BRN482 Corporate Financial Policy Clifford W. Smith, Jr. Summer Overhead 4 * Covers readings on course outline through Smith/Warner (1979)

Bond Contracts Conflicts of Interest  Dividend payouts  Claim dilution  Asset substitution  Underinvestment

Bond Covenants Restrictions on:  Investment policy  Dividend policy  Financing policy  Required bonding activities

Bond Covenants  Restrictions on Investment – Direct restrictions on investment of physical assets seldom observed – Restrictions on financial investments – Restrictions on disposition of assets – Security provisions (i.e. mortgage loans) – Asset maintenance – Restrictions on mergers

Mergers Under what circumstances are bondholders made better off or worse off by a merger?

Mergers  Under what circumstances are bondholders made better off or worse off by a merger?  Suppose bondholders in the old firms receive bonds in the new firm with equal priority and the same contract provisions as before. B A (V, F, T, σ 2  r, DIV) vs B AB (V, F, T, σ 2  r, DIV)

Mergers Benchmark Case: In this benchmark case, the merger should leave the value of the bonds roughly unchanged V A + V B = V AB F A / V A = F AB / V AB = F B / V B T A = T B σ 2 A = σ 2 AB = σ 2 B ; ρ AB = 1 DIV A = DIV AB = DIV B

Deviations from the benchmark case. Suppose: B A B B V A + V B < V AB F A / V A < F AB / V AB < F B / V B T A < T B σ 2 A < σ 2 AB < σ 2 B σ 2 A > σ 2 AB < σ 2 B DIV A < DIV AB < DIV B Mergers

Deviations from the benchmark case. Suppose: B A B B V A + V B < V AB + + F A / V A < F AB / V AB < F B / V B - + T A < T B + - σ 2 A < σ 2 AB < σ 2 B - + σ 2 A > σ 2 AB < σ 2 B + + DIV A < DIV AB < DIV B - + Mergers

In what type of firms will bondholders be most concerned about mergers?  low debt  low variance  low dividend  bonds with long maturity Mergers

Solutions to the Underinvestment Problem Restrictions on dividends  Suppose I agree to a maximum dividend payment of $25 per period until the bond is repaid.

Dividend Restrictions Time Project A B – Bond Max Div = 25

Dividend Restrictions Time NVP Project A B – Bond Div (A+B) =125 Max Div = 25

Dividend Restrictions Time NVP Project A B – Bond DIV (A+B) =125 DIV (A-) =100 Max Div = 25

Who Benefits from Dividend Restrictions  Without Restriction Bond DIV2080 – =100  With Dividend Restriction Bond DIV (A+B) =125

Restrictions on Dividends Bond Covenants Dividend Reservoir Dividends Earnings and Stock Sales

 Inventory for Dividends  Dividend Constraint Dividend Restrictions D t < max [ 0, D t ] *

 Cash Flow Identity Uses of Funds = Sources of Funds D t + R t + P t + I t = CF t + S t + B t Dividend Restrictions

 Cash Flow Identity Uses of Funds = Sources of Funds D t + R t + P t + I t = CF t + S t + B t CF t = E t + DEP t + R t + L t  D t = E t + DEP t + L t + S t + B t  P t  I t Dividend Restrictions

 Combining the cash flow identity with the dividend constraint yields* Dividend Restrictions * Assuming the Dip, D = 0

 Combining the cash flow identity with the dividend constraint yields Dividend Restrictions

 Book Value   Book Value of Debt of Assets  Combining the cash flow identity with the dividend constraint yields

 Placing a ceiling on dividends effectively places a floor on real investment Dividend Restrictions  Book Value   Book Value of Debt of Assets

Dividend Restrictions  Improve dividend payout problem  Improve claim dilution problem  Improve underinvestment problem  May exacerbate asset substitution problem Dividend Restrictions

Restrictions on Financing  Option pricing analysis might lead you to predict "me first" rules in bond contracts  Instead, we observe restrictions on financial ratios such as: interest expense funded debt net tangible assetsearnings

Use of balance sheet vs income statement for financing restrictions Restrictions on Financing

Other Financing Issues  Leasing  Convertible Bonds  Callable Bonds  Sinking Funds

Solutions to the Underinvestment Problem Sinking fund provisions  A bond with a sinking fund provides for the repayment of some of the principle before expiration

Sinking Funds Time Project A B – Bond

Sinking Funds Time Project A B – Bond DIV A+B = =125

Sinking Funds Time Project A B – Bond DIV A+B = =125 DIV A- = =110

Bonding Activities  All financial statements sent to stockholders must also be sent to bondholders  Specify accounting techniques (GAAP)  Financial Reports Audited by Independent Auditor  Officers Certificate of Compliance  Purchase of Insurance