according to this leverage trade-off hypothesis, firms that adopt corporate strategies that can be characterized by .... a firm, thereby making them arguably exogenous for the majority of firms, and the law prohibits firms from ..... contract on the
resource flexibility and financial leverage is car man- ufacturing. ..... borrowing to be exogenous, and focus on the interac- ...... states, and therefore, dVD/dI > 0.
test was applied to test the significance of difference in capital structure. .... The basic objective of the study was (i) to find the .... 17% answered the first part.
Nov 20, 2004 - The University of Chicago Graduate School of Business, Chicago, Illinois 60637 ... managerial incentives may drive a manager to deviate from .... and managers, on the firm's optimal production and financial decisions.
capital structure models emphasize the importance of investment outlays as a first-order ... leverage with these two variables is significantly different during the war period .... at the rate of one percent, while there was no tax on individual inco
marketYbased measures affect all types of capital by indirectly increasing the costs of capital movements and ... and also describes the numerical solution method used in the paper. II. THE MODELING .... regulations The effects of political risk on t
3.7 Capital investment appraisal: Accounting responsibilities. 21. 4. Conclusions and ... external reporting and internal business decision-making that is increasingly ...... Management and Cost Accounting, 5e, Prentice Hall, USA. Bhimani, A.
Financial Enterprise Services, Intel Corporation, Chandler, Arizona 85226, [email protected] Chen Peng ... ded devices in vehicles, homes, and medical equip- ment. ...... neering from the University of New Mexico in Albuquerque.
Sep 1, 2013 - automated assembly systems. Achim Kampker, Peter BurggrÃ¤f, Cathrin Wesch-Potente, Georg Petersohn, Moritz Krunke *. WZL, Laboratory for ...
Jan 13, 2013 - initiations and omissions: Overreaction or drift? Journal of Finance 50(2), 573-608. Mitton, T., 2004. Corporate governance and dividend policy ...
Mar 21, 2008 - 321) notes that âfinancial firms' investment incentives are influenced by debt in the ...... geltendem Recht und dem Vertrag Ã¼ber eine Verfassung.
Mar 26, 2012 - investment and the amount of investment (Business Dictionary, 2012). The present value of the expected cash flows is computed by discounting them at the required rate of return (13.7% in this case). Below is given the computation of NP
The determination of the cost of capital is an important part of any regulatory decision. ... regulators and their American counterparts do not necessarily use the same model ... CAPM or another valuation model to determine a company's WACC seem to b
Consequently, it is important to understand how these managerial traits affect cor- ... assumed to be rational in all respects, except for how they perceive their firm's .... of corporate finance. Roll's (1986) hubris hypothesis of takeovers examines
Debt in firms with concentrated ownership can also be used as a .... mostly used by firms where managerial agency costs are highest. Firms owned by .... for at least 5 years. We define a family firm as one where the founder, or descendents of.
the impact of alternative debt structures on corporate investment and leverage policies. Dynamic Investment, Capital .... We first set up a dynamic formulation where the firm is a collection of growth options and assets ...... Using the standard gues
trade-off between interest tax-shield benefits and bankruptcy costs of debt. ... At the investment instant, the firm can finance the project by issuing debt and equity ... literature, however, ignores the fact that corporate income tax schedules are
+c# !% 7"!% Î´"T . (9). This solution is obtained under the assumption that 7
New York University and Imperial College, London. Piero Gottardi ... with positive probability and their assets are liquidated at fire-sale prices. ... and the Brevan Howard Centre at Imperial College is gratefully acknowledged. ...... management.
next largest survey that we know of studies 298 large firms and is presented in J. Moore and A. Reichert, âAn Analysis of the. Financial Management Techniques Currently Employed by Large U.S. Corporations,â Journal of Business Finance and ... the
Mar 27, 2014 - and investing the obtained capital from debt. .... instance, Krishnan and Moyer (1997) found ..... costs of bankruptcy and financial distress.
with labor market success later in life (Wise 1975, Jencks 1979, Filer 1981, Goldsmith 1997,. Dunifon and ..... the economy is still a short run economy in which, in standard neo-classical fashion, the market exists at a ..... of their GDP per year a
shareholders) diverge, there arise possibilities of suboptimal investment decisions ... the debt and the price at which it exercises its growth option to expand. .... is also well-known in the Gaussian case, and it is definable from. GHd r â Îº(1).
