Dynamical Corporate Finance: An Equilibrium Approach

206 Pages·2021·2.472 MB·English

by  Umberto Sagliaschi, Roberto Savona

Contributions to Finance and Accounting
Umberto Sagliaschi
Roberto Savona
Dynamical
Corporate
Finance
An Equilibrium Approach
Contributions to Finance and Accounting
The book series ‘Contributions to Finance and Accounting’ features thelatest
researchfromresearchareaslikefinancialmanagement,investment,capitalmarkets,
financial institutions, FinTech and financial innovation, accounting methods and
standards,reporting,andcorporategovernance,amongothers.Bookspublishedin
thisseriesareprimarilymonographsandeditedvolumesthatpresentnewresearch
results, both theoretical and empirical, on a clearly defined topic. All books are
publishedinprintanddigitalformatsanddisseminatedglobally.
Moreinformationaboutthisseriesathttp://www.springer.com/series/16616
Umberto Sagliaschi (cid:129) Roberto Savona
Dynamical Corporate
Finance
An Equilibrium Approach
UmbertoSagliaschi RobertoSavona
QuaestioCapitalSGRSpA DepartmentofEconomicsandManagement
Milan,Italy UniversityofBrescia
Brescia,Italy
ISSN2730-6038 ISSN2730-6046 (electronic)
ContributionstoFinanceandAccounting
ISBN978-3-030-77852-1 ISBN978-3-030-77853-8 (eBook)
https://doi.org/10.1007/978-3-030-77853-8
©TheEditor(s)(ifapplicable)andTheAuthor(s),underexclusivelicensetoSpringerNatureSwitzerland
AG2021
Thisworkissubjecttocopyright.AllrightsaresolelyandexclusivelylicensedbythePublisher,whether
thewhole orpart ofthematerial isconcerned, specifically therights oftranslation, reprinting, reuse
ofillustrations, recitation, broadcasting, reproductiononmicrofilmsorinanyotherphysicalway,and
transmissionorinformationstorageandretrieval,electronicadaptation,computersoftware,orbysimilar
ordissimilarmethodologynowknownorhereafterdeveloped.
Theuseofgeneraldescriptivenames,registerednames,trademarks,servicemarks,etc.inthispublication
doesnotimply,evenintheabsenceofaspecificstatement,thatsuchnamesareexemptfromtherelevant
protectivelawsandregulationsandthereforefreeforgeneraluse.
Thepublisher,theauthors,andtheeditorsaresafetoassumethattheadviceandinformationinthisbook
arebelievedtobetrueandaccurateatthedateofpublication.Neitherthepublishernortheauthorsor
theeditorsgiveawarranty,expressedorimplied,withrespecttothematerialcontainedhereinorforany
errorsoromissionsthatmayhavebeenmade.Thepublisherremainsneutralwithregardtojurisdictional
claimsinpublishedmapsandinstitutionalaffiliations.
ThisSpringerimprintispublishedbytheregisteredcompanySpringerNatureSwitzerlandAG.
