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Acknowledgements While bearing my name as sole author, this book is largely a collective undertaking and would not exist without the talent and generosity of a large number of people. First of all, this book owes much to my collaboration with Bengt Holmström. Many chapters indeed borrow unrestrainedly from joint work and discussions with him. This book benefited substantially from the input of researchers and students who helped fashion its form and its content. I am grateful to Philippe Aghion, Arnoud Boot, Philip Bond, Giacinta Cestone, Gilles Chemla, Jing-Yuang Chiou, Roberta Dessi, Mathias Dewatripont, Emmanuel Farhi, Antoine Faure-Grimaud, Daniel Gottlieb, Denis Gromb, Bruno Jullien, Dominique Olié Lauga, Josh Lerner, Marco Pagano, Parag Pathak, Alessandro Pavan, Marek Pycia, Patrick Rey, Jean-Charles Rochet, Bernard Salanié, Yossi Spiegel, Anton Souvorov, David Sraer, Jeremy Stein, Olga Shurchkov, David Thesmar, Flavio Toxvaerd, Harald Uhlig, Michael Weisbach, and several anonymous reviewers for very helpful comments. Jing-Yuang Chiou, Emmanuel Farhi, Denis Gromb, Antoine Faure-Grimaud, Josh Lerner, and Marco Pagano in particular were extremely generous with their time and gave extremely detailed comments on the penultimate draft. They deserve very special thanks. Catherine Bobtcheff and Aggey Semenov provided excellent research assistance on the last draft. Drafts of this book were taught at the Ecole Polytechnique, the University of Toulouse, the Massachusetts Institute of Technology (MIT), Gerzensee, the University of Lausanne, and Wuhan University; I am grateful to the students in these institutions for their comments and suggestions. I am, of course, entirely responsible for any remaining errors and omissions. Needless to say, I will be grateful to have these pointed out; comments on this book can be either communicated to me directly or uploaded on the following website: http://www.pupress.princeton.edu/titles/8123.html Note that this website also contains exercises, answers, and some lecture transparencies which are available for lecturers to download and adapt for their own use, with appropriate acknowledgement. Pierrette Vaissade, my assistant, deserves very special thanks for her high standards and remarkable skills. Her patience with the many revisions during the decade over which this book was elaborated was matched only by her ever cheerful mood. She just did a wonderful job. I am also grateful to Emily Gallagher for always making my visits to MIT run smoothly. At Princeton University Press, Richard Baggaley, my editor, and Peter Dougherty, its director, provided very useful advice and encouragement at various stages of the production. Jon Wainwright, with the help of Sam Clark, at T&T Productions Ltd did a truly superb job at editing the manuscript and typesetting the book, and always kept good spirits despite long hours, a tight schedule, and my incessant changes and requests. I also benefited from very special research environments and colleagues: foremost, the Institut d’Economie Industrielle (IDEI), founded within the University of Toulouse 1 by Jean-Jacques Laffont, for its congenial and stimulating environment; and also the economics department at MIT and the Ecole Nationale des Ponts et Chaussées (CERAS, now part of Paris Sciences Economiques). The friendly encouragement of my colleagues in those institutions was invaluable
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xii Acknowledgements My wife, Nathalie, and our children, Naïs, Margot, and Romain, provided much understanding, support, and love during the long period that was needed to bring this book to fruition. Finally, may this book be a (modest) tribute to Jean-Jacques Laffont. Jean-Jacques prematurely passed away on May 1, 2004. I will always cherish the memory of our innumerable discussions, over the twenty-three years of our collaboration, on the topics of this book, economics more generally, his many projects and dreams, and life. He was, for me as for many others, a role model, a mentor, and a dear friend
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Introduction This introduction has a dual purpose: it explains the book’s approach and the organization of the chapters; and it points up some important topics that receive insufficient attention in the book (and provides an inexhaustive list of references for additional reading). This introduction will be of most use to teachers and graduate students. Anyone without a strong economics background who is finding it tough going on a first reading should turn straight to Chapter 1. Overview of the Field and Coverage of the Book The field of corporate finance has undergone a tremendous mutation in the past twenty years. A substantial and important body of empirical work has provided a clearer picture of patterns of corporate financing and governance, and of their impact for firm behavior and macroeconomic activity. On the theoretical front, the 1970s came to the view that the dominant Arrow–Debreu general equilibrium model of frictionless markets (presumed perfectly competitive and complete, and unhampered by taxes, transaction costs, and informational asymmetries) could prove to be a powerful tool for analyzing the pricing of claims in financial markets, but said little about the firms’ financial choices and about their governance. To the extent that financial claims’ returns depend on some choices such as investments, these choices, in the complete market paradigm of Arrow and Debreu, are assumed to be contractible and therefore are not affected by moral hazard. Furthermore, investors agree on the distribution of a claim’s returns; that