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

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

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

4. 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

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

6. 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)

7. 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

8. 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

9. 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

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

11. 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.

12. Dividend Restrictions
Time
Project A
B –
Bond
 Max Div = 25

13. Dividend Restrictions
Time NVP
Project A
B –
Bond
Div(A+B) = 125
Max Div = 25

14. Dividend Restrictions
Time NVP
Project A
B –
Bond
DIV(A+B) = 125
DIV(A-) = 100
Max Div = 25

15. Dividend Restrictions
Who Benefits from
Dividend Restrictions
Without Restriction
Bond
DIV – = 100
With Dividend Restriction
Bond
DIV (A+B) = 125

16. Bond Covenants Restrictions on Dividends Earnings and Stock Sales
Reservoir
Dividends

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

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

19. 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

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

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

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

23. 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

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

26. 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

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

28. Other Financing Issues
Leasing
Convertible Bonds
Callable Bonds
Sinking Funds

29. 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

30. Sinking Funds Time Project 0 1 2 A -50 100 50 B – -75 100
Bond

31. Sinking Funds Time Project 0 1 2 A -50 100 50 B – -75 100
Bond
DIVA+B= = 125

32. Sinking Funds Time Project 0 1 2 A -50 100 50 B – -75 100
Bond
DIVA+B = = 125
DIV A- = = 110

33. 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