908 Lecture 6

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Topics in Financial Economics: Hart’s Hard Budget

Constraint Model

Tianxi Wang

Economics Department, U of Essex

Tianxi Wang (Economics, U of Essex) 1 / 9

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The Objectives

Applicable for the public company: Do not allow the renegotiation of debt.


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The Objectives


Core: How to constrain the management of the public company.


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The Objectives


Core: How to constrain the management of the public company.Give a role for the long term debt.

Based on the book by Oliver Hart (1995), "Firms, Contracts andFinancial Structure" (Chapter 6, page 126-140).


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Background Assumptions of The model:

The company has a large number of small investors. ) No

renegotiation.


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renegotiation.

The capital structure decisions are made to maximize the …rm’s value,rather than to maximize the management’s utility subject to investorsbreaking even: The capital structure is not decided by the

(professional) management, but by the founding investors and theentrepreneur.


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renegotiation.The capital structure decisions are made to maximize the …rm’s value,rather than to maximize the management’s utility subject to investorsbreaking even: The capital structure is not decided by the


The manager’s utility is strictly increasing in the assets under hiscontrol, but independent of his monetary compensation (power beforemoney). ) The manager do not like liquidation and always want to

invest, which is the source of con‡ict interest. This assumption isextreme, but allows us to focus on the control rights.


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renegotiation.The capital structure decisions are made to maximize the …rm’s value,rather than to maximize the management’s utility subject to investorsbreaking even: The capital structure is not decided by the


The manager’s utility is strictly increasing in the assets under hiscontrol, but independent of his monetary compensation (power beforemoney). ) The manager do not like liquidation and always want to

invest, which is the source of con‡ict interest. This assumption isextreme, but allows us to focus on the control rights.

The management cannot divert the company’s cash into its ownpocket. Otherwise, we would not see the public company.


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The model of Hard Budget Constraint: The Set Up

The …rm has assets in place. There are three dates, t = 0, 1 and 2.


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The …rm has assets in place. There are three dates, t = 0, 1 and 2.At t = 0: Decide the …rm’s capital structure, which consists of shortterm debt P 1, long term debt P 2, and the equity E . Both types of debt are senior to new claims issued in the future.


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The …rm has assets in place. There are three dates, t = 0,

1 and 2.

At t = 0: Decide the …rm’s capital structure, which consists of shortterm debt P 1, long term debt P 2, and the equity E . Both types of debt are senior to new claims issued in the future.

At t = 1: The assets …rst yield cash y 1. Then the assets are eitherliquidated, yielding cash L, or continued. For the former, that is theend of the story; for the latter, the …rm carries on to t = 2.


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1 and 2.



At t = 2, the assets yield cash y 2. Then the …rm is wound up.


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1 and 2.




At t = 0, y 1, y 2 and L are uncertain. All the uncertainty is resolved at

t = 1 and there is symmetric information throughout.


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1 and 2.





t = 1 and there is symmetric information throughout.The liquidation decision is not contractible.


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1 and 2.





t = 1 and there is symmetric information throughout.The liquidation decision is not contractible.

Investors are risk neutral, and the risk free rate is 0.


Wh If h Li id i D i i I C ibl ?

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What If the Liquidation Decision Is Contractible?

At t = 1: If the assets are liquidated now, they yield L; if they arecarried on, they will yield y 2.




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The optimal contract between investors and the manager is:



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Then, the value of the …rm at t = 0 is:


Wh t If th Li id ti D i i I C t tibl ?

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But the cash ‡ows y 2 and L are not contractible in particular: Theyare observed by investors and the manager, but not veri…able to thecourt.


Wh t If th Li id ti D i i I C t tibl ?


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The con‡ict of interest: The manager wants to continue in any case,but investors want to liquidation if L > y 2.



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The con‡ict of interest: The manager wants to continue in any case,but investors want to liquidation if L > y 2.

The core of the model consists in how to decision capital structure toconstrain the manager, so as to enforce the optimal liquidation.


When Does Liquidation Occur?

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Liquidation happens if the …rm cannot fully repay its short term debt

P 1 at t = 1.



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Liquidation happens if the …rm cannot fully repay its short term debt

P 1 at t = 1.At t = 1, it has cash y 1 in hand.



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Liquidation happens if the …rm cannot fully repay its short term debtP

1 at t = 1.

At t = 1, it has cash y 1 in hand.

If y 1 P 1, the manager has no problem to repay the short term debtand liquidation does not happen.



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1 at t = 1.



If y 1 < P

1, the cash in hand is not su¢cient to service the debt, but

the manager can obtain additional proceeds by issuing new debt. The…rm, if not liquidated, has y 2 at t = 2, but also has to repay debt P 2,which reduces its ability to borrow, namely, its debt capacity.



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1 at t = 1.At t = 1, it has cash y 1 in hand.


If y 1 < P



Therefore, at t = 1, the most it can borrow is



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1 at t = 1.



If y 1 < P



Therefore, at t = 1, the most it can borrow is

therefore, liquidation happens if and only if

y 1 < P 1 and


The Optimal Capital Structure


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The intuition: Use short term debt to drain cash ‡ow and use longterm debt to drain the debt capacity.



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If y 1 = 5, L = 6 and y 2 = 7, what is the optimal contract?