Theregisteredcompanyaddressis:Gewerbestrasse11,6330Cham,Switzerland
Contents
1 Introduction .................................................................. 1
1.1 Introduction ............................................................. 1
1.2 TheRealmofCorporateFinance....................................... 2
1.3 EquilibriumApproach,MarketStructure
andCorporateGovernance ............................................. 3
1.3.1 BuildingontheNeoclassicalSynthesis........................ 6
1.3.2 Market Completeness, Pricing Kernel
andtheObjectiveoftheFirm .................................. 9
1.4 Roadmap ................................................................ 12
1.4.1 PlanoftheBook................................................ 12
1.4.2 Prerequisites..................................................... 14
References..................................................................... 15
2 TheValueoftheFirmandItsSecurities.................................. 19
2.1 NotationandBasicSetting ............................................. 20
2.1.1 BudgetConstraintsandPolicies ............................... 22
2.1.2 DefaultandBankruptcyProcedures ........................... 25
2.2 TheModiglianiandMillerTheorems.................................. 27
2.2.1 IrrelevanceofDividendPolicy................................. 27
2.2.2 TheIrrelevanceofFinancingPolicy........................... 29
2.2.3 DebtTaxShieldandBankruptcyCosts........................ 32
2.3 CapitalStructureandCorporateGovernance ......................... 34
2.3.1 InvestmentDecisionsandAgencyCosts ...................... 34
2.3.2 OptimalInvestments,CapitalBudgeting
andDebtOverhang............................................. 35
2.3.3 TheValueofCorporateGovernance........................... 38
2.4 AGeneralExpressionfortheValueoftheFirm....................... 46
2.4.1 AbstractSecurities.............................................. 46
2.4.2 Restructuring,RenegotiationandLiquidationProcedures.... 48
2.4.3 TheValueoftheFirm .......................................... 49
2.4.4 Dividends,BuybacksandExpectedEquityReturns.......... 51
v
vi Contents
2.5 RelatedLiterature....................................................... 53
References..................................................................... 54
3 Borrowing Constraints,Debt Dynamics andInvestment
Decisions ...................................................................... 57
3.1 CollateralConstraintsandOptimalCapitalStructure................. 58
3.1.1 SecuredDebtandFlotationCosts.............................. 58
3.1.2 StrictIndividualRationalityandAbsenceofDefaultRisk... 60
3.1.3 TheValueoftheFirm,OptimalCapitalStructure
andTheWeightedAverageCostofCapital ................... 64
3.2 Perfect Product Market Competition and Optimal
investment-FinancingDecisions ....................................... 67
3.2.1 TheValueoftheUnleveredFirm .............................. 69
3.2.2 OptimalInvestmentandFinancingDecisions................. 72
3.3 FinancialReturnsandtheInvestmentCAPM ......................... 75
3.3.1 FundamentalsandSecuritiesReturns.......................... 75
3.3.2 CapitalBudgetingandWACC ................................. 77
3.3.3 TheHamadaEquation.......................................... 78
3.3.4 TheInvestmentCAPMandtheCross-Section
ofEquityReturns............................................... 78
3.4 DebtAgencyCostsandtheTrade-offTheory......................... 79
3.5 RelatedLiterature....................................................... 81
References..................................................................... 83
4 ImperfectCompetition,WorkingCapitalandTobin’sQ................ 85
4.1 TheLimitsofPerfectProductMarketsCompetition.................. 86
4.2 MonopolisticCompetitionandMarketPower......................... 88
4.2.1 TimingofDecisionsandOptimalPriceSetting............... 89
4.2.2 OptimalInvestmentandFinancingDecisions................. 92
4.2.3 ConstantPriceElasticityofDemandandtheValue
oftheFirm ...................................................... 94
4.3 ImperfectCompetitionandtheCross-SectionofStockReturns...... 96
4.3.1 Tobin’sQ,ExpectedStockReturnsandResidualIncome.... 96
4.3.2 EmpiricalConsiderations....................................... 99
4.4 EquilibriumModelsandSecurityAnalysis............................ 103
4.4.1 ASimpleQuantitativeModel.................................. 103
4.4.2 ExpectedFundamentals ........................................ 104
4.4.3 StockMarketMultiplesandValuationModels................ 106
4.5 RelatedLiterature....................................................... 109
References..................................................................... 110
5 ContinuousTimeModels,UnsecuredDebtandCommitment.......... 113
5.1 GeneralSettingandValuation.......................................... 114
5.1.1 TheSetting...................................................... 114
5.1.2 TheValueoftheFirmandItsSecurities....................... 116
Contents vii
5.2 TheHamilton–Jacobi–BellmanApproach............................. 118
5.2.1 Risk-NeutralValuation......................................... 121
5.3 Commitment,OptimalDefaultandtheStatic Trade-off
TheoryofCapitalStructure............................................. 123
5.3.1 OptiontoDefaultandExpectedDefaultTime ................ 125
5.3.2 TheOptimalDefaultBoundary................................ 129
5.3.3 OptimalStaticCapitalStructure............................... 130