Working Paper 9110
ON FLEXIBILITY, CAPITAL STRUCTURE, AND INVESTMENT DECISIONS FOR THE INSURED BANK by Peter Ritchken, James Thomson, Ray DeGennaro, and Anlong Li
Peter Ritchken is an associate professor at the Weatherhead School of Management, Case Western Reserve University. James Thomson is an assistant vice president and economist at the Federal Reserve Bank of Cleveland. Ray DeGennaro is an assistant professor in the Department of Finance at the University of Tennessee. Anlong Li is a graduate student at the Weatherhead School of Management. The authors thank Andrew Chen, Myron Kwast, and Lucille Mayne for helpful comments and suggestions. Working papers of the Federal Reserve Bank of Cleveland are preliminary materials circulated to stimulate discussion and critical comment. The views stated herein are those of the authors and not necessarily those of the Federal Reserve Bank of Cleveland or of the Board of Governors of the Federal Reserve System. July 1991
Most models of deposit insurance assume that the volatility of a bank's assets is exogenously provided. Although this framework allows the impact of volatility on bankruptcy costs and deposit insurance subsidies to be explored, it is static and does not incorporate the fact that equityholders can respond to market events by adjusting previous investment and leverage decisions. This paper presents a dynamic model of a bank that allows for such behavior. The flexibility of being able to respond dynamically to market information has value to equityholders. The impact and value of this flexibility option are explored under a regime in which flat-rate deposit insurance is provided.
Almost all models of deposit insurance take the underlying source of risk, namely, the volatility of the bank's assets, to be exogenously provided.
Within this framework, the relative merits of the firm
increasing its volatility and leverage can be easily explored.
disadvantage of this approach is that it is static and does not recognize the fact that equityholders can respond to market events by dynamically adjusting previous investment and leverage decisions.
dynamic behavior can lead to changing levels of portfolio risk over time, with commensurate effects on the value of deposit insurance. This 2 is the classic moral hazard problem. The objective of this paper is to establish a model that identifies how equityholders select a capital structure and investment policy under a flat-rate deposit insurance regime. The model we consider is dynamic and
shareholders to adapt their asset portfolio decisions to market events.
We investigate how this flexibility option affects portfolio decisions and risk-taking. Our findings show that with no opportunities to revise portfolio decisions, optimal bank financing and investment policies are bang-bang;
that is, shareholders will either fully protect the charter
value or fully exploit the insurance subsidy granted by the insurer.
special case of our one-period model reduces to the model developed by
The 1iterature on deposit insurance using an option pricing framework was pioneered by Merton 119771. For a review of the literature, see Flood [ 19901. The moral hazard problem has been well discussed by Kane [19851. Fixed-rate deposit insurance gives bank owners strong incentives to increase risk. Kane illustrates that the incentive scheme can become so socially perverse that projects with a negative net present value may be optimally selected. The term "flexibility option" is derived from the asset option pricing literature and has been discussed by Breman and Schwartz [19851, McDonald and Siege1 [1985, 19861, Kester [19841, and Triantis and Hodder [19901.
Marcus t19841. However, unlike his model, ours allows equityholders to select risks dynamically and therefore allows moral hazard incorporated.
With a finite number of portfolio rebalance points
remaining before an audit, bang-bang policies may no longer be optimal and interior solutions may exist.
Finally, we investigate how the
flexibility option granted to equityholders affects the value of deposit insurance.
We show that ignoring the flexibility option leads to
understating the value of deposit insurance.
