .
*
Explanation.
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NPV per unit of investment:
maximized at Intuition.
Borrower’s utility
Optimum: 21
Optimal
"expected unit cost of effective
investment"
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Utility:
Utility
=
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Generalization: liquidation value LI :
Intuition.
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CORPORATE DEMAND FOR LIQUIDITY
1 WAIT-AND-SEE POLICY IS SUBOPTIMAL
even with "perfect" financial market, investors won't bring in more
than at date 1.
Conversely, initial investors willing to have their
claims diluted.
Dilution only
(even worse if debt overhang, etc.)
2 HOARDING:
* Nonrevocable credit line
no right to dilute
or right to dilute
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* Securities: same
CORPORATE RISK MANAGEMENT
Modeling: • "Adverse" shocks with
(ex: foreign exchange risk).
• Can get insurance at fair rate.
Idea: obtain insurance so that does not mess up decision making.
• HEDGING
For an arbitrary
Remark : could be a conditional credit line (less common).
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NO HEDGING
Firm can withstand shocks such that
Hence:
where
Let
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Lemma : H is more convex than F
convex
convex
Proof :
Arrow-Pratt:
In contrast, manager ex post may or may not hedge if given the choice
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"risk averse" w.r.t.
Firm
"risk loving" w.r.t.
Mean preserving spread
Firm better off
DIFFERENCE: "unavoidable"; option !
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OPTIMALLY INCOMPLETE HEDGING
Full hedging is too stark a result.
Transaction costs... and 5 other reasons for hedging incompletely.
(a) Market power
Forward sales and over-supply by monopolist or oligopolist.
(b) Several correlation of profits
Example:
• random short-term income r (exogenous)
• "attractive-reinvestment-opportunities effect": probability of
success p + (r) where ' > 0.
But "easier-refinancing effect": good news make it easier to return
to the capital market.
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Optimal policy:
(firm should keep some of its cash-flow as retained earnings)
(c) Aggregate risk
Like CAPM: economic agents share (in different proportions) the
aggregate risk.
(d) Asymmetric information
(e) Incentives
Short-term profit r in general is endogenous. Motivates investment-
to-cash-flow sensitivity: see next section.
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II. SOFT BUDGET CONSTRAINT
Basic idea:situation in which capital market is too soft: refinances when not ex ante
optimal to do so.
Date 0 Date 1
date 0 signal (or realization)
moral hazard informative about
(or AS) date-0 behavior
about
date-1continuation
incomeparameters
r •
• L
• 2nd period
prospects
(R, pH …)
want to punish if r small, etc. 32
• KEY: Monetary punishments limited (especially if continuation!)
Often liquidation (interference,…) only punishment or at least complementary punishment.
• EXAMPLE: r endogenous
Perhaps even deterministic
Low date-0 effort
- monetary rewards
High date-0 effort
Private benefit B0I of shirking at date 0.
State-invariant continuation rule does not provide incentives. Two possibilities:
• very small cost (2nd order) for B0 small
• not credible if 33
Text: if works
at date 0
if shirks
MLRP : increasing
Optimal policy:
over "relevant range" (small if B0 small).
SBC SBC
n o
r
"retained-earnings policy" Soft Budget Constraint
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Jensen
III. FREE CASH FLOW
Easterbrook
• r exogenous (no SBC issue)
deterministic safe cash flow (public utilities,
banks,
mature industries)
• Generalized formulae:
Free cash flow assumption:
Payment:
ST debt
dividend (with ceiling) 35
CRITIQUES
Uncertainty not flexible enough, risk of liquidity problem
Ex:
Rigid (ST debt): • liquidity risk
(see hedging stuff)
P1 high: good reinvestments not made
P1 low: free cash flow
• does not respond to news about L, future prospects need to make use of market
information !
Secret reinvestments just before r accrues.
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