is, financial markets are not plagued by problems of asymmetric information. Viewed through the Arrow–Debreu lens, the key issue for financial economists is the allocation of risk among investors and the pricing of redundant claims by arbitrage. Relatedly, Modigliani and Miller in two papers in 1958 and 1963 proved the rather remarkable result that under some conditions a firm’s financial structure, for example, its choice of leverage or of dividend policy, is irrelevant. The simplest set of such conditions is the Arrow–Debreu environment (complete markets, no transaction costs, no taxes, no bankruptcy costs).1 The value of a financial claim is then equal to the value of the random return of this claim computed at the Arrow–Debreu prices (that is, the prices of state-contingent securities, where a state-contingent security is a security delivering one unit of numéraire in a given state of nature). The total value of a firm, equal to the sum of the values of the claims it issues, is thus equal to the value of the random return of the firm computed at the Arrow– Debreu prices. In other words, the size of the pie is unaffected by the way it is carved. Because we have little to say about firms’ financial choices and governance in a world in which the Modigliani–Miller Theorem applies, the latter acted as a detonator for the theory of corporate finance, a benchmark whose assumptions needed to be relaxed in order to investigate the determinants of financial structures. In particular, the assumption that the size of the pie is unaffected by how this pie is distributed had to be discarded. Following the lead of a few influential papers written in the 1970s (in particular, Jensen and Meckling 1976; Myers 1977; Ross 1977), the principal direction of inquiry since the 1980s has been to introduce agency problems at various levels of the corporate structure (managerial team, specific claimholders). 1. For more general conditions, see, for example, Stiglitz (1969, 1973, 1974) and Duffie (1992)
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2 Introduction This shift of attention to agency considerations in corporate finance received considerable support from the large empirical literature and from the practice of institutional design, both of which are reviewed in Part I of the book. Chapters 1 and 2 offer introductions to corporate governance and corporate financing, respectively. They are by no means exhaustive, and do not do full justice to the impressive body of empirical and institutional knowledge that has been developed in the last two decades. Rather, these chapters aim at providing the reader with an overview of the key institutional features, empirical regularities, and policy issues that will motivate and guide the subsequent theoretical analysis. The theoretical literature on the microeconomics of corporate finance can be divided into several branches. The first branch, reviewed in Part II, focuses entirely on the incentives of the firm’s insiders. Outsiders (whom we will call investors or lenders) are in a principal–agent relationship with the insiders (whom we will call borrowers, entrepreneurs, or managers). Informational asymmetries plague this agency relationship. Insiders may have private information about the firm’s technology or environment (adverse selection) or about the firm’s realized income (hidden knowledge);2 alternatively outsiders cannot observe the insiders’ carefulness in selecting projects, the riskiness of investments, or the effort they exert to make the firm profitable (moral hazard). Informational asymmetries may prevent outsiders from hindering insider behavior that jeopardizes their investment. Financial contracting in this stream of literature is then the design of an incentive scheme for the insiders that best aligns the interests of the two parties. The outsiders are viewed as passive cash collectors, who only check that the financial contract will allow them to recoup on average an adequate rate of return on their initial investment. Because outsiders do not interfere in management, the split of returns among them (the outsiders’ return is defined as a 2. The distinction between adverse selection and hidden knowledge is that insiders have private information about exogenous (environmental) variables at the date of contracting in the case of adverse selection, while they acquire such private information after contracting in the case of hidden knowledge. residual, once insiders’ compensation is subtracted from profit) is irrelevant. That is, the Modigliani– Miller Theorem applies to outside claims and there is no proper security design. One might as well assume that the outsiders hold the same, single security. Chapter 3 first builds a fixed-investment moralhazard model of credit rationing. This model, together with its variable-investment variant developed later in the chapter, will constitute the workhorse for this book’s treatment. It is then applied to the analysis of a few standard themes in corporate finance: the firm’s temptation to overborrow, and the concomitant need for covenants restricting future borrowing; the sensitivity of investment to cash flow; and the notion of “debt overhang,” according to which profitable investments may not be undertaken if renegotiation with existing claimants proves difficult. Third, it extends the basic model to allow for an endogenous choice of investment size. This extension, also used in later chapters, is here applied to the derivation of a firm’s borrowing capacity. The supplementary section covers three related models of credit rationing that all predict that the division of income between insiders and outsiders takes the form of inside equity and outside debt. Chapter 