We survey 392 CFOs about the cost of capital, capital budgeting, and capital structure. Large firms rely heavily on present value techniques and the capital asset pricing model, while small firms are relatively likely to use the payback criterion. We find that a surprising number of firms use their firm risk rather than project risk in evaluating new investments. Firms are concerned about maintaining financial flexibility and a good credit rating when issuing debt, and earnings per share dilution and recent stock price appreciation when issuing equity. We find some support for the pecking-order and trade-off capital structure hypotheses but little evidence that executives are concerned about asset substitution, asymmetric information, transactions costs, free cash flows, or personal taxes. Key words: capital structure, cost of capital, cost of equity, capital budgeting, discount rates, project valuation, survey. 1 We thank Franklin Allen for his detailed comments on the survey instrument and the overall project. We

It is well known that firms are more likely to issue equity when their market values are high, relative to book and past market values, and to repurchase equity when their market values are low. We document that the resulting effects on capital structure are very persistent. As a consequence, current capital structure is strongly related to historical market values. The results suggest the theory that capital structure is the cumulative outcome of past attempts to time the equity market.

This paper provides a new explanation for the use of convertible preferred equity in venture capital. It explains that the key feature of the convertible security is to create different cash flow rights for acquisitions and IPOs. It shows how the convertible security implements an optimal trade-off between the need to allocate cash flows to the venture capitalist and the desire to make efficient exit decisions. This approach also explains some puzzling contract features, such as automatic conversion in case of an IPO, or the use of participating preferred equity, where conversion never benefits the investors.

This paper examines the ability of the risk-shifting hypothesis and the backdoor equity hypothesis to explain firms ’ decisions to issue convertible debt. Using a security choice model that incorporates pre-offer issue, issuer, and macroeconomic information, we document significant variation in the market reaction to new convertible debt issues depending on whether investors expect the motivation for issuance to be asset substitution or asymmetric information. Our results suggest that both motives explain the use and design of convertible debt. Some firms issue convertible debt instead of straight debt to mitigate the costs of bondholder/stockholder agency conflicts. Other issuers use convertible debt instead of common equity to reduce the costs of adverse selection. Thus, in contrast to standard securities like straight debt or common equity, which solve some financing problems but exacerbate others, hybrid securities such as convertible debt are seen as providing a more flexible funding choice that can solve conflicting financing problems. Financial economists study the security issue decision to understand more fully why firms choose to issue a particular security and how investors in financial markets react to that choice. The research documents several results about investor reaction to the announcement of

Venture capital ¯nancing is characterized by extensive use of convertible securities and stage ¯nancing. In a model where an entrepreneur obtains funding for a project from a venture capitalist, we illustrate an advantage of convertible debt over a mixture of debt and equity in stage ¯nancing situations. Essentially, when the venture capitalist retains the option to abandon the project, the entrepreneur has an incentive to engage in window dressing and bias positively the short-term performance of the project, reducing the probability that it will be liquidated. An appropriately designed convertible debt contract prevents such short-termistic behavior since window dressing also increases the probability that the venture capitalist will convert debt into equity.

It is common for firms to issue or purchase options on the firm’s own stock. Examples include convertible bonds, warrants, call options as employee compensation, or the sale of put options as part of share repurchase programs. This paper shows that option positions with implicit borrowing—such as put sales and call purchases—are tax-disadvantaged relative to the equivalent synthetic option with explicit borrowing. Conversely, option positions with implicit lending—such as compensation calls—are tax-advantaged. We also show that firms are better off from a tax perspective issuing bifurcated convertible bonds— bonds plus warrants—rather than an otherwise equivalent standard convertible. The put option sales which have been popular with some firms are like issuing debt with non-deductible interest and thus have a tax cost. For example, we estimate that in 1999 the tax cost to Microsoft of written puts was about $80m per year.

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Many firms issue hybrid securities such as convertible debt instead of standard securities like straight debt or common equity. Theoretical arguments suggest that firms face high debt- and equityrelated external financing costs, and that convertible debt minimizes the sum of these financing costs for some issuers. Moreover, theory suggests that an appropriately designed convertible security provides efficient investment incentives. We show, however, that firms perform poorly following the issuance of convertible debt. Our empirical evidence suggests that the efficient investment decisions predicted by theory are not achieved by the actual design and issuance of convertible debt securities in practice. We suggest an alternative interpretation of convertible debt offers in which investors ration the participation of some issuers in the seasoned equity market. 2

Numerous theoretical models show how management incentive schemes can reduce the distortionary effects of financial leverage. However, there is little empirical support for the models ’ prediction that highly levered firms should offer less stock-based compensation. We stress that the incentive effects of financial leverage can be directly offset by adjusting the exercise price of executive stock options, and that the standard practice of setting exercise prices near the prevailing stock price accomplishes much of the necessary adjustment. In a large sample of Canadian option-granting firms, we find no evidence that risk-taking incentives are increased by financial leverage. This is true both cross-sectionally and over time. JEL Classification Numbers G32, D23, J33Financial structure can affect real decisions through two distinct channels. First, debt obligations restrict the flow of funds into the firm 1. Second, as argued by Jensen and Meckling (1976), financial leverage induces shareholders to favor risky projects even if such projects reduce total firm value. 2 Haugen and Senbet (1981) were the first to point out that financial leverage will not distort risk choices if managers ’ incentives differ appropriately from those of

Banking systems vary widely in the degree of specialization they impose on financial intermediaries. In particular, banks are often limited to holding only one category of financial claims. By contrasting two polar extremes- the ’American ’ model of specialized banking and the ’German ’ model of universal banking- this paper explores the institutional consequences of such regulatory restrictions. In an incomplete contracts setting, intermediaries first decide on the acquisition of managerial resources that later determines their course of action in a financing, renegotiation and interference game. German style universal financial intermediation results in optimal mixed debt-equity finance, contractual corporate governance, absence of secondary markets and non-renegotiated reorganization by banks. American style specialized banking leads to suboptimal outcomes with renegotiation, markets for corporate control and financial specialization unless several sources of outside finance are selected in order to replicate efficient capital structures. The results also shed light on the emerging new American banking paradigm, the duality between managerial labor and capital markets and banking system design.