Journal of Applied Corporate Finance W I N T E R 1 9 9 6 V O L U M E 8. 4 On Financial Architecture: Leverage, Maturity, and Priority by Michael J. Barclay and Clifford W. Smith, Jr. , University of Rochester ON FINANCIAL ARCHITECTURE: LEVERAGE, MATURITY, AND PRIORITY by Michael J. Barclay and Clifford W. Smith, Jr. , University of Rochester n an article published in this journal a year ago, we reported the findings of our study of corporate financing and payout policies covering some 6,700 industrial companies over the past 30 years. Our analysis suggests that the most important systematic determinant of a company’s leverage ratio and dividend yield is the nature of its investment opportunities. Companies whose value consists largely of intangible growth options (as indicated by high market-to-book ratios and heavy R spending) have significantly lower leverage ratios and dividend yields, on average, than companies whose value is represented primarily by tangible assets (with low market-to-book ratios and high depreciation expense).
We explained this pattern of financing and dividend choices as follows: For high-growth firms, the “underinvestment problem” associated with heavy debt financing and the flotation costs of high dividends make both policies potentially quite costly. But, for mature firms with limited growth opportunities, high leverage and dividends can have substantial benefits from controlling the “free cash flow” problem???the temptation of managers to overinvest in mature businesses or make diversifying acquisitions. Taxes, too, may play a role in this pattern since low-growth companies are likely to be generating more taxable income and thus have greater use for interest tax shields. But, because there are important managerial incentive benefits as well as costs to having higher debt and dividends, companies would have optimal leverage and dividend ratios even in a world without income taxes. ) I
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Throughout our previous paper, we effectively assumed that all debt financing is the same. In practice, of course, debt can differ in several important respects, including maturity, covenant restrictions, convertibility, call provisions, security, and whether the debt is privately placed or held by widely-dispersed public investors. Each of these features is potentially important in determining the extent to which debt financing can help control (or exacerbate) problems.
For example, as we argue below, companies with lots of investment opportunities can be expected to issue debt with shorter maturities, not only to protect lenders against the greater uncertainty associated with growth firms, but also to preserve their own financing flexibility and future ability to invest. Growth companies are also likely to choose private over public sources of debt because renegotiating a troubled loan with a banker (or a handful of private lenders) will generally be much easier than getting hundreds of widely dispersed bondholders to restructure the terms of a public bond issue.
In this paper, we expand the scope of our earlier study, examining broader facets of corporate financial architecture. Here we focus specifically on the maturity and priority structure of the firm’s debt by looking at 6000 firms during the period 1981-1993. As in our earlier study, we test three basic explanations of these corporate financing choices. In addition to the incentive-contracting argument described above, we also test “signaling” and “tax” explanations. Consistent with our earlier findings, this study provides strong evidence for the incentive-contracting explanation, but only weak support for the signaling and tax arguments. s two other recently published studies by Barclay and Smith: “The Maturity Structure of Corporate Debt,” Journal of Finance, Vol. 50, No. 2 (1995); and “The Priority Structure of Corporate Liabilities,” Journal of Finance, Vol. 50, No. 3 (1995). 1. Michael J. Barclay, Clifford W. Smith, Jr. and Ross L. Watts (1995) “The Determinants of Corporate Leverage and Dividend Policies,” Journal of Applied Corporate Finance 7: 4, 4-19. This article draws heavily on both that article, as well 4 BANK OF AMERICA OF APPLIEDOF APPLIED CORPORATE FINANCE JOURNAL JOURNAL CORPORATE FINANCE
TABLE 1 SOURCES OF CORPORATE DEBT AVERAGE MATURITY COVENANTS Affirmative Negative ISSUE COSTS Commercial Paper Bank Debt Non???Bank Private Debt Public Debt 35 daysa 5. 6 yearsb 15. 3 yearsb 18. 0 yearsb Rare Limitedd Large Common Common Small Common Common Smallc Rare Common Largec a. J. O. Light and W. L. White (1979) The Financial System (Irwin: Homewood, IL). SEC rules exempt public debt with maturities less than 270 days from registration. b. Average maturities reported in Christopher James (1987) “Some Evidence on the Uniqueness of Bank Loans,” Journal of Financial Economics 19, 217???235. . David Blackwell and David Kidwell (1988), “An Investigation of Cost Differences Between Public Sales and Private Placements of Debt,” Journal of Financial Economics 27, 253???278, estimate that average flotation costs per $1000 are $7. 95 for private debt and $11. 65 for public debt. d. Commercial paper typically contains few covenants other than cross default provisions that protect lenders in the case of default on other loans. CHARACTERISTICS OF CORPORATE LIABILITIES Corporate debt claims differ in a number of dimensions in addition to maturity and priority.
To the extent that maturity and priority structures are strongly correlated with other debt features (for example, whether the debt is public or private), it is important to recognize at the outset that corporate choices of maturity and priority may be effectively “bundled” into choices of other critical financial aspects. Thus, we begin by noting some of these correlations in order to provide a broader context for interpreting our empirical results. Maturity Sources of Debt. As Table 1 shows, maturity is correlated with whether the debt is held by banks or insurance companies (private placements) or public bondholders.
Commercial paper, with its maximum maturity of 270 days, is of course the shortest-term instrument. Bank debt comes next, with an average maturity of 5. 6 years, followed by (non-bank) private placements (15. 3 years) and public debt (18 years). Which of these sources of debt the firm chooses, however, is likely to be influenced by two other important considerations: (1) issue costs, which in 2. David W. Blackwell and David Kidwell, “An Investigation of Cost Differences Between Public Sales and Private Placements of Debt, Journal of Financial Economics 22 (1988). urn are determined in large part by the size of the firm; and (2) the extent and kinds of restrictive covenants contained in the debt agreement. Issue Costs (and Firm Size). The fixed issue costs of public debt issues and commercial paper programs are generally much higher than the fixed costs of a bank loan or private placement. One widely cited study of some 250 debt offerings over the period 1979-1983 estimates that the average issue cost per $1000 was $11. 65 for public debt, but only $7. 95 for private debt. Public debt and commercial paper also have more pronounced scale economies than bank or other private debt. For example, borrowers issuing directly-placed commercial paper will usually borrow at least $1 billion per month to cover the substantial costs of distribution and marketing. 3 Thus, larger firms are more likely to issue public debt and commercial paper than are smaller firms. The average size (total assets) of firms issuing public debt in the study cited above was $3. 4 billion as compared to $2. 3 billion for issuers of private debt.
