The Cost of Debt

We use exogenous variation in tax benefit functions to estimate firm‐specific cost of debt functions that are conditional on company characteristics such as collateral, size, and book‐to‐market. By integrating the area between the benefit and cost functions, we estimate that the equilibrium net benefit of debt is 3.5% of asset value, resulting from an estimated gross benefit (cost) of debt equal to 10.4% (6.9%) of asset value. We find that the cost of being overlevered is asymmetrically higher than the cost of being underlevered and that expected default costs constitute only half of the total ex ante costs of debt.     

The collateral channel: Evidence on leverage and asset tangibility

We examine how asset structure is related to leverage in different institutional environments, using tens of thousands of firm-level observations from small, privately held, emerging market firms that are likely to face financing constraints. Our empirical analysis indicates that the linkage between asset tangibility (fixed assets as a portion of total assets) and leverage (measured as long-term debt over total assets) varies, such that in countries with fewer restrictions on collateral (land transferability), the relationship between these variables is much tighter. This also applies to the linkage between tangibility and debt maturity structure (measured as long-term debt over total debt). We find no evidence that industry concentration in different countries or changing composition of firms over time is driving our findings. The results are robust to using firm-level fixed effects specifications, to clustering error terms at the country level, and to using an alternative proxy for collateral law regime.     

Financially Constrained Stock Returns

We study the effect of financial constraints on risk and expected returns by extending the investment-based asset pricing framework to incorporate retained earnings, debt, costly equity, and collateral constraints on debt capacity. Quantitative results show that more financially constrained firms are riskier and earn higher expected stock returns than less financially constrained firms. Intuitively, by preventing firms from financing all desired investments, collateral constraints restrict the flexibility of firms in smoothing dividend streams in the face of aggregate shocks. The inflexibility mechanism also gives rise to a convex relation between market leverage and expected stock returns.     

Can material asset reorganizations affect acquirers’’ debt financing costs?——Evidence from the Chinese Merger and Acquisition Market

In this paper, we investigate whether material asset reorganizations (MARs), a special form of merger and acquisition (M&A) transactions, can affect the acquirers’ cost of debt financing. Further, we examine the effect of acquiring firms’ accounting information quality on the cost of debt and on the association between MARs and debt costs. We predict that compared to conventional M&As, large-scale acquisitions through MARs can generate a much greater influx of assets from target firms. This raises the acquirers’ asset collateral and thus reduces the cost of debt. Because the quality of accounting information is a key factor affecting the cost of debt, we suggest that it has a spillover effect on the debt-cost effect of MARs. Using M&A transactions by listed companies in the Chinese A-share market from 2008 to 2014 as our sample, we find that MARs are associated with a higher asset collateral and lower ex post cost of debt than conventional M&As. Furthermore, we show that the acquiring firms’ accounting information quality has a significant negative effect on debt costs, and the negative association between MARs and the cost of debt is more pronounced when accounting information quality is higher.     

Collateral pricing

We examine how collateral affects the cost of debt capital. Using a novel data set of secured debt issued by U.S. airlines, we construct industry-specific measures of collateral redeployability. We show that debt tranches that are secured by more redeployable collateral exhibit lower credit spreads, higher credit ratings, and higher loan-to-value ratios—an effect which our estimates show to be economically sizeable. Our results suggest that the ability to pledge collateral, and in particular redeployable collateral, lowers the cost of external financing and increases debt capacity.     

Asset Revaluations and Assessment of Borrowing Capacity

Prior research has found support for contracting, political cost and information asymmetry explanations for managements’ decision to revalue non-current assets. This study proposes that asset revaluations occur to signal available borrowing capacity via an increase in collateral values at the time of increases in secured debt and that the economic benefits associated with an asset revaluation will be greatest for firms when they are experiencing times of declining cash flows from operations. Results imply that firms that have undertaken an asset revaluation are more likely to be experiencing declining cash flows from operations than firms that have not revalued. This study also investigates whether the incidence of valuations coincides with increases in levels of secured borrowings due to lenders’ demands for current values of assets offered as collateral. The evidence indicates that firms are more likely to record an asset revaluation if they have increased their secured borrowings, and that most non-year-end revaluations emanate directly from contracting with lenders.     

Bias in an Empirical Approach to Determining Bond and Mortgage Risk Premiums

Empirical studies of bond and commercial mortgage performance often quantify a required risk premium by examining the difference between the promised yield and the realized yield as adjusted for default occurrence. These studies omit the effects of various other sources of risk, however, including collateral asset market risk, interest rate risk, and possibly call risk. These omissions downwardly bias the empirical risk premium estimate on the debt. In this paper, we disentangle and quantify the sources of this bias by modeling secured coupon debt (the commercial mortgage) as used in the calculation of a realized investment return. We consider deterministic and stochastic interest rate economies with mortgage contracts that are either noncallable or subject to a temporary prepayment lockout period. Given realistic parameter values associated with the term structure, underlying asset dynamics, and debt contracting, we show that the magnitude of the bias can be significant.     

