The Value of Financial Flexibility: Equilibrium Liquidation Values and Endogenous Capital Structure Heterogeneity

Abstract

Firms with lower leverage are not only less likely to experience financial distress but are also better positioned to acquire assets from other distressed firms. With endogenous asset sales and values, each firm’s debt choice then depends on the choices of its industry peers. With indivisible assets, otherwise identical firms may adopt different debt policies — some choosing highly levered operations (e.g., to take advantage of tax benefits), others choosing more conservative policies to wait for acquisition opportunities. Moreover, the acquisition channel induces firms to reduce debt when assets become more redeployable. Finally, our paper highlights a simple pitfall: theoretical implications for debt do not always map into empirically measured implications for debt-to-value ratios, because value is also endogenous.