Moreover, the size of the average public debt issue was roughly twice the average private issue ($80 million as compared to just under $40 million). Covenants. The alternative sources of debt listed in Table 1 also differ in their use of covenants. Debt contracts frequently contain covenants that 3. P. S. Rose, Money and Capital Markets (Irwin: Homewood, IL, 1992). 5 VOLUME 8 NUMBER 4 WINTER 1996 TABLE 2 CHARACTERISTICS OF CORPORATE LIABILITIES Capitalized Leases Secured Debt Ordinary Debt Subordinated Debt Preferred Stock Common Stock Types of Corporate Liabilities
PRIORITY OF CLAIM Can Default Trigger Bankruptcy? CONTROL RIGHTS Highest Yes Right to restrict use of leased asset Right to limit activities specified in covenants No Right to limit activities and conditional voting rights Lowest Voting rights CORPORATE TAX SHIELDS: Cash Flows Depreciation Lease and interest payments are deductible Depends on the structure of the contract Dividend payments are not deductible Assets financed with debt or equity can be depreciated Flotation Costs Flotation Flotation costs amortized over the life of costs in lease the issue payment
Flotation costs not deductible TAX LIABILITY FOR CLAIMHOLDERS: Individuals Corporations Lease and interest payments are ordinary income Dividends are ordinary income 70% of dividends excluded from taxable income restrict the firm’s investment, payout, and financing policies. The covenants can be either affirmative covenants (for example, those requiring the firm to maintain specific working capital balances) or negative covenants (those prohibiting the firm from issuing additional debt unless a specified financial ratio is maintained).
Bank debt generally contains the most extensive covenants, normally including both affirmative and negative covenants. Non-bank private debt also tends to include both affirmative and negative covenants. By contrast, public debt usually includes negative but rarely affirmative covenants; and commercial paper contains few covenants at all. Many firms, of course, borrow money from more than one source; for example, they may use both public debt issues and bank loans.
In this case, public debt holders are typically protected by cross-default provisions that put the debt in default if the firm violates a covenant in any of its outstanding debt. 6 Priority As illustrated in Table 2, differences in priority also tend to be associated with differences in other aspects of corporate claims. Specifically, in addition to their priority in bankruptcy, these claims have different control rights and tax implications. Rights in Bankruptcy. Default on promises made in lease or debt contracts generally gives the claimholders the right to force the firm into bankruptcy.
Of the claims that we examine, capital leases usually have the highest priority in bankruptcy. Default on a promised lease payment typically gives the lessor the right to repossess the leased asset. If the lessee files for bankruptcy and argues that the asset is essential to the ongoing operation of the firm, the court can prevent the lessor from repossessing the leased asset. However, if the lessee affirms the lease contract, the court requires that the lessee make the specified lease payments to the lessor throughout the bankruptcy process. In con- JOURNAL OF APPLIED CORPORATE FINANCE
For mature firms with limited growth opportunities, high leverage can add substantial value by helping to control the “free cash flow” problem???the temptation of managers to overinvest in mature businesses or make diversifying acquisitions. trast, debtholders typically are not paid until the bankruptcy process is resolved. Debt contracts contain provisions that specify the priority of the claim in bankruptcy. Secured debt gives the debtholders title to pledged assets until the bonds are paid in full. In liquidation, secured debtholders have first claim on the pledged assets.
If the value of the pledged assets is less than the amount owed, secured debtholders have a claim on the firm’s other assets for the shortfall. Subordinated debt generally specifies that with the occurrence of a stipulated event (such as bankruptcy or default on payments to senior debt), its claimholders are paid only after senior debtholders are paid in full. Thus, subordinated debtholders agree to stand at the back of the line of debtholders. Common and preferred stockholders do not have the right to force a firm into bankruptcy. In bankruptcy, preferred stock has higher priority than common stock, but lower priority than debt.
Control Rights. Lease contracts generally restrict corporate decisions only with respect to the leased asset. For example, the lease contract might specify required maintenance activities or limit subleasing of the asset, but the contract normally would not include provisions restricting the firm’s financing or payout policies. (Internal Revenue Service rules prohibit such provisions in lease contracts. ) Debt contracts generally include covenants limiting investment, financing, or dividend decisions, but normally do not give lenders the right to initiate policy. Such rights would be expensive under the U.
S. bankruptcy code. If a debt issue were to give lenders such control rights and the firm were to default on other payments, the firm’s other creditors could sue the lender, claiming the lender received an unfair preference, and have the effective priority of that lender’s debt reduced. Preferred stock issues also sometimes include covenants limiting corporate policy choices (for example, prohibiting dividend payments to common stockholders unless preferred dividends have been paid). However, such preferred-stock covenants are typically less extensive than those in debt contracts.
Preferred stock also can convey certain voting rights, but these voting rights generally are conditioned on specific corporate events such as an omission of a preferred dividend or a merger. Common stockholders have voting rights as specified in the corporate charter. They typically elect the board of directors, which in turn appoints 7 corporate management. They also must approve certain corporate activities like mergers and corporate charter amendments. Taxes. The various claims have materially different tax consequences for the parties to the contracts.
Lease and interest payments are tax deductible expenses for the firm; but, under U. S. tax law, dividend payments are not. Assets financed with either debt or stock can be depreciated. There is greater flexibility in allocating depreciation tax shields in leases, which can be structured so that either the lessor or the lessee receives the depreciation expense. In lease contracts, origination expenses are generally reflected in the schedule of lease payments and thereby deductible. Debt flotation costs are amortized over the life of the issue and are also deductible.
Flotation costs are not tax-reducing expenses in either common or preferred stock issues; they are a direct charge to the capital account. For lessors and bondholders, the lease and interest payments are ordinary income. The tax consequences of dividends for stockholders are different for individuals and corporations. If the stockholder is an individual, it is ordinary income; if the stockholder is a corporation, 70% of the dividend is excluded in the calculation of taxable income. HISTORICAL EVIDENCE Table 3 (see next page) summarizes our basic indings on leverage, maturity, and priority for the entire sample of industrial firms (SIC classifications between 2,000 and 5,999) listed on the COMPUSTAT data base for the years 1981-1994. Leverage. For all the companies over this 14year period, the average debt-to-total-capital ratio is 21%. COMPUSTAT balance-sheet data provides a broad view of corporate debt. In addition to bonds and mortgages, total debt also includes capitalized lease obligations, paper companies’ timber contracts, publishing companies’ royalty contracts payable, and similar long-term fixed claims.
