CORPORATIONS Creditors November 28, 2006

1
CORPORATIONS CreditorsNovember 28, 2006
2
CORPORATIONS Creditors
Set of Cost Minimizers
Set of Profit Maximizers
3
CORPORATIONS Creditors
4
CORPORATIONS Creditors Firm Size

• The previous lectures emphasized the efficiency
  and optimality of the form of business that a
  firm might adopt.
• For example, sole proprietorships carry the most
  flexibility, in the extreme, but sacrifice
• the advantages of distributing the risks of long
  term investment over many individuals,
• the economies of scale and
• specialization offered by incorporating the firm.

5
CORPORATIONS Creditors Firm Size

• V

Sole Shareholder Corporation
Vs E
Us Fs
F
6
CORPORATIONS Creditors Firm Size
V
Expansion Path of Firm at agency costs
0 Expansion path with optimal mix of credit and
equity
F
7
CORPORATIONSCreditors Firm Size

• V

Point where corporation becomes too big for owner
and owner can start buying additional needs on
the open market EBoundary
Vs E
Us Equity Expansion
Path Fs
Slope -1
F
8
CORPORATIONS Creditors Firm Size
V
Expansion Path of Firm at agency costs
0 Expansion Path of Firm at agency costs A
Agency costs A
E
Slope -1 Slope -a
F
9
CORPORATIONS Creditors Firm Size
V
Expansion Path of Firm at agency costs
0 Expansion path with optimal mix of credit and
equity Expansion Path of Firm at agency costs A
Agency costs A
E
F
10
CORPORATIONS Creditors
11
CORPORATIONS Creditors Insider Trading

• In the previous lectures, the two major
  investors in the firm were insiders and
  outsiders

12
CORPORATIONS Creditors Insider Trading
V
Utility Curve of Insider Insider Trading
Restricted Utility Curve of Insider
Insider Trading
Unrestricted
Slope -1 Slope -a
F
13
CORPORATIONS Creditors Insider Trading
V
Impact of manager shareholder on outside
shareholders
Vs E
E Us Fs
F
14
CORPORATIONS Creditors
15
CORPORATIONS Creditors

• Now what happens when one introduces a third
  party the lender or creditor?

16
CORPORATIONS Creditors

• .

Banks Debentures Bonds
17
CORPORATIONS Creditors

• Why can the failure of the entrepreneur or
  manager to maximize the value of the firm be
  perfectly consistent with efficiency?
• Why is the sale of common stock a viable source
  of capital even though managers do not maximize
  the value of the firm?
• Why is debt relied upon as a source of capital
  before debt financing irregardless of tax
  advantages?
• Why do companies issue preferred stock?

18
CORPORATIONS Creditors

• Modigliani and Miller (1958) argued that in the
  absence of bankruptcy costs and tax subsidies on
  the payment of interest, the value of the firm is
  independent of the financial structure.
• Modigliani and Miller later (1963) argued that
  the existence of tax subsidies on interest
  payments would cause the value of the firm to
  rise with the amount of debt financing by the
  amount of the capitalized value of the tax
  subsidy.
• This line of argument implies that the firm
  should be financed almost entirely with debt.

19
CORPORATIONS Creditors

• Jensen and Meckling argue that as long as the
  "agency cost of debt financing (issuing bonds to
  creditors) remains below the "agency cost" of
  equity, then more debt is optimal.
• The optimality of expanding debt for the firm
  ceases when the two types of "agency costs"
  become equal.
• Jensen and Meckling at 339-340

20
CORPORATIONS Creditors
21
CORPORATIONS Creditors Limited Liability

• Limited liability is a form of insurance to the
  shareholders.
• A firm is hit with a sudden downturn, or worse,
  an unforeseeable catastrophe, like Bhopal, India,
  in 1984, that causes the firm's liability to
  greatly exceed the total investment the
  shareholders made in the firm.
• Limited liability is a rule of law that attaches
  to the corporate firm of business association.

