Debt Capacity Research Articles

Real Options and Hidden Leverage∗

Financial leverage is customarily measured by the ratio of debt to net assets or debt to enterprise value. These measures usually understate effective leverage, because corporate commitments to ongoing and future capital investments create hidden leverage that acts like debt, but does not appear on book balance sheets.Hidden leverage acts like debt in two important ways. First, it increases financial risk. The more hidden leverage, the more volatile are stock market returns. Second, failure to meet hidden‐leverage obligations is costly. Failure may mean loss of investment opportunities or other damage to the company's long‐term prospects and value.In the case of growth companies, the most important source of hidden leverage is options for future investment. Investment opportunities are real call options, where the underlying asset is a real (as distinct from a financial) asset. Suppose an energy company has a good greenfield site and the opportunity to build a petrochemical plant when and if the time is ripe. The future decision will depend on the spread between feedstock and product prices, on energy and transportation costs, and on the resolution of other uncertainties that will determine the plant's future NPV. Though the plant may never be constructed, the option to construct it is valuable now.Most companies also have real put options: opportunities to abandon assets. Abandonment options are generally more abundant in mature or declining industries.Starting with insight that real call options are equivalent to leveraged positions in the underlying asset, the authors use option pricing concepts to calculate the amounts of option leverage. They show why high‐growth companies like Apple are effectively far more leveraged than their GAAP accounting balance sheets would suggest. Such analysis helps explain why companies like Apple also keep so much cash and marketable securities on hand.Growth (call) options typically have negative debt capacity, which displaces explicit borrowing. Abandonment (put) options have positive debt capacity, which allows the company to borrow more than its assets in place would normally support. This can explain the high debt ratios in many LBOs.The authors explore other effects of hidden leverage. For example, standard procedures for estimating the weighted average cost of capital (WACC) will overestimate WACC for growth firms and underestimate it for mature firms with valuable abandonment options.

Rethinking Risk Management

This paper presents a theory of corporate risk management that goes beyond the “variance‐minimization” model that long dominated academic discussions of the subject. It argues that the primary goal of risk management is not to dampen swings in corporate earnings, cash flows, or value, but rather to provide protection against the possibility of costly lower‐tail outcomes—situations that would cause financial distress or make a company unable to carry out its investment strategy. In the jargon of finance specialists, risk management can be viewed as the purchase of “well‐out‐of‐the‐money put options” designed to limit downside risk.By eliminating downside risk and reducing the expected costs of financial trouble, risk management can also help a company to achieve both its value‐maximizing capital structure and its optimal ownership structure. For besides increasing corporate debt capacity, the reduction of downside risk also encourages larger equity stakes for managers by shielding their investments from “uncontrollables.”The paper also departs from standard finance theory in suggesting that some companies may have a comparative advantage in bearing certain financial market risks—an advantage that derives from information acquired through their normal business activities. Although such specialized information may lead some companies to take speculative positions in commodities or currencies, it is more likely to encourage “selective” hedging, a practice in which the risk manager's “view” of future price movements influences the percentage of the exposure that is hedged.But to the extent that such view‐taking becomes an accepted part of a company's risk management program, it is important to evaluate managers’ bets on a risk‐adjusted basis and relative to the market. If risk managers want to behave like money managers, they should be evaluated like money managers.

Stiffing the creditor: Asset verifiability and bankruptcy

Evidence suggests that asset pledgeability, debt complexity, and control rights of dispersed debt influence financial distress resolution. We model how courts’ imperfect verifiability of assets and valuable control of misaligned creditors shape firms’ debt structure and create coordination problems that determine distress outcomes and financing. A key result is that an increase in verifiability allows financially constrained firms to fund projects by pledging more assets to misaligned creditors, making contract renegotiation in distress times more difficult and increasing the probability of bankruptcy. Since equity receives less in the event of distress, constrained firms choose riskier projects with higher returns. Consistent with our model, bankruptcy filings increase after the U.S. Supreme Court decision imposing a “market test” to assess the value of stockholders’ interest in debtor proposals. The effect is stronger for firms with low asset verifiability. These firms also experienced an increase in recovery rates, debt capacity, and risk-taking. Our findings suggest that reforms improving the verifiability of assets substantially impact credit access. However, our results also point out that improving asset verifiability may be insufficient for constrained firms with aligned creditors. Therefore, complementary reforms that facilitate firms’ access to creditors from different market segments may be necessary.

