Residual Cash Flow Research Articles

Financial Leverage, Information Quality, and Efficiency*

ABSTRACTWe examine information quality and financial leverage when an entrepreneur needs financing to undertake a risky project and his effort input affects the project's outcome. We show that information quality and financial leverage interact to play active roles in both investment and effort decisions. Our analysis shows a positive association between leverage and optimal information quality—when leverage is low (high), low (high) information quality is optimal. This is because with low leverage, the entrepreneur is already motivated by his large share of the outcome to exert effort, and high information quality is not efficient as a precise bad signal discourages the entrepreneur's effort. In contrast, when leverage is high and thus the entrepreneur is less motivated by his residual cash flows, high information quality is optimal, because a precise good signal encourages the entrepreneur's effort. Our study highlights the joint effect of information quality and financial leverage on overall efficiency through firms' effort inputs as well as on defining investment efficiency.

The 'Embodied Equity' Theory of Term Structure

This study analytically specifies the residual cash flow stream that real capital embodies. The specification separates debt cash flows from equity and obtains an equilibrium condition equating marginal physical product and real user cost of capital. Analysis of the user cost specification reveals that the equilibrium interest rate is an increasing function of the debt contract's loan-to-value ratio and average period of debt. The basic reason why the interest rate increases with average period is this: the equity financing rate exceeds the interest rate, a lengthening debt average period reduces to equity the discounted cost of debt, the financing rate increases to re-establish equilibrium. The “embodied equity” hypothesis advanced herein joins the expectations hypothesis, the liquidity preference hypothesis, and the market segmentation hypothesis as a fundamental explanation for the upward slope on the yield curve.

An examination of labor unions and firm’s tax ethical behavior in the USA

Prior research finds that firms with strong business ethics are less likely to be tax aggressive. Labor union is one of the key stakeholders influencing firm’s tax aggressive behavior, whereas the bargaining process between labor union and firms exhibits ethical dilemma. Although industry-wide labor union coverage is commonly used in prior study to explore the monitoring role of labor unions in constraining management’s aggressive financial and tax decisions of their associated firms, we argue that firm-specific labor unions, which represent a different bargaining power of the employees, do play an important role in determining firms’ tax ethical decisions. Specifically, we examine whether and how the firm-specific labor union coverage impacts firms’ tax aggressiveness decisions over and above industry-wide labor union coverage. We hypothesize and find that firm-specific labor unions influence the associated firms to be more tax aggressive, which results in higher levels of residual cash flows. We also find that industry-wide labor unions influence the associated firms to be less tax aggressive, which is consistent with prior findings. We perform further analyses and find that the results are more pronounced for the firms with greater industry-wide labor unions representation. These results demonstrate that the inclusion of and interaction between the firm-specific and industry-wide labor unions matter in determining corporate’s tax aggressiveness decisions, which highlight firm’s ethical perplexity between tax savings and social commitments.

Timber royalty reform to improve the livelihoods of forest resource owners in Papua New Guinea

Inequitable timber resource rents are a problem that has plagued tropical forest management in countries throughout the world, including Papua New Guinea (PNG), which exported 21% of the world's tropical hardwood logs during the last decade. Rural tropical forest resource owners (FROs) often have limited economic resources and resource rents from timber harvests can help them access goods and services that they otherwise cannot afford. This paper uses historical log export data and timber royalty rates to compare the timber resource rents received by FROs in PNG to log export duties and levies collected by the PNG government and the residual cash flows collected by logging companies from log exports. Between 2007 and 2017, PNG's FROs received an annual average of 6.1% of the market value of the logs harvested. By comparison, the PNG government received an annual average of 42.3% from duties and levies and the logging industry received 51.6% for its costs/profits. We also found that the real value of royalties for different timber species has declined by between 32% and 66% since 1991 due to the use of the fixed-rate system. We recommend that future royalty payments in PNG be calculated as a percentage of market value and that there be greater public participation in the determination of the appropriate income split to provide a more equitable distribution of timber harvest revenues between different actors.