We also include short-term notes, bank acceptances and overdrafts, sinking funds and installments on loans, and the current portion of long-term debt. In contrast to common corporate practice in defining leverage ratios, we define total capital as the current market value of total equity plus the book value of the firm’s other liabilities. Although it introduces more variability into the leverage ratios (some of which may not reflect a conscious shift in VOLUME 8 NUMBER 4 WINTER 1996
TABLE 3 HISTORICAL EVIDENCE ON CORPORATE LEVERAGE, MATURITY, AND PRIORITY LEVERAGE (n=55,713) MATURITY (n=43,945) More than one year More than two years More than three years More than four years More than five years PRIORITY (n=37,147) Capitalized Leases Secured Debt Ordinary Debt Subordinated Debt Classes of Fixed Claims Scaled by Total Capital Standard Mean Median Deviation Scaled by Total Fixed Claims Standard Mean Median Deviation .21 .18 .17 .16 . 14 . 12 . 10 . 08 .14 . 11 . 08 . 06 . 04 .15 . 14 . 13 . 12 . 11 .69 . 56 . 46 . 39 . 32 .80 . 65 . 51 . 39 . 28 .30 . 2 . 32 . 31 . 29 .01 . 07 . 07 . 03 .00 . 02 . 02 . 00 .04 . 11 . 11 . 08 .11 . 40 . 38 . 10 .00 . 31 . 21 . 00 .19 . 37 . 40 . 23 corporate financing policy), our use of market equity in calculating total capital reflects our view that it is ultimately the long-term cash-generating ability of the firm (captured in its market value, not its balance sheet) that provides a better guide to corporate leverage. 4 The fact that our study covers 15 years of corporate experience should go far toward “washing out” the effects of such undesired variability on leverage ratios.
As one example of the insights afforded by our method, while book leverage ratios have increased dramatically since the late 1970s, average debt-to-market capitalization ratios have remained roughly constant over this period. Maturity. COMPUSTAT reports the amount of long-term debt payable in each of years one through five from the firm’s fiscal year end. As shown in Table 3, the average amount of debt payable in more than one year is 16% of total capital (or, as we note below, about 75% of total debt claims). If maturity is extended to more than five years, this fraction falls to 8% of total capital (or just under 40% of total debt).
For purposes of our remaining analysis, we classify debt payments as long term if they are scheduled to occur in more than three years. Using this definition, we find that the average ratio of longterm debt to capital is 12%, and short-term debt to capital is 11%. 5 As a percentage of total debt, longterm debt is 46% for the average firm (and 51% for the median). Priority. As reported in the lower part of Table 3, the average ratio of capital leases to total capital is 1%; secured debt to capital is 7%; ordinary debt to capital is 7%; and subordinated debt to capital is 3%.
As a percentage of total fixed claims, capitalized leases represent 11%, secured debt 40%, ordinary debt 38%, and subordinated debt 10%. THE INVESTMENT OPPORTUNITY SET AND FINANCIAL STRUCTURE As we observed earlier, a company’s financial structure can affect its managers’ incentives to invest wisely (taking all positive-NPV projects and rejecting all others) and to operate efficiently. For some companies, heavy debt financing can improve managerial incentives and increase value; but, in other cases, it is more likely to distort incentives and reduce value.
More specifically, in mature firms with limited growth opportunities, high leverage can add value by controlling the “free cash flow” problem???namely, the temptation of managers to overinvest (or fail to 4. As we also pointed our in last article, however, book debt-to-capital ratios also contain useful information about corporate debt policy in the following sense: To the extent book values provide accurate assessments of the tangibility of assets, they too serve as useful indicators of corporate debt capacity. 5.
The reason these two measures, 12% and 11%, do not add to the mean total leverage ratio of 21% is that the two calculations are performed on somewhat different samples. 8 JOURNAL OF APPLIED CORPORATE FINANCE High-growth companies face a steeply-sloped “term structure” for their debt, both because of the high probability of financial trouble and because of the valuereducing incentives that can arise if they get into trouble. make necessary cutbacks) in mature core businesses or, what often proves worse, to make diversifying acquisitions.
But, in the case of high-growth firms with many profitable investment opportunities, debt financing can lead to a very costly underinvestment problem. To begin with the extreme case, companies that wind up in Chapter 11 face considerable interference from the bankruptcy court with their investment and operating decisions, not to mention the substantial direct costs of administration and reorganization. And, even in circumstances much less extreme than bankruptcy, debt-financed companies are more likely than their debt-free counterparts to pass up valuable investment opportunities.
Especially when faced with the possibility of default, corporate managers are not only likely to put off major capital projects, but also to make shortsighted cutbacks in R, maintenance, advertising, or training that end up reducing the value of the firm. This is not just another allegation of the “myopic” behavior for which American managers are so often criticized in the popular press. As Stewart Myers demonstrated in his classic 1977 article, “Determinants of Corporate Borrowing,”6 there is a rational basis for this shortsightedness.
Assume, just for the sake of illustration, that a high-growth technology firm manages to persuade its local bankers to fund its investment with a high percentage of bank debt. 7 Suppose further that sales fail to materialize as quickly as projected, and that management now is confronted with a dilemma: Either cut the R budget (which is expected to generate much of the future growth of the business) or face a very high probability of default on the loans. What the firm really needs in such circumstances is an infusion of new equity.
But potential new shareholders face a major obstacle: Much of the value created (or preserved) by their investment will go toward shoring up the creditors’ position. To induce new equity players to participate, either the bank will be forced to write down the value of its loans substantially (which it would be understandably reluctant to do), or the new equity will come at a very high price (in the form of excessive dilution of ownership). Thus, as a consequence of its earlier financing choices, managers may pass up a valuable investment opportunity. 6. Stewart C.
Myers, “Determinants of Corporate Borrowing,” Journal of Financial Economics, Vol. 5 (1977), pp. 147-175. As this example is meant to illustrate, companies whose value consists primarily of investment opportunities (or “growth options,” as Myers calls them) are likely to find debt financing very costly. For such companies, the lack of good collateral will make debt expensive to obtain in the first place. And, for those high-growth firms that do manage to get such funding, the costs of financial difficulty in the form of lost opportunities are likely to be substantial.