Analisis Pengaruh Profitabilitas, Likuiditas, dan Leverage terhadap Financial Distress pada Perusahaan Transportasi yang Terdaftar di BEI Tahun 2018-2020

Financial distress is a condition where management is unable to overcome financial problems that cause a successive decline in financial performance before the company is declared bankrupt. This study has something to be achieved, namely analyzing the possibility of financial distress in companies with financial ratios as indicators, including profitability ratios, liquidity ratios, and leverage ratios. The sample taken is a transportation company listed on the Indonesia Stock Exchange for the period 2018-2020. Purposive sampling was used as a sample selection method and 13 companies were obtained that matched the criteria proposed by the author. Data analysis with logistic regression using IBM SPSS version 25. As a result, the profitability represented by ROA has no effect on financial distress because when profits decline, there are still other funds from both internal and external sources to cover liabilities. Liquidity represented by the current ratio has no effect on financial distress because the companies have the ability to fund current debt with total assets. Meanwhile, leverage represented by DAR has a significant effect on financial distress. The solution that can be done by transportation companies with consecutive losses for 2 years is to be disciplined in paying short-term debts and efficiently use debt capacity so that companies can get large profits from their debts so that financial difficulties can be avoided.

Asset tangibility, information asymmetries and intangibles as determinants of family firms leverage

Using a sample of Spanish tourism small and medium-sized firms, we have tested the impact of family control, publicly-available information and tangibility on financial structure, providing a multi-theoretical model that incorporates contributions from the classical theory of finance, inspired by agency theory, the behavioural theory of the firm and strategic theory. The results point to the need to jointly consider the effects of information transmission practices, asset investment decisions and ownership structures on debt capacity. The results show how family control is associated with propensity to take on debt, so that the desire to maintain social control and socioemotional wealth prevails over risk aversion, being the relationship between family ownership and leverage more complex and contingent than has been assumed in financial and behavioural models. In addition, this study contributes further evidence on the importance of family reputational intangibles, showing a positive indirect effect on firms’ leverage capacity and relating to the gap left by finance theory regarding the value of intangibles for debt, which has meant that their value in reducing information asymmetries in the capital market has been overlooked.

Revenue diversification and municipally owned companies’ role in shaping the debt of municipalities

AbstractWe aim to identify the role of revenue diversification and the municipally owned companies’ financial flexibility in shaping the short‐term and the long‐term debt of municipalities in Poland and this debt's repayments. To reflect the impact of this agency relationship on the municipalities’ debt, we consider explanatory variables from two sectors: public and corporate finance. We merge data retrieved from the Local Data Bank, the financial and budget statements of municipalities, and the municipally owned companies’ financial and ownership data from the ORBIS database. We use the ordinary least squares method for cross‐sectional data and the ordinal logit model to estimate a firm's unused debt capacity. We show that a municipally owned company's leverage extends the long‐term debt capacity of municipalities via off‐balance sheet financing. The municipally owned companies’ financial flexibility helps municipalities increase their revenue diversification and shape their debt to cover capital spending despite limited fiscal autonomy under fiscal debt constraints. Unlike revenue diversification in the USA, revenue diversification in Poland does not allow Polish municipalities to reduce short‐term debt. We contribute to the literature by exploring the role of the municipally owned companies’ financial flexibility (leverage and unused debt capacity) in shaping a municipality's debt capacity.