Suda Electric Vehicle Company: Private Equity Investment in China

In March 2013, the Shipston Group, the family office of billionaire industrialist Michael D. Dingman, was considering a private equity investment in the SuDa Electric Vehicle Company (SuDa), a rapidly growing maker of electric bicycles (e-bikes) in the People's Republic of China (PRC). This field-based case explores the differences between investments that are funded through a family office compared to a more traditional committed fund. Shipston began investing in the PRC in 2005, focusing on China-for-China investments, and in sectors that would benefit from the continued expansion of the Chinese middle class. Over the past decade, the PRC had experienced rapid growth in the number of individuals moving from the rural areas to the cities in search of better employment. As a result, the cities had grown much larger, often necessitating long distances between an employee's residence and place of work. The dual trends of urbanization and industrialization had also resulted in heavily polluted cities and an overwhelmed public transportation system. E-bikes provided an affordable and energy-efficient means of transportation that appealed to this new group of urban settlers. After several rounds of due diligence, Shipston is evaluating whether it should invest CNY37.8 million (USD6.0 million) for a 10% equity stake in SuDa. The case provides an analytical exercise where students are provided a forecast model of the expected cash flows to the SuDa investment and asked to evaluate whether the investment can meet Shipston's 20% return requirement. In order to evaluate the investment, students must construct equity residual cash flows and estimate the internal rate of return for the investment.This case has been taught successfully in a second-year MBA elective in private equity and can be used in other courses focusing on valuation. The students should be familiar with basic valuation techniques, including equity residual cash flow analysis. The case can also be used in courses on international finance to discuss the differences in the business environment between the PRC and other developed markets. Excerpt UVA-F-1766 Rev. Jul. 5, 2017 SuDa Electric Vehicle Company: Private Equity Investment in China In March 2013, the cold of winter of Beijing was about to give way to spring. Winston Wang had just gotten off the phone with Alex Chen, the owner of the SuDa Electric Vehicle Company (SuDa). Wang, after graduating with an MBA from a top U.S. university and a few job stints overseas, had returned to his home country as an investment manager with the Shipston Group (Shipston), a family office founded by billionaire industrialist Michael D. Dingman. The strong economic growth of the People's Republic of China (PRC) had attracted capital from foreign private equity (PE) firms, but finding good investments had often proven elusive. In the “hot” industries like technology, pharmaceuticals, and natural resources, capital was no longer scarce and the competition was intense to invest in good target companies. Also because of the more regulated nature of the PRC's business environment, foreign investors frequently found themselves with less influence over the target company's management and business compared to investments in more developed markets. As a family office, Shipston was able to take a longer-term view of an investment's potential future growth and value compared to PE firms organized as committed fund-limited partnerships. B

Insurance valuation: A computable multi-period cost-of-capital approach

We present an approach to market-consistent multi-period valuation of insurance liability cash flows based on a two-stage valuation procedure. First, a portfolio of traded financial instrument aimed at replicating the liability cash flow is fixed. Then the residual cash flow is managed by repeated one-period replication using only cash funds. The latter part takes capital requirements and costs into account, as well as limited liability and risk averseness of capital providers. The cost-of-capital margin is the value of the residual cash flow. We set up a general framework for the cost-of-capital margin and relate it to dynamic risk measurement. Moreover, we present explicit formulas and properties of the cost-of-capital margin under further assumptions on the model for the liability cash flow and on the conditional risk measures and utility functions. Finally, we highlight computational aspects of the cost-of-capital margin, and related quantities, in terms of an example from life insurance.

The role of the cash flow in evaluation of the real investment project

This article discusses the importance of cash flow to evaluate the efficiency of real investment projects. The main aim of this study is to synthesize and develop the methodological foundations of the definition and evaluation of cash flow from the sale of real investment projects. Based on the analysis and synthesis of existing approaches to the definition of the «cash flow» it has been proposed to consider it as an economic category, which reflects the economic benefit from the sale of real investment projects. A prerequisite for this is the need to take account of cash flow for all types of business enterprises (operating, financial, investment). The most fully meets these requirements residual cash flow, which is proposed to use to evaluate the effectiveness of real investment projects in the calculation of individual indicators in order to obtain more reliable results.This study can be continued in the direction of clarifying the approach to discounting cash flows when determining their present value.

