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BRN482Corporate Financial Policy
Clifford W. Smith, Jr.Summer 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, σ2r, DIV)
Mergers
Benchmark Case:
In this benchmark case, the merger should leave the value of the bonds roughly unchanged
VA + VB = VAB
FA / VA = FAB / VAB = FB / VB
TA = TB
σ2A = σ2
AB = σ2B; ρAB = 1
DIVA = DIVAB = DIVB
Deviations from the benchmark case.
Suppose: BA BB
VA + VB < VAB
FA / VA < FAB / VAB < FB / VB
TA < TB
σ2A < σ2
AB < σ2B
σ2A > σ2
AB < 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 < σ2
AB < σ2B - +
σ2A > σ2
AB < 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
Mergers
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
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
Restrictions on Dividends
Bond Covenants
Dividend
Reservoir
Dividends
Earnings andStock Sales
Inventory for Dividends
Dividend Constraint
Dividend Restrictions
Dt < max [ 0,
Dt ]
*
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
Dt = Et + DEPt + Lt + St + Bt Pt
It
Dividend Restrictions
Combining the cash flow identity with the dividend constraint yields*
Dividend Restrictions
* Assuming the Dip, D = 0
Combining the cash flow identity with the dividend constraint yields
Dividend Restrictions
Dividend Restrictions
Book Value Book Value of Debt of Assets
Combining the cash flow identity with the dividend constraint yields
Combining the cash flow identity with the dividend constraint yields
Placing a ceiling on dividends effectively places a floor on real investment
Dividend Restrictions
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
Dividend Restrictions
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:
interest expense funded debt net tangible assets earnings
Use of balance sheet vs
income statement for financing restrictions
Restrictions on Financing
Other Financing Issues
Leasing
Convertible Bonds
Callable Bonds
Sinking Funds
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