Conversely, for mature companies with few profitable investment opportunities whose value comes primarily from “assets in place” (tangible assets that provide good collateral for lenders), the indirect costs of financial distress or even bankruptcy are likely to prove quite low. The low costs of financial distress, together with the control benefits of debt cited earlier, will cause such companies to have significantly higher leverage ratios than highgrowth firms.
Maturity and Investment Opportunities: The Theory The above argument provides clear predictions for how leverage ratios should vary with a firm’s investment opportunities. But what about the maturity and priority of its debt? Should the debt of highgrowth firms be expected to have shorter or longer maturities than that of mature companies, and should it be predominantly secured or unsecured? After discussing the underinvestment problem in his 1977 article, Myers goes on to suggest that the problem can be managed in a number of different ways.
Besides the obvious solution of having highgrowth firms use less debt, he also proposes that such companies will tend to use debt with shorter maturities. Rather than go through Myers’s chain of reasoning here, we will try instead to capture the “intuition” of the argument by using another simple example. Suppose you are the new CFO of a Silicon Valley firm, and you have decided to raise capital through a straight public debt issue. You have already determined the size and all other aspects of the issue???everything except its maturity.
When you meet with your investment banker, you tell her that you are considering maturities of 5, 10, 20, and 30 years (and you are willing to forgo any call 7. This example is reproduced from our earlier article cited in footnote 1. 9 VOLUME 8 NUMBER 4 WINTER 1996 provision to make the deal more attractive to investors). Her first impulse is to blurt out that even the thought of 20- or 30-year straight debt for a Silicon Valley firm is rank folly. Instead she calmly assures you that her firm can find investors for any of these issues, provided the coupon is right.
Drawing on her knowledge of the market, she says that the required spreads over comparable-maturity Treasuries are likely to be 200 basis points for your 5year bonds, 350 bp for 10-year bonds, 550 bp for 20-year bonds, and 750 bp for 30-year bonds. Faced with these alternatives, you quickly go for the 5-year issue. But now consider the same discussion taking place with the CFO of a gas pipeline company. In this case, the investment banker quotes spreads that range from 100 basis points on the short end to 150 bp on the long end. Here the CFO is more than likely to end up choosing 30-year bonds.
As this example illustrates, corporate financing decisions reflect the outcome of negotiations between issuers and capital providers over pricing and terms. High-growth firms, because of the increased risk they pose for lenders, are likely to find it prohibitively expensive to obtain long-term (straight) debt. And it’s not only the higher variability of the cash flows and the lack of good collateral that give lenders pause in such cases; it’s also the problems that can arise if the firm’s fortunes suddenly shift??? for the worse or even for the better.
If things improve dramatically, the firm is going to want to get out of its debt-service commitment by refinancing as soon as possible (and, for this reason, will probably resist giving investors’ more than a year or so of call protection). This is another example of the importance of preserving flexibility in financing companies with lots of growth options. But, if things take a sudden turn for the worse, then having longterm debt outstanding can exacerbate the underinvestment problem described earlier. Of course, the pressure of debt service alone, regardless of maturity, could cause management to defer valuable investments.
But having longer-term debt actually makes the problem less tractable because the value of such debt will have fallen significantly more than the value of short-term debt. As we noted in our earlier example, what growth companies typically need in such circumstances is an infusion of new capital, preferably equity. But new investors are likely to be put off (or charge very high prices for the capital) because so much of the value preserved by their investment will go toward restoring the value of the bonds.
In short, new investors in such situations (unless they can get higher priority than the current bondholders) bear most of the risk, but receive only part of the expected return created by their investment. And, so, to return to Myers’s argument, the management of a high-growth firm that chooses to issue debt can better protect the firm’s ability to make valuable investments by having the debt come due before the firm must “exercise” its growth options. In contrast to large, mature companies, the timing of investment opportunities for high-growth firms is less predictable???indeed, they are likely to come along at any time.
But, when such opportunities present themselves, management typically needs to react quickly. In such cases, having 100% equity and large cash reserves on hand provides the most flexibility; but, if the firm has debt outstanding, shortterm debt is more flexible than long-term debt. 8 In sum, high-growth companies face a steeplysloped “term structure” for their debt, both because of the high probability of financial trouble and because of the value-reducing incentives that can arise if they get into trouble.
For these reasons, we would expect those growth companies that use debt to rely primarily on short-term bank loans (secured, say, by working capital) or perhaps medium-term convertibles (which overcome lenders’ reluctance, and effectively reduce the coupon rate, by giving them a piece of the upside). By contrast, low-growth companies with lots of tangible assets face a relatively flat “term structure,” and they can be expected to use public debt with its longer maturities.
Priority and Investment Opportunities: The Theory Of course, high-growth firms might like to issue longer-term debt if it were offered to them with the same terms and conditions as short-term debt. 8. In this sense, Myers’ analysis provides a rationale for value-maximizing firms to match effective maturities of their assets and liabilities. At the end of an asset’s life, the firm faces a reinvestment decision. Issuing debt that matures at this time helps to establish the appropriate investment incentives when new investment is required.
More importantly, however, this analysis indicates that the maturity of a firm’s tangible assets is not the sole determinant of its debt maturity. The firm’s intangible assets???its growth options???play a critical role as well. 10 JOURNAL OF APPLIED CORPORATE FINANCE Complicated capital structures with claims of different priority can produce fierce conflicts among creditors when firms have difficulty servicing their debt. And it is precisely in the case of companies with promising investment opportunities that such creditor conflicts have the potential to destroy the most value.
Similarly, they might prefer to issue unsecured or subordinated debentures to maintain as much operating flexibility as possible. But potential lenders generally respond to the greater uncertainty in such situations by demanding security (typically in receivables or inventory, since there is little in the way of long-term, tangible assets) as well as shortening maturities. Of course, a CFO has considerable flexibility in structuring a public debt issue. But changing the priority of the issue will also change its reception in the marketplace.
