Executive Summaries Source: Financial Management, Vol. 23, No. 4 (Winter, 1994), pp. 75-80 Published by: Wiley on behalf of the Financial Management Association International Stable URL: http://www.jstor.org/stable/3666085 . Accessed: 10/06/2014 19:49 Your use of the JSTOR archive indicates your acceptance of the Terms & Conditions of Use, available at . http://www.jstor.org/page/info/about/policies/terms.jsp . JSTOR is a not-for-profit service that helps scholars, researchers, and students discover, use, and build upon a wide range of content in a trusted digital archive. We use information technology and tools to increase productivity and facilitate new forms of scholarship. For more information about JSTOR, please contact [email protected]. . Wiley and Financial Management Association International are collaborating with JSTOR to digitize, preserve and extend access to Financial Management. http://www.jstor.org This content downloaded from 193.104.110.128 on Tue, 10 Jun 2014 19:49:33 PM All use subject to JSTOR Terms and Conditions
Transcript
Executive SummariesSource: Financial Management, Vol. 23, No. 4 (Winter, 1994), pp. 75-80Published by: Wiley on behalf of the Financial Management Association InternationalStable URL: http://www.jstor.org/stable/3666085 .
Accessed: 10/06/2014 19:49
Your use of the JSTOR archive indicates your acceptance of the Terms & Conditions of Use, available at .http://www.jstor.org/page/info/about/policies/terms.jsp
.JSTOR is a not-for-profit service that helps scholars, researchers, and students discover, use, and build upon a wide range ofcontent in a trusted digital archive. We use information technology and tools to increase productivity and facilitate new formsof scholarship. For more information about JSTOR, please contact [email protected].
.
Wiley and Financial Management Association International are collaborating with JSTOR to digitize, preserveand extend access to Financial Management.
http://www.jstor.org
This content downloaded from 193.104.110.128 on Tue, 10 Jun 2014 19:49:33 PMAll use subject to JSTOR Terms and Conditions
Alternative Tests of Agency Theories of Callable Corporate Bonds Why are some bonds callable and others not? Financial
economists are likely to answer: "agency problems." According to agency theories, the widespread use of callable bonds arises from asymmetric information, a risk incentive or asset substitution problem, or an underinvestment
problem. We conclude that agency problems, while potentially
important for individual cases, are not likely to be the main reason why some firms' bonds are callable and others are not.
In the asymmetric information theory, managers who know their firms are undervalued in the market will not want to issue bonds at a discount. A call option solves this problem because the market also underestimates a good firm's chances of calling the bond, thus undervaluing the call option sold by the firm.
In the underinvestment model, news about the firm arrives after the bonds have been sold, and managers will decide on further investment using this news. If the news is
good, some managers may not want to make additional investments because they only help the bondholders. The call
option solves the underinvestment problem because it allows
managers to recontract the debt when news is revealed and make the full, value-maximizing investment.
The third theory deals with the problem of managers taking on riskier projects after the debt has been issued. These projects have lower payoffs on average but can pay off handsomely to shareholders in some instances and leave bondholders to suffer in the other cases. The call option provides an incentive to stay with the safer projects because the shareholders, who own the call option, will see its value decline if they switch projects.
These theories are difficult to distinguish empirically because there are no direct measures of agency costs. How do we know which firms have favorable inside information? What are the riskier projects that might be undertaken? Previous studies have tested these theories by examining the
leverage ratios, growth opportunities, profitability, and other financial variables of firms that issue callable debt. While these variables may be highly correlated with agency problems, they provide little information about the individual theories.
We examine several areas in which the various theories can be distinguished. First, we look at subsequent rating changes to see if callable bonds are more likely to be
upgraded. We also check whether they are downgraded less often than noncallable bonds.
Second, we examine the date when the bond may be called. According to the asymmetric information and underinvestment theories, the first call date is an important aspect of the recontracting that occurs with a call option. Both theories rely on the call date being near the date the news comes out. If the bond is callable too soon or too late, the call option does not efficiently resolve the agency problem. Thus, we look at the distribution of first call dates to determine if they are set consistent with these theories.
