Dr. Brandon Lockhart, assistant professor of finance at the UNL College of Business Administration, has recently had his paper, “Shareholder Returns, Trade Credits, and Operating Constraints” recognized by the Financial Management Association (FMA) Conference as a semi-finalist for top corporate paper among those to be presented at the annual meeting in Denver during October 19-22. In addition, the FMA’s journal, Financial Management
, accepted another of his papers, “Shareholder Returns from Supplying Trade Credit” for publication.
Lockhart, who co-authored the paper with Dr. Matthew D. Hill of the University of Mississippi and Dr. G. Wayne Kelly of Southern Mississippi University, continues a research stream he has followed during his career, focusing on the impact of the firm's financing decisions on its operating and investment decisions. Previously a commercial banker himself, Lockhart said the subject matter has a practical level of interest to him as well.
“Corporate finance gets interesting when the financing decision affects the firm's investment and operating decisions, which usually results from a conflict of interest or an information problem between relevant parties,” Lockhart said. “There are managers, there are shareholders, there are debt holders, and each of them might have private interests that differ across the parties.
The problem Lockhart describes is well-known and established in the corporate finance literature. Traditionally, textbooks have taught that paying off debt with "excess" cash is always optimal. Excess cash should be used to extinguish outstanding debt, or if the firm has no debt then the excess cash should be distributed to shareholders. Since the rate of return on idle cash cannot dominate these two opportunities.
“Finance literature up until just a few years ago, had the strong assumption that the ability to go to the bank for a loan, which is your debt capacity and "excess" cash were perfect substitutes. If you had excess cash then you should absolutely repay any debt you had outstanding, because the after-tax earnings on your cash is less than the after-tax cost of the debt. If we observed that a firm had excess cash, then the logical conclusion was that a conflict of interest was driving the decision. In other words, managers and/or shareholders likely had a private incentive to retain the excess cash instead of repaying the debt holder or making a distribution,” he said.
But recently, this traditional view has been challenged. Lockhart argues that in some situations it makes sense to keep excess cash inside the firm, especially if excess cash and debt capacity are not perfect substitutes.
“Younger firms and firms with more growth opportunities may find it more difficult to access the external markets tomorrow. Convincing the banker to lend to you can change quickly -- as we saw during the last credit crisis. If so, the debt capacity you have today might not be there tomorrow. You might be a technology firm with a great project that you believe is going to change the world, but if you can’t convince the market to fund the project or if you expect to be unable to convince the market to fund a future project when the funding is needed, then cash policy today becomes more important,” Lockhart said.
Disclosure issues can also play into the equation when dealing with firms. One example is technology companies.
“Apple has zero debt and they have nearly $80 billion in cash. That's about $1.6 million of cash on hand per Apple employee, and about $80 per share. This cash policy is hard to explain. I would argue that one reason that they have so much cash on hand is because if they instead fund themselves with debt, then they have to start disclosing their investment opportunities to the banker. The "unknown" regarding their next technology innovation is extremely important to them. They source their new in-development product components, such that very few, if any, suppliers understand the whole product too early. It’s kind of like Coca-Cola in that very few, if any, know the complete formula. A banker might be last on the list of people with whom Apple desires to share such private information. Such disclosure might be necessary if the firm were reliant on the debt markets," he said.
In two papers, Lockhart and co-authors Hill and Kelly examine the shareholder value implications of firms’ use of supplier-customer credit. Information problems that can drive transactions costs for debt and equity issues can sometimes be mitigated by the unique relationship maintained between supplier and customer firms. In some cases, this "trade credit" can serve as an important source of financing for borrowers that might have trouble communicating their story to a bank or to equity markets.
“Suppose I am the manufacturer of some product and I have all these customers who could use my product for their output, but the customers are having trouble getting financing. I can extend them trade credit -- I give them the product on credit terms so they don’t have to go to the bank, for example. Or maybe I am a supplier who needs to enter a new market or just generally desires to increase market share. The extension of trade credit to your customer can have strategic value. In the first paper, we find that shareholders recognize this strategic value of the extension of trade credit from the supplier's perspective and that the importance of this strategic value varies among firms in predictable ways, consistent with established theories. The motivations for using trade credit and the predictions regarding its value creation from the borrowing-firm's perspective are not the same as for the supplying firm. The second paper evaluates these related, but distinct questions from the borrowing-firm's perspective," Lockhart said.
He and his co-authors hope their detailed look at how bank debt, trade credit and cash are managed by contemporary firms will help modernize the research regarding the various financing options available, and ultimately lead to improved instruction in the classroom.
Lockhart joined the UNL College of Business Administration in 2009 and has research interests in empirical corporate finance including capital structure, and the management and regulation of financial institutions.