Capital Structure and Debt Priority

We study a defaultable firm's debt priority structure in a simple structural model where the firm issues senior and junior bonds and is subject to both liquidity and solvency risks. Assuming that the absolute priority rule prevails and that liquidation is immediate upon default, we determine the firm's interior optimal priority structure along with its optimal capital structure. We also obtain closed‐form solutions for the market values of the firm's debt and equity. We find that the magnitude of the spread differential between junior and senior bond yields is positively, but not linearly related to the total debt level and the riskiness of assets. Finally, we provide an in‐depth analysis of probabilities of default and the term structure of credit spreads.     

Securityholder Taxes, Corporate Capital Structures and the Priority Structure of Debt

This paper shows that the firm has an incentive to issue multiple classes of debt that are differentiated by seniority to enhance securityholder tax-timing option values. The analysis establishes that there is at least one mix of senior and junior debt that maximizes the tax option gain from having multiple priority classes of debt. An analytic example provides specifications for the optimal amount of leverage and the optimal mix of senior and junior debt. Relative to the case of only one class of debt, a multiple debt priority structure increases the optimal amount of corporate leverage.     

TOWARD A MORE COMPLETE MODEL OF OPTIMAL CAPITAL STRUCTURE

Most corporate finance practitioners understand the trade-off involved in making effective use of debt capacity while safeguarding the firm's ability to execute its business strategy without disruption. But quantifying that trade-off to arrive at an optimal level of debt can be a complicated and challenging task. This paper develops a simulation model of capital structure that starts by generating multiple estimates of market rates (LIBOR, currency rates) and corresponding company operating cash flows. To arrive at an optimal capital structure, the model then incorporates the shareholder value effects of alternative financing decisions by directly measuring the costs of financial distress, including the costs of missed investment opportunities and higher working capital requirements.
The model generates both a target credit rating and a lower fallback rating that permits a higher level of debt to maintain investments and dividends when operating cash flows are weak. As the model shows, companies with volatile cash flows and significant investment opportunities can add substantial shareholder value by establishing a fallback credit rating that is one or two notches below the target rating. The model also optimizes the mix of fixed versus floating debt, the maturity structure, and the currency composition. Another distinctive feature of the model is its ability to estimate the expected cost of alternative liability structures that can provide the liquidity insurance necessary to sustain the firm through periods of severe stress. This cost turns out to be quite small relative to the total market capitalization of the average firm.     

Leverage and pricing of debt in LBOs

We show that the structure and pricing of debt in LBOs mostly depend on a single characteristic of the target firm, pre-LBO profitability. We find a positive relationship between pre-LBO profitability and deal leverage that is consistent with a dynamic trade-off theory of capital structure in the presence of adjustment costs. We argue that the wide range of debt tranches used in LBO financing can be folded into two main categories, senior and junior debt, where the pricing of senior and junior debt depends on their relative use and on bankruptcy risk. Our evidence also suggests that senior lenders oversupply cheap credit during hot buyout markets.     

Monitoring and Structure of Debt Contracts

This paper presents a theory of optimal debt structure when the moral hazard problem is severe. The main idea is that the optimal debt contract delegates monitoring to a single senior lender and that seniority allows the monitoring senior lender to appropriate the full return from his monitoring activities. The theory explains (i) why debt contracts are prioritized, (ii) why short-term debt is senior to long-term debt, and (iii) why financial intermediaries usually hold short-term senior debt whereas long-term junior debt is widely held. Another implication of the theory is that covenant and maturity structures will be set to conform to the seniority structure.     

Bloomberg Intelligence Roundtable on The Theory and Practice of Capital Structure Management

Since the formulation of the M&M propositions almost 60 years ago, financial economists have been debating whether there is such a thing as an optimal capital structure—a proportion of debt to equity that maximizes shareholder value. Some finance scholars have followed M&M in arguing that both capital structure and dividend policy are largely “irrelevant” in the sense that they have no significant, predictable effects on corporate market values. Another school of thought holds that corporate financing choices reflect an attempt by corporate managers to balance the tax shields and disciplinary benefits of greater debt against the costs of financial distress. Yet another theory says that companies do not have capital structure targets, but simply follow a financial “pecking order” in which retained earnings are preferred to outside financing, and debt is preferred to equity when outside funding is required. In this roundtable, a leading finance professor is joined by six practitioners in discussing whether and how capital structure decisions and payout policies can create value, with special attention to the healthcare industry. The consensus is that for those parts of the pharma industry with large growth opportunities, equity financing should be the main source of capital. But for those parts of the industry with shrinking prospects, increasing levels of debt and raising dividends are recommended.     

