Companies finance investment projects with internal and external funds. Although the specific mix differs across industries, one
Question:
Companies finance investment projects with internal and external funds. Although the specific mix differs across industries, one theme emerges––most companies borrow from banks, even when they have grown large enough to access public debt and equity markets easily. Understanding why is essential to a manager’s duty to maximize shareholder wealth. Commercial banks create value for firm shareholders by solving adverse-selection and moral-hazard problems in financing. Solving adverse-selection problems means sorting good borrowers from bad–– that is, determining which firms have the means to repay their loans. Solving moral-hazard problems means monitoring borrowers after loans are made––that is, ensuring firms with the means to repay actually do so. Firm shareholders benefit when banks offer attractive funding by sorting and monitoring efficiently. For publicly traded companies, bank loans also benefit shareholders by conferring “seals of approval.” Because banks specialize in originating and monitoring loans, their lending decisions convey information to financial markets about borrowers. When, for example, a bank lends to firm X, the market learns firm X has projects with cash flows sufficient to cover the principal and interest, and firm X’s management is likely to use some of those cash flows to pay off the loan. The positive signal enhances shareholder wealth by (i) credibly revealing good news about the prospects and management of firm X and (ii) lowering firm X’s cost of funding from non-bank sources. Studies in the 1980s and 1990s confirmed the value of bank lending to shareholders– –announcements of extension or renewal of bank credit typically boosted the stock prices of borrowing firms. Since the 1990s, financial innovation has changed bank lending. Traditionally, originating banks had trouble selling business loans because buyers assumed the motivation was negative inside information about borrowers. But then Wall Street discovered business loans could be securitized like mortgages––that is, the loans could be purchased from originators and bundled, with cash flows from the bundle used to make principal and interest payments on newly issued debt securities. Driven by securitization, U.S. loan sales soared from well under $50 billion per year in the early 1990s to over $400 billion per year since 2007. Banks love the new flexibility––existing business loans can easily be sold for cash to make new loans. But there is a potential downside––dilution of the signal from the original loan. Prior to securitization, markets saw extension of credit as good news about borrowers because banks were stuck with the loans to maturity. To assess the impact of securitization, a recent study re-examined the market’s reaction to bank lending decisions––but with a twist. This research looked at movement in the stock prices of borrowing firms when originating banks (i) first announced loans and (ii) later announced sales of those loans. Interestingly, both events were good for shareholders. The jump in a borrower’s stock price for initial loans was comparable to earlier studies, but the bump for subsequent sales was even larger. Evidently, loan sales emit a positive signal because banks value the flexibility enough to avoid dumping “lemons” on securitizers.
Does the value of bank loans as seals of approval vary across different types of firms (i.e., new vs. established, larger vs. smaller, robust financial shape vs. distressed)?
Step by Step Answer:
Principles of Managerial Finance
ISBN: 978-0134476315
15th edition
Authors: Chad J. Zutter, Scott B. Smart