Corporate Financial Policy EXP 482 Corporate Financial Policy Clifford W. Smith, Jr. Winter 2007 - Overhead 4 * Covers readings on course outline through Smith/Warner (1979)

Bond Contracts Conflicts of Interest Dividend payouts Claim dilution Asset substitution Underinvestment

Bond Covenants Restrictions on: Investment policy Dividend policy Financing policy Required bonding activities

Bond Covenants Restrictions on Investment Direct restrictions on investment of physical assets seldom observed Restrictions on financial investments Restrictions on disposition of assets Security provisions (i.e. mortgage loans) Asset maintenance Restrictions on mergers

Mergers Under what circumstances are bondholders made better off or worse off by a merger?

Mergers Under what circumstances are bondholders made better off or worse off by a merger? Suppose bondholders in the old firms receive bonds in the new firm with equal priority and the same contract provisions as before. BA(V, F, T, σ2 , r, DIV) vs BAB(V, F, T, σ2, r, DIV)

Mergers Benchmark Case: σ2A = σ2AB = σ2B; ρAB = 1 VA + VB = VAB FA / VA = FAB / VAB = FB / VB TA = TB σ2A = σ2AB = σ2B; ρAB = 1 DIVA = DIVAB = DIVB In this benchmark case, the merger should leave the value of the bonds roughly unchanged

Mergers Deviations from the benchmark case. Suppose: BA BB VA + VB < VAB FA / VA < FAB / VAB < FB / VB TA < TB σ2A < σ2AB < σ2B σ2A > σ2AB < σ2B DIVA < DIVAB < DIVB

Mergers Deviations from the benchmark case. Suppose: BA BB VA + VB < VAB + + FA / VA < FAB / VAB < FB / VB - + TA < TB + - σ2A < σ2AB < σ2B - + σ2A > σ2AB < σ2B + + DIVA < DIVAB < DIVB - +

Mergers In what type of firms will bondholders be most concerned about mergers? low debt low variance low dividend bonds with long maturity

Underinvestment Problem Solutions to the Underinvestment Problem Restrictions on dividends Suppose I agree to a maximum dividend payment of $25 per period until the bond is repaid.

Dividend Restrictions Time Project 0 1 2 A -50 100 50 B – -75 100 Bond 120 -20 -100  Max Div = 25

Dividend Restrictions Time NVP Project 0 1 2 A -50 100 50 B – -75 100 Bond 120 -20 -100 Div(A+B) 25 25 75 = 125 Max Div = 25

Dividend Restrictions Time NVP Project 0 1 2 A -50 100 50 B – -75 100 Bond 120 -20 -100 DIV(A+B) 25 25 75 = 125 DIV(A-) 25 25 50 = 100 Max Div = 25

Dividend Restrictions Who Benefits from Dividend Restrictions Without Restriction Bond 70 -20 -50 DIV 20 80 – = 100 With Dividend Restriction Bond 120 -20 -100 DIV (A+B) 25 25 75 = 125

Bond Covenants Restrictions on Dividends Earnings and Stock Sales Reservoir Dividends

Dividend Restrictions Inventory for Dividends Dividend Constraint Dt < max [ 0, Dt ] *

Dividend Restrictions Cash Flow Identity Uses of Funds = Sources of Funds Dt + Rt + Pt + It = CFt + St + Bt

Dividend Restrictions Cash Flow Identity Uses of Funds = Sources of Funds Dt + Rt + Pt + It = CFt + St + Bt CFt = Et + DEPt + Rt + Lt Þ Dt = Et + DEPt + Lt + St + Bt - Pt - It

Dividend Restrictions Combining the cash flow identity with the dividend constraint yields* * Assuming the Dip, D = 0

Dividend Restrictions Combining the cash flow identity with the dividend constraint yields

Dividend Restrictions Combining the cash flow identity with the dividend constraint yields Book Value   Book Value of Debt of Assets

Dividend Restrictions Combining the cash flow identity with the dividend constraint yields Placing a ceiling on dividends effectively places a floor on real investment Book Value   Book Value of Debt of Assets

Dividend Restrictions Improve dividend payout problem Improve claim dilution problem Improve underinvestment problem May exacerbate asset substitution problem

Restrictions on Financing Option pricing analysis might lead you to predict "me first" rules in bond contracts Instead, we observe restrictions on financial ratios such as: funded debt interest expense net tangible assets earnings

Restrictions on Financing Use of balance sheet vs income statement for financing restrictions

Other Financing Issues Leasing Convertible Bonds Callable Bonds Sinking Funds

Underinvestment Problem Solutions to the Underinvestment Problem Sinking fund provisions A bond with a sinking fund provides for the repayment of some of the principle before expiration

Sinking Funds Time Project 0 1 2 A -50 100 50 B – -75 100 Bond 120 -60 -60

Sinking Funds Time Project 0 1 2 A -50 100 50 B – -75 100 Bond 120 -60 -60 DIVA+B= 35 + 0 + 90 = 125

Sinking Funds Time Project 0 1 2 A -50 100 50 B – -75 100 Bond 120 -60 -60 DIVA+B = 35 + 0 + 90 = 125 DIV A- = 70 + 40 + 0 = 110

Bonding Activities All financial statements sent to stockholders must also be sent to bondholders Specify accounting techniques (GAAP) Financial Reports Audited by Independent Auditor Officers Certificate of Compliance Purchase of Insurance