Wiley American Finance Association

American Finance Association
Super Premium Security Prices and Optimal Corporate Financing Decisions

Author(s): David W. Glenn
Source: The Journal of Finance, Vol. 31, No. 2, Papers and Proceedings of the Thirty-Fourth
Annual Meeting of the American Finance Association Dallas, Texas December 28-30, 1975 (May,
1976), pp. 507-524
Published by: Wiley for the American Finance Association
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THE JOURNAL OF FINANCE VOL. XXXI, NO. 2 - MAY 1976
SUPER PREMIUM SECURITY PRICES AND OPTIMAL

CORPORATE FINANCING DECISIONS
DAVID W. GLENN*
I. INTRODUCTION
DETERMINATION OF the appropriate capital structure for the wealth maximizing

firm is a central topic in the study of business finance and has spawned numerous
articles and studies by academicians and practitioners alike. An important segment
of this body of literature has received notable acclaim from theoreticians and has
served to focus all thinking in this area. It consists, at the risk of over-
simplification, of derivations of J. B. Williams' [25, 1938] "Law of the Conservation
of Investment Value"-stating that the firm's market value is independent of its
financial structure-under ever more general conditions. In their landmark article,
Modigliani and Miller [16, 1958] used the now familiar arbitrage argument to prove
the Williams' entity theory of value under assumptions which included that firms
may be grouped into equivalent risk classes, that corporate debt is riskless, and that
perfect capital markets exist. Hamada [8, 1969], in an application of the capital
asset pricing model to the problems of business finance, proved the capital
structure irrelevance propostion in the absence of the MM risk class assumption.
And Stiglitz [23, 1969], also in the context of a market equilibrium model, further
generalized the irrelevance thesis to encompass the issuance of risky corporate
debt.
The systematic investigation of specific types of capital market imperfections has
also yielded meaningful results, clarifying both the manner in which markets
function and the complex nature of the capital structure problem.' This paper
extends the analysis of capital market imperfections by developing positive implica-
tions concerning the existence of specific institutional portfolio restrictions for
firms' financing decisions.
In a companion paper2 a single period, two parameter capital asset pricing model
was utilized to demonstrate that statutory investment restrictions imposed on the
portfolio choices of major financial institutions and certain practices accompanying
the shorting of securities combine to create a market situation wherein some
securities sell at unwarranted price premiums from the viewpoint of firms' share-
holders. The present paper introduces wealth maximizing firms into this equi-
librium model as active decision agents seeking to optimize financial structure by
issuing both debt and equity securities. The analysis indicates that some, but not
* Assistant Professor, The University of Utah. The author wishes to thank Professors Robert H.
Litzenberger, William F. Sharpe, and James. C. Van Horne for their helpful comments and suggestions.
1. See, for example, Modigliani and Miller [15, 1963], Kraus and Litzenberger [11, 1973], and
Rubinstein [21, 1973].
2. Glenn [5, 1976].
507

508 The Journal of Finance
all, firms face interior optimal capital structures and highlights similarities in the
market effects of institutional portfolio restrictions on investors and firms.
The paper is organized as follows. Section II summarizes the security exchange
model of capital market equilibrium developed in the companion paper. In the
context of this summary, observed institutional portfolio restrictions are briefly
introduced and implications of their market existence important to firms' financing
decisions are discussed. Section III develops equilibrium valuation equations for
corporations. These equations indicate that capital structure is a relevant decision
variable for some, but not for all, wealth maximizing firms. Section IV introduces
firms into the equilibrium capital market model under the assumption that firms'
investment decisions are given. The financial structures for certain of these firms
are shown to be determined endogeneously and to provide security supply equa-
tions for the investment grade issues purchased in equilibrium by restricted
investors. In addition, similarities in the market effects of institutional imperfec-
tions on investors and firms are noted. Finally, Section V presents a summary of
the principle results and conclusions.
II. INSTITUTIONAL PORTFOLIO RESTRICTIONS AND SUPER PREMIUM

SECURITY PRICES
An important aspect of contemporary financial markets is that certain institutional

investors controlling substantial amounts of wealth are restricted by statutes and
rulings to investments in specific eligible securities. Major purchasers of corporate
securities affected by such legislation include mutual savings banks, state and local
government retirement funds, and life insurance companies.3 Together, these
financial institutions hold the majority of corporate bonds outstanding and account
for well over half of all purchases of new corporate debt.4
According to most observers, the primary purpose of the legal restrictions is to
protect policyholders' reserves and depositors' and beneficiaries' assets by preserv-
ing safety of principal. Consequently, the general characteristic of securities eligible
for purchase by legally restricted investors is that the perceived probability of
default in the payment of interest and principal, or dividends, be low. In practice,
eligible securities are generally known as "investment grade" securities and are
often taken to be those fixed income issues and their equivalents rated BBB or
better by one or more national rating agencies or found on the legal lists of the
states in question.
Several financial writers, including Durand [4, 1952], Hickman [9, 1958], and
Dougall [3, 1970], have suggested that legal portfolio restrictions create differentials
in risk-adjusted yields among broad security groups. Durand, for example, asserts
that investment restrictions, including statutory restrictions, result in a forced
demand for high grade bonds that pushes bond prices to a premium vis-a-vis
3. The footnotes to Glenn [5, 1976] contain a brief review of the restrictions imposed upon each of
these types of institutions.
4. See Kaufman and McKeon [10, 1974], pp. 13-16.

