Wednesday, December 29, 2010

Corporate finance in illiquid markets

In corporate finance, we examine how a business decides what investments to take (the investment decision), how much to borrow to fund these investments (the financing principle) and how much to return to stockholders (the dividend principle), if it wants to maximize its value. Traditional corporate financial prescriptions on each of these dimensions assume that both capital and asset markets are liquid. Introducing illiquidity into the process changes the game in significant ways.

a. Investment Principle: In most corporate finance books, the capital budgeting chapters wend their way through familiar territory. The best decision rule for investment analysis for a value-maximizing firm is the NPV rule and firms should accept all positive net present value investments. Within the NPV rule, you estimate expected cash flows on each investment and discount these cash flows back at a risk-adjusted rate. The expected cash flows are assumed to be available to the firm (to reinvest elsewhere or to pay dividends) and the risk adjusted for in the discount rate is macroeconomic or market risk.

How would introducing illiquidity alter this process? First, illiquid capital markets limit access to external funds (from both equity and debt) and may act as an impediment to taking every positive NPV investment. Second, if not all positive net present value investments can be accepted, the firm is better off getting the most bang for the buck. Thus, using a percentage return such as IRR to judge investments, instead of NPV, may allow a firm to generate the most value. Third, not all cash flows are equally liquid. Firms can be restricted in their use of cash flows, if they face regulatory or lender-imposed constraints or invest in countries with remittance restrictions.  Finally, the discount rates (costs of equity and capital) will be higher for firms, if there is illiquidity, since there will be transactions costs associated with raising money. Firms facing more liquidity constraints are therefore less likely to take longer term infrastructure investments, with large negative cash flows up front and positive cash flows on the back end.

b. Financing Principle: The optimal mix of debt and equity for a firm is the one that maximizes its value. If we hold operating cash flows fixed, this is usually achieved when the cost of capital is minimized. In conventional corporate finance, then, the optimal financing mix is the one that minimizes the overall cost of capital, with neither the cost of equity and debt reflecting liquidity concerns. In the APV approach, it is the dollar debt level that maximizes value, after taking into consideration the tax benefits of debt and expected bankruptcy costs.

Using both the cost of capital and APV approaches, bringing in illiquidity into the equation will alter the dynamics. Illiquidity will push up both the costs of debt and equity and the effects on the optimal debt ratio will then depend on whether the equity or the debt market is more illiquid. If the equity market is illiquid and the debt market (bonds or bank loans) is liquid, the optimal debt ratio will rise in the face of illiquidity. In contrast, if the equity market is liquid and the debt market is not, the optimal debt ratio will fall as liquidity concerns rise. In the APV approach, illiquidity will raise both the probability of bankruptcy (since distressed firms will be unable to raise new financing to keep going) and the cost of bankruptcy (since assets will have to be sold at much bigger discount in an illiquid asset market). The net effect should be a decline in the use of debt by illiquid firms.

c. Dividend policy: There are two big questions that animate the dividend principle: How much cash should you return to stockholders (and how much should you hold back)? What form should you return the cash in, dividends or stock buybacks? In conventional corporate finance, firms are advised to return any cash that they have no use for in the current period back to stockholders, since it is assumed that they can return to liquid capital markets and raise new funding. It follows that cash balances should be minimal. And the form in which cash gets returned will be a function of investor taxes. If dividends and price appreciation are taxed at the same rate, investors should be indifferent between the two. If dividends are taxed more highly, firms should use stock buybacks.

Introducing illiquidity into this decision changes the answers to both questions. Firms that are more concerned about illiquidity should return less cash to stockholders and hold back more cash. Thus, you would expect cash balances to be higher at small and emerging market companies or during liquidity crises. The evidence seems to back this proposition. Investors faced with illliquid markets will value dividends more, simply because they represent cash in hand, whereas price appreciation is more risky (since you have to sell your stock to get it). Consequently, you should expect dividends to rise in the face of higher illiquidity, while stock buybacks to fall off.

In summary, you should expect firms in illiquid market to invest less in long term projects, to use less debt to fund these investments and to accumulate more cash, while paying out more in dividends.

I have a paper on the effects of illiquidity on financial theory, where I look at the implications for corporate finance in more detail:


  1. Out of topic:-

    Dear Prof,

    I just read your research paper on relative valuation, you've mentioned that "When buying a stock, it is common to look at the price paid as a multiple of
    the earnings per share generated by the company. When buying a business, as opposed to just the equity in the business, it is common to examine
    the value of the firm as a multiple of the operating income or the EBITDA"
    What is the difference when we use EV/EBITDA as opposed to P/E when acquiring a stock?

    One more question, in private equity, they always claimed that they look into a business not a stock, except for LBO, they just invest (in common) only for minority stake, does it account for buying a stock or buying a business?

  2. In all acquisitions including LBOs, you are buying the stock to control the business. Hence, you should be using enterprise value multiples.

  3. Dear Prof,

    Assume that the company is low capital intensive, which the depreciation is not so high and not distort the comparables of firm in the same industry, can i still use P/E instead of enterprise value multiple? Coz i think that they do not differ much in valuation results.

  4. Dear AD,
    What about the relation between the size of an asset and its liquidity? Many illiquidity characteristics are associated with small size (cost of leverage, access to capital markets, ability to pay dividends, etc). While applying a discount to the level of illiquidity of an asset don’t we risk a double counting for the “lack of size”?

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