In general, attempts by highgrowth firms to issue low-priority claims will attract little investor interest and low prices; and, hence, such firms will be forced to offer high promised rates. For this reason, the CFOs of most growth firms can be expected to choose high-priority claims such as secured debt. Another reason high-growth firms can be expected to avoid low-priority debt is the destruction of value that can take place if the firm gets into financial trouble. Complicated capital tructures with claims of different priority can produce fierce conflicts among creditors when firms have difficulty servicing their debt. And it is precisely in the case of companies with promising investment opportunities that such creditor conflicts have the potential to destroy the most value. This possibility, of course, will be reflected in the high cost of unsecured or subordinated public debt for such companies. But even those CFOs initially willing to pay the higher cost for the flexibility (lack of covenants) provided by public debt may be deterred by the prospect of the value lost through underinvestment. Tests of the Theory To test these propositions, we ran a series of regressions designed to examine the strength of the correlations of a firm’s leverage ratio, its debt maturity, and the priority of its debt with its investment opportunity set. To run such tests, however, we required a measure of growth opportunities. Because stock prices should reflect intangible assets 9. Financing new investment projects with senior claims limits wealth transfers from stockholders to existing bondholders and thus reduces the incentives to underinvest.
The underinvestment problem can also be reduced if the firm preserves the right to finance new investments with high priority claims, such as secured debt or leases. For a discussion of the role of secured debt in controlling the underinvestment problem, see Rene Stulz and Herbert Johnson, “An Analysis of Secured Debt,” Journal of Financial Economics, Vol. 14 (1985), pp. 501-521. 10. We estimate the market value of the firm’s assets as the book value of assets minus the book value of equity plus the market value of equity. The market-to-book uch as growth opportunities but corporate balance sheets do not, we reasoned that the larger a company’s “growth options” relative to its “assets in place,” the higher on average will be its market value in relation to its book value. We accordingly used a company’s market-to-book-ratio as our proxy for its investment opportunity set. 10 The Evidence on Leverage. The results of our regressions summarized in Table 4 provide strong support for the argument. Companies with high market-to-book ratios have significantly lower leverage than companies with low market-to-book ratios.
The correlation between the market-to-book ratio and leverage is highly statistically significant (with a t-statistic of ???103. 03). Perhaps more important than these measures of statistical significance, however, is the “economic” significance of this relation. We measure economic impact as the percentage change in the leverage ratio associated with changing the market-to-book ratio from the 10th to the 90th percentile in our sample. To illustrate, if the market-to-book ratio increases from 0. 84 (the lowest 10th percentile) to 2. 92 (the 90th percentile), the predicted leverage ratio falls by 12. 4 percentage points, or 61. 2% of the average leverage ratio of 21%. Put another way, an increase in the market-to-book ratio from about 0. 8 to almost 3. 0 is associated, on average, with a drop in the firm’s leverage ratio from over 27% to under 15%. The Evidence on Maturity. The coefficients are also negative and highly significant in a pair of regressions designed to test correlations between market-to-book and corporate use of short-term debt and long-term debt. (The t-statistic for this variable is ???63. 90 in the short-term debt regression and ???64. 82 in the long-term debt regression. The negative coefficient indicates that, on average, firms with more growth options have less short-term as well as less long-term debt in their capital structures. The economic impact of the market-to-book ratio on debt maturity is also material (???54. 5% in the shortterm debt regression and ???54. 65% in the long-term debt regression). ratio is then calculated as the estimated market value of assets divided by the book value of assets. The estimated market-to-book ratio has several extreme observations. For example, 98 percent of the ratios are between 0. 7 and 9. 58. The range for this variable, however, is 0. 19 to 260. 30. To prevent extreme observations from having an undue influence on the regression results, we discard observations if the market-to-book ratio is greater than ten. Discarding these observations reduces the statistical significance of this variable in the regressions, but increases the size of the coefficient. 11 VOLUME 8 NUMBER 4 WINTER 1996 TABLE 4 THE DETERMINANTS OF CORPORATE FINANCIAL ARCHITECTURE1,2 Leverage Maturity Priority Short-Term Long-Term Capitalized Secured Debt Debt Leases Debt
Ordinary Debt Subordinated Debt Intercept 27. 44 (122. 15) 23. 72 (125. 21) 12. 13 (62. 14) 0. 17 (1. 34) 16. 72 (74. 20) ???0. 42 (???1. 97) ???18. 72 (???35. 34) INVESTMENT OPPORTUNITIES Market-to-Book ???6. 16 ???3. 24 ???3. 39 (???103. 03) (???63. 90) (???64. 82) [???61. 15] [???54. 46] [???54. 65] Regulation 11. 76 (38. 07) [55. 37] ???1. 31 (???5. 93) [???11. 54] 11. 49 (50. 52) [101. 27] ???0. 65 (???18. 78) [???89. 32] ???3. 84 (???6. 85) [???253. 64] ???2. 53 (???41. 10) [???70. 99] 3. 76 (4. 47) [51. 23] ???2. 69 (???44. 78) [???78. 80] 7. 76 (10. 26) [110. 09] ???2. 87 (???19. 51) [???248. 67] 0. 31 (0. 19) [12. 0] SIGNALING Abnormal Earnings (???0. 11) ???0. 98 (???4. 46) (???7. 93) [???1. 03] [???2. 67] TAX Tax-Loss Carryforward 6. 06 (35. 36) [28. 52] Term-Structure ???0. 12 (???2. 59) [???3. 01] SIZE Firm Value 0. 36 (10. 41) [9. 82] Adjusted R2 0. 23 0. 32 (2. 49) [0. 86] (???0. 02) (???0. 24) [???0. 46] ???0. 10 (???0. 69) [???0. 46] ???0. 62 (???4. 40) [???2. 93] 0. 30 (1. 02) [4. 11] 0. 49 (5. 37) [32. 31] ???0. 47 (???9. 89) [???11. 77] 2. 04 (12. 53) [27. 73] 0. 64 (4. 23) [9. 09] 6. 12 18. 76) [256. 72] ???1. 42 (???53. 41) [???70. 58] 0. 16 1. 08 (39. 63) [54. 12] 0. 24 36,297 ???0. 07 (???3. 58) [???25. 1] 0. 02 30,566 ???1. 46 (41. 24) [???109. 12] 0. 10 30,566 2. 02 (62. 44) [156. 97] 0. 15 30,566 1. 63 (22. 52) [372. 38] 0. 02 30,566 No. of Observations 45,906 36,297 1. Dependent variables expressed as percentages of total debt. 2. t-statistics in parentheses; economic impact measures in brackets. These findings largely reinforce our earlier cited leverage results???namely, that high-growth firms use less debt in general, and so both short-term and long-term debt are reduced. But what about such companies’ relative use of short-term and long-term debt? 12