Third, in another test of the underinvestment theory, we examine whether call options are used more often by firms with heavy capital expenditures. The theories revolve around investment activity, so the most frequent issuers of callable debt should be investing more than the average firm. Finally, we calculate the call option values to determine if the riskiest firms are issuing more valuable call options.
In each of our tests, we find the agency theory is
unsupported by the data. Our results suggest that callable bonds are not upgraded more than other bonds, and worse, are actually downgraded more often. In addition, the call dates show a degree of uniformity that is implausible for the
agency theories. For example, nearly all speculative-grade bonds are callable in three or five years. Moreover, we find that the firms with the most investment activity are the ones that issue noncallable debt, not callable debt as predicted. Lastly, we find that bonds of riskier firms include much less valuable call options than do those of high-grade firms. This reflects not only the much longer maturity of investment-grade bonds but also the fact that call premiums are higher on low-grade bonds.
The agency theories were developed in the late 1970s when nearly all corporate bonds were callable. But, beginning in the early 1980s, the use of call options has declined steadily. Our evidence suggests that the decline in the use of call provisions has not been accompanied by changes in agency problems or the solutions used to combat them. For example, agency theory predicts a greater reliance on callable debt among riskier firms. Over the 1980s, corporations took on more debt and default rates rose, but they used callable debt steadily less over the decade.
Calling Nonconvertible Debt and the Problem of Related Wealth Transfer Effects
The convention in corporate finance is that issuers seeking to maximize shareholder value should call a bond issue the first time its market price reaches its call price. Less well-accepted is that this rule implicitly assumes one of three conditions: 1) the issuer has only one debt issue outstanding, 2) all the issuer's bonds are riskless in terms of default, or 3) the issuer finances every call so that its debt structure does not change at all as a result of the refunding operation.
We demonstrate that the "textbook" rule does not hold in the absence of these qualifications. Resort to a call option, perhaps accompanied by the sale of a refunding issue, usually changes the value of other debt issues by promoting or demoting their claims. For example, calling and not refunding a senior debt issue transfers wealth to junior debtholders, who effectively become the new senior debtholders. Therefore, minimizing the value of a particular bond issue does not necessarily maximize the value of stockholder equity.
Analysis indicates that the majority of called bonds are not refunded. When refundings do occur, issuers almost
always change their debt structure in the process, so the textbook rule will not apply to the vast majority of corporate call decisions.
Currently. callable bonds frequently sell for more than their call prices, with this effect most pronounced for bonds in the middle of the credit spectrum. Two findings are consistent with call policies that take account of the effects of changing debt structures. First, when a call or refunding will boost the priority of existing issues, it can be optimal to delay the call, which may then allow the market price to exceed the call price. Second, this effect will not be pronounced for very strong credits, where priorities are less important because there is little or no risk of default, or for
very weak credits whose market prices are depressed below the call prices. The effect will be important, however, for intermediate credits.
These results are important to investors in the corporate bond market. To value an embedded call option accurately or to predict call decisions correctly, it is necessary to do more than model interest rate behavior and understand a bond's contractual features. Investors, particularly those buying intermediate credits, must also consider a corporation's debt structure and refinancing policies.
Event Risk Bond Covenants, Agency Costs of Debt and Equity, and Stockholder Wealth
A relatively recent innovation in the issuance of corporate debt has been the inclusion of event risk protection provisions in bond indentures. Event risk covenants (ERCs), adopted primarily during the height of the LBO activity in the U.S., typically allow for redemption of a bond issue in the event of a takeover, merger, or corporate anti-takeover restructuring that would drain a firm's assets. This study focuses on the impact that ERCs have on agency costs of debt and equity and on stockholder wealth.
