Dynamic Corporate Finance under Costly Equity Issuance.

• Author: Bolton, Patrick

Two fundamental concepts in corporate finance are the net present value (NPV) rule and the Modigliani-Miller (MM) irrelevance proposition. When financial markets operate without frictions, when investors can trade securities that correspond to all relevant risks, when investors and managers share the same information, when incentives are aligned, and when there are no tax distortions, then corporate finance boils down to a valuation exercise and a simple investment decision rule: undertake all investments with a positive NPV. How companies and investments are financed is irrelevant.

This characterization of financial markets is frequently taken as approximately valid; a plausible and convenient simplification even if it poorly reflects reality. Corporate income taxation, the interest tax shield for debt, and bankruptcy costs are often the only deviations from this view that are considered when explaining corporate financing choices.

Although tax distortions and bankruptcy costs are obviously relevant, they cannot alone account for most observed corporate financial decisions. They cannot explain why companies hold so much cash, their leverage dynamics, nor their payout, equity issuance, and investment policies. We show in our research that the cost of issuing equity is a key and practically relevant distortion. Because of asymmetric information or incentive misalignment, firms must incur costs when raising external funds (1) and these costs are higher for equity than for debt financing. (2)

When firms face external financing costs, they seek to avoid such financing. This is a key reason that firms retain earnings and accumulate cash (corporate savings). With Hui Chen, we analyze a dynamic model with three main building blocks: (1) an investment rule based on the marginal value of incremental capital investment relative to its cost, (2) cash, equity, and a credit line as funding sources (together with hedging), and (3) equity issuance costs and cash carry costs. (3) A first, key result of our analysis is that investment is no longer determined by equating the marginal cost of investing with the marginal addition to the firm's valuation from such capital, as in the neoclassical theory of investment. Instead, investment is determined by the ratio of the marginal increase in the firm's value to the marginal value of cash. The marginal cost of investing equals the marginal product of capital, also known as marginal q, divided by the marginal value of cash.

When firms are flush with cash, the marginal value of cash is about one, so that this equation is approximately the same as the equation under MM irrelevance. But when firms are close to running out of internal funds, or close to the limit of their credit line, the marginal value of cash is much larger than one, so that marginal product may need to yield a much higher return, and optimal investment may be far lower, than the level predicted under MM neutrality.

Figure 1 illustrates the sizable value destruction that a financial crisis can cause, as firms are shut out of capital markets and can only rely on internal funds to continue their operations. (4) Panels A and B show that firm value is increasing and concave in cash holdings, that the marginal value of cash always exceeds one, and that it is very large when the firm runs out of cash. Panel C shows that firms substantially cut investment and engage in very costly fire sales when liquidity is low. The firm values a dollar in hand at about $30 and sells about 60 percent of its productive capital at a significant value discount when it is close to being inefficiently liquidated, in sharp contrast to the predictions of the neoclassical theory of investment. Finally, Panel D reveals how nonlinear and nonmonotonic investment-cash sensitivity can be, indicating that investment-cash sensitivity is a poor measure of how financially constrained a firm is. (5)

A second key result concerns the firm's optimal cash-inventory policy. That involves continuous management of cash reserves through adjustments in investment, asset sales, and corporate hedging between two barriers: a lower bound at which the firm must tap external financing after exhausting all its cash reserves, and an upper bound at which the firm has...