Solvency Tests, Debt Capacity, and Security Design

Abstract

It can be hard to explain why firms do not issue more debt. I use a simple model of a debtor firm to demonstrate the impact of legal solvency tests on a firm’s debt capacity and the debt securities it is able to issue. I assume that a firm must be solvent under two legal solvency tests – the balance sheet test and the ability to pay test – immediately after borrowing. I motivate this assumption in two ways. First, the state of insolvency effectively shifts fiduciary duties to creditor welfare, limiting the firm’s ability to act exclusively in shareholders’ interest subject to other legal obligations. Second, the state of insolvency subjects the firm’s decisions to fraudulent transfer laws that also effectively limit the firm’s freedom to operate. The model explains why firms may be unable to finance themselves more fully with debt, even if other assumed rationales against doing so (e.g., costs of financial distress) are non-binding. This may be part of the explanation – previously ignored – for why debt is not used more frequently in high growth firms where there are relatively low probabilities of success (ability to pay) even when growth options generate high asset values. It may also be part of the explanation for why we do not see more ultra-high-yield debt, by which I mean debt that promises a yield significantly in excess of the rates we currently observe in the high-yield market.