22
CORPORATIONS Creditors Limited Liability

• Imperfect Information
• Decreasing Marginal Costs Due to Precaution
• Increasing Marginal Costs Due To Production

C1
Strict Liability Rule MC1 Contracted Liability
Rule MC1 Expected Liability MC1
a1
23
CORPORATIONS Creditors Limited Liability

• Limited liability insures total liability to the
  shareholders will not exceed their total
  investment.
• Such a rule does not attach to sole proprietors
  or partners.
• In those firms total liability not only may
  exceed the investment, but may attach to the
  personal assets of the investors.

24
CORPORATIONS Creditors Limited Liability

• Imperfect Information
• Decreasing Marginal Costs Due to Precaution
• Increasing Marginal Costs Due To Production

C1
Limited Liability Rule Expected Liability
MC1
a1
25
CORPORATIONS Creditors Limited Liability

• Imperfect Information
• New Expectation Damages Rule Subject To The
  Limited Liability Rule

C1
Limited Liability Rule
a1
26
CORPORATIONS Creditors Limited Liability

• As with other forms of insurance, limited
  liability poses a "pooling problem".
• Pooling equilibria" emerge where different agents
  are expected to perform the same action under the
  same law.
• Different agents will do different actions,
  although they may "strategically" change their
  behaviour to act more uniformly.
• The group that performs below expectation commit
  a "moral hazard".

27
CORPORATIONS Creditors Limited Liability

• The agency costs of unlimited liability would be
  much higher than simply paying a premium in the
  form of higher interest rates to the creditors of
  the corporation in return for their acceptance of
  a contract which grants limited liability to the
  shareholders.
• The creditors would then bear the risk of any
  non-payment of debts in the event of the
  corporations bankruptcy. (Jensen and Meckling,
  p. 331)

28
CORPORATIONS Creditors Limited Liability

• Limited liability does not mean that every firm
  will take irrational risks, but some might.
• In these cases, limited liability, like other
  forms of insurance creates moral hazards.
• The most frequently discussed moral hazard of
  limited liability is bankruptcy.

29
CORPORATIONS Creditors
30
CORPORATIONS Creditors Liability Rules

• At common law, suits by creditors against debtors
  for unpaid debts were technically complex, drawn
  out and expensive.
• Those businesses that needed their money quickly
  sought other remedies, through their guilds,
  trade fairs or private "for hire" enforcers.

31
Banks Debentures Bonds
Revenue Canada, Judgments
Employees, Suppliers
32
CORPORATIONS Creditors Liability Rules

• In Italy, lenders adopted a custom of breaking
  (rupto) the selling stall (banco)of a defaulting
  debtor so that customers would know to pay the
  lenders directly instead of the debtor

33
CORPORATIONS Creditors Liability Rules

• The agency cost of debt financing appreciates
  significantly when the firm does not have
  sufficient net worth to pay all classes of
  creditors.
• The probability and cost of potential bankruptcy
  adversely effects the value of the firm.

34
CORPORATIONS Creditors Liability Rules

• Another drawback of bankruptcy is its finality.
  Bankruptcy kills the business.
• In an economy without a relatively costless
  bankruptcy procedure, competing creditors might
  seize assets critical to the corporation's
  operation and worsen an already suboptimal
  situation

35
CORPORATIONS Creditors Liability Rules

• What would be the main motivation for this kind
  of legislation?
• Difficulties of recontracting debts at common law
• Foakes v. Beer
• Gilbert Steel
• Prisoners Dilemna The Uncooperative Game
• Without the prioritization or hierarchy of
  creditors, there is a suboptimal Nash
  equilibrium

36
CORPORATIONS Creditors Liability Rules

• The common law also recognized the right of
  lenders to "contract" their own remedies in the
  agreement that accompanied the loan.
• Usually such agreements provided that legal title
  to the firm's assets be transferred to the lender
  for the duration of the loan.
• Railways and large manufacturing concerns were
  frequently controlled in this matter. Such
  lenders are treated as "secured lenders" with the
  highest priority over other creditors.

37
CORPORATIONS Creditors Liability Rules

• In the 1930s, both Canada and the United States
  passed legislation that enabled corporations to
  request breathing space to freeze creditor
  action while reorganization
• United States Chapter 11
• Canada Corporation Creditors Arrangement Act

38
CORPORATIONS Creditors Liability Rules

• Stelco case latest in a long line of cases that
  included
• Eatons
• Consumers Distributors
• Dylex
• Many others