In particular, as the
number of portfolio revisions allowed prior to an audit date increases. a bank's ability to exploit the insured-deposit base increases.
can only be to the detriment of the flat-rate deposit insuree. This paper is organized as follows.
Section I1 develops a
one-period model of a banking firm in which the equityholders optimally select their capital structure and their investment policy over the time remaining before an audit.
In this case, the firm invests either all or
none of its wealth in risky assets. preferable.
interior solutions are
Moreover, under certain assumptions, we show that the
equityholders' interests are best served by supplying the minimum amount of capital. Section I11 extends the analysis to the two-period case and shows that interior solutions may be optimal.
Section IV considers the
case in which multiple portfolio-revision periods remain prior to the audit. Numerical illustrations are provided to highlight the fact that the
implications and concludes the paper.
11. A One-Period Model of a Banking Firm Consider an insured bank with one period remaining until an audit by the insuring agency. At the initial time, t=O, the deposit base is 1-a and the capital supplied by the shareholders is a.
Deposits are fully
insured by the agency, which levies a fixed-rate premium per dollar deposited. Let P(t) be the value of this deposit insurance net of the premium.
P(t) can be viewed as government-contributed capital.
the deposits are insured, their value at the end of the period is (l-a)e'*T,
where r* is the rate of return on the deposits.
simplicity, we assume that deposit inflows and outflows are equal over this period. Depositors, unlike the bank, may be faced with high transaction costs and may be unable to hold the riskless asset directly.
bank deposits may have unique characteristics, such as convenience yields, that make assets.
substitutes for riskless
In either case, barriers to entry, such as the need for a
government license or charter, allow banks to raise deposits at rates below the risk-free rate, r.
This positive spread produces an
intangible asset, or charter value, in the form of future monopoly rents.
If the charter obtains its value solely from monopolistic rents
attributable to the interest-rate spread, and if this spread remains constant or grows over time, then the charter value equals the deposit base, D(O) = 1-a.
In general, however, due to deregulation or increased
competition from other financial intermediaries, monopolistic rents are likely to erode over time.
Usually, the rents are taken to be some
function of the deposit base at time t.
For example, Marcus [I9841
assumes that the charter value is a fraction of the deposit base. Let C(0) represent the present value of this charter. If the bank fails the audit, it loses its charter. option on the charter.
Thus, at time 0, the bank holds a call
Let G(O) be the value of this claim.
follows, we assume that the liability g r o s at the risk-free rate; that is, r* = r, with the capitalized value of the deposit spread reflected in the charter value. We assume that the bank invests 1-q in riskless discount bonds and q in risky securities.
Assuming no dividends, the risky portfolio
follows a diffusion process of the form
where p and
are the instantaneous mean and volatility, respectively,
and dz is the Wiener increment.
The bank's balance sheet at time 0 can be summarized as follows: Assets Tangible Assets Riskless Asset Risky Asset
Liabilities and Net Worth 1-q q
Intangible Assets Government Subsidy P(0) Charter Value G(O)
Deposits D(O)=l-u Shareholder-contributed Capital u Government-contributed Capital P(0) Charter Value G(0)
Total = 1 + P(O) + G(O)
Shareholder Equity Total = 1 - u + E(0)
Clearly, E(0) = u + P(0) + GIO). The initial value of the bank's tangible assets is V(0) = 1. Given q, the value of these assets follows the process
Conditional on the capital structure decision, a, and the investment decision, q, the value of the tangible assets of the firm at time T is
where x is a normal random variable with mean p
s2/2 and variance s2 .
At the audit date, T, the deposit base is D(T) = (1-alerT. If the liquidation value of the marketable assets, V(T), is less than the deposit base, then the bank is declared insolvent and the shareholders receive nothing.
If, however, the bank is declared solvent, the
equityholders receive a claim worth V(T)
Let E(T) be the
shareholders' equity at time T. Then, we have
if V(T) > D(T) otherwise
Using standard option pricing methods, shareholder equity at time 0 is