The Capital Structure Puzzle: The Evidence Revisited

Since the formulation of the M&M propositions almost 50 years ago, financial economists have been debating whether there is such a thing as an optimal capital structure—a proportion of debt to equity that maximizes shareholder value. Some finance scholars have followed M&M in arguing that both capital structure and dividend policy are largely "irrelevant" in the sense that they have no significant, predictable effects on corporate market values. Another school of thought holds that corporate financing choices reflect an attempt by corporate managers to balance the tax shields and disciplinary benefits of greater debt against the costs of financial distress. Yet another theory says that companies do not have capital structure targets, but simply follow a financial "pecking order" in which retained earnings are preferred to outside financing, and debt is preferred to equity when outside funding is required.
In reviewing the evidence that has accumulated since M&M, the authors argue that taxes, bankruptcy (and other "contracting") costs, and information costs all appear to play an important role in corporate financing decisions. While much of the evidence is consistent with the argument that companies set target leverage ratios, there is also considerable support for the pecking order theory's contention that firms are willing to deviate widely from their targets for long periods of time. According to the authors, the key to reconciling the different theories—and thus to solving the capital structure puzzle—lies in achieving a better understanding of the relation between corporate financing stocks (the levels of debt and equity in relation to the target) and flows (or which security to issue at a particular time).     

Corporate capital structure and pension-funding strategy

This article provides an integrated analysis of pension funding and corporate financing strategies in the presence of default risk. The article shows that when the marginal personal income tax rate is constant, the financing decision with respect to pension funding is influenced entirely by tax considerations. When the marginal personal income tax is progressive, the optimal financing of pension funding depends on the cyclical nature of the firm (as characterized by the sign of beta), the riskiness of pension assets, and ERISA regulations concerning the pension-benefit guaranty rate, the marginal pension insurance premium and the firm's legal responsibility for its unfunded pension obligations. It is shown that a necessary condition for partial pension funding is that the marginal insurance premium imposed by PBGC must be less than actuarially fair, and a necessary condition for pension funding to be financed by both debt and equity is that beta must be positive.     

Optimality of project financing: Theory and empirical implications in finance and accounting

During the 1980s a fairly active market developed in the private placement of limited recourse project financing. Although this form of financing is gaining in importance, we know very little about it. This article presents a theoretical analysis of project financing. In the model of the firm presented, outstanding risky debt gives rise to agency costs of underinvestment that are offset by the benefit of debt-related tax shields. The tradeoff specifies the optimal leverage for a firm. Within this framework, we consider the optimality of financing a new project with a nonrecourse project financing arrangement. We derive implications for 1) the characteristics of a new venture that will be project financed, 2) the wealth gains from project financing over that of financing with straight debt, and 3) the optimal allocation of debt across the different assets (the sponsor firm vs. the new venture). It is shown that a project financing arrangement, where the debt is optimally allocated to the sponsor firm and the new venture, increases value by reducing agency costs and increasing the value of tax shields (compared to the case of straight debt financing). The optimal allocation of debt in project financing involves assigning to the sponsor firm and the new venture debt levels equal to their individual optimal capital structures. Several testable empirical implications in finance and accounting are developed.     

Can the Trade-off Theory Explain Debt Structure?

We examine the optimal mixture and priority structure of bankand market debt using a trade-off model in which banks havethe unique ability to renegotiate outside formal bankruptcy.Flexible bank debt offers a superior trade-off between tax shieldsand bankruptcy costs. Ease of renegotiation limits bank debtcapacity, however. Optimal debt structure hinges upon whichparty has bargaining power in private workouts. Weak firms havehigh bank debt capacity and utilize bank debt exclusively. Strongfirms lever up to their (lower) bank debt capacity, augmentwith market debt, and place the bank senior. Therefore, thetrade-off theory offers an explanation for: (i) why young/smallfirms use bank debt exclusively; (ii) why large/mature firmsemploy mixed debt financing; and (iii) why bank debt is senior.The trade-off theory also generates predictions consistent withinternational evidence. In countries in which the bankruptcyregime entails soft (tough) enforcement of contractual priority,bank debt capacity is low (high), implying greater (less) relianceon market debt.     