Premium Security Prices and Optimal CorporateFinancing Decisions 509
market prices for other issues. That is, a sort of "super premium for safety" is
reflected in the prices of investment grade securities.
As expressed by these authors, the super premium argument fails to adequately
explain why super premium prices are not eliminated by arbitrage5 or why, if super
premium prices exist, unrestricted investors are observed holding significant
amounts of high grade bonds in their investment portfolios. These insights are
provided in a companion paper where, in addition to statutory restrictions, specific
market arrangements associated with the security short sale process are formally
recognized. In essence, these arrangements are demonstrated to create effective
barriers to arbitrage activities by limiting investors' incentives to sell super pre-
mium securities short. The market practices directly responsible for erecting this
barrier against short sales are that (a) the proceeds of a short sale are held in
escrow pending return of the borrowed shares, and importantly, that (b) any
interest accruing to these proceeds is not credited to the account of the initiator of
the short position.
Prior to exploring the firm's capital structure decision in a market characterized
by the existence of a restricted investor subset and institutional barriers against
shorting, it is necessary to clarify the nature of the composition of investors'
optimal risky portfolios and the equilibrium price structure for risky securities
under such conditions. Therefore, a brief review of the equilibrium model de-
veloped in the companion paper and a short discussion of selected results is
presented here.
To begin, make the following assumptions:
Basic Assumptions
(a) Investors are risk averse and choose portfolios as if maximizing the expecta-
tion of a quadratic utility function of end of period portfolio value, subject to a
wealth constraint.
(b) Investors may borrow or lend an unlimited amount at an exogeneously
determined riskless rate of interest.
(c) Investors have identical expectations concerning the joint distributions of end
of period portfolio wealth.
(d) There are no external drains inherent in the market mechanism. That is,
information is available to all at no cost, there are no personal income taxes, and
transactions costs are zero. In addition, all assets are perfectly divisible.
Assumption (a) induces the formation of diversified portfolios by investors and
places the analysis in the framework of a single period, two parameter model.
Given perfect security divisibility and costless security exchange by (d), assump-
tions (a) and (b) together are sufficient to imply that each investor allocates his
wealth, irrespective of its level, between the riskless asset and a unique risky mutual
fund. When investors additionally possess homogeneous probability beliefs, as
5. Durand, who does comment on this problem, contends that arbitragers lack sufficient funds to
eliminate price differentials.

assumed in (c), optimal portfolios for investors with identical portfolio opportuni-
ties consist of investment in the riskless asset and the same risky mutual fund.6
The effects of statutory investment restrictions and institutional barriers against
shorting are incorporated into the model by assuming that:
Institutional Portfolio Restrictions
(e) Capital market participants can be meaningfully separated into categories of
restricted and unrestricted investors.7 Corresponding to any restricted investor, the
risky security universe can be partitioned into eligible and ineligible security
subsets. Moreover, for convenience, the exogeneously determined set of eligible
(investment grade) issues is identical for all restricted investors.
(f) Institutional securities market arrangements result in an effective barrier
against selling securities short.8
Prior to discussing the impact of market assumptions (e) and (f), it is helpful to
introduce notation. Designate by A* the set of investors a=1,2,...,A whose
portfolio choices are not affected by statutory regulation and denote the set of
remaining investors, b=A+1,A+2,...,A+B, whose portfolios are comprised
primarily of investment grade securities, by B*. In addition, let I* represent the set
of investment grade securities i = 1,2,..., I comprising the restricted investors'
eligible security opportunity set and designate the mutually exclusive set of remain-
ing risky securities, j = I + 1,I + 2, .. ., I + J, by J*. Figure 1 depicts this notation.
Finally, let f represent the riskless asset which any investor may purchase or issue
without limit.
Since investors with nonidentical opportunities necessarily form different op-
timal risky portfolios, it follows from (e) that in equilibrium two unique optimal
6. If, in addition, the portfolio opportunities of all investors are identical, as in a perfect capital
market, the optimal risky mutual fund for each investor must necessarily be the market portfolio,
consisting of value weighted proportionate holdings of all risky securities. Moreover, security prices will
adjust until the equilibrium expected rate of return on any security is a linear function of its
contribution to total market risk.
7. Assumptions (a) and (e) imply the definition of utility functions for restricted, as well as
unrestricted, investors. As noted above, most restricted investors are actually finanical intermediaries-
particularly life insurance companies and state and local government retirement funds. These interme-
diaries aggregate the funds of individual investors and purchase portfolios on their behalf. Barring
additional market imperf,ections, individuals would either bypass restricted intermediaries and directly
purchase primary securities in the desired proportions, or they would hold claims against restricted
institutions only in lieu of the underlying risky assets. In either event, the individual's net portfolio of
risky securities would be the market portfolio. Thus, for implications derived from (e) to be useful as
approximations of reality requires that many individuals concentrate on otherwise undue amount of
their portfolio wealth in restricted intermediary claims. The discussion in the companion paper clarifies
this point and suggests that weak statistical evidence and casual observation imply that this is indeed the
case.
8. To the extent that security certificates may be borrowed, a constraint against short sales is quite
unrealistic. The analysis in the companion paper, however, indicates that the nonnegativity approxima-
tion produces market implications virtually identical to those developed under the current provisions of
the escrow requirement. The nonnegativity approximation is used here because it simplifies the
presentation.

