FUTURE INVESTMENT OPPORTUNITIES AND THE VALUE OF THE CALL PROVISION ON A BOND

Abstract

THE AUTHOR OF THE preceding Comment argues that any incentive problem created by future investment opportunities must ultimately be caused by some impediment to negotiation between shareholders and bondholders. While we do not disagree with this point, we do disagree with assertion that it is nowhere hinted at in our paper. In first place, reader of our paper will search in vain for statement that our model assumes away transactions costs. The term has come to have a rather imprecise catch-all connotation, but at least two separate categories might be distinguished. The first category might be termed costs and would encompass costs of trading relatively homogeneous commodities on organized exchanges. Brokerage fees or bid-ask spreads, for example, would reflect trading costs. The second category might be called costs and would include any costs incurred by two parties in making and enforcing a contractual bargain, particularly in case of non-standardized goods or services. That we had such negotiating costs in mind when we wrote our paper should be clear from statement in Discussion section that the call privilege provides a relatively simple and inexpensive way to alleviate perverse incentives created by debtor-creditor relationships [1, p. 1199]. If we did not explicitly assume away all transaction costs, is there anything about structure of our model that implicitly requires them to equal zero? We would argue that there is not. It is true that we have not defined any bid-ask spreads around our expressions for market values of firm's securities, so it might be fairly stated that we have implicitly assumed away trading costs. It is also true that our model yields Modigliani-Miller [3] financial irrelevance result for case of no growth opportunities. One might be tempted to infer from this that all negotiating costs arising between bondholders and shareholders have also been assumed away, but that would be unwarranted. The ModilgianiMiller Theorem might indeed fail if debtor-creditor relationship created incentive problems that could not be handled at negligible cost. Recall, however, that within our simplified framework scope of firm's discretionary activity is severely limited. If new investment at t = 1 is ruled out, and if current investment is already fixed, shareholders will be unable to alter risk characteristics of assets to bondholders' detriment. Moreover, firm has no cash flow at t = 1, so it could only harm bondholders through dividend payments if it sells existing assets or issues new debt to finance these dividends. But these are precisely kinds of actions that can be dealt with inexpensively through restrictive covenants. The bondholders need only prohibit sale of assets