‘Hot’ Debt Markets and Capital Structure

This paper examines the motives of debt issuance during hot‐debt market periods and its impact on capital structure over the period 1970–2006. We find that perceived capital market conditions as favourable, an indication of market timing, and adverse selection costs of equity (i.e., information asymmetry) are important frictions that lead certain firms to issue more debt in hot‐ than cold‐debt market periods. Using alternative hot‐debt market issuance measures and controlling for other effects, such as structural shifts in the debt market, industry, book‐to‐market, price‐to‐earnings, size, tax rates, debt market conditions and adjustment costs based on debt credit ratings, we find that firms with high adverse selection costs issue substantially more (less) debt when market conditions are perceived as hot (cold). Moreover, the results indicate that there is a persistent hot‐debt market effect on the capital structure of debt issuers; hot‐debt market issuing firms do not actively rebalance their leverage to stay within an optimal capital structure range.     

The Capital Structure Puzzle: Another Look at the Evidence

Since the formulation of the Miller and Modigliani propositions over 60 years ago, financial economists have been debating whether there is such a thing as an optimal capital structure—a proportion of debt to equity that can be expected to maximize long‐run shareholder value. Some finance scholars have followed M&M in arguing that both capital structure and dividend policy are irrelevant in the sense of having no significant, predictable effects on corporate market values. Another school of thought holds that corporate financing choices reflect an attempt by corporate managers to balance the tax shields and disciplinary benefits of more debt against the costs of financial distress. Still another theory says that companies do not have capital structure targets, but instead follow a financial pecking order in which retained earnings are generally preferred to outside financing, and debt is preferred to equity when outside funding is required. In reviewing the evidence that has accumulated since M&M, the authors argue that taxes, bankruptcy and other contracting costs, and information costs all appear to play important roles in corporate financing decisions. While much, if not most, of the evidence is consistent with the idea that companies set target leverage ratios, there is also considerable support for the pecking order theory's contention that managements are willing to deviate widely from their targets for long periods of time. According to the authors, the key to reconciling the different theories—and thus to solving the capital structure puzzle—lies in achieving a better understanding of the relation between corporate financing stocks (that is, total amounts of debt and equity) and flows (which security to issue at a particular time). Even when companies have leverage targets, it can make sense to deviate from those targets depending on the costs associated with moving back toward the target. And as the authors argue in closing, a complete theory of capital structure must take account of these adjustment costs and how they affect expected deviations from the targets.     

A Dynamic Model of Optimal Capital Structure

This paper presents a continuous time model of a firm that candynamically adjust both its capital structure and its investmentchoices. In the model we endogenize the investment choice aswell as firm value, which are both determined by an exogenousprice process that describes the firm's product market. Withinthe context of this model we explore cross-sectional as wellas time-series variation in debt ratios. We pay particular attentionto interactions between financial distress costs and debtholder/equityholderagency problems and examine how the ability to dynamically adjustthe debt ratio affects the deviation of actual debt ratios fromtheir targets. Regressions estimated on simulated data generatedby our model are roughly consistent with actual regressionsestimated in the empirical literature.     

THE CAPITAL STRUCTURE PUZZLE: ANOTHER LOOK AT THE EVIDENCE

Since the formulation of the M & M irrelevance propositions 40 years ago, financial economists have been debating whether there is such a thing as optimal capital structure—a proportion of debt to equity that maximizes current firm value. Some finance scholars have followed M & M by arguing that both capital structure and dividend policy are largely “irrelevant” in the sense that they have no significant, predictable effects on corporate market values. Another school of thought holds that corporate financing choices reflect an attempt by corporate managers to balance the tax shields and disciplinary benefits of greater debt against the increased probability and costs of financial distress. Yet another theory says that companies do not have capital structure targets, but instead follow a financial pecking order in which retained earnings are preferred to outside financing, and debt is preferred to equity when outside funding is required. In reviewing the evidence that has accumulated since M & M, the authors argue that taxes, bankruptcy (and other “contracting”) costs, and information costs (the main factor in the pecking order theory) all appear to play an important role in corporate financing decisions. While much if not most of the evidence is consistent with the argument that companies set target leverage ratios, there is also considerable support for the pecking order theory's contention that firms are willing to deviate widely from their targets for long periods of time. According to the authors, the key to reconciling the different theories—and thus to solving the capital structure puzzle—lies in achieving a better understanding of the relation between corporate financing stocks (leverage ratios) and flows (specific choices between debt and equity). Even if companies have target leverage ratios, there will be an optimal deviation from those targets—one that will depend on the transactions and information costs associated with adjusting back to the target relative to the costs of deviating from the target. As the authors argue in closing, a complete theory of capital structure must take account of these adjustment costs and how they affect expected deviations from the target.     