INVESTOR RISKY SECURITY

POPULATION UNIVERSE
A*(UN RESTRICTED) J * SECURITIES
(RESTRICTED (INVESTMENT
SEC RITIES
GRADE)
EITED-
FIGURE 1
risky mutual funds exist. Designate by N* the risky mutual fund purchased by
unrestricted investors a E A * and let Z* denote the restricted investor risky mutual
fund. Also, define indices n = 1,2, .. ., N and z = 1,2, .. ., Z to represent the individ-
ual risky issues comprising mutual funds N* and Z*. Conservation of the fixed
security endowment requires that funds N* and Z* be portfolio complements and
(f) confines the aggregate position of the optimal risky fund formed by either
investor subset to zero or positive shareholdings, not to exceed the initial supply,
for any risky security.
It is obvious that in equilibrium all shares of ineligible risky securities]jeJ* will
be contained in fund N*. Shares of investment grade securities i & I*, however,
may be held by either restricted or unrestricted investors, or by both. This situation
creates a dual pricing structure for investment grade claims. The dual relationships
between risk and end of period security value are given by
Restricted Investors' Security Market Line: I Relations
P f+[ 22Cb E(YB)] (Cov-, Y,yz I
where E is an expectations operator,

signifies a random variable,
R represents the end of period share value of the asset in question,
P is the equilibrium market price,
C is the taste parameter in the investor's quadratic utility function, and
Y is the aggregate end of period wealth of the individual investor, investor
subset, or risky mutual fund in question;
and

UnrestrictedInvestors' Security Market Line: I + J Relations
Pj} Pj[< 2Ca E(fYA*)j (Cov P vYN*)- (2)
Relation (1), shown graphically in Figure 2, states that in equilibrium the

expected per dollar return for any investment grade security is less than or equal to
a riskless component plus a premium for bearing risk. The risk premium is given by
the product of two terms. The first is the inverse of the aggregate of restricted
investors' risk tolerance functions and may be termed the market price of risk
reduction in the restricted investor market. For convenience, this term will be
designated by 'DB* in subsequent discussions. The second is the security risk which
is nondiversifiable in the same market. This relevant risk is equal to the per dollar
contribution of the security to the variance of the end of period value of the
restricted investors' optimal risky mutual fund. Relation (2) describes a parallel
situation for the unrestricted investor market.
E(R-) M(R.)
ERR;
_~ ~ ~ ~ ~ ~~~~~F Y
pi Pi Pi
Rf Rfe
Cov (YN
Cov (Ppi~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~
YZ Cov (FYN*)
Restricted Investors' Security MarketLine Unrestricted Investors' Security Market Line

FIGURE 2
It is evident from relations (1) and (2) and Figure 2 that in both markets some
investment grade securities sell at super premium prices. Securities plotting as if on
the market line in a given market are held in equilibrium by the investors in that
market and, by definition, are the security elements from which the relevant
optimal risky mutual fund is comprised. Securities plotting as if below the line,
even though legally acceptable for either investor group, are not held by investors
in the market in question, nor are they found in the reference risky mutual fund for
such investors. All outstanding shares of these (super premium) issues are con-
tained in the optimal risky mutual fund of the other set of investors and their
market prices are determined by the active demands for such shares from that
investor set.

While this market situation is similar in concept to the super premium for safety,
it is now apparent that super premium prices owe to the joint effects of market
segmentation and institutional barriers against shorting and cannot be attributed to
the safety characteristics of investment grade claims. By segmenting security
markets, statutory restrictions create two equilibrium required risk premiums for
any investment grade issue, one for each investor group evaluating it. The security's
market price is determined by the demand from that investor market in which the
required risk premium is lower. To investors in the other market, the security
appears priced at a premium. There need be no pressure for price revisions since
the institutional barriers limit investors' incentives to sell super premium issues
short. The implications of this situation for firms' capital structure decisions will
now be discussed.
III. THE FIRM'S EQUILIBRIUM MARKET VALUE
It was concluded in the preceding section that market prices of individual securities
are determined either by the demands of unrestricted investors or by the demands
of restricted investors. While it is possible that any specific investment grade
security may be attractive to both groups of investors simultaneously, and that its
price may be determined by the joint demand of both groups, such a situation does
not affect the analysis and need not be separately considered. Therefore, let the
subscript z in conjunction with P, the variable for price, indicate that price is
determined in the restricted investor market. Of course z also implies that units of
the respective issue are purchased by restricted investors. Similarly, let n represent
price determination and purchase by unrestricted investors. In addition, to enable
firms to be introduced into the analysis, let K represent the number of firms in the
market, let k = 1,2,... , K be an index identifying the kth firm, and let / = 1,2, .... , K
be an index associated with the fixed income obligations of the kth firm.
Assuming that equity securities do not qualify for an investment grade rating
and abstracting from the possibility that future investment opportunities available
to the firm may be reflected in the price of its shares, the equilibrium market value
of the firm's equity may be written from (2) as
Market Value of the Firm's Common Shares
E[Ok_RiDl]-(A*Cov(Ok_R Dl; Y*)
PnkXk=
Rf/ Pf
where, for the kth firm,