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If y 1 = 5, L = 6 and y 2 = 7, what is the optimal contract?Generally, if it is known at t = 0 that y 2 > L, the optimal capitalstructure has ; if it is known at t = 0 that y 2 L, theoptimal capital structure has .



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p p


If y 1 = 5, L = 6 and y 2 = 7, what is the optimal contract?Generally, if it is known at t = 0 that y 2 > L, the optimal capitalstructure has ; if it is known at t = 0 that y 2 L, theoptimal capital structure has .More interestingly: At t = 0 there are two states: (y A

1

, y A

2

, LA) and(y B 1 , y

B 2 , L

B ); y A2 > LA but y B 2 < L

B , that is, the best decision is tocontinue for case A and to liquidate for case B.



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p p


If y 1 = 5, L = 6 and y 2 = 7, what is the optimal contract?Generally, if it is known at t = 0 that y 2 > L, the optimal capitalstructure has ; if it is known at t = 0 that y 2 L, theoptimal capital structure has .More interestingly: At t = 0 there are two states: (y A

1

, y A

2

, LA) and(y B 1 , y

B 2 , L

B ); y A2 > LA but y B 2 < L


1 y A1 + y A2 > y

B 1 + y

B 2 : The social best can be achieved by setting



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p p


If y 1 = 5, L = 6 and y 2 = 7, what is the optimal contract?Generally, if it is known at t = 0 that y 2 > L, the optimal capitalstructure has ; if it is known at t = 0 that y 2 L, theoptimal capital structure has .More interestingly: At t = 0 there are two states: (y A1 , y

A2 , L

A) and(y B 1 , y

B 2 , L

B ); y A2 > LA but y B 2 < L


1 y A1 + y A2 > y

B 1 + y


2 y A1 + y A2 y B 1 + y B 2 , y A1 > y B 1 : The social best can be achieved bysetting




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p p



A2 , L

A) and(y B 1 , y

B 2 , L

B ); y A2 > LA but y B 2 < L


1 y A1 + y A2 > y

B 1 + y



3 y A1 + y A2 y

B 1 + y

B 2 , y

A1 y

B 1 : The social best can never be achieved;

if liquidation happens in state B, it must happen in state A. Prove it.



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A2 , L

A) and(y B 1 , y B 2 , LB ); y A2 > LA but y B 2 < LB , that is, the best decision is tocontinue for case A and to liquidate for case B.

1 y A1 + y A2 > y

B 1 + y



3 y A1 + y A2 y

B 1 + y

B 2 , y

A1 y

B 1 : The social best can never be achieved;

if liquidation happens in state B, it must happen in state A. Prove it.

If debt renegotiation is possible:Tianxi Wang (Economics, U of Essex) 7 / 9

Critical Thinking - 1: Hard Budget Constraint

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The model explains two features of debt well: It is senior to equity;and it imposes "hard" budget constraint, namely, if a failure to repay

it fully leads to a penalty in the form of bankruptcy.



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it fully leads to a penalty in the form of bankruptcy.If debt is junior,



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it fully leads to a penalty in the form of bankruptcy.If debt is junior,If debt is postponable,



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it fully leads to a penalty in the form of bankruptcy.If debt is junior,If debt is postponable,Before compare the model here and of the last week to the othertheories of debt, take the Oliver Hart’s remark: If the payment to

investors are contractible, then it is easy to align the manager’sinterest with the …rm’s value; for each payment P , the manager getsθP , where θ is smaller.



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investors are contractible, then it is easy to align the manager’sinterest with the …rm’s value; for each payment P , the manager getsθP , where θ is smaller.The other theories of debt:



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1

Tax theory: It cannot explain the feature of hard budget constraint.



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1

Tax theory: It cannot explain the feature of hard budget constraint.2 Jensen-Meckling: It depends on the seniority of debt, but fails, again,to account for that.



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1

Tax theory: It cannot explain the feature of hard budget constraint.2 Jensen-Meckling: It depends on the seniority of debt, but fails, again,to account for that.

3 Myers-Majluf: It depends on the seniority of debt, but it presumes themanager acts in the interest of old shareholders; if the manager onlycares the …rm’s value, he has no incentive to issue debt.


Critical Thinking - 2: Regularities

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The leverage goes up with the proportion of tangible assets:



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The leverage goes down with pro…tability:




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The leverage goes down with pro…tability:1 If the pro…tability is represented by y 1:



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The leverage goes down with pro…tability:1 If the pro…tability is represented by y 1:2 If it is represented by L:



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The leverage goes down with pro…tability:1 If the pro…tability is represented by y 1:2 If it is represented by L:3 If it is represented by y 2:



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The exchange o¤er: The manager in the model, if started withequities only, will not issue any debt. Oliver Hart said he will in faceof hostile take-over. For example, y 1 = y 2 = 100, L = 150. But thereare on evidence that debt-swap-equity deals are o¤ered beforeimpending of takeover.



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The exchange o¤er: The manager in the model, if started withequities only, will not issue any debt. Oliver Hart said he will in faceof hostile take-over. For example, y 1 = y 2 = 100, L = 150. But thereare on evidence that debt-swap-equity deals are o¤ered beforeimpending of takeover.

As , It can hardly explain outside equity, in two senses: The…rm’s value can be maximized without any outside equity; in theextension, the manager will use free cash up for empire buildingrather than for dividend, so outside equity is infeasible.

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908 Lecture 6

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