Default Risk, Asset Pricing, and Debt Control

The pricing and control of firms’ debt has become a majorissue since Merton’s (1974) seminal article. Yet Mertonas well as other recent theories presume that the asset valueof the firm is independent of the debt of the firm. However,when using debt finance, firms may have to pay a premium foran idiosyncratic default risk and may face debt constraints.We demonstrate that firm-specific debt constraints and endogenousrisk premia, based on collateralized borrowing, affect the assetvalue of the firm and, in turn, the collateral value of thefirm. In order to explore the interdependence of debt financeand asset pricing of firms, we endogenize default premia andborrowing constraints in a production-based asset pricing model.In this context then the dynamic decision problem of maximizingthe present value of the firm faces an additional constraintgiving rise to the debt-dependent firm value. We solve for theasset value of the firm with debt finance by the use of numericaldynamic programming. This allows us to solve the debt controlproblem and to compute sustainable debt as well as the firm’sdebt value.     

Financial Frictions,Investment Delay,and Asset Market Interventions

We construct a dynamic macro model to incorporate financial frictions and investment delay. Investment is undertaken by entrepreneurs who face liquidity frictions in the equity market and a collateral constraint in the debt market. After calibrating the model to the U.S. data, we quantitatively examine how aggregate activity is affected by a shock to equity liquidity and a shock to entrepreneurs' borrowing capacity. We then analyze the effectiveness of government interventions in the asset market after such financial shocks. In particular, we compare the effects of government purchases of private equity and of private debt in the open market. In addition, we examine how these effects of government interventions depend on the option to delay investment.     

Debt Financing,Corporate Financial Intermediaries and Firm Valuation

In this paper we consider the role of financial intermediaries in the valuation of firms and projects. We show that security prices should reflect both used and unused debt capacity if some corporations can act as financial intermediaries and can capture the tax benefits of debt capacity unused by the operating firm. We also provide some reasons why the value of the firm might be increased if the financing and operating risks of the firm are separated and financial intermediaries issue debt rather than the unit operating the asset.     

CONVERTIBLE DEBT AND RISK‐SHIFTING INCENTIVES

I argue that convertible debt, in contrast to its perceived role, can produce shareholders’ risk‐shifting incentives. When a firm's capital structure includes convertible debt, every investment decision affects not only the distribution of the asset value but also the likelihood that the debt will be converted and thereby the distribution of the firm's leverage. This suggests that managers can engage in risk‐increasing projects if a higher asset risk generates a more favorable distribution of leverage. Empirical evidence using 30 years of data supports my argument.     

Optimal Security Design and Dynamic Capital Structure in a Continuous-Time Agency Model

We derive the optimal dynamic contract in a continuous‐time principal‐agent setting, and implement it with a capital structure (credit line, long‐term debt, and equity) over which the agent controls the payout policy. While the project's volatility and liquidation cost have little impact on the firm's total debt capacity, they increase the use of credit versus debt. Leverage is nonstationary, and declines with past profitability. The firm may hold a compensating cash balance while borrowing (at a higher rate) through the credit line. Surprisingly, the usual conflicts between debt and equity (asset substitution, strategic default) need not arise.     

An Empirical Model of Optimal Capital Structure1

The authors provide a reasonably user‐friendly and intuitive model for arriving at a company's optimal, or value‐maximizing, leverage ratio that is based on the estimation of company‐specific cost and benefit functions for debt financing. The benefit functions are downward‐sloping, reflecting the drop in the incremental value of debt with increases in the amount used. The cost functions are upward‐sloping, reflecting the increase in costs associated with increases in leverage. The cost functions vary among companies in ways that reflect differences in corporate characteristics such as size, profitability, dividend policy, book‐to‐market ratio, and asset collateral and redeployability. The authors use these cost and benefit functions to produce an estimate of a company's optimal amount of debt. Just as equilibrium in economics textbooks occurs where supply equals demand, optimal capital structure occurs at the point where the marginal benefit of debt equals the marginal cost. The article illustrates optimal debt choices for companies such as Barnes & Noble, Coca‐Cola, Six Flags, and Performance Food Group. The authors also estimate the net benefit of debt usage (in terms of the increase in firm or enterprise value) for companies that are optimally levered, as well as the net cost of being underleveraged for companies with too little debt, and the cost of overleveraging for companies with too much. One critical insight of the model is that the costs associated with overleveraging appear to be significantly higher, at least for some companies, than the costs of being underleveraged.     

Managerial Preference,Asymmetric Information,and Financial Structure

If firm performance affects managers' wealth or reputation, preferences of managers dominate firms' financing decisions. When information about real asset investment is symmetric, managers finance exclusively with equity. If managers know more about asset quality than do investors and if managers are sufficiently risk averse, they signal high-quality projects with debt. Increases in collateral value decrease risky debt use. Increases in interest rates that do not change productive opportunities increase debt use. The explanation for these and further results is based on underpricing of equity and overpricing of debt at the margin.     