P is the share price of the common stock,
X is the number of shares outstanding,
O is the random single period operating income,
R' is the random end of period security value, and
D' is the number of outstanding fixed income securities.
As indicated by the subscript n, this value is determined in the unrestricted investor
market and is given by capitalizing the certainty equivalent of the firm's earnings to
equity at one plus the riskless rate. The certainty equivalent is equal to the

expectation of earnings to equity, E [Ok -RD], minus a correction for risk. The
market determined risk premium is the product of (A*, the price of risk reduction
in the unrestricted investor market, and Cov(Ok-R'D1; YN*), the risk that is
nondiversifiable in the same market.
The shares of an unlevered but otherwise identical firm are also traded in the
unrestricted investor market. The equilibrium value of such a firm, PkXk', is
Market Value of Unlevered Firm
ok] DA.Cov(Ok, YN*)
pk'Xk =E[
pk'~~~k'
Rf /Pf
The market value of the firm's fixed income securities depends upon whether
such securities are purchased and held by restricted or by unrestricted investors.
Assuming the former only,
Value of Securities if Purchased by Restricted Investors
E= E[RD'
1= [
]- B*Cov(R'D', Yz4)
P,1D 5
-~Rf / Pf
If, however, the securities do not qualify for an investment grade rating, or if any
part of the investment quality issue is purchased and held by unrestricted investors,
then
Value of Debt if Purchased by UnrestrictedInvestors
E [ RWD]- (DA*Cov(R'D',YN*)
Rf/ Pf (6)
Solving both (5) and (6) for E-[i?'D'], alternately substituting into (3), and
solving for P X + P D, yeilds.
Value of Firm Unable to Issue Super Premium Securities
pkXk + plD -pkxk' (7)