The Impact of Debt Capacity on Firm’s Growth: (A Case Study of Selected Firms from Pharmaceutical Industry in Pakistan)

The ultimate goal of all activities within organizations is to achieve higher growth and finding new sources for mounting firm capital. This study aims to investigate debt capacity as the source of firm capital and its impact on firm’s growth. The objectives of this research to shows the relationship between market to book ratio and debt to asset ratio. Multiple liner regression is used between Growth and book leverage. By selected pharmaceutical sector that has been listed at Karachi stock exchange in Pakistan. In this research 8 companies are selected that are listed at Karachi Stock Exchange during the period of 2005-2014. In this paper secondary data is used. The result reveals a significant positive relationship between the debt to asset ratio and market to book ratio and debt to asset ratio. It displays that there is no negative effect of debt capacity on firm’s growth.

Present-biased government and sovereign debt dynamics

This paper studies the sovereign debt dynamics when the government exhibits present-biased preferences and can freely adjust sovereign debt. First, present bias plays a dual role. If the country is moderately indebted, the desire for instantaneous gratification drives the government to issue debt. However, with excessive indebtedness, the top concern is to procrastinate costly default, and present bias serves as an implicit commitment device that induces the government to repurchase existing debt. Second, the severe present-biased government suffers from debt intolerance: it has small debt capacity and pays high sovereign credit spreads, despite potentially maintaining a low target debt level. Finally, we find that long-term debt and budgetary restriction can mitigate the negative impact of present bias by disciplining the government’s over-borrowing incentives.

The effect of real estate prices on peer firms

AbstractWe investigate peer effects from corporate real estate. Shocks to real estate prices shift firms' debt capacity, which has a significant impact not only on firm investment but also on the investment of peer firms. This peer effect from corporate real estate is stronger when firms or their peers have more investment opportunities; financially constrained firms invest more out of their own price shocks, while the peer effect is stronger for unconstrained firms; and we find significant peer effects within groups of small and large firms, respectively. Firms finance additional investment from peer real estate shocks using cash reserves. Overall, we document a new channel through which real estate is an economically significant determinant of corporate investment.

Influence of Cross-Listing on the Relationship between Financial Leverage and R&D Investment: A Sustainable Development Strategy

Investment in research and development (R&D) is an important sustainable strategy for firms in developing unique products to own their differentiation and competitive advantages. Financial leverage is influential in R&D investment. However, previous studies identified different relationship between financial leverage and R&D investment. This study revisits this puzzle from a unique perspective that targets firms undertaking international cross-listings. This specification allows us to test whether firms are willing to prioritize R&D funding when debt capacity is enhanced. This is a new perspective that has never been explored in the relationship between debt financing and R&D investment. We find that the launch of cross-listing significantly increases the level of firm financial leverage, which is followed by a significant increase in corporate investment in R&D. The aggressive strategy of cross-listing firms that enhance financial leverage to support more investment in R&D further significantly influences their industrial rivals to increase investment in R&D as a responding strategy. Overall, these results show that firms exploit the timing of international cross-listing to increase their leverage to further fund R&D, which also stimulates an intra-industry contagion effect. Our findings suggest a new viable path for funding R&D that carries important implications for corporate sustainability.

Debt Capacity and Financial Performance of Quoted Firms in Nigeria

Introduction: The field of research treating debt capacity can be comprehended as a unique piece of a lot more extensive capital structure hypothesis. This started with the paper of Modigliani/Miller in 1958. There has been a continuous and serious hypothetical dialog about the ideal capital structure of an organization. One generally new piece of the related discussion is debt capacity and potential connection to the capital structure of an organization.
 Purpose: The purpose of the study was to examine the effect of debt capacity and financial performance of quoted firms in Nigeria. This study expected that debt capacity can be a way to characterize and deal with the capital structure of an organization.
 Methodology: The study formulated 3 hypotheses and the least square multiple regression was used for hypothesis testing empirical results based on 2014 to 2018 accounting and marketing data for 20 quoted firms in Nigeria lend some support to the pecking order and static tradeoff theories of optimal capital structure. Data were sourced from the Nigeria Stock Exchange, Security and Exchange Commission, and other relevant data sources. This study investigated, experimentally, if there might be a significant relationship between the debt capacity of organizations and their financial and market performance. 
 Findings: A firm’s debt capacity was found to have a significant impact on the firm’s accounting performance measure. Debt capacity measures have a positive and significant relationship with the market performance measure (Tobin’s Q). A fascinating finding is that all the influence estimates have a positive and exceptionally critical association with the market execution measure (Tobin’s Q), which could somewhat bolster Myers, (1977)’s contention that organizations with high transient obligation to add up to resources have a high development rate and superior.
 Unique contribution to theory, practice and policy: The consequences of this result further affirm some earlier discoveries by different researchers and prior analysts and the exploration work has had the option to discover answers to the examination addresses prior brought up in the basic part in the accompanying ways. It was therefore recommended that Companies can finance themselves with debt and equity capital. By increasing the amount of debt capital relative to its equity capital, a company can increase its return on equity. Also, in transition, the economic environment is more volatile and riskier than in developed markets. Therefore, a management scheme of capital structure that provides for flexibility in financing is preferable.

