Download November 28, 2006

CORPORATIONS
Creditors
November 28, 2006
CORPORATIONS
Creditors
Set of Cost Minimizers
Set of Profit Maximizers
CORPORATIONS
Creditors
Firm
Size
CORPORATIONS
Creditors – Firm Size
• The previous lectures emphasized the
efficiency and optimality of the form of
business that a firm might adopt.
• For example, sole proprietorships carry
the most flexibility, in the extreme, but
sacrifice
• the advantages of distributing the risks of long term
investment over many individuals,
• the economies of scale and
• specialization offered by incorporating the firm.
CORPORATIONS
Creditors – Firm Size
•
V
Sole Shareholder Corporation
Vs
E
Us
Fs
F
CORPORATIONS
Creditors – Firm Size
V
Expansion Path of Firm at agency costs = 0
Expansion path with optimal mix of credit and
equity
F
CORPORATIONS
Creditors – Firm Size
•
V
Point where corporation becomes too big for
owner and owner can start buying additional
needs on the open market
EBoundary
Vs
E
Us
Equity Expansion
Path
Slope = -1
F
Fs
CORPORATIONS
Creditors – Firm Size
V
Expansion Path of Firm at agency costs = 0
Expansion Path of Firm at agency costs = A
Agency costs = A
Slope = -1
E*
Slope = -a
F
CORPORATIONS
Creditors – Firm Size
V
Expansion Path of Firm at agency costs = 0
Expansion path with optimal mix of credit and
equity
Expansion Path of Firm at agency costs = A
Agency costs = A
E*
F
CORPORATIONS
Creditors
Insider
Trading
CORPORATIONS
Creditors – Insider Trading
• In the previous lectures, the two major
“investors” in the firm were “insiders” and
“outsiders”
CORPORATIONS
Creditors – Insider Trading
V
Utility Curve of Insider – Insider Trading
Restricted
Utility Curve of Insider – Insider
Trading Unrestricted
Slope = -1
Slope = -a
F
CORPORATIONS
Creditors – Insider Trading
V
Vs
Impact of manager
shareholder on outside
shareholders
E
E* Us
Fs
F
CORPORATIONS
Creditors
Competing
Creditors
CORPORATIONS
Creditors
• Now what happens when one introduces a
third party – the lender or creditor?
CORPORATIONS
Creditors
• .
Banks
Debentures
Bonds
Secured Creditors
Preferred Creditors
Unsecured Creditors
Shareholders
CORPORATIONS
Creditors
• Why can the failure of the entrepreneur or
manager to maximize the value of the firm be
perfectly consistent with efficiency?
• Why is the sale of common stock a viable source
of capital even though managers do not
maximize the value of the firm?
• Why is debt relied upon as a source of capital
before debt financing irregardless of tax
advantages?
• Why do companies issue preferred stock?
CORPORATIONS
Creditors
• Modigliani and Miller (1958) argued that in the
absence of bankruptcy costs and tax subsidies
on the payment of interest, the value of the firm
is independent of the financial structure.
• Modigliani and Miller later (1963) argued that the
existence of tax subsidies on interest payments
would cause the value of the firm to rise with the
amount of debt financing by the amount of the
capitalized value of the tax subsidy.
• This line of argument implies that the firm should
be financed almost entirely with debt.
CORPORATIONS
Creditors
• Jensen and Meckling argue that as long
as the "agency cost“ of debt financing
(issuing bonds to creditors) remains below
the "agency cost" of equity, then more debt
is optimal.
• The optimality of expanding debt for the
firm ceases when the two types of "agency
costs" become equal.
• [Jensen and Meckling at 339-340]
CORPORATIONS
Creditors
Limited
Liability
CORPORATIONS
Creditors – Limited Liability
• Limited liability is a form of insurance to the
shareholders.
• A firm is hit with a sudden downturn, or worse, an
unforeseeable catastrophe, like Bhopal, India, in 1984, that
causes the firm's liability to greatly exceed the total
investment the shareholders made in the firm.
• Limited liability is a rule of law that attaches to
the corporate firm of business association.
CORPORATIONS
Creditors – Limited Liability
• Imperfect Information
$C1
•Decreasing Marginal Costs Due to Precaution
•Increasing Marginal Costs Due To Production
Strict Liability Rule –
MC1
Contracted Liability
Rule – MC1
Expected Liability –
MC1
a1
CORPORATIONS
Creditors – Limited Liability
• Limited liability insures total liability to the
shareholders will not exceed their total
investment.