To gain some insight into this question, we also express the maturity variables as a percentage of total debt instead of total capital. Consistent with Myers’s argument that the underinvestment problem can be controlled by shortening debt maturity, we find that firms with more more growth options (higher mar- JOURNAL OF APPLIED CORPORATE FINANCE TABLE 5 THE DETERMINANTS OF CORPORATE FINANCIAL ARCHITECTURE1,2 Intercept Maturity Long-Term Debt Priority Capitalized Leases Secured Debt Ordinary Debt Subordinated Debt 26. 47 (53. 92) 0. 73 (1. 13) 1. 54 (9. 15) [28. 7] ???20. 11 (???7. 09) [???182. 73] 0. 45 (1. 05) [1. 35] 1. 42 (3. 09) [12. 91] 83. 63 (102. 58) 1. 02 (4. 66) [5. 16] 4. 12 (1. 36) [10. 21] 1. 04 (1. 94) [0. 85] ???2. 47 (???4. 22) [???6. 12] ???14. 06 (???14. 10) ???3. 53 (???12. 99) [???18. 24] 7. 40 (2. 07) [18. 51] ???216 (???3. 28) [???1. 82] ???3. 69 (???5. 19) [???9. 24] ???72. 39 (37. 75) ???5. 73 (???11. 55) [???113. 62] ???0. 80 (???0. 13) [???7. 69] 1. 67 (1. 58) [5. 42] 19. 71 (16. 73) [189. 52] INVESTMENT OPPORTUNITIES Market-to-Book ???4. 56 (???34. 69) [???17. 94] Regulation 14. 70 (25. 72) [31. 63] 0. 92 (2. 83) [0. 60] SIGNALING Abnormal Earnings
TAX Tax-Loss Carryforward Term-Structure ???0. 93 (???7. 67) [???5. 60] 5. 69 (82. 70) [69. 56] 0. 23 36,297 ???1. 11 (???1. 18) [???55. 20] 0. 02 30,566 ???9. 48 (???73. 70) [???128. 54] 0. 17 30,566 11. 06 (71. 58) [151. 57] 0. 18 30,566 5. 75 (22. 02) [301. 95] 0. 01 30,566 SIZE Firm Value Adjusted R2 No. of Observations 1. Dependent variables expressed as percentages of total debt. 2. t-statistics in parentheses; economic impact measures in brackets. ket-to-book ratios) use larger proportions of shortterm debt (see Table 5). This result is both statistically significant (t = ???34. ) and economically material Lessons on Capital Structure from LBOs. In a discussion of recent changes in the financial structure of LBOs (in the article immediately following), Jay Allen, Senior Managing Director of Bank of America, makes the following observation: “In contrast to the LBOs of the ’80s, [in the 90s] there has been considerably more more attention paid to the appropriate debt-to-equity ratio for specific deals. For example, in financing the LBO of a standard manufacturing company in a relatively mature industry, Bank of America will typically structure a 6-7 year senior bank moving from the 10th to the 90th percentile of market-to-book reduces the ratio of long-term debt to total debt by 17. 9 percentage points). term loan and revolving credit facility. The amount of the senior debt will typically be 3-4 times EBITDA, with sponsorcontrolled capital composing 20-25% of the capital structure. By contrast, in financing recent LBOs of highergrowth, technology-driven investments by Welsh, Carson, Anderson, & Stowe and DLJ Merchant Banking, we provided senior bank facilities with 3-4 year maturities and senior debt-to-EBITDA multiples of under 2. ; and sponsor-controlled capital represented more than 35% of the capital structure. 13 VOLUME 8 NUMBER 4 WINTER 1996 Priority. The regressions in Table 4 also indicate that firms with more growth options in their investment opportunity sets issue fewer fixed claims of all priority classes. This, too, is consistent with previous results on leverage ratios indicating that firms with more growth options tend to have less debt in their capital structures. The economic impact appears material.
Changing the market-to-book ratio from the 10th to the 90th percentile reduces leasing by 89%, secured debt by 71%, ordinary debt by 78%, and subordinated debt by almost 250%. Findings reported in Table 5 indicate that firms with more growth opportunities issue a significantly larger proportion of higher-priority fixed claims???or, alternatively, a lower proportion of unsecured or junior debt???than low-growth firms. The Structure of Debt Financing in Silicon Valley. Founded in 1983, Silicon Valley Bancshares has traditionally served the needs of high-tech companies in California and elsewhere.
Recently, it has expanded into industry “niches” most commercial banks tend to avoid???telecommunications and software start-ups, bio-tech firms, and small manufacturers of medical devices. “In lending to small, high-risk businesses,” comments former CFO Dennis Uyemura, “there are a few very basic rules to observe: (1) Keep the debt ratios very low, of course, and try to ensure the borrower has substantial cash reserves; (2) Keep the maturities short, to preserve flexibility for lender and borrower alike; and (3) Secure everything you can.
Attaching assets not only increases your chances of getting paid back, but also deters borrowers from bringing in junior creditors. Junior creditors are likely to cause big problems if the firm has trouble servicing the debt. ” To estimate the effects of regulation, we constructed a “dummy variable” that was set equal to one for firms in regulated industries and zero otherwise. The regulated industries we examine are two: gas and electric utilities (as represented in SIC codes 4900 to 4939) and telecommunications (SIC 4812 and 4813) through 1982.
Consistent with our argument about the investment opportunity set, regulation has both a statistically and economically material impact on leverage. Based on the coefficient from the regression reported in Table 4, regulation is expected to increase leverage ratios by about 11 percentage points (t = 34. 87), which amounts to a 55% increase in the average leverage ratio of our entire sample. Other things equal, regulation increases long-term debt by 11. 5 percentage points while reducing short-term debt by 1. 3 percentage points. These effects are statistically significant (t = 50. 2 for long-term debt and t = -5. 93 for short-term debt) and economically material (101% for long-term debt and ???11. 54% for short-term debt. Finally, regulated firms use fewer leases, but more secured debt and ordinary debt. These effects are also economically material (???254% for capitalized leases, 51% for secured debt, and 110% ordinary debt. ) If we examine maturity and priority classes as a fraction of total fixed claims, we get a similar picture. As reported in Table 5, regulated firms use higher proportions of long-term debt and ordinary debt, but lower proportions of capitalized leases.