and
Super Premium Value of Levered Firm
(P 11 I,
PkXk+PIDI= Pkk
pkXk+plDlpk' | FACOV(R 'D fN*)
I
-(B* COV(fiID YZ.)]
j. (8)
/Pf
~~~~~~Rf
If fixed income securities are sold to unrestricted investors, the firm's sharehold-
ers do not benefit from a price premium and (7) applies. This result corresponds
9. These equations are similar to those presented by Rubinstein. [21, 19731 in the context of his
evaluation of the firm's capital structure decision in separated markets. In contrast to the present model,
Rubinstein's partial equilibrium analysis assumes a particular relationship between the prices of risk
reduction in the two investor markets, does not allow for common security opportunities among the
investor sets, and ignores the arbitrage activities of firms in eliminating required return differentials.

to the MM Proposition I and implies that debt financing does not affect sharehold-
ers' portfolio opportunities and that capital structure is therefore irrelevant.
For firms whose investment grade claims are purchased entirely by restricted
investors, shareholders benefit from a price premium; (8) applies; and financial
structure becomes a matter of some concern. The total savings in capital costs
resulting from the super premium issue, given in the numerator of the last term in
(8), is the product of [PA.*Cov(R 7/P,f YN*)- 4B* Cov(R 7/P, Yz*)], the per dollar
interest savings associated with the super premium price, and P,fD 1, the dollar value
of securities issued. When capitalized at one plus the riskless rate, these total
savings represent the increase in portfolio wealth accruing to shareholders as a
result of both the firm's financial structure and its ability to issue securities to
restricted investors at super premium prices.
IV. OPTIMAL CAPITAL STRUCTURE DECISIONS
In the equilibrium model underlying Section II, probability characteristics and

market supplies of the various security issues were taken as given. Section III
demonstrated, however, that some but not all firms can increase share value
through an appropriate financing policy. Accordingly, this section introduces firms
into the capital market model as decision making agents seeking to optimize
market value by issuing various amounts of debt and equity securities. The analysis
utilizes the following assumptions:
Additional Basic Assumptions
(g) Firms are price takers and act as if seeking to maximize the market value of
their common shares.
(h) Firms' investment decisions are predetermined. Moreover, investors agree on
the relevant probability assessments concerning each firm's random, single period
operating income.
(i) Transformation functions exist for each firm. These functions relate alterna-
tive levels of bondholder claims against operating income to the relevant risk of
such claims for both restricted and unrestricted investors and are continuous and
differentiable over the allowable range of the firm's debt capacity.
Under (g) firms act as if they are unable to influence either the prices for risk
reduction in the two investor markets or the probability characteristics of investors'
optimal portfolios. The firm takes these variables as given and, subject to its ability
to issue both debt and equity claims, seeks to exploit super premium situations by
maximizing (8).
Assumption (h) implies that each firm has determined its investment decision
and now seeks the most appropriate means of financing such investment. Its
purpose is to allow investor determination of the probability distribution of returns
accruing to both shareholders and bondholders, given alternative firm decisions
with respect to capital structure.10
10. This assumption is similar to the MM assumptions relating to the firm's operating income. In a
timeless context, MM regard the stream of profits accruing to the firm as a random variable subject to a
probability distribution, imply that the probability distribution is unaffected by financial structure, and
impose identical probability beliefs among investors.

Given (h), the end of period return on the firm's debt depends entirely upon the
realized value of operating income. Assumption (i) recognizes the existence of
relationships between the distribution of operating income and the risk
characteristics of the firm's debt obligations. These relationships may be written as
TransformationRule for Debt Risk in the UnrestrictedInvestor Market: K Equations
FN*[COV(RD, YN*);NE(RD)] = (9)
and
TransformationRule for Debt Risk in the Restricted Investor Market: K Equations
Fz*[Cov(R'D',YZ*);E(RD)] =0. (10)
As discussed above, the benefit accruing to shareholders from an exercise of the

firm's ability to issue super premium debt depends upon P,'D', the dollar value of
super premium securities issued. Given (g), the firm's effect on P, is confined to the
characteristics of the probability distribution of returns for the firm's bonds. Thus,
the firm's decision simply requires determination of the portion of the probability
distribution about operating income to promise to debt holders and can be
represented by
Firm's Objective Function: K Equations
Max[ 4A*Cov(R'D I YN*)-B*COV(RIDI,YZ*)] (11)
w.r.t. E(R'D')
This decision is similar to a production decision in the sense that the firm takes a
given distribution of returns to investment and produces packages of risk and
return for purchase by restricted and unrestricted investors, subject to transforma-
tion functions. As with production functions, transformation functions describe the
relationship between inputs (probability distributions about operating income and
end of period wealth for each investor subset) and outputs (risk and return on debt
securities in the two investor markets), and are exogeneously determined.
The market imperfections giving rise to the institutional portfolio constraints on
investors' decisions also imply the following restrictions on firms' decisions:
Additional Institutional Constraints
(j)' Known institutional limits exist on firms' abilities to transform operating
income into investment grade claims.
(k) Firms cannot produce and issue negative debt.
Assumption (i) approximates an effect of the previously discussed statutory
investment restrictions. Since the risk of default on debt securities increases as the

degree of leverage increases, firms are necessarily limited in the amount of

investment grade claims they may produce at any point in time. That is, some limit
