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* This article was prepared for the Conference in Honor of Stew Myers that was held
September 5-6, 2008. We are grateful for the comments of conference participants, and
particularly for the many suggestions for improvement by the editor, Don Chew.
1. Miller (1988), p. 7.
2. Though, as Miller himself conceded in a paper also published in 1977, such tax
benets could be largely if not completely offset by taxes paid by individual holders of
debt (as well as any tax benets associated with equity). The current consensus on the
tax benets of debt, to the extent one exists, puts them in an intermediate range of 10-20
cents per dollar of debt.
would likely accept even without the assurance that the postrestructuring investment will be madewould be to reduce
the debt claim below $100 and give the creditors warrants
with an exercise price higher than $100. In this case, while
the upside provided by these warrants would compensate
the old creditors for their larger writedown, the equityholders would have greater incentive to invest because a smaller
portion of the payoffs from the new investment would accrue
to the old creditors in the bad scenario.7
least for mature companies with stable cash ows and limited
growth opportunities, is high leverage. By forcing such
companies to pay out (in the form of interest and principal)
cash ow that cannot be protably reinvested, debt nancing
has the potential to conserve value that might otherwise be
lost through negative-NPV investments. 14
The Liquidity Paradox. Thus, whereas Stew held up equity
nancing as the solution to a debt-induced underinvestment
problem, Mike Jensen saw debt as a means of curbing what
might be described as a corporate overinvestment problema
problem stemming from excess cash or liquidity.15 In Stews
early work on capital structure, he assumed that corporate
decisions are aimed primarily at maximizing rm value.
But in more recent work, he follows Jensen and Meckling
by entertaining the possibility that corporate managers have
motives other than value maximization.
For example, in a 1998 paper called The Paradox of
Liquidity, Stew and Raghuram Rajan (another of the coauthors of this article) explore a different kind of corporate
liquidity problem, but one that also has its roots in agency
costs. In this case, the conict is not the one between managers and shareholders discussed by Jensen and Meckling.
Rather its a conict between the managers (as representative
of the shareholders) of companies with lots of liquid assets
and the creditors of such companies. The problem is this:
unless the liquid assets are placed in a lock-box, management may have no credible way of ensuring that it will not
suddenly transform those assets in ways that hurt the creditors. To illustrate the problem, think of a bank that, having
just closed a large 10-year debt nancing after promising
to invest the proceeds in loans to large, investment-grade
companies, decides instead to take a big position in subprime
mortgage-backed securities. As this example is meant to show,
while liquidity helps ensure that assets can be sold for higher
values if and when creditors get their hands on them, the
chances of creditors actually getting their hands on them are
reduced by the possibility of managements converting them
into less liquid and riskier assets.
As a result of this ability to shift liquidity against the
creditors, would-be borrowers tend to nd extremely liquid
assets almost as hard to borrow against as highly illiquid
assets. This ability to transform assets against the interests
of creditorsliterally overnighthelps explain why investment banks tend to nd long-term capital so costly, despite
the liquidity of their own balance sheets, and why so much
circumstances. A similar argument was also presented by Nobel laureate Joseph Stiglitz
in a 1974 paper.
15. A number of nance scholars since then have attempted to integrate these two
counterbalancing factorsthe underinvestment problem associated with too much debt
and the free cash ow problem associated with too littleinto a unied theory of capital
structure. Among the most notable is a modeling framework presented in a 1995 paper
by Oliver Hart and John Moore that explores how these two offsetting factors are expected to inuence the nancing decisions of companies with different levels of (cash
ow) protability and growth opportunities.
22. An example of the latter is Stews work with Saman Majd on abandonment options. See Myers and Majd (1984).
23. The tremendous growth in the appeal and range of applications of real options in
the last 25 years has been attributed by many to the increasing rates of change and
volatility in markets, which reinforces the importance for managers of positioning their
rms to respond to uncertainty. For an early work that codied this body of work on real
options and linked it to the literature on investment decisions under uncertainty, see
Avinash Dixit and Robert Pindyck, Investment under Uncertainty (1994).
24. From the Supreme Court Decision on Federal Power Commission et al. v. Hope
Natural Gas Company, 320 U.S. 591 (1949) at 603.
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25. In a series of papers, Stew put forward a range of arguments and evidence showing why this basic methodology was the most practical and robust, and why it was superior to other ways of nding of rates of return (see, for example, Myers 1972b, 1973a,
1973b, and 1978). Myers and Borucki (1994) contains a case study of a sample electric and gas utilities to investigate one of the main alternative methods for nding costs
of equity capital. This alternative methodology involves backing out the equity rate of
return for each company from the current stock price and projections of future cash ows
based on analyst estimates. For many of the companies investigated, the costs of equity
found in this way are plausible. However, there is considerable noise in the estimates and
this suggests that benchmark averages rather than single-company estimates should be
used. More importantly, the results suggest that methodologies such as those based on
the CAPM should also be used for conrmation.