Two separate hypotheses are presented and tested relative to the use of ERCs: the stockholder wealth enhancement hypothesis and the management entrenchment hypothesis. The stockholder wealth enhancement hypothesis argues that ERCs would benefit stockholders and increase the value of a firm by lowering its agency costs of debt. Agency costs of debt are the result of conflicting interests between stockholders and bondholders. Two major problems arise out of these conflicting interests. First, there is a risk incentive problem if management substitutes riskier assets for assets of less risk, increasing the volatility of the cash flows associated with the firm's assets. Second, there may be an underinvestment problem if the value of a firm's investment opportunities is revealed to be less than the face value of the maturing debt plus the costs of undertaking the investment projects, and managers may forgo some positive-NPV projects. It has been shown that these problems can be mitigated, and the agency costs of debt reduced, by inclusion of covenants like ERCs in the bond indenture.
Standard event study analysis is performed on the stock returns for two samples, one consisting of event risk protected bonds and the other of nonprotected bonds. The announcement date of each bond issue in both samples represents the date of first knowledge of these issues by the public. The results show that, while the two-day announcement period abnormal return is a statistically significant -0.588% for the nonprotected sample and an insignificant 0.138% for the protected sample, the between-sample difference is statistically significant at the 0.05 level. Thus, the event study results indicate that the issuance of bonds with ERCs has a more positive impact on stockholder returns than issuance of nonprotected bonds. These results provide evidence supporting the stockholder wealth enhancement hypothesis while failing to support the management entrenchment hypothesis.
The effect of ERCs, however, may not be equal across all firms because of differences in the magnitude of agency costs of debt and equity. We therefore also examine the impact of
agency costs of debt and equity (and other firm and bond characteristics) on stockholder wealth using regression analysis.
The regression results indicate that ERCs and, in particular, stronger ERC protection are associated with a more positive impact on stockholder wealth. The estimated coefficients for the interactive agency costs of equity variables are not significantly different from zero, as expected. The estimated coefficients for the interactive agency costs of debt variables, on the other hand, have the expected signs, and the estimated coefficient for the interactive bond callabilty variable is significantly different from zero. These results provide further evidence that the increase in stockholder wealth likely comes from a significant reduction in the agency costs of debt because of inclusion of ERCs in a bond indenture.
As argued in the management entrenchment hypothesis, however, the inclusion of ERCs may lower the value of a firm by increasing the agency costs of equity. Since a typical ERC requires the firm to compensate bondholders for losses associated with special events, such as a merger or takeover, the costs of an acquisition, even when the acquisition is in the best interests of stockholders, may be greater than it would have been in the absence of ERCs. The presence of these covenants may reduce the pressure on management to utilize the firm's assets in the most valuable way. These covenants, then, may serve to entrench management by providing a shield that protects management from the market forces that affect corporate control, increasing the agency costs of equity.
The results of this study hold certain implications for managers. First, the degree of agency costs of debt should be a factor in the decision to issue protected or nonprotected bonds. That is, firms with relatively higher agency costs of debt stand to benefit from the issuance of protected bonds, while firms with relatively higher agency costs of equity do not have an incentive to issue such bonds.
Second, firms issuing protected bonds have tended to be significantly smaller than firms issuing nonprotected bonds. If size proxies for a firm's reputation in the market and potential degree of financial distress, relatively smaller firms may be required to provide additional protection in the form of ERCs that might not be required for larger firms.
Taxes and the Returns to Foreign Acquisitions in the United States Do U.S. tax laws have an impact on foreign direct
investment in the U.S.? Recent findings suggest that the level of foreign direct investment depends on the U.S. tax regime but that the premiums paid by foreign firms to acquire U.S. assets are unrelated to the tax environment. The latter conclusion is counterintuitive because one would expect that changes in the desirability of foreign investments in the U.S. also affect the price paid for these investments. We therefore re-examine the previous evidence using a larger sample and a data set spanning two recent tax reforms: the 1981 Economic Recovery Tax Act (ERTA) and the 1986 Tax Reform Act (TRA).
