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.

We analyze how directors with financial expertise affect corporate decisions. Using a novel panel data set, we find that financial experts exert significant influence, though not necessarily in the interest of shareholders. When commercial bankers join boards, external funding increases and investment-cash flow sensitivity decreases. However, the increased financing flows to firms with good credit but poor investment opportunities. Similarly, investment bankers on boards are associated with larger bond issues but worse acquisitions. We find little evidence that financial experts affect compensation policy. The results suggest that mandating financial expertise on boards may not benefit shareholders if conflicting interests (e.g., bank profits) are neglected.

In a setting where firms can choose their capital structures, we derive the optimal compensation contract for employees who are averse to bearing their own human capital risk, while equity holders can diversify this risk away. In the absence of other frictions, the optimal contract implies that all firms will be unlevered, and instead will hold cash. In the presence of corporate taxes, the optimal contract implies optimal debt levels consistent with those observed, implying that the importance of human capital risk is comparable to that of taxes in the capital structure decision. Our model makes a number of predictions for the cross-sectional distribution of firm leverage. Consistent with existing empirical evidence, it implies the existence of persistent unexplained idiosyncratic differences in leverage across firms. It also predicts that, ceteris paribus, firms with more leverage should pay higher wages, an as yet unexplored empirical implication of the model. JEL classification: G14.

... financial policies. These "under-leveraged" firms carry substantially less debt than predicted by dominant theories of capital structure (Graham (2000) and Myers (1984)). This paper examines the phenomenon of financial conservatism by studying firms that adopt a persistent policy of low leverage. Our major findings are as follows. 1) Conservative firms follow a pecking order style financial policy. A high flow of funds and substantial cash balances allow them to fund the bulk of discretionary expenditures internally. 2) Financial conservatism is largely transitory. Seventy percent of low leverage firms drop their conservative financial policy; almost 50% do so within five years. 3) Conservative firms stockpile financial slack or debt capacity. Their "stockpiles" are utilized later to finance discretionary expenditures, particularly acquisitions and capital expenditures.. 4) Financial conservatism is not an industry-based phenomenon. Conservative firms do, however, have relatively high market-to-book and operate relatively frequently in industries thought to be sensitive to financial distress. 5) Conservative firms do not have low tax rates, high non-debt tax shields or face severe information asymmetries.

This paper develops a model in the spirit of Hennessy and Whited (2005) in which the capital structure dynamics associated with transitory debt fully explain the long-horizon leverage paths documented by Lemmon, Roberts, and Zender (2008). The model shows how and why debt serves as a transitory financing vehicle to meet the funding needs associated with random shocks to investment opportunities. It yields a variety of new testable predictions about the time paths of leverage and the link between investment and capital structure dynamics. Although these dynamics also reflect financing frictions, predictable variation in capital structure primarily reflects the attributes of firms ’ investment opportunities–e.g., the volatility and serial correlation of investment shocks, the marginal profitability of investment, and the nature of capital stock adjustment costs–with the linkage between investment attributes and leverage dynamics reflecting firms ’ usage of transitory debt.

This paper argues that the standard pecking order hypothesis is only a special case of the adverse selection argument about external financing. It only applies when there is no asymmetric information about risk so that there is no adverse selection cost of debt. As soon as outside investors are imperfectly informed about risk, debt, a concave claim, will be mispriced. Using a large unbalanced panel of publicly traded US firms, we present robust and economically significant evidence i) that there is a general adverse selection in which firms issue consistently more equity and less debt if risk matters more and ii) that the special case of the pecking order, i.e. no adverse selection cost of debt, works well when risk does not matter, irrespective of firms ’ age, size, market-to-book ratio, tangibility or the time period. We thank Heitor Almeida, Dan Bergstresser, Kobi Boudoukh, Alexander Ljungqvist, Eli Ofek, Daniel Wolfenzon, Jeff Wurgler and seminar participants at NYU for helpful comments.- 0-The pecking order theory of capital structure, one of the most influential theories of corporate leverage, has recently fallen on hard times. On the one hand, the theory has considerable intuitive appeal. Firms seeking outside finance naturally face an adverse

This article presents the growing research area of Behavioural Corporate Finance in the context of one specific example: distortions in corporate investment due to CEO overconfidence. We first

We estimate firm-specific marginal cost of debt functions for a large panel of companies between 1980 and 2007. The marginal cost curves are identified by exogenous variation in the marginal tax benefits of debt. The location of a given company’s cost of debt function varies with characteristics such as asset collateral, size, book-to-market, asset tangibility, cash flows, and whether the firm pays dividends. By integrating the area between benefit and cost functions we estimate that the equilibrium net benefit of debt is 3.5 % of asset value, resulting from an estimated gross benefit of debt of 10.4 % of asset value and an estimated cost of debt of 6.9%. We find that the cost of being overlevered is asymmetrically higher than the cost of being underlevered and that expected default costs constitute approximately half of the total ex ante cost of debt. We thank Rick Green (the Acting Editor), and an anonymous referee, Heitor Almeida, Ravi Bansal,

This paper studies the valuation of assets with debt tax shields when debt policy is a general time-dependent function of the asset’s unlevered cash flows, value, and history. In a continuous-time setting, it shows that the value of a project’s debt tax shield satisfies a partial differential equation, which simplifies to an easily solved ordinary differential equation for most plausible debt policies. A large class of cases exhibits closed-form solutions for the value of a levered asset, the value of its tax shield, and the appropriate cost of capital for discounting unlevered cash flows so as to account for the value of the tax shield. Perhaps the most popular application of financial theory is capital budgeting. Virtually every student of finance starts his education in the field by learning how to discount future cash flows. By the end of a first course, the student has developed the basic tools to implement a discounted cash flow analysis in a real world setting. Because the real world setting must account for the relative advantage of debt financing, arising from the debt interest tax subsidy, students of finance generally learn that such subsidies can be accounted for by discounting unlevered cash flows (also referred to as “free cash flows”) at a tax-adjusted weighted average cost of capital (or W ACC). Such tax adjustments to the discount rate

This paper estimates costs of external finance, applying indirect inference to a dynamic structural model where the corporation endogenously chooses investment, distributions, leverage and default. The cor-poration faces double taxation, costly state verification in debt markets, and linear-quadratic costs of external equity. Consistent with direct evidence on underwriter fee schedules, behavior is best explained by rising marginal costs of external equity, starting at 5.2%. Contrary to the notion that corporations are debt conservative, leverage is consistent with small (11.6%) bankruptcy costs. Investment-cash flow sensitivities are not a sufficient statistic for financing costs. The cash flow coefficient decreases in external equity costs and increases in bankruptcy costs. When the model is simulated using our parameter esti-mates, the cash flow coefficient across Fazzari, Hubbard, and Petersen’s dividend classes is U-shaped. The difference between cash flow coefficients across dividend classes actually decreases as costs are increased.