Asset liquidity, capital structure, and secured debt

Erwan Morellec
2001
Journal paper

Abstract

This paper investigates the impact of asset liquidity on the valuation of corporate securities and the firm's financing decisions. I show that asset liquidity increases debt capacity only when bond covenants restrict the disposition of assets. By contrast, I demonstrate that, with unsecured debt, greater liquidity increases credit spreads on corporate debt and reduces optimal leverage. The model also determines the extent to which pledging assets increases firm value and relates the optimal size of the pledge to firm and industry characteristics. Finally, I show that asset liquidity and security provisions may help explain leverage ratios and credit spreads observed in practice.

Official source

https://infoscience.epfl.ch/record/148484?ln=en

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This dissertation consists of three chapters. The first chapter empirically investigates how the intensity of product market competition affects the cost of debt. Using a large sample of loans to publicly traded US manufacturing firms, the chapter provides evidence that an intensification of product market competition among firms significantly increases the cost of bank loans. The analysis reveals that the effect is strongest in industries with high illiquidity and specificity of assets. This finding indicates that the liquidation value of assets is an important channel through which competition affects the cost of debt. Moreover, loans to firms that operate in more competitive industries contain more covenants restricting the firms' financing and dividend policies. Overall, the results suggest that banks explicitly take into account the risk arising from product market competition when pricing and designing debt contracts. The second chapter tests whether equity risk reflects the shareholders' incentives to default strategically on the firm's debt obligations. The chapter develops a model that relates shareholders' incentives to default strategically with the likelihood that debt renegotiations fail. Using an international cross-section of stocks to exploit the exogenous variation of insolvency procedures across countries and to test the model's predictions, the analysis reveals that the equity beta increases with the degree of creditor protection. Moreover, the equity beta decreases with the costs of liquidation and shareholders' bargaining power, and the sensitivity of this relationship weakens as country's creditor protection toughens. The results are economically important, and robust to various specifications and estimation techniques. The third chapter investigates how the debt structure and the strategic interaction between shareholders and creditors in the event of default affect expected stock returns. By endogenizing shareholders' decision to default, the model generates new predictions linking firm characteristics to expected stock returns through an intuitive economic mechanism. In particular, the model predicts that expected stock returns are higher for firms that face high debt renegotiation difficulties, and that have a large fraction of secured or convertible debt. Expected stock returns are lower for firms whose shareholders maintain strong bargaining power, and for firms subject to high liquidation costs. Using a large sample of publicly traded US firms between 1985 and 2005, the third chapter presents new evidence on the link between debt structure, renegotiation frictions, and stock returns, which is supportive of the model's predictions.

EPFL2010

Essays in Corporate Finance

Thomas Antonius Geelen

In this thesis I study how firms choose their optimal debt maturity. The recent financial crisis illustrated why debt maturity is an important determinant of firmsâ capital structure and it also renewed economistsâ interest in this topic, see for example Brunnermeier and Oehmke (2013), He and Milbradt (2016), Ju and Ou-Yang (2006), Crouzet (2016), and Huang et al. (2017). This thesis exists of two chapters. In the first chapter, titled âInformation Dynamics and Debt Maturityâ, I develop a dynamic model of financing decisions and optimal debt maturity choice in which creditors face adverse selection and learn about the firmâs quality from news. In equilibrium, shareholders may choose to postpone debt issuance to reduce adverse selection and improve the pricing of newly issued debt. Over time, the benefits of learning decrease and zero-leverage firms eventually decide to issue debt. Because shorter maturity debt is less sensitive to information, younger firms issue shorter maturity debt to alleviate adverse selection while mature firms issue longer maturity debt, leading to a life-cycle theory of debt maturity. In the second chapter, titled âDebt Maturity and Lumpy Debtâ, I develop a dynamic capital structure model in which shareholders determine a firmâs leverage ratio, debt maturity, and default strategy. In my model, the firmâs debt matures all at once. Therefore, after repaying the principal shareholders own all the firmâs cash flows and can pick a new capital structure. The possibility to alter the capital structure at maturity gives shareholders the incentive to issue finite maturity debt and allows me to study firmsâ joint choice of leverage and debt maturity. I also extend my model by allowing for time-varying capital supply to study time-variation in firmsâ joint choice of leverage and debt maturity.

EPFL2018

EPFL2010