Dynamic decision making in corporate finance and capital markets

Kurshev, Alexander (2010) Dynamic decision making in corporate finance and capital markets. Doctoral thesis, University of London: London Business School.

Abstract

Since at least Coase (1937) much (if not most) of financial economics research is devoted to assessing how the presence of externalities and frictions aects the decision-making process of corporate managers and capital-market participants. The main objective of the present thesis is to understand how certain frictions (such as the tax advantage to debt, the costs of bankruptcy and debt issuance, and overconfidence of capital-market investors) affect an agent's actions and whether these eects can contribute to explaining the stylized facts about corporate finance and capital markets. Chapters 1 and 2 of this thesis contribute to the literature on the choice of a firm's capital structure. Chapter 1 marries two strands of the corporate finance literature: the research that studies how a firm dynamically adjusts its debt level and the literature that investigates the firm's optimal mix of bank and public debt. This chapter proposes a framework of dynamic capital structure in the presence of both bank and market debt. The model demonstrates that, under tougher bankruptcy regimes, a firm finds it beneficial to issue more bank debt at each refinancing point and to restructure less frequently. Higher bank debt capacity also makes the firm more valuable, which increases its incentives to avert bankruptcy. The model therefore predicts that, in countries with tougher bankruptcy regimes, firms restructure less frequently, add more bank debt at each restructuring, and have a lower likelihood of default. When a firm has an option to adjust its future debt levels, the optimal leverage ratios and the optimal debt structure are more in line with what is observed empirically. Chapter 2 investigates whether a dynamic capital structure model can explain the cross-sectional size-leverage relationship. The driving force considered is the presence of fixed costs of external financing that lead to infrequent restructuring and create a wedge between small and large firms. The model shows that the firm size has four eects on leverage. Small firms choose higher leverage at the moment of refinancing to compensate for less frequent rebalancings. The longer waiting times between refinancings lead to lower levels of leverage at the end of restructuring periods. Within a refinancing cycle, the intertemporal relation between leverage and firm size is negative. Finally, there is a mass of firms opting for no leverage. The analysis of a dynamic economy demonstrates that in the cross-section the relation between leverage and size is positive, and thus, fixed costs of financing contribute to the explanation of the stylized size-leverage relation. However, the relationship changes sign when we control for the presence of unlevered firms. Chapter 3 studies the eect of the excess volatility on the trading strategies of capital-market participants. It proposes a general-equilibrium model of sentiment with two classes of agents and stock prices being excessively volatile because one class is overconfident about a public signal. The trading strategy of the rational investors is determined and analyzed. Because overconfident traders introduce an additional source of risk, rational investors are deterred by their presence and reduce the proportion of wealth invested into equity except when they are extremely optimistic about future growth. Moreover, their optimal portfolio strategy is based not just on a current price divergence but also on their expectation of future sentiment behaviour and a prediction concerning the speed of convergence of prices. Thus, the portfolio strategy includes a protection in case there is a deviation from that prediction. Long maturity bonds are found to be an essential accompaniment of equity investment, as they serve to hedge this "sentiment risk".