The value of regulated utilities was also affected greatly by the high ination of the
1970s and 1980s. The standard method of utility regulation involved measuring the rate
base in terms of original cost. However, in inationary times this leads to front-end loading as ination eats away the value of the original cost. Myers, Kolbe and Tye (1985)
show how an alternative called the trended original cost rate base can adjust for this
problem by increasing the rate base with ination (but with the unwanted consequence
of providing a windfall gain to current shareholders. The moderation in ination in the
1980s and the low ination that was experienced in 1990s and early to mid 2000s
meant that this kind of change became unnecessary, but the need for it may be revived
in the coming years.
26. See Phillips, Cummins and Allen (1998), which uses the techniques developed
in Black and Cox (1976) and Merton (1977) to determine the price of insurance by line
using only line-specic liability growth rates and the overall risk of the rm.
11
References
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Paper, Sloan School, Massachusetts Institute of Technology.
S. Bhattacharya and A. Faure-Grimaud, 2001, The Debt
Hangover: Renegotiation with Non-contractible Investment,
Economics Letters, Vol. 70(3), pp. 413-419.
F. Black and J. Cox, 1976, Valuing Corporate Securities: Some Effects of Bond Indenture Provisions, Journal of
Finance, Vol. 31(2), pp. 351-367.
R. A. Brealey, S.C. Myers, and F. Allen, 2008, Principles of
Corporate Finance, 9th Edition, New York, McGraw-Hill.
R.A. Brealey, S.C. Myers, and A. Marcus, 2007,
Fundamentals of Corporate Finance, 5th Edition. New York,
McGraw-Hill.
C. Calomiris and C. Kahn, 1991, The Role of Demandable Debt in Structuring Optimal Banking Arrangements,
American Economic Review, Vol. 81(3), pp. 497-513.
D.W. Diamond and R.G. Rajan, 2001, Liquidity Risk,
Liquidity Creation, and Financial Fragility: a Theory of
Banking, Journal of Political Economy, Vol. 109(2), pp. 287327. Available at SSRN: http://papers.ssrn.com/sol3/papers.
cfm?abstract_id=112473.
O.D. Hart and J.H. Moore, 1995, Debt and Seniority: an Analysis of the Role of Hard Claims in Containing
Management, American Economic Review, Vol. 85(3), pp.
567-585.
K. Froot, D. Scharfstein, and J. Stein, 1989, Debt
Forgiveness, Indexation, and Investment Incentives, Journal
27. In brief, the method involves nding a base-level discount rate that equates the
value of after-tax cash ows to investors with the required investment. This base level is
then adjusted to account for uncertainty and the asymmetric nature of the returns due
to the sunk costs.
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Available at http://faculty.chicagogsb.edu/randall.kroszner/
research/repudiation4.pdf.
B. Lambrecht and S.C. Myers, 2008, Debt and Managerial Rents in a Real-options Model of the Firm, forthcoming
Journal of Financial Economics. Available at SSRN: http://
papers.ssrn.com/sol3/papers.cfm?abstract_id=908065.
R.C. Merton, 1977, An Analytical Derivation of the
Cost of Deposit Insurance and Loan Guarantees: An Application of Modern Option Pricing Theory, Journal of Banking
and Finance, Vol. 1(4), pp. 3-11.
F. Modigliani and M.H. Miller,1958, The Cost of
Capital, Corporation Finance and the Theory of Investment,
American Economic Review, Vol. 48(3), pp. 261-297.
M. H. Miller, 1988, The Modigliani-Miller Propositions After Thirty Years, Journal of Economic Perspectives,
Vol. 2(4), pp. 99-120.
S. C. Myers, 1968, A Time-State-Preference Model of
Security Valuation, Journal of Financial and Quantitative
Analysis, Vol. 3(1), pp. 1-33.
S. C. Myers,1972a, Application of Finance Theory to
Public Utility Rate Cases, Bell Journal of Economics and
Management Science, Vol. 3(1), pp. 58-97.
S. C. Myers, 1972b, On the Use of in Regulatory
Proceedings: A Comment, Bell Journal of Economics and
Management Science, Vol. 3(2), pp, 622-627.
S. C. Myers, 1973a, A Simple Model of Firm Behavior
under Regulation and Uncertainty, Bell Journal of Economics
and Management Science, Vol. 4(1), pp. 304-315.
S. C. Myers, 1973b, On Public Utility Regulation under
Uncertainty. Risk and Regulated Firms, Ed: R.H. Howard,
Lansing, MI: Michigan State University Public Utilities
Papers.
S. C. Myers, 1974, Interactions of Corporate Financing
and Investment Decisions -- Implications for Capital Budgeting, Journal of Finance, Vol. 29(1), pp. 1-25.
S. C. Myers, 1977, Determinants of Corporate Borrowing, Journal of Financial Economics, Vol. 5(2), pp. 147-175.
S. C. Myers, 1978, On the Use of Modern Portfolio
Theory in Public Utility Rate Cases: A Comment, Financial
Management, Vol. 7(3), pp. 66-68.
Management
S. C. Myers, 1984, The Capital Structure Puzzle,
Journal of Finance, Vol. 39(3), pp. 575-592.
Journal of Applied Corporate Finance Volume 20 Number 4
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