Determinants of capital structure: Evidence from Sidama credit and saving microfinance institution

Different industry-specific and macro-economic factors influence the capital structure of microfinance institutions (MFI). So, the objective of this study is to identify industry-specific determinants of capital structure with the selected branch of Sidama MFI, Sidama region, Ethiopia. To this end, the researcher employed a quantitative research approach with an explanatory research design where the effect caused by the independent variable on the dependent variable is observed through regression analysis. The secondary data were collected from Sidama MFIs consolidated and audited financial statements from 2009 to 2019 G.C. Then, both descriptive and inferential statistical analysis has been done. The researcher employed a regression analysis model to identify the effect of five explanatory variables on capital structure measured through debt to equity ratio. Thus, the result of regression analysis showed that out of five independent variables incorporated in the model, all five variables such as growth (negative), profitability (positive), firm size (positive), earning volatility (positive), and asset tangibility (positive) and statistically significant respectively. This study recommends that the microfinance institutions at all company levels improve debt capacity in proportion to asset tangibility more than the current status.

Credit Default Swaps around the World

Abstract We analyze the impact of the introduction of credit default swaps (CDSs) on real decision-making within the firm. Our structural model predicts that CDS introduction increases debt capacity more when uncertainty about the credit events that trigger CDS payment is lower. Using a sample of more than 56,000 firms across 51 countries, we find that CDSs increase leverage more in legal and market environments where uncertainty about CDS obligations is reduced and when property rights are weaker. Our results highlight the importance of legal uncertainty in the interpretation of the underlying trigger events of global credit derivatives.

Research on the Impact of Macroeconomic Fluctuations on the Market Value of Enterprises

This article takes China’s A-share listed companies from 2004 to 2019 as a research sample to examine the impact of macroeconomic fluctuations on the operating debt behavior of listed companies and the relationship between corporate operating debt decision-making and corporate value under the background of macroeconomic fluctuations. The results find that: During the economic downturn, companies use operating liabilities more actively during the economic downturn, and operating liabilities have a stronger effect on the promotion of corporate value; during economic downturns, companies with stronger residual operating debt capacity have higher corporate value. This paper has enriched the empirical evidence of the relationship between macroeconomic fluctuations and micro-firm financial behavior, and has certain enlightenment significance for company managers to grasp the law of macroeconomic development and make scientific and reasonable debt decisions.

Debt Capacity, Cash Holdings, and Financial Constraints

This research seeks to clarify the relationship among cash holdings, debt capacity, and financial constraints. Compared with other firms, financially constrained firms show relatively smaller decreases in debt capacity when they hold more cash. Cash holdings also help financially constrained firms receive more bank loans, across different types of debts. Heterogeneous beliefs in loan contracts help explain this relationship. Whereas some predictions indicate that cash can act as a financing source, substituting for debt capacity, this study reveals that cash holdings also can complement debt capacity when a firm is financially constrained.