• Such a rule does not attach to sole
proprietors or partners.
• In those firms total liability not only may
exceed the investment, but may attach to
the personal assets of the investors.
CORPORATIONS
Creditors – Limited Liability
• Imperfect Information
$C1
•Decreasing Marginal Costs Due to Precaution
•Increasing Marginal Costs Due To Production
Limited Liability Rule
Expected Liability –
MC1
a1
CORPORATIONS
Creditors – Limited Liability
• Imperfect Information
$C1
• New Expectation Damages Rule Subject To The Limited Liability Rule
Limited Liability Rule
a1
CORPORATIONS
Creditors – Limited Liability
• As with other forms of insurance, limited liability
poses a "pooling problem".
• Pooling equilibria" emerge where different
agents are expected to perform the same action
under the same law.
• Different agents will do different actions,
although they may "strategically" change their
behaviour to act more uniformly.
• The group that performs below expectation
commit a "moral hazard".
CORPORATIONS
Creditors – Limited Liability
• The agency costs of unlimited liability would be
much higher than simply paying a premium in
the form of higher interest rates to the creditors
of the corporation in return for their acceptance
of a contract which grants limited liability to the
shareholders.
• The creditors would then bear the risk of any
non-payment of debts in the event of the
corporation’s bankruptcy. (Jensen and Meckling,
p. 331)
CORPORATIONS
Creditors – Limited Liability
• Limited liability does not mean that every
firm will take irrational risks, but some
might.
• In these cases, limited liability, like other
forms of insurance creates moral hazards.
• The most frequently discussed moral
hazard of limited liability is bankruptcy.
CORPORATIONS
Creditors
Rules of
Liability
CORPORATIONS
Creditors – Liability Rules
• At common law, suits by creditors against
debtors for unpaid debts were technically
complex, drawn out and expensive.
• Those businesses that needed their
money quickly sought other remedies,
through their guilds, trade fairs or private
"for hire" enforcers.
Secured Creditors
Banks
Debentures
Bonds
Preferred Creditors
Revenue Canada, Judgments
Unsecured Creditors
Employees, Suppliers
Shareholders
CORPORATIONS
Creditors – Liability Rules
• In Italy, lenders adopted a custom of
breaking (rupto) the selling stall (banco)of
a defaulting debtor so that customers
would know to pay the lenders directly
instead of the debtor
CORPORATIONS
Creditors – Liability Rules
• The agency cost of debt financing
appreciates significantly when the firm
does not have sufficient net worth to pay
all classes of creditors.
• The probability and cost of potential
bankruptcy adversely effects the value of
the firm.
CORPORATIONS
Creditors – Liability Rules
• Another drawback of bankruptcy is its
finality. Bankruptcy kills the business.
• In an economy without a relatively costless
bankruptcy procedure, competing creditors
might seize assets critical to the
corporation's operation and worsen an
already suboptimal situation
CORPORATIONS
Creditors – Liability Rules
• What would be the main motivation for this
kind of legislation?
• Difficulties of recontracting debts at common law
» Foakes v. Beer
» Gilbert Steel
• Prisoners Dilemna – The Uncooperative Game
» Without the prioritization or hierarchy of creditors,
there is a “suboptimal” Nash equilibrium
CORPORATIONS
Creditors – Liability Rules
• The common law also recognized the right of
lenders to "contract" their own remedies in the
agreement that accompanied the loan.
• Usually such agreements provided that legal title
to the firm's assets be transferred to the lender
for the duration of the loan.
• Railways and large manufacturing concerns
were frequently controlled in this matter. Such
lenders are treated as "secured lenders" with the
highest priority over other creditors.
CORPORATIONS
Creditors – Liability Rules
• In the 1930’s, both Canada and the United
States passed legislation that enabled
corporations to request “breathing space”
to freeze creditor action while
reorganization
• United States – Chapter 11
• Canada – Corporation Creditors Arrangement Act
CORPORATIONS
Creditors – Liability Rules
• Stelco case – latest in a long line of cases
that included
•
•
•
•
Eaton’s
Consumers Distributors
Dylex
Many others