4 analyzes some determinants of borrowing capacity. Factors facilitating borrowing include, under some conditions, diversification, existence of collateral, and willingness for the borrower to make her claim illiquid. In each instance, the costs and benefits of these corporate policies are detailed. In contrast, the ability for the borrower to renegotiate for a bigger share of the pie reduces her ability to borrow. The supplementary section develops the themes of group lending and of sequential-projects financing, and draws their theoretical connection to the diversification argument studied in the main text. Chapter 5 looks at multiperiod financing. It first develops a model of liquidity management and shows how liquidity requirements and lines of credit for “cash-poor” firms can be natural complements to the standard solvency/maximum leverage requirements imposed by lenders. Second, the chapter shows that the optimal design of debt maturity and the “free-cash-flow problem” encountered by cashrich firms form the mirror image of the “liquidity
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Introduction 3 shortage problem” faced by firms generating insuf- ficient net income in the short term. In particular, the model is used to derive comparative statics results on the optimal debt maturity structure. It is shown, for example, that the debt of firms with weak balance sheets should have a short maturity structure. Third, the chapter provides an integrated account of optimal liquidity and risk management. It first develops the benchmark case in which the firm optimally insulates itself from any risk that it does not control. It then studies in detail five theoretical reasons why firms should only partially hedge. Finally, the chapter revisits the sensitivity of investment to cash flow, and demonstrates the possibility of a “soft budget constraint.” Chapter 6 introduces asymmetric information between insiders and outsiders at the financing stage. Investors are naturally concerned by the prospect of buying into a firm with poor prospects, that is, a “lemon.” Such adverse selection in general makes it more difficult for insiders to raise funds. The chapter relates two standard themes from the contracttheoretic literature on adverse selection, market breakdown, and cross-subsidization of bad borrowers by good ones, to two equally familiar themes from corporate finance: the negative stock price reaction associated with equity offerings and the “pecking-order hypothesis,” according to which issuers have a preference ordering for funding their investments, from retained earnings to debt to hybrid securities and finally to equity. The chapter then explains why good borrowers use dissipative signals; it again revisits familiar corporate finance observations such as the resort to a costly certifier, costly collateral pledging, short-term debt maturities, payout policies, limited diversification, and underpricing. These dissipative signals are regrouped under the general umbrella of “issuance of low-information-intensity securities.” Chapter 7, a topics chapter, first analyzes the two-way interaction between corporate finance and product-market competition: how do market characteristics affect corporate financing choices? How do other firms, rivals or complementors, react to the firm’s financial structure? Direct (profitability) and indirect (benchmarking) effects are shown to affect the availability of funds as well as financial structure decisions (debt maturity, financial muscle, corporate governance). The chapter then extends the class of insider incentive problems. While the standard incentive problem is concerned with the possibility that insiders waste resources and reduce average earnings, managers can engage in moral hazard in other dimensions, not so much to reduce their efforts or generate private benefits, but rather to alter the very performance measures on which their reward, their tenure in the firm, or the continuation of the project are based. We call such behaviors “manipulations of performance measures” and analyze three such behaviors: increase in risk, forward shifting of income, and backward shifting of income. The second branch of corporate finance addresses both insiders’ and outsiders’ incentives by taking a less passive view of the role of outsiders. While they are disconnected from day-to-day management, outsiders may occasionally affect the course of events chosen by insiders. For example, the board of directors or a venture capitalist may dismiss the chief executive officer or demand that insiders alter their investment strategy. Raiders may, following a takeover, break up the firm and spin off some divisions. Or a bank may take advantage of a covenant violation to impose more rigor in management. Insiders’ discipline is then provided by their incentive scheme and the threat of external interference in management. The increased generality brought about by the consideration of outsiders’ actions has clear costs and benefits. On the one hand, the added focus on the claimholders’ incentives to control insiders destroys the simplicity of the previous principal–agent structure. On the other hand, it provides an escape from the unrealism of the Modigliani–Miller Theorem. Indeed, claimholders must be given proper incentives to intervene in management. These incentives are provided by the return streams attached to their claims. The split of the outsiders’ total return among the several classes of claimholders now has real implications and security design is no longer a trivial appendix to the design of managerial incentives. This second branch of corporate finance can itself be divided into two subbranches. The first, reviewed