Why adding firm value with a put feature in debt contracts is better than renegotiation

Abstract

In this paper, we analyze the ability of putable debt to add firm value. To stress the impact of a put feature, we compare the resulting optimal firm values and capital structures to those of a firm with straight debt that can be renegotiated. For this purpose, we consider a time-independent firm value model with tax-deductibility of coupon payments, bankruptcy costs in the case of a default, and dynamic restructuring. We find that a put right can always be designed so that a put is enforced for low asset values but the bond remains alive for high asset values. The optimal firm value arising from this type of equilibrium strategy is remarkable for several reasons: The optimal firm value under putable debt is always higher than under straight debt even under renegotiation with arbitrary negotiation power of debt and equity holders. Moreover, the optimal firm value under putable debt always benefits from higher bankruptcy costs, while the optimal firm value under straight debt suffers. Accordingly, a higher volatility of asset value returns can be favorable for a high firm value under putable debt, while it always destroys value of a firm with straight debt.