Corporate Debt Value,Bond Covenants,and Optimal Capital Structure

This article examines corporate debt values and capital structure in a unified analytical framework. It derives closed-form results for the value of long-term risky debt and yield spreads, and for optimal capital structure, when firm asset value follows a diffusion process with constant volatility. Debt values and optimal leverage are explicitly linked to firm risk, taxes, bankruptcy costs, risk-free interest rates, payout rates, and bond covenants. The results elucidate the different behavior of junk bonds versus investment-grade bonds, and aspects of asset substitution, debt repurchase, and debt renegotiation.     

Agency Costs, Risk Management, and Capital Structure

The joint determination of capital structure and investment risk is examined. Optimal capital structure reflects both the tax advantages of debt less default costs (Modigliani and Miller (1958, 1963)), and the agency costs resulting from asset substitution (Jensen and Meckling (1976)). Agency costs restrict leverage and debt maturity and increase yield spreads, but their importance is small for the range of environments considered. Risk management is also examined. Hedging permits greater leverage. Even when a firm cannot precommit to hedging, it will still do so. Surprisingly, hedging benefits often are greater when agency costs are low.     

Dynamic Capital Structure Choice: Theory and Tests

This paper develops a model of dynamic capital structure choice in the presence of recapitalization costs. The theory provides the optimal dynamic recapitalization policy as a function of firm-specific characteristics. We find that even small recapitalization costs lead to wide swings in a firm's debt ratio over time. Rather than static leverage measures, we use the observed debt ratio range of a firm as an empirical measure of capital structure relevance. The results of empirical tests relating firms' debt ratio ranges to firm-specific features strongly support the theoretical model of relevant capital structure choice in a dynamic setting.     

Capital Structure, CEO Dominance, and Corporate Performance

We use agency theory to investigate the influence of CEO dominance on variation in capital structure. Due to agency conflicts, managers may not always adopt leverage choices that maximize shareholders’ value. Consistent with the prediction of agency theory, the evidence reveals that, when the CEO plays a more dominant role among top executives, the firm adopts significantly lower leverage, probably to evade the disciplinary mechanisms associated with debt financing. Our results are important as they demonstrate that CEO power matters to critical corporate outcomes such as capital structure decisions. In addition, we find that the impact of changes in capital structure on firm performance is more negative for firms with more powerful CEOs. Overall, the results are in agreement with prior literature, suggesting that strong CEO dominance appears to exacerbate agency costs and is thus detrimental to firm value.     

Optimal Capital Structure,Endogenous Bankruptcy,and the Term Structure of Credit Spreads

This article examines the optimal capital structure of a firm that can choose both the amount and maturity of its debt. Bankruptcy is determined endogenously rather than by the imposition of a positive net worth condition or by a cash flow constraint. The results extend Leland's (1994a) closed-form results to a much richer class of possible debt structures and permit study of the optimal maturity of debt as well as the optimal amount of debt. The model predicts leverage, credit spreads, default rates, and writedowns, which accord quite closely with historical averages. While short term debt does not exploit tax benefits as completely as long term debt, it is more likely to provide incentive compatibility between debt holders and equity holders. Short term debt reduces or eliminates “asset substitution” agency costs. The tax advantage of debt must be balanced against bankruptcy and agency costs in determining the optimal maturity of the capital structure. The model predicts differently shaped term structures of credit spreads for different levels of risk. These term structures are similar to those found empirically by Sarig and Warga (1989). Our results have important implications for bond portfolio management. In general, Macaulay duration dramatically overstates true duration of risky debt, which may be negative for “junk” bonds. Furthermore, the “convexity” of bond prices can become “concavity.”     