Collateralizing liquidity

I develop a dynamic model of optimal funding to understand why financial assets are used as collateral instead of being sold to raise funds. Firms need funds to invest in risky projects with nonobservable returns. Since holding these assets allows firms to raise these funds, investing firms value the asset more than noninvesting ones. When assets are less than perfectly liquid and investment opportunities are persistent, collateralized debt minimizes asset transfers from investing to noninvesting firms and thus is optimal. Frictions in asset markets lead to an illiquidity discount and a collateral premium, which increase with the asset’s illiquidity.     

Bank Debt,Flexibility, and the Use of Proceeds from Asset Sales

In the theory of financial intermediation, bank debt is often characterized as being more readily renegotiable than public debt. Banks are also conjectured to gain valuable non-public information through closer monitoring. Given these features, bank debt can theoretically be more flexible than public debt and can lead to better investment/liquidation decisions. We investigate this possibility using a sample of firms facing the important decision of whether to reinvest the proceeds from asset sales or whether to distribute the proceeds to debtholders. While higher levels of leverage are associated with an increased probability of distributing proceeds to creditors, this relationship is significantly muted for bank debt as opposed to public debt. This finding is consistent with the conjecture that bank debt provides enhanced flexibility when compared to public debt. Further we find that asset sale announcement period abnormal stock returns are increasing in firms’ use of bank debt, but not public debt. This suggests that market participants believe that banking relationships are leading to better decision making for this particular type of investment/liquidation decision. We find no significantly different effects of bank vs. public debt on the initial decision to undertake an asset sale in the first place. Thus, in the context of asset sales, the main observable difference arises in the use of proceeds decision, rather than the initial asset sale decision.     

Sizing Up Repo

To understand which short‐term debt markets experienced “runs” during the financial crisis, we analyze a novel data set of repurchase agreements (repo), that is, loans between nonbank cash lenders and dealer banks collateralized with securities. Consistent with a run, repo volume backed by private asset‐backed securities falls to near zero in the crisis. However, the reduction is only $182 billion, which is small relative to the stock of private asset‐backed securities as well as the contraction in asset‐backed commercial paper. While the repo contraction is small in aggregate, it disproportionately affected a few dealer banks.     

Fiscal Requirements for Dynamic and Real Determinacies in Economies with Private Provision of Liquidity: A Monetarist Assessment

We study the impact of fiscal policies on the inherent links between inflation, unemployment, and asset prices in an environment where firms provide liquidity and the central bank follows a constant money growth rate rule. Firms, other than hiring workers, also supply private assets that are not only useful as a store of value but also as collateral. When firms are not taxed and public debt is scarce, the economy is non-Ricardian so that real indeterminacies can be observed. Moreover, labor market characteristics do not affect the demand for government liabilities. However, when agents face public and private asset scarcity, labor market conditions then impact asset prices and inflation. We further show that irrespective of the type of asset scarcity agents face, when firms are taxed non-ad valorem, not only the level of tax revenues but also its composition matter for real allocations. Moreover, we show that labor market conditions directly affect the dynamics of all government liabilities and inflation.     

Stock and Bond Return Comovement as a Different Way to Assess Information Content: The Case of Debt Covenant Violation Disclosures

We propose a supplementary way to assess the information content of a financial statement disclosure based on the comovement of asset returns in different markets in response to information that has price implications for both. The influence of a signal that strongly influences at least two asset markets measures a dimension of information content less clearly reflected in single‐market responses. We apply our method to debt covenant violation (DCV) disclosures. These are the outcome of a debt renegotiation when the covenant promises in a debt agreement to manage the agency costs of debt are broken. We find that stock and bond return comovement is highest one day before DCV disclosure and differs depending on whether the debt covenant is waived or not waived. We find that stock and bond return comovement in the days following a DCV disclosure decreases more for non‐waiver disclosures than for waiver disclosures. This supports the theory that a non‐waiver outcome shifts control rights and bargaining power to the creditors. Consistent with this theory, single‐market tests show that bonds with a non‐waiver disclosure versus a waiver disclosure earn positive excess returns following a DCV disclosure whereas the reverse is true for stocks.     

The Regulation of Private Money*

Financial crises are bank runs. At root, the problem is short-term debt (private money), which while an essential feature of market economies, is inherently vulnerable to runs in all its forms (not just demand deposits). Bank regulation aims at preventing bank runs. History shows two approaches to bank regulation: the use of high-quality collateral to back banks’ short-term debt and government insurance for the short-term debt. Also, explicit or implicit limitations on entry into banking can create charter value (an intangible asset) that is lost if the bank fails. This can create an incentive for the bank to abide by the regulations and not take too much risk.