Financial Constraints, Debt Capacity, and the Cross Section of Stock Returns in Nepalese Listed Non-Financial Firms

This study aims to determine whether debt capacity holds differential impact in the cross section of stock return for financial constrained and financial unconstrained Nepalese enterprises. Considering listed non-financial firm as population, study collect quantitative nature of 10 year balanced panel data from 11 nonfinancial firms listed in Nepal Stock Exchange (NEPSE) and actively traded during the period of 2008 to 2018. Data were obtained by using secondary source. As per propose of the study firm has been categorized financial constrained and financial unconstrained using the basis of book value of assets. Obtained data were analyzed by using multivariate econometric model. Study found that market value of equity, book to market ratio, and debt capacity are major explanatory variables of stock returns for financially constrained firms. Study further found that debt capacity has positive significant impact on stock returns for financial constrained firms. However, with regard to financial unconstrained firm’s debt capacity impact on stock return is insignificant. Study concluded that debt capacity hold differential impact in the cross section of stock returns in Nepalese nonfinancial firms.

Optimal capital structure, ambiguity aversion, and leverage puzzles

We introduce ambiguity about the asset value dynamics of a firm into a trade-off framework of capital structure. We characterize investors’ preferences by recursive multiple priors utility. We show that equity holders’ ambiguity aversion significantly reduces the optimal leverage and debt capacity. In particular, equity holders with sufficiently strong ambiguity aversion perceive their asset value dynamics to be “too valuable to lose” upon bankruptcy and therefore optimally choose zero leverage and forgo the tax benefits of debt to avoid possible default. We also show that the distortion effect of ambiguity on the leverage choice is stronger (weaker) when a firm’s equity and debt markets are segmented (integrated).

Do firm characteristics affect debt capacity? Evidence in CEO succession

ABSTRACT Should firms decrease or increase their debt capacity after professional CEO succession? Examining a sample of all publicly traded firms from 1991 to 2016 in Taiwan, this research finds that firms with professional CEO successors tend to raise less debt and consider the succession of professional managers to be more conservative because they are afraid of being monitored more severely. From the perspectives of firms’ characteristics, those with professional CEO successors and high cash holdings and investment levels are more likely to increase their debt capacity, while those of a larger size and higher post-succession profitability volatility decrease their ability at raising debt. Finally, we hand-collect data and develop a novel method to identify the real founders and reconfirm our empirical evidence. Our findings present financial implications for boards of directors which they can evaluate firms’ cash holdings, investment level, firm size, and profit volatility before deciding on whether to name a CEO successor to take over their firms.

Bank capital, government bond holdings, and sovereign debt capacity

I develop a model where the sovereign debt capacity depends on the capitalization of domestic banks. Low-capital banks optimally tilt their government bond portfolio toward domestic securities, linking their destiny to that of the sovereign. If the sovereign risk is sufficiently high, low-capital banks lend less to the productive sector to further increase their holdings of domestic government bonds, lowering sovereign yields. In this case, a government that regulates bank capital faces a trade-off. On the one hand, high-capital banks lend more to the productive sector. On the other hand, low-capital banks support the home sovereign debt capacity.

TIMING, RECURRENCE, AND EFFECTS OF FIXED ASSET REVALUATION: EVIDENCE FROM BANGLADESH

This study intended to explore when and how often fixed asset revaluation (FAR) is practiced in Bangladesh and explain the impacts of FAR on net asset value (NAV), stock prices, and debts of companies. Based on 175 listed companies on the Dhaka Stock Exchange, this study found increasing use of the revaluation model where the textile industry witnessed the highest number of revaluations. Most of the listed companies were irregular revaluer, and they performed FAR during the bull market in 2010. Most newly listed companies did it just before their initial public offerings (IPO). The results of the Wilcoxon signed-rank test imply that the changes in NAV, stock prices, and total debts after revaluation were statistically significant. This study found evidence of enhancing debt capacity and stock prices of several companies through improved NAV. The findings will assist regulators to recognize the consequence of revaluation and enable them to take an appropriate stance for controlling abusive and creative reporting. The study will also make investors cautious about companies with revaluation induced assets. This study suggests that companies practicing the revaluation model should perform FAR on regular intervals to reduce information asymmetry about assets’ value and thus help improve investors’ confidence. Keywords: Fair value accounting, IAS 16, PP&E, Bull-bear market, Information asymmetry, NAV JEL Classifications : G1, G11, M41, M48 DOI: https://doi.org/10.32479/ijefi.10828