must exist beyond which additional debt offerings are perceived to constitute
sufficient risk that the firm's debt will not qualify for an investment grade rating. It
is not inconsistent with the statements of national rating agencies11 to express this
institutional limit as a function of E(O)/a(O), the inverse of the coefficient of
variation of the firm's operating income:
Investment Grade Security Limitations. K Equations
B( Ok)
E(R'D ')?k ,
(12)
,g(o k)
where, for firm k, T is an institutional debt acceptability factor.

Finally, as assumsd in (k), it is necessary to require that
Nonnegative Debt Requirements:K Equations
E(RiD)> 0. (13)
The rationale for this restriction is discussed later.

Conditionsfor Firm Equilibrium
The value of Tk for the kth firm is determined outside the model. Designate
(K- F) as the number of firms unable to issue securities with the preferential
investment grade rating. For such firms, "'k = 0; valuation equation (7) applies; and
capital structure is irrelevant. The remaining F firms seek to maximize (1 1), subject
to (12) and (13). The Lagrangian for these firms is
Lagrangianfor Investment Grade Firms: F Equations
e = oA* Cov(R 77'D', YN*) - (B* Cov(R 'D', i4*)
-I [ E(~RD)]- 2[ "k E(O) -IE(RDl)| (14)
where 1 and (?2 are Lagrangian multipliers.

Utilizing (d), (g), (h), and (i), the first order optimality conditions for firms'
production of investment grade securities are
F Conditions
-- < E
E(RID l), ( 15)
(01~~~~~~~~~~~(5
11. In this regard see, for example, Moody's [17, 1970], pp. v and vi.

F Conditions
_
*a- =0 < Ekk~E(O)
(( )-E(R/D), (16)
(02 (O)
F Equations
_ ='
\ , dCov(R'D'YN*) dCov(R'D, Yz*)
_ A* ~- -OB* +9 02-
aE(R DI) dE (R DI dE(R'D')
(17)
By nature of constraints (12) and (13), both cannot simultaneously be binding

for any single firm. The three remaining possibilities are 1. neither constraint is
binding, 2. (12) alone is binding, and 3. (13) alone is binding. The number of firms
falling into Cases 1, 2, and 3 will be designated by F1, F2, and F3 respectively and
each of these cases will be considered in turn. Prior to discussing the cases,
however, it is important to note the existence of sign restrictions on xl and W2, the
artificial variables associated with the two constraints. Specifically, as the
Lagrangian is formulated above, the values of co and 02 corresponding to any firm
are necessarily less than or equal to zero.12
1. Neither constraint is binding
When the optimal firm solution is in the interior of the feasible region with
respect to both the non-negative debt constraint and the institutional investment
grade security limitation, w, and w2 can be set to zero in the solution. Optimality
condition (17) may thus be rewritten as
12. For notational convenience, define
AA* Cov(RD', YN-) -4B' (R'D', Yz.) V.

From (17),
av
2
8E (, ZDWI)
The differential d of the contribution to value V is
dV= a-v dE(R'D').

aE(RID')
Combining the above yields
dV- dE(Ri'D1)wl - dE(R'D ')W2
When w, ? 0, the optimal solution is on the boundary with respect (13). The only allowable variation in
this solution is therefore dE(R 'D') >0, but any variation implies dV <0. This can only be true if eoI<0.
Similarly, when w2 # 0, (12) is binding and the only allowable variation from the optimum is
dE(R ID1)< 0. Since any variation from the optimum again implies dV < 0, it is also required that 02 < 0.
Of course when the optimal solution is in the interior of the feasible set with respect to a constraint,
the value of the artifical variable corresponding to that constraint is zero. Consequently, for any firm it
is required that w < 0 and 02 O.

F, Equations
d Cov(R 'D1, Y) dCov(R'D', YN*) (18)

dE(R'D') dE(R'D')
The derivatives in (18) express the rate of change in nondiversifiable risk for
restriced and unrestricted investors with respect to the production of investment
grade claims by the firm. The product of the market price of risk reduction and the
rate of change of risk in the same market is the incremental required risk premium
on investment grade promises. As long as this incremental premium is greater in
the unrestricted market, the interest savings resulting from the production of
additional claims, which are purchased by restricted investors at lower required risk
premiums, will cause share value to increase. Condition (18) states that investment
grade financing continues until the incremental required risk premiums in the two
markets are equal.13 That is, because of the nature of their transformation func-
tions, F1 firms reach an interior optimum capital structure in the absence of
constraints. 14
2. Binding upper limit on investment grade claims.

When the optimal solution is on the boundary of the feasible region with respect
to (12), the firm's institutional limitation on investment grade claims is active and
W2 <0. Moreover, since (13) is not binding, the complimentary slack requirement
associated with (13) implies that =o 0. Hence, (17) may be rewritten either as
F2 Equations
d Cov(R 'D, ) d Cov(R 'D, YN*) + (l9a)
dE(RID') dE(R'Di)
or
F2 Equations
d Cov(R 'DI, d
dCov(R 'D'IYN*)
dE(R'D') dE(k'D') (19b)
13. It is, perhaps,worthnotingthat if (18) definesa minimumand if, for either(9) or (10) thereis at
most one value of E(R 'D) within the relevantrangefor which the second derivativeis zero, then the
firm is properly an element of F3 and the relevant maximizingcondition is (20a). Rather than
minimizingvalue by selling debt to restrictedinvestorsat low prices, unrestrictedinvestorswould
purchasethe entireofferingand the marketvalue of the firm'sdebt would remainunchanged.
14. In the event that several values of E(R'Dl) within the range of allowable investmentgrade
offeringssatisfy (18), then all such values, as well as the end point of the allowablerange,would be
evaluatedand the global optimumchosen.
It is also possible,but extremelyunlikely,that for certainof the F, firmsthe capitalstructuredecision
is indeterminate.The nature of the transformationfunctions may be such that investmentgrade
securitiesare equally attractivein both marketsthroughoutthe relevantrange. However,since this
possibilityseemsratherremote,it is ignoredin the subsequentdiscussion.

As long as the incremental required risk premium is smaller for restricted

investors than for unrestricted investors, as is the situation shown in (19b), the firm
finds it beneficial to issue investment grade securities. In the present case the firm
