MULTISTAGE FINANCING LIQUIDITY RATIOS SOFT BUDGET CONSTRAINT FREE CASH FLOW RISK MANAGEMENT 2th set of transparencies
Tunis, May 2005 Jean TIROLE
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?,…) Liability side : – long term debt and equity WHY? Concern about refinancing.
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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, • 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 Financing
1
continue
2 Outcome
Liquidation, downsizing
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• How to meet these needs?
2 options Date 1 go to capital market : new debt, new equity DILUTION Date 0 hoard liquidity
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 Easterbrook 1984 ST debt Dividend pump out money
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 (a) Weak balance sheet short maturity structure. (b) Highly indebted firms ( a ST basis. weak balance sheet) more likely to borrow on
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Reinterpretation: growth prospects No liquidation. Rather: if : p becomes (with and p = pH or pL ).
Incentive constraint:
ST debt: firms with better growth opportunities should select longer maturities.
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CASH-POOR FIRM: Example: r = 0. "Wait-and-see" policy suboptimal
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TWO-SHOCK CASE AND VARIABLE INVESTMENT SCALE
Timing
1 • Investment I • Borrows I-A “INTACT” (no reinvestment needed) “DISTRESSED” (reinvestment per unit of investment) 2 MH (choice pH or pL ) Outcome RI p 1-p
0
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Assumptions (1) There exists store of value ( 1 (2) remember 1)
(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 Policy #2 when
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CONTINUUM OF SHOCKS
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a) OPTIMAL CONTRACT (later: implementation) • Only investors can cover continuation rule. Optimum: continue: needs liquidate (nothing for entrepreneur) Pledgeable income after continuation Suppose for the moment one can contract on
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multiplier I = k A
Maximized at
. Explanation.
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NPV per unit of investment:
maximized at Borrower’s utility
Intuition.
Optimum:
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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, diluted. initial investors willing to have their claims
Dilution only (even worse if debt overhang, etc.) 2 HOARDING: * Nonrevocable credit line no right to dilute or * Securities: same right to dilute
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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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Lemma : H is more convex than F convex
Proof :
Arrow-Pratt:
In contrast, manager ex post may or may not hedge if given the choice
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Fir m
"risk averse" w.r.t. "risk loving" w.r.t.
Mean preserving spread
Firm better off
DIFFERENCE: "unavoidable";
option !
Alternative transfer risk (conditional credit line, indexed debt,..).
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INCOMPLETE HEDGING AND THE INVESTMENT-CASH FLOW SENSITIVITY Rationales for incomplete hedging: Market power. Serial correlation of profits. Example: ST profit r random. Date-2 probability of success: with
increasing in r. On the other hand, capital market at date 1) grows with r.
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(amount that can be raised on
Still
Aggregate risk. Asymmetric information. Incentives (see below).
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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 0 moral hazard (or AS) about Date 1 signal (or realization) informative about date-0 behavior
date-1 continuation income parameters • r • L • 2nd period prospects (R, pH …) want to punish if r small, etc.
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• 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 High date-0 effort Private benefit B0I of shirking at date 0. State-invariant continuation rule does not provide incentives. Two possibilities: - monetary rewards (beyond expansive - state-contingent continuation rule in case of continuation)
• very small cost (2nd order) for B0 small • not credible if
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Investment-cash flow sensitivity Yes: But impact of financial constraints unclear: F(•) uniform where λ is constant.
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Text:
if works
at date 0
MLRP : Optimal policy: over "relevant range" (
increasing
small if B0 small).
no
BC S
SBC
r small "retained-earnings policy"
Soft Budget Constraint
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III. FREE CASH FLOW
•r exogenous (no SBC issue) deterministic safe cash flow
Jensen Easterbrook
(public utilities, banks, mature industries)
• Generalized formulae:
Free cash flow assumption:
Payment: ST debt
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dividend (with ceiling)
CRITIQUES Uncertainty Ex: Rigid (ST debt): • liquidity risk (see hedging stuff) not flexible enough, risk of liquidity problem
P1 high: good reinvestments not made P1 low: free cash flow • does not respond to news about L, future prospects make use of market information ! Secret reinvestments just before r accrues.
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need to