Human capital,capital structure,and employee pay: An empirical analysis

We test the predictions of Titman (1984) and Berk, Stanton, and Zechner (2010) by examining the effect of leverage on labor costs. Leverage has a significantly positive impact on cash, equity-based, and total compensation of chief executive officers (CEOs). Compensation of new CEOs hired from outside the firm is positively related to prior-year firm leverage. In addition, leverage has a positive and significant impact on average employee pay. The incremental total labor expenses associated with an increase in leverage are large enough to offset the incremental tax benefits of debt. The empirical evidence supports the theoretical prediction that labor costs limit the use of debt.     

How Entrenchment, Incentives and Governance Influence REIT Capital Structure

Although recent literature has confirmed the importance of viewing a firm??s capital structure choices of leverage and debt maturity as jointly determined, to date there has been little analysis of the importance of traditional governance variables on a firm??s capital structure decisions using a simultaneous equations approach. We examine the influence of managerial incentives, traditional managerial monitoring mechanisms and managerial entrenchment on the capital structure of Real Estate Investment Trusts (REITs). Using panel data, we estimate a system of simultaneous equations for leverage and maturity and find that firms with entrenched CEOs use less leverage and shorter maturity debt. This is consistent with the expectation that managers acting in their own self interest will choose lower leverage to reduce liquidity risk and use short maturity debt to preserve their ability to enhance their compensation and reputations by empire building. We also find evidence that traditional alignment mechanisms such as equity and option ownership have an offsetting effect; and that firms where the founder serves as CEO choose higher leverage and longer maturity debt. The results also provide evidence that leverage and maturity are substitutes, firms with high profitability and growth opportunities use less leverage and firms with liquid assets use more leverage and longer maturity debt.     

Does the Source of Capital Affect Capital Structure?

Prior work on leverage implicitly assumes capital availabilitydepends solely on firm characteristics. However, market frictionsthat make capital structure relevant may also be associatedwith a firm’s source of capital. Examining this intuition,we find firms that have access to the public bond markets, asmeasured by having a debt rating, have significantly more leverage.Although firms with a rating are fundamentally different, thesedifferences do not explain our findings. Even after controllingfor firm characteristics that determine observed capital structure,and instrumenting for the possible endogeneity of having a rating,firms with access have 35% more debt.     

Capital structure,executive compensation,and investment efficiency

This paper examines how the similarity between the executive compensation leverage ratio and the firm leverage ratio affects the quality of the firm’s investment decisions. A larger leverage gap (i.e., a bigger difference between these two ratios) leads to more investment distortions. Managers with more debt-like compensation components tend to under-invest, whereas managers with larger equity-based compensation engage more in over-investment. Furthermore, investment distortion is likely to increase the equity (debt) value when compensation leverage is lower (higher) than firm leverage. These findings suggest that managers can deviate from an optimal investment policy to increase the value of their portfolio, and that a lower leverage gap can reduce agency costs.     

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.     

Firing Costs and Capital Structure Decisions

I exploit the adoption of state‐level labor protection laws as an exogenous increase in employee firing costs to examine how the costs associated with discharging workers affect capital structure decisions. I find that firms reduce debt ratios following the adoption of these laws, with this result stronger for firms that experience larger increases in firing costs. I also document that, following the adoption of these laws, a firm's degree of operating leverage rises, earnings variability increases, and employment becomes more rigid. Overall, these results are consistent with higher firing costs crowding out financial leverage via increasing financial distress costs.     

CEO's Inside Debt and Dynamics of Capital Structure

Debt‐type compensation (inside debt) exacerbates the divergence in risk preferences between the chief executive officer (CEO) and shareholders and, in turn, affects capital structure decisions. An excessively risk‐averse CEO tends to use less debt than the shareholders desire, reduce debt quickly when the firm is overlevered, but is reluctant to increase debt when the firm is underlevered. We find that higher CEO's inside debt ratio (i.e., inside debt as a percentage of total incentive compensation) is associated with lower firm leverage and faster (slower) leverage adjustments toward the shareholders’ desired level for overlevered (underlevered) firms. The CEO's inside debt ratio most conducive to capital structure rebalancing is around 10% of the firm's market debt ratio.     