How Big Are the Tax Benefits of Debt?

I integrate under firm-specific benefit functions to estimate that the capitalized tax benefit of debt equals 9.7 percent of firm value (or as low as 4.3 percent, net of personal taxes). The typical firm could double tax benefits by issuing debt until the marginal tax benefit begins to decline. I infer how aggressively a firm uses debt by observing the shape of its tax benefit function. Paradoxically, large, liquid, profitable firms with low expected distress costs use debt conservatively. Product market factors, growth options, low asset collateral, and planning for future expenditures lead to conservative debt usage. Conservative debt policy is persistent.     

Government financing decisions and asset returns

This paper presents an empirical investigation of the relation between government financing decisions and asset returns. In particular, the focus is on whether a substitution of debt financing for tax financing of a given level of expenditures is associated with an increase in interest rates. The paper brings a different perspective to empirical investigations of government fiscal policies by examining the response of asset prices in an efficient capital market to such policies rather than focusing on aggregate consumption behavior. The results are consistent with the idea that asset prices are unrelated to how the government finances its expenditures. The results, however, also indicate that the capital market is not indifferent with respect to the level of government expenditures as higher interest rates are associated with increases in government purchases.     

Investment timing and optimal capital structure under liquidity risk

Deterioration in debt market liquidity reduces debt values and affects firms' decisions. Considering such risk, we develop an investment timing model and obtain analytic solutions. We carry out a comprehensive analysis in optimal financing, default, and investment strategies, and stockholder–bondholder conflicts. Our model explains stylized facts and replicates empirical findings in credit spreads. We obtain six new insights for decision makers. We propose a ‘new trade-off theory’ for optimal capital structure, a new tax effect, and new explanations of ‘debt conservatism puzzle’ and ‘zero-leverage puzzle’. Failure in recognizing liquidity risk results in substantially over-leveraging, early bankruptcy or investment, overpriced options, and undervalued coupons and credit spreads. In addition, agency costs are surprisingly small for a high liquidity risk or a low project risk. Interestingly, the risk shifting incentive and debt overhang problem decrease with liquidity risk under moderate tax rates while they increase under high tax rates.     

A jump-diffusion model for pricing corporate debt securities in a complex capital structure

This paper proposes a jump-diffusion model, in closed form, to price corporate debt securities, senior and junior, with the same maturity and violation of the absolute priority rule. We take the structural approach that the firm's asset value follows a jump-diffusion process in a stochastic interest rate economy. Default occurs only if the firm value at the maturity of the corporate debts is less than the sum of the prespecified face values. Unlike previous models in the structural approach, our model is consistent with the current term structures of credit spreads for both senior and junior debts. In particular, it captures realistic short maturity credit spreads observed in the market. The key idea is to allow the jump intensity to be a time-dependent function. As an application, valuation of credit spread options is presented.     

An Integrated Model of Debt Issuance, Refunding, and Maturity

We integrate previous work in this area and develop a multiperiod model that simultaneously determines bond refunding, bond issuance, maturity structure, cash holdings, and bank borrowing policies. The focus here is on providing the required debt funds in the most cost efficient fashion. A strength of the model is that it allows for time varying interest costs, transaction costs, issuance costs, and refunding costs to be firm specific. The output of the model lays out the optimal financing decisions for each time interval that minimize the total discounted cost of providing the funds that match the requisite funds. By limiting the surplus funds available, the model minimizes the management incentive to over invest and thereby reduces the agency costs. The model has economic implications for the financing decisions and the firm's default risk, growth opportunities, riskiness of cash flows, and firm size. JEL Classification: G30     

HOW FIRM CHARACTERISTICS AFFECT CAPITAL STRUCTURE: AN INTERNATIONAL COMPARISON

In this empirical study I examine the factors correlated with capital structure in France, Germany, Japan, the United Kingdom, and the United States. Although mean leverage and many firm factors appear to be similar across countries, some significant differences remain. Specifically, differences appear in the correlation between long-term debt/asset ratios and the firms' riskiness, profitability, size, and growth. These correlations may be explained by differences in tax policies and agency problems, including differences in bankruptcy costs, information asymmetries, and shareholder/creditor conflicts. The findings of this study suggest links between varying choices in capital structure across countries and legal and institutional differences.