issues such claims until the institutional constraint becomes binding. Consequently,
from (16), the optimum value is E(R'D')= '!E(O')/u(O). Moreover, the equi-
librium value of W2 in (19a) may be interpreted as a measure of the incremental
cost to shareholders of the firm's institutional inability to issue additional claims
against operating income and still maintain an investment grade rating.
3. The institutional nonnegativity constraint is binding.
If the optimal firm solution is on the boundary with respect to the nonnegative
debt constraint, w < 0 and C02 =0. This implies
F3 Equations
and dE(R 'D, ) dE(RD ) (20a)

F3 Equations
d Cov(R 'D, 4Z*) dCov(R 'D, YN*)
DB* O
>A* (20b)
dE(R'D') dE(RID')
(20b) indicates that in Case 3 the marginal required risk premium for investment
grade claims is smaller in the unrestricted market. In such circumstances, and in
the absence of constraints, the firm would maximize share value by issuing negative
claims on operating income to restricted investors. Since this is not allowed, the
optimum is E(R 'ID) =0 and the value of w, may be interpreted to be the
incremental cost to shareholders of the firm's inability to issue negative debt. This
solution does not imply that the optimal capital structure is all equity but, rather,
than any investment grade claims the firm may issue will be purchased by
unrestricted investors. Hence, the capital structure decision for the F3 firms in Case
3 is indeterminate.
The F1 firms of Case 1 reach an interior optimal capital structure in the absence
of constraints. These firms would be observed issuing high grade claims at a variety
of quality ratings ranging from the highest to the lowest in the investment grade
category. F2 firms, however, optimize their market values by issuing the maximum
amount of senior securities consistent with receiving investment grade ratings.
Heuristically, the nature of the transformation functions is expected to be such that
F1 is likely small relative to F2. If this is true, the model implies that most firms
able to sell investment grade issues to restricted investors will issue securities rated
BBB up to the point where additional offerings would result in a loss of the
investment grade rating altogether."5
15. It is interesting to note that Case 2, where the preponderance of firms facing optimal capital
structures are expected to fall, provides a concrete rationale for what is perhaps the earliest verbalization
of the interior optimal capital structure concept, Graham and Dodd's "Principal of Optimum Capital
Structure" (in [6, 1934], Chapter LV):
"The optimum capital structure for any enterprise includes senior securities to the extent that they
may be safely issued and bought for investment."

Firms' Nonnegative Debt Restrictions

As discussed previously, institutional practices associated with the escrow re-
quirement limit investors' incentives to sell super premium securities short. In the
absence of such barriers restricted investors would sell super premium issues to
unrestricted investors and invest the proceeds. These transactions would persist
until all super premium prices were eliminated.
The same type of arbitrage would occur if Case 3 firms sold negative claims to
restricted investors. Negative claims consist of a firm payment to restricted inves-
tors in return for their promise to pay a random end of period sum, equal in
amount to the firm's end of period payment on outstanding investment grade
claims (which, in Case 3, are held by unrestricted investors). Negative claims
against the firm are therefore nothing more than investors' short positions and
consistency requires that firms be unable to issue such securities.
The implication of the above is straightforward. It makes little difference
whether restricted investors sell investment grade claims short to unrestricted
investors directly, or whether firms act as intermediaries by purchasing restricted
investors' short positions and either reselling the resultant promises at higher prices
in the unrestricted market or distributing the realized end of period returns on such
claims to shareholders on a proportionate basis. Institutional barriers limit either
type of transaction and protect the differential required risk premiums for invest-
ment grade securities against such arbitrage activities.
A second similarity in the effects of institutional constraints imposed upon
investors and those imposed upon firms deserves attention. In the market depicted
here, all unrestricted investors place their funds at risk in the same risky mutual
fund. Since all hold the firm's shares in proportion to their risk investment, all
benefit proportionately from an exercise of the firm's ability to issue investment
grade claims at super premium prices. In the absence of institutional barriers
against shorting, unrestricted investors themselves could issue super premium
securities to restricted investors directly. Their short positions would become
components of the unrestricted investor reference mutual fund and unrestricted
investors would benefit proportionately to their funds at risk. Hence, the wealth
maximizing firm merely provides a means for shareholders to circumvent institu-
tional barriers against shorting when it is desirable to do so. Consequently, firm
offerings of super premium debt represent portfolio opportunities which sharehold-
ers' themselves cannot duplicate. However, the firms' ability to act as an agent by
issuing claims backed by equity owners to restricted investors is limited by the
institutional upper barrier on the amount of investment grade claims the firm may
issue. This limit effectively bounds the firm's ability to arbitrage away required
return differentials in the two investor markets and insulates the super premium
against the capital structure decisions of wealth maximizing firms.
The Formal Market Model
The simultaneous solution to the set of equilibrium conditions developed in the
companion paper and underlying Section II herein determines the number of units
of each security held by each investor in equilibrium as well as the equilibrium
price per unit of each risky security; a total of A (I + J + 1) + B(I + J + 1) + (I + J)
market variables. The analysis in the present section extends this equilibrium model

to permit the endogeneous determination of selected firms' financial structures and

the market supplies of investment grade issues selling at super premium prices in
