Bank financing and shareholder wealth

Ashok Rao and John Edmunds

European Management Journal, 2001, vol. 19, issue 2, 168-173

Abstract: This article shows that European firms do their shareholders a disservice if they use bank financing, especially if that financing comes with restrictive covenants and floating interest rates. The restrictive covenants discourage expansion and the floating interest rates make the firm's cash flows less stable. The better way to finance the firm is with fixed-rate bonds. With bond financing, the covenants are less restrictive and the firm's interest expense is more stable. The simulation approach which the authors have developed gives estimates of how much each attribute of the financing affects the company's share price. The effects that they found are large -- for example, choosing fixed-rate bond financing over floating-rate bank financing adds 17.4 per cent to the stock price. Interest expense is an important component of cost in the author's simulation, and making it fixed instead of floating brings enough stability to the firm's cash flow to deliver a large increase in the stock price. Also, postponing a new factory, as managers might do to avoid violating the restrictive covenants of bank loans, lowers the stock price 19.7 per cent. In the simulation, the firm has adequate capacity at the beginning, but in many scenarios becomes capacity-constrained after one or two years. Stock market investors gain if the company buys the factory sooner, because they place a high value on growth and market share.

Keywords: Bank; Financing; Shareholder; Wealth; Bond; Financing; Financial; Covenants (search for similar items in EconPapers)
Date: 2001
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