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- Title
CAPITAL STRUCTURE REARRANGEMENTS AND ME-FIRST RULES IN AN EFFICIENT CAPITAL MARKET.
- Authors
KIM, E. HAN; MCCONNELL, JOHN J.; GREENWOOD, PAUL R.
- Abstract
In this paper, we examined the effect of capital structure rearrangements that violate the me-first rule. We examined this phenomenon for the no-tax case and for the tax case. In both cases, violation of the me-first rule should result in a windfall gain to stockholders and a windfall loss to bondholders. We then examined one specific case in which the me-first rule was violated. When firms form captive finance subsidiaries and use their earnings and assets to support the borrowing of the subsidiary, they create a new class of security holders with income claims that are superior to those of their original bondholders. This form of capital structure rearrangement is a violation of the me-first rule. The empirical evidence indicates that stockholders have on average earned excess returns and old bondholders have suffered windfall losses when firms have formed captive finance subsidiaries. The implications of the empirical results are threefold: First, the results support the theoretical analysis of the effect of a me-first rule violation. Second, the results add to the growing evidence in support of an efficient stock market in which information is impounded in security prices as it becomes available. More importantly, the evidence is supportive of a relatively efficient bond market in which bond prices adjust relatively quickly to new information. Third, the results emphasize the risks that bondholders bear because they wield no direct managerial control over a firm's operations until the firm actually defaults on its interest or principal repayment obligations. As discussed above, creditors' income claims may be abridged not only through formation of captive finance companies, but also through other financial manipulations that do not violate "normal" indenture agreements.
- Subjects
CORPORATE taxes; MARKET value; CAPITAL structure; STOCKHOLDERS; BONDHOLDERS; CAPITAL market; CORPORATE finance; EFFICIENT market theory; LONG-term business financing; ASSETS (Accounting); LIABILITIES (Accounting)
- Publication
Journal of Finance (Wiley-Blackwell), 1977, Vol 32, Issue 3, p789
- ISSN
0022-1082
- Publication type
Article
- DOI
10.1111/j.1540-6261.1977.tb01989.x