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 2 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"

0 Financing Cash need overruns/reinvestment shortfall in earnings 1 Liquidation, downsizing continue 2 Outcome 5

• How to meet these needs?

2 options Date 1 Date 0 go to

capital market

: new debt, new equity DILUTION

hoard liquidity

SECURITIES CONTRACT • credit line (ST) • revolving credit (often option to convert into LT loan) 6

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 8

(IC) 9

10

(i) (ii) Then (first best) [Third case (iii) no funding ] 11

CASH-RICH FIRM

: Theory of maturity structure:

Weak balance sheet short maturity structure.

12

CASH-POOR FIRM

: Example:

r = 0

.

"Wait-and-see" policy suboptimal 13

II. VARIABLE INVESTMENT VERSION 2.1

Two-shock case

Timing 0 • • Investment

I

Borrows

I-A

1 “INTACT” (no reinvestment needed) “DISTRESSED” (reinvestment per unit of investment)  2

p

MH (choice

H

or p

L

) Outcome

RI p 1-p 0

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Assumptions

(1) There exists store of value ( 1 1) (2) remember (3) Interpretation 15

Policy #1

: abandon in case of distress 16

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 Contract.

Investment

I

.

External financing

I-A

.

Need for cash infusion realized.

Distribution on 1 No pay money to pay

p

MH

H p L

2 Outcome

p 1-p RI 0

Project abandoned (liquidation) Yields 0 (later : yields LI) 18

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  0

I

   

p H

  

R



B



p

  

I

   19

 IR   

F

(  * )  0

I



I



A

      0  * 

f

(  )

d

    

I

multiplier

I = k A

1

k

(  * )  1   0  * 

f

(  )

d

 

F

(  * )  0  *  20

NPV per unit of investment: maximized at Intuition.

Borrower’s utility Optimum: 21

Optimal

"expected unit cost of effective investment" 22

Utility: Utility = 23

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 * Securities: same 25

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). 26

NO HEDGING Firm can withstand shocks  such that Hence: where Let 27

Lemma

: H is more convex than F convex Proof : Arrow-Pratt: convex In contrast, manager ex post may or may not hedge if given the choice 28

Firm "risk averse" w.r.t.  "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) (b)

Market power

Forward sales and over-supply by monopolist or oligopolist

.

Several correlation of profits

• • Example: random short-term income success

p

 +  (

r

) where 

r

(exogenous) "attractive-reinvestment-opportunities effect": probability of

' > 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 moral hazard (or AS) about signal (or realization) informative about date-0 behavior date-1 income

r

continuation parameters • •

L

• 2nd period prospects (

R

,

p H

…) 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 - monetary rewards Private benefit

B 0 I

of shirking at date 0.

State-invariant continuation rule does not provide incentives. Two possibilities: • very small cost (2nd order) for

B 0

small • not credible if 33

Text:

if works at date 0 if shirks MLRP : increasing Optimal policy: over "relevant range" (small if

B 0

small).

SBC "retained-earnings policy"

r

Soft Budget Constraint 34

III. FREE CASH FLOW

Jensen 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):

P 1

high: good reinvestments not made

P 1

low: free cash flow

•

liquidity risk (see hedging stuff) • does not respond to news about

L

, future prospects market information !

 need to make use of

Secret reinvestments just before r accrues.

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