EDP Renewables North America: Tax Equity Financing and Asset Rotation

This case examines an innovative project finance solution in the renewables industry. In 2015, the CEO of EDP Renovaveis, S.A. (EDPR), the world's third-largest wind energy producer, was being briefed by the U.S. finance team on the financing of a 200 MW “wind farm” (or wind power plant). EDPR had ambitious growth targets and to keep its capital structure targets it was doing this capital investment using project finance. In the U.S. market, the solution was “tax equity” investment (a hybrid between debt and equity) to take advantage of the tax incentives for wind energy and the second source of external financing consisted of the “asset rotation” or “cash equity” investment from institutional investors. This project would be EDPR's 14th tax equity and 5th U.S.-based cash equity asset rotation transaction. The finance team had to develop a valuation model to explain to the CEO the key drivers of returns to EDPR shareholders with this particular financing strategy. How much did the tax equity and asset rotation financing strategy really boost the returns for EDPR shareholders? What made more sense, an attractive IRR on residual cash flows or a higher NPV for the complete project? Some competitors seemed to favor a public “YieldCo” (a portfolio of renewable energy–generating assets formed into a corporation and sold to the public); should EDPR consider it an alternative financing solution? The questions piled up as the team prepared to go through the analysis. Excerpt UVA-F-1757 Aug. 9, 2016 EDP Renewables North America: Tax Equity Financing and Asset Rotation In November 2015, Jo©o Manso Neto, the CEO of EDP Renovaveis, S.A. (EDPR), was arriving at the Houston, Texas, headquarters of EDP Renewables North America (EDPR-NA), its platform for the United States, Canada, and Mexico. He was going to be briefed by Gabriel Alonso (CEO of EDPR-NA), Bernardo Goarmon (EVP Finance of EDPR-NA), and the finance team on a new 200 MW wind farm investment located in Florida. Right before entering the meeting room, Manso Neto passed the state-of-the-art dispatch center that oversaw all of the 34 wind farms located across 12 U.S. states and one Canadian province. Over 2,300 wind turbines, totaling more than 4.2 GW of installed capacity, were monitored in real time for load factors and energy output. The new Rising Star wind farm under construction in Florida consisted of 90 turbines, and its start of operations was scheduled to occur at the end of 2015.

Institutional influences on board composition of international joint venture firms listing on emerging stock exchanges: Evidence from Africa

The attraction of blue-chip listings in emerging stock markets is a major policy initiative common across much of the developing world. In many cases however, local blue-chip firms are the result of foreign Multinational Enterprise (MNE) firms engaging with local indigenous partners to form an international joint venture (IJV). These are unique with bilateral governance structures underscoring co-ownership between partners of residual cash flows and assets of the IJV. Using a unique and comprehensive sample of 202 IPO firms from across the emerging African region evidence of both a pronounced internal as well as external role for IJV boards was found. Social and political legitimacy concerns dominate the external role of boards in particular. Increasing proportions of boards drawn from commercial and governmental social elites are associated with IJV IPO firms in high institutional quality while lower proportions of these elites are associated with civil code law jurisdictions rather than common law. Governmental elites are associated with country-level improvements in corruption control and political stability while commercial elites are only marginally associated with improvements in political stability, regulatory quality, rule of law and democratic voice and accountability measures.

Sensitivity of external resources to cash flow under financial constraints

This paper explores the external financing–cash flow relationship in capital structure theory by comparing unlisted (financially constrained) and listed (financially unconstrained) companies. We postulate that investment is determined endogenously in the case of unlisted firms, as they are strongly dependent on internally generated funds (cash flow). Consequently, unlisted firms invest their cash flow in profitable projects, using any residual cash flow to increase their holdings of safe assets. In turn, listed companies determine their investment exogenously and may reduce leverage if they raise an excess of cash flow. As a result, listed companies would react more negatively to shocks in cash flow. Our findings reveal that both unlisted and listed companies show a negative external financing–cash flow relationship, that of the latter being clearly more intense.

