External Equity Financing Research Articles

Renegotiation and the Impossibility of Optimal Investment

In a model with asymmetric information and external equity financing, it is impossible to achieve socially optimal investment because of renegotiation possibilities. The contractual solution suggested by Dybvig and Zender (1991) is not dynamically consistent--the manager's contract would be renegotiated, resulting in inefficient investment. Moreover, no other compensation contract that would induce the manager to invest efficiently survives renegotiation. Contracts that pay the manager based on the stock price, while producing suboptimal investment as in Myers and Majluf (1984), are robust to renegotiation. Article published by Oxford University Press on behalf of the Society for Financial Studies in its journal, The Review of Financial Studies.

International perspectives on the supply of informal venture capital

Despite major changes in the number and range of sources of finance for new and small ventures in the United Kingdom in recent years, there continues to be a shortage of risk capital for ventures actively seeking external equity finance. In the United States the informal venture capital market plays a major role in filling this equity gap, particularly in the early stages of venture development. However, there is little comparable information on the size of the informal venture capital pool in the United Kingdom or other European economies, despite recent recognition that the apparent underdevelopment of this market in the U.K. represents a major barrier to the development and growth of new ventures. This paper, therefore, presents the first analysis of the informal venture capital market in the U.K. and compares the characteristics and attitudes of U.K. informal investors with those in the U.S. The data reported in this paper have been obtained from a combination of postal survey and snowball sample techniques that generated useable information from 86 informal investors. Informal investors are playing an important role in venture financing in the U.K. in three ways: they make small scale investments in new and early stage ventures, where the equity gap is most significant; they are more permissive in their financing decisions than the formal venture capital industry in terms of having lower rejection rates, longer exit horizons, and lower target rates of return; and they invest locally and can thereby close the regional equity gap arising from the overconcentration of venture capital investment in the core South-East region in the U.K. In terms of demographics, U.K. informal investors share many of the characteristics of North American informal investors: they are predominantly male, with an entrepreneurial background, financially well-off without being super-rich, and identify investment opportunities from friends and business associates. There are a number of key differences, that may be attributable to differences in contextual factors such as personal tax regimes, regulatory environments, wealth distribution, and the structure of the formal venture capital and IPO markets. For example, U.K. informal investors are significantly older than those in the U.S. reflecting the influence of higher U.K. tax rates on the rate of capital and wealth accumulation. More generally, in comparison to U.S. investors, U.K. informal investors: have more investment opportunities brought to their attention; seriously consider more proposals but invest in no more opportunities; operate independently with syndication and joint investment relatively uncommon, reducing the average total investment per financing round available to ventures; fail to identify entrepreneurs themselves as a primary source of information on investment opportunities; have higher rate of return and capital gains expectations; are slightly less patient investors; and are rather less satisfied with the overall performance of their informal investment portfolios, reflecting intercountry and intertemporal variations in investment climate and conditions. It appears, therefore, that the general inefficiency of the informal capital market identified by Wetzel (1987) (which reflects the invisibility of informal investors, the fragmented nature of the market, and the imperfect channels of communication between investor and entrepreneur) is compounded in the U.K. case. The extent to which this reflects contextual differences on the one hand or simply a slower developmental process in the U.K. will only be common methodological basis. Based on the evidence presented in this paper, however, a key conclusion is that the information networks available to U.K. informal investors are less effective than those in North America, and in particular appear to contain lower quality information and a higher degree of redundant information. Specific forms of intervention in the market by, for example, stimulating the flow of information through the promotion of informal investment networking and brokerage services along the lines of U.S. and Canadian examples such as VCN and COIN therefore appear defensible.

The vanishing harberger triangle

This paper shows that the double taxation of corporate dividends (or profit repatriations) implies a nucleus theory of the corporation. After the firm is set up with a small stock of original capital, it enters a phase of purely internal growth during which no dividends are paid and no shares are issued. The phase terminates when an efficient stock of capital has been accumulated and dividends are paid. During the growth phases, the tax distortion is inversely related to the tax burden and it is larger than conventional formulae for the cost of internal and external equity finance suggest.

Effects of personal taxes and equity issuing costs on the firm's investment decision

The existence of preferential taxes on capital gains relative to ordinary income is widely understood to create a systematic preference for internal rather than external equity financing. This preference is magnified by the existence of issuing costs on new equity. This paper develops a procedure to account for these market imperfections in terms of an adjusted net present value that directly adjusts a project's net present value calculated without regard to the imperfections. Once the correct adjustment procedure is developed, the practical implications of personal taxes and issuing costs on the firm's investment behavior clearly emerges. These market imperfections have created a discontinuous function for the firm in obtaining equity capital. Many rational wealth-maximizing firms are forced to make investment decisions in a situation similar to capital rationing as the separation theorem between investing and financing does not generally hold. This explanation of a potentially long-run need for capital rationing is consistent with otherwise perfect capital markets.

The Corporate Dividend-Saving Decision

The purpose of this paper is to derive and test a model of the dividend-saving decision for a shareholder wealth-maximizing firm. Starting with the basic proposition that shareholders should prefer capital gains income to dividend income in a world of differential taxes and transactions costs, dividends are viewed as basically a residual in the corporate decision process. The term residual does not imply that there is no dividend decision or that dividend policy does not affect the worth of the firm since, as argued, the selection of an optimal level of dividends in an uncertain environment still involves the forecasting of future investment needs and the selection of a dividend-saving program to finance these needs at minimum cost. The relevant costs in this context relate to the possible accumulation of excess liquidity resulting from insufficient dividends on the one hand and the possible need for external equity financing resulting from excessive dividends on the other.