5.3.4 CreditSpreadsintheLelandModel........................... 131
5.4 EndogenousInvestmentandAgencyCostsofCapitalStructure..... 133
5.4.1 DebtOverhang.................................................. 133
5.4.2 Risk-Shifting.................................................... 137
5.5 RelatedLiterature....................................................... 140
References..................................................................... 141
6 DynamicCapitalStructurewithoutCommitment....................... 143
6.1 Commitment,TimeConsistencyandDebtCapacity.................. 145
6.2 ADiscreteTimeModel................................................. 147
6.2.1 TheLeverageRatchetEffect................................... 147
6.2.2 TheCoaseConjecture.......................................... 150
6.3 TheContinuousTimeCase............................................. 151
6.3.1 AnIrrelevanceResult........................................... 151
6.3.2 GlobalOptimalityandtheLeverageRatchetEffect .......... 153
6.3.3 TheValueoftheFirm .......................................... 155
6.3.4 LeverageDynamics............................................. 157
6.3.5 PositiveRecoveryValues....................................... 159
6.4 EndogenousInvestmentandTheCostofCapital ..................... 162
6.4.1 DebtOverhang.................................................. 162
6.4.2 RiskShifting.................................................... 163
6.4.3 TheWeightedAverageCostofCapital........................ 165
6.5 RelatedLiterature....................................................... 168
References..................................................................... 169
7 Extensions..................................................................... 171
7.1 AQuantitativeCorporateFinanceModel ............................. 172
7.1.1 ModelSet-Up................................................... 172
7.1.2 OptimalProductionandPricingDecisions.................... 175
7.1.3 OptimalInvestmentandFinancingDecisions................. 177
7.2 BorrowingConstraints.................................................. 180
7.2.1 TheModel....................................................... 180
7.2.2 TheCross-SectionofStockReturns .......................... 183
7.3 AnIntroductiontoNumericalSolutionMethods
andStructuralEconometrics............................................ 184
7.3.1 DiscreteDynamicProgramming............................... 184
7.3.2 ThecaseofDefaultableDebt .................................. 188
7.3.3 TheGeneralizedMethodofMoments......................... 189
viii Contents
7.4 Non-MarkovPerfectEquilibria ........................................ 191
7.4.1 TheSetting...................................................... 192
7.4.2 ConstantLeveragePolicies..................................... 193
7.4.3 Time-ConsistentConstantLeveragePolicies.................. 195
7.4.4 LimitstoTax-DeductibilityofInterestExpenses ............. 196
7.4.5 FinalConsiderations............................................ 197
Appendix ...................................................................... 198
References..................................................................... 201
Chapter 1
Introduction
1.1 Introduction
The way in which leverage and its expected dynamics impact on firm valuation
is very different from the assumptions of the traditional static capital structure
framework. The purpose of this book is to re-characterize the firm’s valuation
processwithinadynamicalcapitalstructureenvironment,bydrawingonavastbody
of recent and more traditional theoretical insights and empirical findings on firm
evaluation,also includingasset pricingliterature.We offera new setting in which
practitionersand researchers are providedwith new tools to anticipate changesin
capitalstructureandsettingpricesforfirm’sdebtandequityaccordingly.
We introducethereadertoselectedtheoreticalmodelsincorporatefinancethat
can be used to understand investment and financial decisions on the firms’ side,
their interdependence and related impacts on the value of corporate securities,
such as stocks and bonds. The book is then intended mostly for graduate/phd
students, researchers and financial professionals who are interested in modeling
asset prices and corporate strategy decisions. Our approach is sometimes referred
as“supply-side”or“investment-based”assetpricing,anditcomplementswiththe
moretraditionalapproachderivingfromtheapplicationofoptimalportfoliotheory.
The success of this approach (see Zhang 2017), is the possibility to leverage the
large availability of corporate data and partly overcome aggregation problems, as
opposed to demand side models, such as the Consumption Capital Asset Pricing
Model(e.g.,Rubinstein1976;Lucas1978;Breeden1979),whichinsteadrequires
to know investors’ preferences. To some extent, dynamic corporate finance is the
crossroads where equilibrium asset pricing meets the scope of firms’ production,
investment and financing decisions. In this regard, the book is also intended to
provide a guidance for an advanced practice of equity valuation. To make an
example, consider the practical problem of valuing the debt tax shield. At which
rateshouldwediscountfuturetaxbenefitsofdebt,andhowfuturefinancialleverage
©TheAuthor(s),underexclusivelicensetoSpringerNatureSwitzerlandAG2021 1
U.Sagliaschi,R.Savona,DynamicalCorporateFinance,Contributions
toFinanceandAccounting,https://doi.org/10.1007/978-3-030-77853-8_1