Stakeholder rights and economic performance: The profitability of nonprofits

This paper explores whether ownership matters in a fundamental sense by comparing the performance of stockholder-owned firms with the much less analyzed nonprofit firms. No stakeholder has residual cash flow rights in nonprofit firms, and the control rights are held by customers, employees, and community citizens. Accounting for differences in size and risk and comparing only firms in the same industry, we find that stockholder-owned firms do not outperform nonprofit firms. This result is consistent with the notin that the monitoring function of stockholders may be successfully replaced by other mechanisms. We find evidence that product market competition may play this role as a substitute monitoring mechanism.

EVA/RAROC vs. MCEV Earnings: A Unification Approach

This paper compares different performance metrics used for value-based management in life and non-life insurance business. The goal is to find a consistent basis for performance measurement at the insurance group level. This is important since management techniques used in non-life insurance, such as economic value added and risk-adjusted return on capital, are at first sight very different from those used in life insurance, that is, an analysis of market-consistent embedded value earnings, thus making management difficult at the group level. This paper aims to compare and contrast these concepts and to show that all approaches can be unified under a single consistent framework, and that all present residual cash flow concepts that can be linked under the residual income valuation theory.

NVA: A Value Addition Measure For Capital Project Evaluation

<p class="MsoFootnoteText" style="text-align: justify; margin: 0in 0.5in 0pt; mso-pagination: none;"><span style="font-family: Times New Roman; font-size: x-small;">Corporate financial objective of stockholder wealth maximization and use of discounted cash flow methods for evaluation of capital projects are two of the well-accepted tenets of financial management. Present project evaluation methods, including the Net Present Value (NPV) technique, do not fully meet the stockholder wealth maximization criteria. This paper attempts to scrutinize the relevance of the NPV method in achieving the wealth maximization objective and suggests an alternative value addition measure, named Net Value Added (NVA). In the NPV method, all cash flows pertaining to a project are lumped together and discounted with one single rate, the weighted average cost of capital. The NVA method advocates that a project’s residual (net of its debt servicing) cash flows that belong to stockholders should be classified on the basis of their end-use, viz., equity servicing, capital maintenance, and value creating surplus cash flows.<span style="mso-spacerun: yes;">  </span>As the risks associated with each of these three stockholders’ cash flows are not the same, they are separately discounted at appropriate rate depending upon the associated risk. Power of time (n) is assigned only to real risk-free rate of return and inflation premium to discount equity servicing and capital maintenance cash flows that are subject to exponential growth over time but not to the risk premium.</span></p>

Corporate dividend policy in practice: Evidence from an emerging market with a tax-free environment

Several theories have been proposed to explain why companies pay dividends. However, as of today, the dividend policy remains a puzzle as no convincing explanation has been given as to why firms pay cash dividends to their shareholders. This paper contributes to this debate by examining the dividend policy in an emerging market that has a tax-free environment. Specifically, we follow Brav et al. (2005) and examine this issue using survey and field interviews, in the particular context of the United Arab Emirates. Our results provide support for the proposition that dividend policy is conservative. We also find that dividends in the UAE are considered by managers as a residual cash flow, and are determined after investment decisions are made. When examining the determinants of dividend policy, we find that taxes are not important, that institutional investors are expected to play a role in disciplining managers, and that dividends may play a disciplinary role as well in controlling agency conflicts.

Full-Time Faculty or Part-Time Entrepreneurs

When agents originate and develop inventions, new discoveries, or scientific breakthroughs, do all residual cash flows go to principals - the risk bearers who own the infrastructures, systems, and the productive assets? This research addresses this question, focusing on university scientists who essentially bypass their institutions when they privately sell or license discoveries made at laboratories of said institutions directly to the market. Using a random sample of 54 U.S. universities and 23 394 faculty members, the study shows that bypassing activity is reduced when universities rely on autonomous technology licensing offices (TLOs) and when faculty departments receive greater shares of the royalties from the licensing of said discoveries. Conversely, bypassing activity is increased with more valuable discoveries and heightened entrepreneurial activities on university campuses.