the unrestricted investor market. That is, there now exists K(> I) supply equations,
one for each firm, corresponding to the investment grade claims purchased entirely
by restricted investors. These equations are given by the Fl conditions (18), the F2
equalities (16), and the F3 equalities (15). In addition, for firms whose investment
grade acceptability factor is zero.
K-(Fl + F2 + F3) Equations
E(R'D')=O: (21)
a total of K equalities.
The complete equilibrium solution also requires market values of c and (?2 for
each firm and knowledge of the particular firms comprising Cases 1, 2, and 3.
Thus, the model also includes the 2F complimentary slack requirements
F1 + F2+ F3 Equations
EE(R'D')=O (22)
and
Fl + F2 + F3 Equations
(2[ '1Ek E(ok E(RD'j) | (23)

G(O)
corresponding to constraints (12) and (13), the (F1 + F2) inequalities (15), the
(F1 + F3) inequalities (16), and the remaining (F2+ F3) equalities (17). Finally, the
relevant risks of firms' debt securities may be determined from the transformation
functions (9) and (10).
V. SUMMARY
This paper demonstrates that legal restrictions and institutional barriers, taken
together, have the potential of creating a situation which results in the existence of
an interior optimal capital structure for some, but not for all, firms. Specifically, for
wealth maximizing firms able to sell debt to restricted investors at super premium
prices, corporate financial structure becomes an active deicision variable. For most
such firms the optimum consists of issuing the maximum amount of debt consistent
with obtaining the preferential investment grade rating on debt securities.
Moreover, the institutional limitation on the firm's capacity to issue investment
grade claims effectively bounds the firm's ability to arbitrage away required return
differentials in the two markets and therefore insulates super premium prices
against firms' decisions.
Additionally, it is shown that financial structure remains irrelevant to market
value for firms whose investment grade debt is purchased at least in part by
unrestricted investors as well as for firms unable to receive an investment grade

rating on debt securities. For firms in the former category, the institutional barrier
against short positions protects the dual security pricing structure against argitrage
activities of wealth maximizing firms by preventing the sale of negative debt to
restricted investors at super premium prices.
Finally, Section IV completes the analysis initiated in a companion paper by
incorporating firms into the capital market model as decision agents choosing
optimum financial structures. The financing decisions of these wealth maximizing
firms yield security supply equations corresponding to the eligible securities
purchased entirely by restricted investors in equilibrium and thus provide a partial
determination of the relative market supply of corporate debt.
REFERENCES
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ment," Conferenceon Research and Business Finance. New York, New York: National Bureau of
Economic Research, 1952, 215-247.
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A Model of Capital Market Equilibrium in a Segmented Financial Market," Working Paper,
The University of Utah, March, 1976.
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Super Premium Security Prices and Optimal Corporate Financing Decisions

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SUPER PREMIUM SECURITY PRICES AND OPTIMAL

DETERMINATION OF the appropriate capital structure for the wealth maximizing

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II. INSTITUTIONAL PORTFOLIO RESTRICTIONS AND SUPER PREMIUM

An important aspect of contemporary financial markets is that certain institutional

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INVESTOR RISKY SECURITY

A*(UN RESTRICTED) J * SECURITIES

P f+[ 22Cb E(YB)] (Cov-, Y,yz I

where E is an expectations operator,

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UnrestrictedInvestors' Security Market Line: I + J Relations

Pj} Pj[< 2Ca E(fYA*)j (Cov P vYN*)- (2)

Relation (1), shown graphically in Figure 2, states that in equilibrium the

Restricted Investors' Security MarketLine Unrestricted Investors' Security Market Line

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III. THE FIRM'S EQUILIBRIUM MARKET VALUE

where, for the kth firm,

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Value of Firm Unable to Issue Super Premium Securities

pkXk + plD -pkxk' (7)

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IV. OPTIMAL CAPITAL STRUCTURE DECISIONS

In the equilibrium model underlying Section II, probability characteristics and

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FN*[COV(RD, YN*);NE(RD)] = (9)

Fz*[Cov(R'D',YZ*);E(RD)] =0. (10)

As discussed above, the benefit accruing to shareholders from an exercise of the

Max[ 4A*Cov(R'D I YN*)-B*COV(RIDI,YZ*)] (11)

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degree of leverage increases, firms are necessarily limited in the amount of

where, for firm k, T is an institutional debt acceptability factor.

The rationale for this restriction is discussed later.

e = oA* Cov(R 77'D', YN*) - (B* Cov(R 'D', i4*)

-I [ E(~RD)]- 2[ "k E(O) -IE(RDl)| (14)

where 1 and (?2 are Lagrangian multipliers.

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By nature of constraints (12) and (13), both cannot simultaneously be binding

12. For notational convenience, define

AA* Cov(RD', YN-) -4B' (R'D', Yz.) V.

The differential d of the contribution to value V is

dV= a-v dE(R'D').

dV- dE(Ri'D1)wl - dE(R'D ')W2

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d Cov(R 'D1, Y) dCov(R'D', YN*) (18)

2. Binding upper limit on investment grade claims.

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As long as the incremental required risk premium is smaller for restricted

and dE(R 'D, ) dE(RD ) (20a)

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Firms' Nonnegative Debt Restrictions

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to permit the endogeneous determination of selected firms' financial structures and

(2[ '1Ek E(ok E(RD'j) | (23)

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A(UN RESTRICTED) J SECURITIES

Pj} Pj[< 2Ca E(fYA)j (Cov P vYN)- (2)

FN[COV(RD, YN);NE(RD)] = (9)

Fz[Cov(R'D',YZ);E(RD)] =0. (10)

Max[ 4ACov(R'D I YN)-BCOV(RIDI,YZ)] (11)

e = oA* Cov(R 77'D', YN) - (B Cov(R 'D', i4*)