‘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.     

Debt, bargaining, and credibility in firm–supplier relationships

We examine optimal leverage for a downstream firm relying on implicit (self-enforcing) contracts with a supplier. Performing a leveraged recapitalization prior to bargaining increases the firm's share of total surplus. However, the resulting debt overhang limits the range of credible bonuses, resulting in low input quality. Optimal financial structure trades off bargaining benefits of debt with inefficiency resulting from overhang. Consistent with empirical evidence, the model predicts that leverage increases with supplier bargaining power (e.g., unionization rates) and decreases with utilization of non-verifiable inputs (e.g., human capital).     

Capital Structure as an Optimal Contract Between Employees and Investors

The ex ante optimal contract between investors and employees is derived endogenously and is interpreted in terms of debt, equity, and employees' compensation. Although public equity financing is feasible in this model through verified accounting income, debt is needed to force value-enhancing restructuring before the income realizes. The optimal debt level, however, is lower than that which maximizes the value of the firm when there is nonmonetary restructuring-related cost to employees. The paper explains how stock prices react to exchange offers, how earnings can be diluted by a decrease in leverage, and why employees' claims are generally senior to those of investors. New testable implications about leverage and compensation levels are derived.     

Optimal capital structure under corporate and personal taxation

In this paper, a model of corporate leverage choice is formulated in which corporate and differential personal taxes exist and supply side adjustments by firms enter into the determination of equilibrium relative prices of debt and equity. The presence of corporate tax shield substitutes for debt such as accounting depreciation, depletion allowances, and investment tax credits is shown to imply a market equilibrium in which each firm has a unique interior optimum leverage decision (with or without leverage-related costs). The optimal leverage model yields a number of interesting predictions regarding cross-sectional and time-series properties of firms' capital structures. Extant evidence bearing on these predictions is examined.     

Capital Structure and Firm Efficiency

Abstract:  This paper investigates the relationship between firm efficiency and leverage. We consider both the effect of leverage on firm performance as well as the reverse causality relationship. In particular, we address the following questions: Does higher leverage lead to better firm performance? Does efficiency exert a significant effect on leverage over and above that of traditional financial measures of capital structure? Is the effect of efficiency on leverage similar across different capital structures? What is the signalling role of efficiency to creditors or investors? Using a sample of 12,240 New Zealand firms we find evidence supporting the theoretical predictions of the Jensen and Meckling (1976) agency cost model. Efficiency measured as the distance from the industry's 'best practice' production frontier is positively related to leverage over the entire range of observed data. The frontier is constructed using the non-parametric Data Envelopment Analysis (DEA) method. Using quantile regression analysis we show that the reverse causality effect of efficiency on leverage is positive at low to mid-leverage levels and negative at high leverage ratios. Firm size also has a non-monotonic effect on leverage: negative at low debt ratios and positive at mid to high debt ratios. The effect of tangibles and profitability on leverage is positive while intangibles and other assets are negatively related to leverage.     

Human capital costs,firm leverage,and unemployment rates

Because bankruptcy is costly for employees, theoretical studies argue that firms with higher leverage have to pay their employees higher wages. In this paper we empirically test this prediction. We find that firm leverage is positively related to the wages of employees, both in the United States and in the Netherlands. In the United States, the positive relation between wages and leverage is strongest in the 21st century, which is a period that also shows a positive relation between wages and unemployment rates. We conclude that the human capital costs of bankruptcy are an important disadvantage of debt.     

Measuring the Agency Cost of Debt

We adapt a contingent claims model of the firm to reflect the incentive effects of the capital structure and thereby to measure the agency costs of debt. An underlying model of the firm and the stochastic features of its product market are analyzed and an optimal operating policy is chosen. We identify the change in operating policy created by leverage and value this change. The model determines the value of the firm and its associated liabilities incorporating the agency consequences of debt.     

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.