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Dynamic Corporate Finance Under Costly Equity Issuance Dynamic Corporate Finance under Costly Equity Issuance Patrick Bolton and Neng Wang Two fundamental concepts in cor- Although tax distortions and bank- (3) equity issuance costs and cash carry porate finance are the net present value ruptcy costs are obviously relevant, they costs.3 A first, key result of our analy- (NPV) rule and the Modigliani-Miller cannot alone account for most observed sis is that investment is no longer deter- (MM) irrelevance proposition. When corporate financial decisions. They can- mined by equating the marginal cost of financial markets operate without fric- not explain why companies hold so much investing with the marginal addition to tions, when investors can trade securi- cash, their leverage dynamics, nor their the firm’s valuation from such capital, as ties that correspond to all relevant risks, payout, equity issuance, and investment in the neoclassical theory of investment. when investors and managers share the policies. We show in our research that the Instead, investment is determined by the same information, when incentives are cost of issuing equity is a key and practi- ratio of the marginal increase in the firm’s aligned, and when there are no tax distor- cally relevant distortion. Because of asym- value to the marginal value of cash. The tions, then corporate finance boils down metric information or incentive misalign- marginal cost of investing equals the mar- to a valuation exercise and a simple invest- ment, firms must incur costs when raising ginal product of capital, also known as ment decision rule: undertake all invest- external funds1 and these costs are higher marginal q, divided by the marginal value ments with a positive NPV. How com- for equity than for debt financing.2 of cash. panies and investments are financed is When firms face external financing When firms are flush with cash, the irrelevant. costs, they seek to avoid such financ- marginal value of cash is about one, so This characterization of financial ing. This is a key reason that firms retain that this equation is approximately the markets is frequently taken as approxi- earnings and accumulate cash (corpo- same as the equation under MM irrel- mately valid; a plausible and convenient rate savings). With Hui Chen, we ana- evance. But when firms are close to run- simplification even if it poorly reflects lyze a dynamic model with three main ning out of internal funds, or close to the reality. Corporate income taxation, the building blocks: (1) an investment rule limit of their credit line, the marginal interest tax shield for debt, and bank- based on the marginal value of incremen- value of cash is much larger than one, so ruptcy costs are often the only deviations tal capital investment relative to its cost, that marginal product may need to yield a from this view that are considered when (2) cash, equity, and a credit line as fund- much higher return, and optimal invest- explaining corporate financing choices. ing sources (together with hedging), and ment may be far lower, than the level pre- Patrick Bolton is the Barbara and David Zalaznick Professor of Business at Columbia University and a visiting professor at Imperial College London. An NBER research associate in the Corporate Finance Program, he is a past president of the American Finance Association, a fellow of the Econometric Society and the American Academy of Arts and Sciences, and a corre- sponding fellow of the British Academy. He has coauthored Contract Theory (2005) with Mathias Dewatripont and The Green Swan: Central Banking and Financial Stability in the Age of Climate Change (2020) with Morgan Despres, Luiz Pereira Da Silva, Frédéric Samama, and Romain Svartzman. Neng Wang is the Chong Khoon Lin Professor of Real Estate and Finance at Columbia Business School. He is also a research associate in the NBER’s Asset Pricing Program and a senior research fellow at the Asian Bureau of Finance and Economic Research. Wang is an associate editor of The Journal of Finance and was an editor in finance atManagement Science. His research interests include corporate finance, asset pricing, and macroeconomics. Wang was born and raised in China. He received his BS in chemistry from Nanjing University, an MS in chemistry from the California Institute of Technology, an MA in international relations from the University of California, San Diego, and his PhD in finance from Stanford University in 2002. He lives in Scarsdale, NY, with his wife and three children. 