SIGNALING AND FINANCIAL STRUCTURE Some corporate finance scholars have argued that corporate managers making financing decisions are concerned primarily with the “signaling” effects of such decisions???for example, the tendency of stock prices to fall significantly in response to common stock offerings, but only slightly in response to straight debt offerings. According to signaling theory, outside capital is expensive (that is, firms are effectively forced to issue new capital at an “information discount”) because managers are in a position to know more than outside investors about the firm’s prospects.
And the more risky the security, the larger the information discount is likely to be. Consider the plight of a CFO who wishes to raise additional capital by selling additional debt or equity, but who believes that both of these securities are currently undervalued. If the undervaluation is 14 Maturity and Priority in Regulated Companies Another way of testing the effect of investment opportunities on corporate choices of leverage, maturity, and priority is to look at the special case of regulated companies.
Regulation effectively reduces the possibility for corporate underinvestment simply by transferring much of management’s discretion over investment decisions to regulatory authorities. State utility commissions, for example, oversee utilities’ investments in maintenance and capacity. Given such limits on managerial discretion, and the stability of cash flows ensured by the regulatory process, we would expect regulated firms to have more leverage and use longer-maturity debt than unregulated firms. JOURNAL OF APPLIED CORPORATE FINANCE
Contrary to the predictions of signaling theory, firms whose earnings were about to increase the following year issued less short-term debt and more long-term debt than firms whose earnings were about to decrease. Deregulation of the Telecommunications Industry. In 1982, the telecommunications industry was deregulated. Our theory would predict that this would cause leverage to fall and debt maturity to shorten. As shown in the adjacent figure, leverage ratios have fallen from almost 46% before 1980 to 23. 6% after 1985.
The ratio of longterm debt to total debt has also fallen from 76% before 1980 to 57% after 1985. (We would also expect deregulation to affect firms’ debt-priority mix. But, since COMPUSTAT does not report debt-priority information before 1981, we are unable to investigate this prediction for the telecommunications industry. ) sufficiently large, he might choose to forgo the issue altogether. If he chooses to proceed, however, a CFO intent on preserving value would choose to sell the security that is least undervalued. In this case, he will issue ebt rather than equity because debt is less sensitive to changes in firm value than equity; and he will issue short-term, senior debt rather than longterm, junior debt because the former is less undervalued. But, if the firm is overvalued, he is more likely to issue the most overvalued security???in this case, equity over debt, and long-term, subordinated rather than short-term, senior or secured debt. According to the signaling theory, then, undervalued (or “high-quality”) companies will have higher leverage, more short-term debt, and higher priority claims than overvalued (“low-quality”) firms.
To test these propositions, we classified as “high quality” all firms in a given year whose earnings (excluding extraordinary items and discontinued operations and adjusted for any changes in shares outstanding) increased in the following year; and we designated as low quality all firms whose ordinary earnings decreased in the next year. Leverage. In our leverage regression in Table 4, we find a negative relation between the size of the company’s earnings increase and its leverage ratio, a result that is inconsistent with the signaling hypothesis.
The economic impact of this quality variable, however, is negligible (0. 6%). Maturity. The evidence in Table 4 also appears inconsistent with the predictions of the signaling hypothesis with respect to debt maturity. Firms whose earnings were about to increase the following year in fact had less short-term debt and more longterm debt than firms whose earnings were about to decrease. Similarly, the evidence in Table 5 suggests that undervalued firms have a higher proportion of 15 long-term debt instead of the lower proportion predicted by the theory.
But, again, the economic impact appears immaterial in both cases. Priority. The evidence in Table 4 also offers little support for the signaling hypothesis. Whereas the theory predicts higher ordinary debt for firms about to experience earnings decreases, ordinary debt for such firms in fact turns out to be lower (although, again, the economic impact is small???less than ???3%); and the use of the other priority classes we examine is insignificantly different from that of the average firm in the sample.
As shown in Table 5, the ratio of ordinary debt to total debt is lower for low-quality than for high-quality firms (although, again, the economic impact is small???less than 2%). TAXES AND FINANCIAL STRUCTURE Leverage. The tax hypothesis predicts that companies with low effective marginal tax rates and high non-interest tax shields should have less debt in their capital structure. We use a “dummy” variable that identifies firms with tax-loss carryforwards to proxy for corporate tax status. Here we assume that firms with tax-loss carryforwards have the lowest effective marginal tax rates.
The tax hypothesis predicts a negative coefficient for the tax-loss carryforward variable in the leverage regression. In contrast to the prediction, however, the coefficient on the tax-loss carryforward variable in the leverage regression is actually positive and statistically significant (see Table 4). Nevertheless, this apparent anomaly can be readily explained as a case of “reverse causality. ” That is, companies with lots of tax-loss carryforwards generally acquire them by reporting losses, which reduce their market values and increase their leverage ratios. VOLUME 8 NUMBER 4 WINTER 1996
Maturity. Whenever the term structure of interest rates is not flat, the expected value of the firm’s interest tax shields depends on the maturity structure of its debt. Maturity structure can affect the value of tax shield because, if the firm defaults on its promised debt payments, it may never get to use those interest deductions. When the yield curve is upward sloping, the expected interest expense from issuing long-term debt is greater in the early years of the contract than the expected interest expense from rolling shortterm debt (and the opposite is true in later years of the contract).
To the extent the probability of default increases over time, a firm intent on maximizing the present value of its interest tax shield will use the longest maturity possible. Conversely, if the term structure is downward sloping, issuing short-term debt will maximize the value of the interest tax shield. Thus, the tax hypothesis implies that companies will employ more long-term debt when the term structure has a positive slope. 11 The results reported in Tables 4 and 5, however, provide no support for this tax hypothesis.
The coefficient for the term-structure variable is significantly negative in the long-term debt regression; that is, the more steeply-upward-sloping the yield curve, the more likely are companies to issue not long-term, but short-term debt. Priority. There are two principal ways in which the priority of debt is likely to affect corporate taxes. On the one hand, firms with low effective marginal tax rates (perhaps because of non-interest tax shields like tax-loss carryforwards) are likely to prefer leasing because it effectively allows the benefits of the tax shields to be shifted from the lessee/borrower back to the lessor/lender.
At the same time, the tax system encourages firms facing higher effective marginal tax rates to issue the lowest priority (and thus most risky) debt claims because interest payments on risky debt include a default premium that is tax deductible as paid. As a proxy for the firm’s marginal tax rate, we include a dummy variable that is equal to one if the firm has any taxloss carryforwards and thus has a low effective marginal tax rate. The evidence in Table 4 indicates that firms with more tax-loss carryforwards have significantly more 11. This tax hypothesis is presented in Ivan Brick and S.
