Dual Holders: Valuation, Default Policy, and Capital Structure

Abstract

Dual holders own debt and equity in the same firm. By maximizing the total value of the dual holders' assets, we derive optimal default policies and show that dual holdership reduces default risk. We analyze the two most common priority structures: 1) Dual holders' private debt rank junior to external debt, typically found in small and medium sized companies. 2) Private debt ranks pari-passu to external debt, typically the case for publicly traded debt. The reduction in default probability is larger for the junior-senior case. We calculate the value of debt and other claims, and by the standard approach of trading off tax benefits from debt with bankruptcy costs, we analyze firms' optimal capital structure. Total firm value in the pari-passu case is lower or equal to total firm value in the junior-senior case. Private debt displaces equity financing and equity values can be negative. Any negative equity values are more than offset by positive values of private debt. Without exogenous restrictions, dual holders always prefer to increase private debt. For fixed, sufficiently high levels of private debt, the optimal use of external debt is proportional to the use of private debt. This case illustrates an odd, non-sustainable economic situation for high levels of private debt. Tax benefits from debt decrease the total cost of financing and removes default risk. In this case, the bankruptcy cost is zero, so there is no cost of including debt in the capital structure. All debt is therefore risk-free and credit spreads vanish. In addition, any differences between the two priority structures disappear in this case.