Who is the Ultimate Master of Contractual, Regulatory, Discretionary and Residual Cash Flows? An Answer from the Standpoint of Corporate Governance

This paper sets forth a framework of analysis that links contractual, discretionary, regulatory and residual cash flows with decision rights over them. To attain this purpose, firstly we introduce the standard incremental cash flow model, underlying its main limitations. Secondly, we move on bringing to light cash flows to senior management and directors, as well as the so-often neglected investment portfolio. Next, we settle down to what we are going to call the compact cash flow model that comprises five building blocks, namely those arising out of assets, those addressed to owners, creditors, managers and directors, and lastly the company's investment portfolio. Afterwards, contractual, discretionary, regulatory and residual cash flows are enlarged upon. Last of all, we focus on decision rights over every constituent of each building block. This issue carries weight in Corporate Governance since stakeholders who claim or exercise decision rights, also could trespass on the rules of the game, becoming better off to the expense and damage of other stakeholders.

Who is the ultimate master of contractual, regulatory, discretionary and residual cash flows? An answer from the standpoint of corporate governance

This paper sets forth a framework of analysis that links contractual, discretionary, regulatory and residual cash flows with decision rights over them. To attain this purpose, firstly we introduce the standard incremental cash flow model, underlying its main limitations. Secondly, we move on bringing to light cash flows to senior management and directors, as well as the so-often neglected investment portfolio. Next, we settle down to what we are going to call the compact cash flow model that comprises five building blocks, namely those arising out of assets, those addressed to owners, creditors, managers and directors, and lastly the company’s investment portfolio. Afterwards, contractual, discretionary, regulatory and residual cash flows are enlarged upon. Last of all, we focus on decision rights over every constituent of each building block. This issue carries weight in Corporate Governance since stakeholders who claim or exercise decision rights, also could trespass on the rules of the game, becoming better off to the expense and damage of other stakeholders.

The Role of Triggers in Net Interest Margin (NIM) Securitization Structures

One of the keys to understand how net interest margin securities, or NIMs, are structured is to understand how the “triggers” from the underlying asset-backed transaction work. The purpose of this article is to explain those triggers and their impact on the residual cash flows to a NIM. Triggers have an impact on the reallocation of cash flows in a securitization structure, which in turn can impact the amount of excess spread allocated to the residual holder. Triggers could require an increase in the target overcollateralization (O/C), known as a “step-up” event or they could prevent a release of O/C, or “step down” event. The two primary cash flow triggers are a delinquency trigger and a cumulative loss trigger. “NIM friendly” triggers are triggers where there is no step-up in O/C above the initial O/C and the trigger does not come into effect until the step-down date. Depending on where an investor participates in the capital structure, whether it is in senior, mezzanine, subordinate or first-loss positions, the view on a particular trigger can be very different. <b>TOPICS:</b>Credit risk management, credit default swaps

RMBS NIMS

A net interest margin (NIM) securitization is essentially an interest only (IO) strip, with its cash flow derived from a transaction9s net interest proceeds as well as from interest rate caps, corridors, and swaps, and, for most RMBS NIMs, prepayment penalty charges. Several factors can impact the amount of residual cash flow available to service NIM liabilities. These factors include collateral losses, the timing of losses, prepayment speeds, the interest rate environment, and structural features. NIM performance is heavily dependent on collateral performance in the early life of the transaction. Consequently, performance can be particularly vulnerable to sharp downturns in more credit sensitive sectors of the housing market. <b>TOPICS:</b>MBS and residential mortgage loans, CMBS and commercial mortgage loans

When Labor Has a Voice in Corporate Governance

AbstractEquity ownership gives labor both a fractional stake in a firm's residual cash flows and a voice in corporate governance. Relative to other firms, labor-controlled publicly traded firms deviate more from value maximization, invest less in long-term assets, take fewer risks, grow more slowly, create fewer new jobs, and exhibit lower labor and total factor productivity. Therefore, we propose that labor uses its corporate governance voice to maximize the combined value of its contractual and residual claims, and that this often pushes corporate policies away from, rather than toward, shareholder value maximization.