THE ROLE OF PREFERRED STOCK IN ELECTRIC UTILITY FINANCING*

THIS STUDY UTILIZES the electric utility industry to probe the waning popularity of nonconvertible preferred stock. This industry was selected because it is responsible for one in every three nonconvertible preferred issues marketed over the study period (1950-62). The purpose is to gauge the signs of deemphasis, analyze underlying forces, and evaluate the future role of the security. Data presented and analyzed reflect the declining portion of electric utility capital being raised via preferred stock. Detailed evidence is presented on new issues, refundings, redemption activity, and divestments. On the basis of aggregate data for Classes A and B electric utilities and a study of a core group of 150 companies it was found that a declining trend in preferred stock as a per cent of capitalization exists and is mainly the result of a fall in new offerings. A study of nonconvertible preferred stock contracts (305) indicates a high degree of uniformity which is largely the result of SEC influences under the Holding Company Act of 1935. In general, these issues of preferred stock have cumulative dividend and liquidation preference over common stock and are callable. In the majority of cases contingent voting privileges are given to elect directors upon dividend defaults. Preemptive and participation rights are not present. The low incidence of redemption funds and the frequency of extended retirement periods leads to the conclusion that electric utility straight preferred stocks are generally regarded as permanent capital. A questionnaire-survey of the core group probed a variety of areas, mainly related to forces leading to the lull in preferred stock sales over the past decade. On the basis of the results and extensive examination of the literature, it was concluded that structural shifts in financing are the prime source of deemphasis. The trend of financing reveals a greater reliance upon internally generated funds. The external financing that has been undertaken has been principally in the form of long-term debt. This has been facilitated by somewhat higher debt ratios permitted by regulatory and rating agencies, the cushioning effect of internally generated funds on debt percentages, and the rising levels of federal taxes on corporate income. External equity financing was primarily in the form of common stock. The bullish nature of the market for common stock has permitted many utilities to sell these securities at high price-earnings ratios with little or no dilution. Preferred stock has proven less attractive relative to other means of external financing. A comparison of the assumed role of nonconvertible preferred stock and its role in practice indicates close correlation. In essence the function of the security is to keep debt and equity ratios in line as a compromise vehicle in terms of safety, cost, and flexibility in financing. Moreover, the use of preferred stock carries with it a degree of secondary leverage and when markets are unfavorable for common stock or when dilution of earnings per share is apparent, preferred stock assumes a place in financial planning. An analysis of the practical advantages of substituting

TRENDS IN THE VOLUME AND COMPOSITION OF EQUITY FINANCE*

A FLOOD OF DATA on current and past sources of corporate funds has become available within the last decade. Thanks to the data provided by the National Bureau of Economic Research, the Department of Commerce, the Federal Reserve, and the Securities and Exchange Commission, we can now trace past trends and cycles as well as current developments in the pattern of corporation financing. It is by now well known that since World War II internal equity finance-the re-investment of retained earnings and depreciation funds-has provided a huge proportion of total corporate funds, and that external equity finance-new common stock issue-has played a relatively small role. It has also been popularly assumed that these recent trends are unique, especially as compared with earlier periods of this century. Now, however, we have findings by Professors Lintnerl and Miller2 which deny that fundamental shifts in equity finance have occurred in the post-war period: Lintner denies the uptrend in internal equity finance, and Miller denies the downtrend in external equity finance. The main purpose of this paper is to present evidence that a basic change has indeed taken place since World War II in the composition of equity finance; namely, the substitution of internal for external equity finance. In effect, the relative importance of the two components has changed. This result tends to reject the conclusions of Lintner and Miller. The causes and implications of this structural change in corporate financial patterns will also be explored. It will be argued that the shift from external to internal equity sources of funds:

FACTORS AFFECTING EQUITY FINANCING OF LARGE AMERICAN INDUSTRIAL CORPORATIONS, 1946-56*

EQUITY ISSUES HAVE made up only a small proportion of total longterm external financing by corporations in the United States since the end of World War II. This caused much discussion, especially in the early part of the period, concerning the factors affecting corporate financing. Since the extent of external equity financing varied considerably from 1946 through 1956, a study of corporate financing during that period may disclose the important determinants of such financing. The ratio of external equity financing to total long-term external financing by large industrial corporations displayed greater variation than did the ratio for all corporations. The purposes of this thesis are (1) to determine the most important factors causing the fluctuations in the amount of equity issues and in the ratio of equity issues to total long-term issues by large industrial corporations in the period 1946-56 and (2) to determine the way in which each of these factors affected equity issues in the period. The data for the study came primarily from a random sample of one hundred firms taken from the list in Fortune Magazine of the five hundred largest industrial corporations in the United States in 1955. Since all the preferred stock issues by the corporations were found to include predominantly creditorship covenants, equity issues as defined in the thesis include only common-stock issues. Although debt issues accounted for a large proportion of total issues, the ratio of aggregate equity capital to the total assets of all the corporations was sustained throughout the period by the high level of retained earnings in most of the years. An adequate equity buffer, low financial charges, and good earnings during most of the period meant that debt financing could be used predominantly to obtain any outside capital that was needed without incurring an excessive amount of financial risk. Four factors seem to explain most of the variation in equity issues