10 NBER Reporter • No. 2, June 2021 dicted under MM neutrality. age cash-to-assets ratio for US public cor- or boom times, when external financing Figure 1 illustrates the sizable value porations more than doubled from 1980 costs are affordable (cheap), firms opti- destruction that a financial crisis can to 2006, and remained elevated after the mally time their equity offerings and issue cause, as firms are shut out of capital mar- 2008 financial crisis.6 equity even when there is no immediate kets and can only rely on internal funds to need for external funds. Along with the continue their operations.4 Panels A and Market Timing and timing of equity issuance by firms with B show that firm value is increasing and Financial Crises low cash holdings in good market con- concave in cash holdings, that the mar- ditions, there is also optimal timing of ginal value of cash always exceeds one, Our model predicts that cash hold- stock repurchases by firms with large cash and that it is very large when the firm ings increase when earnings volatility holdings. Just as firms with low cash hold- runs out of cash. Panel C shows that firms rises, but this is not an adequate explana- ings seek to take advantage of low costs substantially cut investment and engage tion for the rise in corporate savings. A of external financing to raise more funds, in very costly fire sales firms with high hold- when liquidity is low. ings will be inclined The firm values a dollar Corporate Cash Balances, Investment, and Valuation to disburse their cash in hand at about $30 through stock repur- A. Firm value/capital ratio B. Marginal value of cash and sells about 60 per- 1.6 30 chases when financing cent of its productive First-best 25 conditions improve. 1.4 capital at a significant 20 This result is consistent value discount when it 1.2 15 with the finding that is close to being inef- aggregate equity issu- Liquidation 10 ficiently liquidated, 1.0 ances and stock repur- 5 in sharp contrast to chases are positively 0.8 0 8 the predictions of the 0.00 0.05 0.10 0.15 0.20 0.25 0.00 0.05 0.10 0.15 0.20 0.25 correlated. When the neoclassical theory of Cash/captial ratio Cash/captial ratio perceived probability investment. Finally, C. Investment-capital ratio D. Investment-cash sensitivity of a crisis rises, firms Panel D reveals how 0.4 20 invest more conser- First-best nonlinear and non- 15 vatively, issue equity monotonic invest- 0.0 sooner, and delay pay- 10 ment-cash sensitivity Liquidation outs to shareholders, all -0.4 can be, indicating that 5 to increase cash hoards investment-cash sensi- that will help them tivity is a poor measure -0.8 0 through the impend- of how financially con- 0.00 0.05 0.10 0.15 0.20 0.25 0.00 0.05 0.10 0.15 0.20 0.25 ing crisis. Finally, we strained a firm is.5 Cash/captial ratio Cash/captial ratio demonstrate that firms’ A second key Source: Bolton P, Chen H, and Wang N. NBER Working Paper 14845, and published as “A Unified Theory of Tobin's q, risk premia have two result concerns the Corporate Investment, Financing, and Risk Management” Journal of Finance, 66(5), October 2011, pp 1545–78 components: pro- firm’s optimal cash- ductivity and financ- inventory policy. That Figure 1 ing. Both risk pre- involves continuous management of cash more plausible explanation is the risk of mia change substantially with firms’ cash reserves through adjustments in invest- a financial crisis, which causes a jump in holdings, especially in a crisis when exter- ment, asset sales, and corporate hedging the cost of external financing and possibly nal financing conditions are poor. between two barriers: a lower bound at even a financial market shutdown. which the firm must tap external financ- With Chen, we further explore how Real Options and ing after exhausting all its cash reserves, firms’ financial policies are affected by Financial Flexibility and an upper bound at which the firm anticipation of random financial crises.7 has accumulated enough cash that it is We show that during such a crisis, firms Real-options theory, which applies safe to pay out any additional earnings. delay payout, cut investment, and engage when investments are lumpy and irrevers- Our model provides insights into how in fire sales of assets even when their ible, is an important subfield of corporate these bounds depend on factors such as productivity remains unaffected, all to finance that generally assumes that firms the growth rate and volatility of earn- avoid incurring prohibitive equity issu- operate in an MM environment. With ings, external financing costs, and capi- ance costs. This is especially true when Jinqiang Yang, we show that the presence tal adjustment costs. It can thus provide a firm enters the crisis with low cash of external financing costs fundamentally part of an explanation for why the aver- reserves. We also find that in normal alters the value and exercising decisions NBER Reporter • No. 2, June 2021 11 associated with real options.9 To avoid performance and to the outside options its target leverage.
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