Abraham Ravid, “On the Relevance of Debt Maturity Structure,” Journal of Finance 40 (1985). The argument assumes that the probability of default increases with time, and the value fixed claims of each priority class. Table 5 suggests that firms with more tax-loss carryforwards issue a higher proportion of both capitalized leases and subordinated debt, but less secured debt and ordinary debt. Although consistent with the argument about leasing, our results provide no support for the argument that firms with high marginal tax rates issue riskier debt.
Overall, then, our tests provide little support for the proposition that taxes have an important impact on corporate leverage choices. We should add, however, that this does not prove that tax considerations do not affect financing decisions. When companies are faced with financing alternatives that are close substitutes (for example, the choice between secured debt and leasing), tax consequences often prove to be the deciding factor. FIRM SIZE AND FINANCIAL STRUCTURE As one final test, we examined whether company size (measured as total capitalization) has a systematic effect on the firm’s financial architecture.
As noted earlier, it is important to control for firm size in this analysis to guard against the possibility that it is firm size???and say, the issue costs and debt sources associated with a given firm size???that is “driving” our earlier findings. For example, a skeptic might argue that the earlier-noted tendency of high-growth firms to have secured debt with shorter maturities may well just reflect that, for many small firms, banks are the only available source of funds. And banks, for reasons related more to regulation than to their borrowers’ needs, tend to provide only relatively short-term, senior loans.
Leverage. The positive firm-size coefficient in the leverage regression is statistically significant, thus implying that bigger firms have more leverage. However, the economic impact of firm size on leverage is relatively small. For example, the largest firms had leverage ratios that were only about one percentage point higher than the average of 21%. Maturity. Firm size is also likely to be potentially correlated with debt maturity for several reasons. As discussed earlier, issuance costs for public issues have a large fixed component, resulting in of the firm’s interest tax shield is reduced upon default.
This would occur, for example, if in reorganization the firm faces binding constraints on the use of taxloss carrybacks. 16 JOURNAL OF APPLIED CORPORATE FINANCE While providing little support for signaling and tax theories, our findings provide strong support for the argument that a firm’s financial architecture can be expected to be determined primarily by its investment opportunities. significant scale economies. Smaller firms are less able to take advantage of these scale economies; and, partly for this reason, they typically opt for private debt with its lower fixed costs.
And, just by virtue of choosing bank debt over public debt for its lower flotation costs, smaller firms will have more short-term debt. As expected, the coefficient for the log of firm value is positive and significant in the long-term debt regression in Table 4, but negative and significant in the short-term debt regression. The economic significance of this variable is also material: the two coefficients imply that moving from the 10th to the 90th percentile for firm size increases the fraction of long-term debt by 54% and reduces the fraction of short-term debt by 70%.
Similarly, the evidence in Table 5 suggests that larger firms issue more longterm debt as a fraction of total debt. Priority. We also expect firm size to affect corporate priority choices. Because public securities have large fixed costs and substantial scale economies, large firms should have a comparative advantage in issuing securities publicly. For example, this would imply that large firms would issue more preferred stock, since it is rarely privately placed, and fewer capital leases, since they are never issued publicly.
The evidence in Table 4 indicates that larger firms issue significantly more ordinary debt and subordinated debt, but significantly less capitalized leases and secured debt. The findings reported in Table 5 suggest that larger firms use less ordinary debt as a percentage of total debt, but there is no significant difference in their use of capitalized leases, secured debt, or subordinated debt as a fraction of total debt. In sum, there are discernible size effects that contribute to the significance of our results???particularly those suggesting the tendency of high-growth firms to issue high-priority debt with shorter maturities.
Nevertheless, even after controlling for such size effects, the variables intended to proxy for a firm’s investment opportunity set???market-to-book ratio and whether the firm is regulated or not???still appear to play a major role in corporate choices of debt maturity and priority. MICHAEL BARCLAY is Associate Professor of Finance at the University of Rochester’s William E. Simon School of Business Administration. CONCLUSION Most academic discussions of capital structure are based on the implicit assumption that all debt is the same.
In reality, of course, corporate debt instruments vary considerably with respect to features such as maturity, covenants, priority, and whether the debt is public or private. In this article, we present the results of our recent efforts to extend empirical studies of capital structure into two relatively new areas: maturity and priority. While providing little support for signaling and tax theories, our findings provide strong support for the argument that a firm’s financial architecture is determined primarily by its investment opportunities.
In brief, we find that companies with high market-to-book ratios (“growth firms”) tend to use less debt than companies with low market-to-book ratios (“mature firms”). Moreover, the lesser debt raised by growth firms also tends to have shorter maturity and higher priority than the debt issued by mature firms. We interpret such financing patterns as the result of efforts to preserve financing flexibility and proper investment incentives in growth firms while providing stronger managerial incentives for efficiency (and reducing taxes) in mature firms.
But if our results are suggestive, many important questions remain. As just one example, although we find a strong positive correlation between market to book and the proportion of short-term, secured debt in the capital structure, our tests do not allow us to distinguish how much of this correlation results from growth firms’ inability???because of their smaller size alone???to use unsecured, longer-term public debt.
We would really like to be able to distinguish between two separate effects: (1) how much of the variation in debt maturity and priority can be attributed to the choice of a given debt source; and (2) given that a certain firm has chosen bank debt or public debt, how much of the remaining variation can be explained using our proxies for the firm’s investment opportunity set, signaling opportunities, and tax position? Future research will undoubtedly tell us more about why firms choose public vs. private debt, and how they choose the call, convertibility, and other provisions attached to their debt.
CLIFFORD SMITH is the Clarey Professor of Finance at the William E. Simon School of Business Administration. 17 VOLUME 8 NUMBER 4 WINTER 1996 Journal of Applied Corporate Finance (ISSN 1078-1196 [print], ISSN 1745-6622 [online]) is published quarterly on behalf of Morgan Stanley by Blackwell Publishing, with of? ces at 350 Main Street, Malden, MA 02148, USA, and PO Box 1354, 9600 Garsington Road, Oxford OX4 2XG, UK. Call US: (800) 835-6770, UK: +44 1865 778315; fax US: (781) 388-8232, UK: +44 1865 471775, or e-mail: [email protected] blackwellpublishing. com.
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