The results of this study illustrate the important impact U.S. taxes have on the price foreign companies pay for
acquisitions in the U.S. The impact is indirect, however, because it is not caused by tax rates but by the effect of investment incentives on the prices of capital goods. This
insight is important for managers of foreign companies who plan to make U.S. investments, for the investment banks who advise them on these transactions, and for domestic companies subject to a foreign takeover.
The 1986 TRA lowered U.S. corporate tax rates, but it eliminated investment tax credits and made depreciation schedules less accelerated. Investment tax credits and accelerated depreciation schedules can be thought of as " implicit taxes" imposed on foreign investors. As a result of investment tax credits and accelerated depreciation schedules, U.S. companies can pay a higher price for new capital investments. If a foreign corporation wants to
purchase assets in the U.S., then it will be forced to pay the market price. It will not, however, receive credit for paying that higher price when it repatriates the profits to its home country.
With the elimination of these "implicit taxes" in the 1986 TRA, it became relatively more advantageous for foreign companies to invest in the U.S. after 1986 than previously. The 1981 ERTA introduced these implicit taxes. Investing
in the U.S. therefore became relatively less advantageous for foreign companies after 1981.
We investigate these predictions using a data base of 779 foreign acquisitions of U.S. assets during the 1979-1988 period. Takeovers, acquisitions of units, and acquisitions of a partial ownership interest are included in this data base. We examine the returns pattern of U.S. target firms subject to a foreign acquisition and determine whether this pattern is consistent with the above predictions.
For takeovers, we find strong support for the tax arguments. The returns of U.S. targets decrease by 23 percentage points from the 1979-1980 period to the 1981-1986 period, and they increase by 26 percentage points from the 1981-1986 period to the 1987-1988 period. After we control for other factors that relate to the returns of target firms in takeovers, we obtain similar results. In addition, we take into account the effect of the dollar exchange rate on target firm returns because the strength and weakness of the U.S. dollar coincided with the 1981 and 1986 U.S. tax reforms. In particular, the value of the dollar started declining in early 1987, when the 1986 TRA went into effect. Even after controlling for the impact of the exchange rate on target firm returns, however, we still document a decrease in the returns to U.S. targets of foreign acquisitions after 1981, and an increase after 1986.
For acquisitions of a partial ownership interest, we find some support for the tax arguments. The returns are higher after 1986 than before 1986. We find no evidence, however, that the 1981 ERTA affected target returns.
Finally, we examine the returns to a sample of foreign bidders who are traded on U.S. exchanges. We find that their stock price does not change systematically when they announce the acquisition of U.S. assets. This result is consistent with evidence on U.S. bidders and suggests that target firms reap all of the benefits in takeovers.
Bidder Incentives for Informed Trading Before Hostile Tender Offer Announcements
Legal constraints that require disclosure of a bid before a controlling interest is purchased give bidders an incentive to
tip arbitrageurs before announcement. When there is no constraint on the number of shares a bidding firm may acquire before announcing its bid, a risk-neutral bidder can
purchase a controlling interest by paying shareholders the value of the firm under incumbent management plus their differential private costs of selling such as taxes and other transaction or information costs. When legal constraints
require a bidder to disclose its bid before a controlling interest is purchased, the bidder must pay the pivotal shareholder's reservation price for the shares necessary to
gain a controlling interest. For a conditional bid, this price is the post-merger value of a minority share plus the pivotal shareholder's private costs of tendering.
These circumstances give the bidding firm an incentive to tip arbitrageurs, so that shareholders with the lowest
private tendering costs own the shares necessary for the bidder to obtain a controlling interest. This decreases the minimum successful bid price and increases profits to the bidder. Because pre-announcement informed trading enables some value-increasing bids to succeed that would otherwise fail, some argue that illegal insider trading should be defined to exclude the tipping of arbitrageurs prior to tender offers. Informed trading prior to announcement does not, however, enable value-decreasing bids to occur because arbitrageurs will not buy a controlling interest in anticipation of a bid if the bid price will be less than the current market price of the share.
