Investment Strategy?

Consider, again, Example 18.3 with the added assumption that the firm also generates funds

internally.The cash flows and payoffs in the different states of the economy are described below.

Value (in $ millions) When

State of the Economy Is

Good

Medium

Bad

Value with investment	$250	$175	$125
Value without investment	50	50	50
Internal cash flow	100	25	100

Is it possible for the firm to select a debt ratio that allows the firm to fund the investment in

the medium and good state of the economy but not in the bad state of the economy?

Answer:It is not possible.The firm can be kept from financing what would be a nega-

tive NPVproject in the bad state of the economy by taking on

(a)a $100 million short-term debt obligation due when the initial cash flows are realized,

and

(b)an additional $26 million in senior debt (or any amount above $25 million) due in the

following year.

These debt obligations, which prevent the firm from borrowing additional amounts in thebad

state of the economy, also prevent the firm from investing in the medium state of the economy

even though doing so is a positive NPVinvestment.If the debt obligations are lowered to

allow the firm to finance its investments in the medium state of the economy, then the firm

also will be able to finance its operations in the bad state of the economy.

Result 18.8

Afirm’s debt level is a determinant of how much the firm will invest in the future and itcan be used to move the firm toward investing the appropriate amount. In general, how-ever, capital structure cannot by itself induce managers to invest optimally.

AMonitoring Role for Banks

Examples 18.3 and 18.4 assumed that the firm’s debt could not be renegotiated, which

is a reasonable assumption if the firm’s debt is held by diffuse debt holders. In this

regard, bank debt may have an advantage over public bonds since it is possible for the

firm to reduce free-rider and information problems if it is dealing with one banker

instead of a large number of bondholders. Therefore, a banker may be able to mitigate

the overinvestment-underinvestment problems described in the examples above by

evaluating the firm’s projects and deciding selectively whether to offer additional credit.

In Example 18.4, an underinvestment problem in the medium state of the economy

will arise if the firm issues $100 million in short-term debt as well as $26 million in

senior debt. The assumption made in this example was that the debt could not be

Grinblatt1298Titman: Financial	V. Incentives, Information,	18. How Managerial	© The McGraw1298Hill
Markets and Corporate	and Corporate Control	Incentives Affect Financial	Companies, 2002
Strategy, Second Edition		Decisions

Chapter 18

How Managerial Incentives Affect Financial Decisions

643

renegotiated even though debt holders would be better off in the medium state of the

economy if they forgave a portion of the firm’s debt obligation. However, if a bank

owns the debt, it will have an incentive to renegotiate the loan in the medium state of

the economy: Otherwise, the firm will go bankrupt and lose a positive NPVproject,

which would increase the value of the bank’s claim. The problem considered in Exam-

ple 18.4 can thus be solved by having the firm take on enough bank debt to prevent it

from taking on the negative NPVproject in the bad state of the economy and by allow-

ing the firm to renegotiate the debt obligation in the medium state of the economy.

Bank financing also may be beneficial when it is necessary to monitor manage-

ment. The free-rider problem which keeps individual shareholders from monitoring the

firm also probably keeps individual debt holders from doing much monitoring. This is

especially true for firms with low leverage ratios since, in this case, the debt holders

are likely to be paid in full even if management does poorly. However, if a firm is

highly leveraged and bankruptcy appears likely, the debt holders will have an incen-

tive to monitor management, especially if they have concentrated holdings.

Bank lending is particularly suited to serve this function since financial institutions

have the resources to hold a large fraction of a firm’s debt and are capable of moni-

toring management. Delegating the monitoring of management to their fixedclaimants

(debt holders) rather than their residual claimants (equity holders) also reduces the asset

substitution problem discussed in Chapter 16 (that is, the incentive of a firm’s man-

agement to choose risky projects that transfer wealth from debt holders to equity hold-

ers). However, if debt holders have more influence over management than equity hold-

ers, then managers, acting in the interests of their debt holders, may be too conservative

in their investment choices.

Another advantage of borrowing through a commercial bank arises for firms with

proprietary information. For example, a firm may be able to exploit favorable market

conditions only if competitors remain unaware of the situation. Hence, a public debt

offering, which reveals this information, places a firm at a competitive disadvantage.

However, if this information can be revealed confidentially to the lender, a firm can

obtain funds at attractive terms without revealing its information to competitors.

AMonitoring Role for Private Equity

Suppliers of private equity, like venture capital firms and leveraged buyouts sponsors,

may provide monitoring services that are similar to those banks provide. These suppli-

ers of private equity capital are likely to provide more monitoring of management for

at least three reasons. First, they generally take substantial equity stakes in the businesses

that they invest in; second, their shares cannot be sold as easily, giving the private equity

holders a greater stake in the long-term profitability of the firms they invest in. Finally,

they have personnel with the kind of expertise that can help the firms in which they

invest create value for their shareholders. In other words, the private equity and venture

capital firms provide advice and consulting as well as monitoring.