Tipping arbitrageurs can affect the bidder's profits in two
ways. First, if arbitrageurs buy sufficient stock prior to announcement that they hold the pivotal share, the first-tier bid price declines, so that profits to the bidder increase. Second, if the pre-announcement price run-up resulting from
trading by the arbitrageurs is embedded in the back-end price, bidder profits decline. Clearly, the bidder will pass on information only if it expects the net impact to be positive. Similarly, arbitrageurs will buy shares only if they expect to sell those shares at a profit. The analysis in this paper shows that tipping does not affect the total profits available from a takeover, but merely their distribution. To illustrate these
points, a model of a conditional, two-tier hostile tender offer in the presence of an upward-sloping supply curve for target firm shares is analyzed.
The model developed has several empirical implications. First, the degree of pre-announcement tipping is negatively related to the degree of expropriation allowed by the legal system. Since this depends on state statute and case law, there will be cross-sectional variation by state and over time.
Tipping is also negatively related to the degree to which any pre-announcement price increase is embedded in the second-tier price. To the extent that this is also determined by case law and statute, cross-sectional variation will be observed.
Second, the model suggests that the higher the private tendering costs of the pivotal share, the greater the incentive to tip arbitrageurs. Thus, the incentive to tip arbitrageurs should be negatively related to the degree of institutional ownership in the target firm, in that greater institutional ownership increases the likelihood that the pivotal share is already held by a shareholder with low tendering costs.
Finally, the incentive to tip increases with decreases in the bidder's toehold. Thus, one would expect more tipping to have occurred since enactment of the Williams Act in 1968, which imposed limits on the number of shares a bidder may acquire before revealing its intentions to the public.
Does Targeted Investing Make Sense? Over the last several years, the Clinton administration has
promoted the idea that pension funds should become more
directly involved in financing local investments with the objective of generating both financial returns and " collateral benefits" in the form of jobs, tax revenues, housing, and stronger local infrastructure. These are called economically targeted investments (ETIs). While political advocates usually agree that these investments should be voluntary and subject to rigorous credit and pricing reviews, there is an
underlying fear in the pension community that ETI goals may become "requirements."
Evidence is accumulating that making ETIs may be a rational pension portfolio strategy on two levels. First, financial theory tells us that there are benefits to investing in assets whose risk/return behavior is different from that of other traditional portfolio assets. In these nontraditional arenas, the negotiating power of pension funds who are willing to invest funds should be considerable. Risk can be mitigated by engineering a" pension-suitable asset" by using some of the governmental and endowment funds that are now flowing into programs of this type.
Second, projects that stimulate the economy of the region that is most immediate to the participants and beneficiaries of the pension plan offer the opportunity to create collateral benefits that can benefit those participants. As long as the analytical standards of the investment manager are not sacrificed to political pressures, the pension plan can "do good" in the process of "doing well."
Finance theorists generally believe that any binding constraint on a pension's portfolio choice necessarily results in suboptimal performance. Their world is one of rational investors and efficient capital markets where competitive pressures drive the prices of all investments into equilibrium. They like clear, rigorous guidelines for portfolio optimization. Adding collateral benefits to the list of factors an investment manager must consider may constrain that manager's choice; it certainly complicates the process. Lack of reliable data on collateral benefits, uncertainty about financial performance, and potential conflicts of interest combine to make consideration of collateral benefits a potentially treacherous process.
No matter how efficient one believes the major debt and
equity markets are, there is little dispute that smaller projects are financed in somewhat less efficient markets. Sponsors of local development projects (housing, business construction, infrastructure, venture capital,...) tend to raise capital in smaller amounts from a limited list of potential investors. The willingness of any given institutional investor to support a project may determine whether or not it occurs, and the terms set by that investor may not be particularly negotiable. This is an asset class pensions have historically avoided, but one where the pension's decision to invest can produce both direct financial benefits and collateral economic benefits as well.
