Increase Debt Capacity Research Articles

Corporate Governance and Collateral Effect of Real Estate

The collateral channel literature predicts that soaring real estate prices increase the debt capacity of firms with more real estate asset holdings. This paper discusses the different relationships between collateral and investment. We find that firms with strong corporate governance were more likely to increase debt capacity via the collateral channel during the real estate boom from 1993 to 2006. Entrenched managers used less debt to finance their investments when their real estate collateral values increased. Our results hold even after controlling for non-collateralized debts and credit rating of the sample firms.

Effects of Fair Value Reporting of Derivatives on Liquidity Management Policies and Firm Value: Evidence From SFAS No. 133

I examine the effects of fair value reporting of derivatives, in accordance with SFAS No. 133, on corporate risk management policies and firm value. Prior studies predict that effective risk management through derivatives use reduces demand for liquidity and increases debt capacity. Using difference-in-differences analyses, I find that firms that are affected by SFAS No. 133 reduced cash holdings. In addition, treatment firms increased leverage but did not experience increased cost of debt or lower credit ratings. These results are consistent with the proposition that SFAS No. 133 encouraged firms to engage in more prudent risk management using derivatives. Finally, the value of firms that are affected by SFAS No. 133 increased. The results overall suggest that fair value reporting of derivatives had significant effects on corporate risk management policies and firm value.

Credit Default Swaps and Borrowers’ Real Earnings Management: Evidence From Credit Default Swap Initiation

In this study, we examine whether the initiation of credit default swap (CDS) trading alters borrowers’ real earnings management activities. Creditors increase debt supply and loosen loan contracts after CDS initiation, which in turn lessens borrowers’ pressure to resort to real earnings management as a way of lowering the cost of debt and increasing debt capacity. Consistent with this prediction, we find that borrowers reduce myopic real earnings management activities after CDS initiation. Furthermore, we show that this negative association between CDS initiation and real earnings management is more pronounced for borrowers with safer financial status and fewer debt covenants. Our findings remain robust to conducting a parallel trend analysis, employing the propensity score matching and the two-stage instrumental variable methods, using alternative measures of real earnings management, and controlling for accrual-based earnings management. Overall, our study suggests a potential “bright side” of CDS contracts by showing that the introduction of CDS contracts reduces, rather than exacerbates, borrowers’ myopic real earnings management behavior.

First-Order Determinants of Capital Structure among Listed Manufacturing Companies in the United States of America

Capital structure plays a critical role which enables manufacturing firms address the dilemma of whether or not an optimal capital structure can be achieved. The total capital of a firm is composed of both debt and equity which makes up firm’s capital structure. The capital structure of manufacturing firms is made up of a combination of internal financing and external financing of the firm. Internal financing composed of equity, preference share capital and shareholder's funds and external financing composed of long term debt and short term debt of the firm. Internal financing using profits as a source of capital for new investment rather than obtaining capital elsewhere distributed as dividends to firm's owners or other investors. External financing is the phrase used to describe funds that firms obtain from outside of the firm. The decade since the onset of the global financial crisis has brought about significant structural changes in the manufacturing sector in USA. This study thus sought to assess the first-order determinants of capital structure among listed manufacturing companies in the United States of America through literature based study methodology. The study found that the manufacturing industry in USA is an industry that dominates companies listed on the New York Stock Exchange, it can be seen from the number of companies listed on NYSE increasing every period. The companies not only required to produce products, but also must be able to manage their capital structure. The study established that the first order determinants of capital structure for listed manufacturing firms in USA consist of financial situation, growth opportunities, size of the firm, product uniqueness, business risk, tax shields, dividend Policy. Furthermore, the first order determinants of capital structure consist of firm size, tangibility, growth opportunities, the non-debt tax shield, the bankruptcy risk, profitability and risk. The study concludes that listed manufacturing firms with the highest asset liquidity may increase debt capacity only when the bond covenants impose restrictions on the disposition of assets. The fact that a company possesses fixed assets to a large extent can be considered by its creditors as a guarantee that will allow them to recover their funds in the case of financial distress experienced by the borrower corporation. If a high-risk company is experiencing a decline in sales, the resulting profit will decrease due to the amount of the fixed costs. Because there is a decrease in profits, the company is not available enough funds to pay off the debt and interest so that it threatens the occurrence of bankruptcy. Keywords: First order determinants, capital structure, listed manufacturing companies, USA.

On the Models to Evaluate a Merger/Acquisition Project

We compare and contrast the existing merger/acquisition evaluation models and based on the results, propose a model that is more complete. The model emphasizes on the need to value not only the target firm, but also the acquiring firm such that 1) the increase in debt capacity for each firm due to the coinsurance benefit that stems from the diversification effect by pooling two firms together can be considered and 2) the synergy gains accrued to each firm can be valued by the firm’s own discount rate. The model provides methods to account for the effect of the increased debt capacity on the valuations.

Bank bailouts, bail‐ins, or no regulatory intervention? A dynamic model and empirical tests of optimal regulation and implications for future crises

AbstractWe model dynamic bank capital structure under three optimally‐designed regulatory regimes for dealing with potential default—bailout, in which the government provides capital; bail‐in, which the private‐sector provides needed funds; and no regulatory intervention, allowing the institutions to fail. Only under the optimally‐designed bail‐in regime do banks recapitalize during times of distress. Their pre‐commitment to recapitalize reduces debt costs and increases debt capacity. No regulatory intervention is suboptimal for all agents. Optimal bailouts and bail‐ins both generate no asset substitution‐moral hazard behavior under optimal policies in which regulators intervene at early stages of distress. Empirical tests of changes in capital behavior from the pre‐Global Financial Crisis bailout period to the post‐crisis bail‐in period corroborate the model's predictions.

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.

Do Firms Purposefully Change Capital Structure? Evidence from an Investment-Opportunity Shock to Drug Firms

AbstractWe study the capital structure changes of drug firms after an investment-opportunity shock brought about by the Biologics Price Competition and Innovation Act. Using a difference-in-difference approach, we show that the shock led drug firms to make their capital structures less constraining by decreasing leverage, shortening debt maturity, increasing unsecured debt, and reducing convertible debt. New debt covenants became less restrictive and firms raised equity to preserve borrowing capacity. Our results support the view that firms actively manage their capital structures to bolster financial flexibility and increase debt capacity in response to new investment opportunities.

Do local governments use municipal companies for off-balance-sheet financing?

Abstract This paper investigates whether municipalities in Poland use their municipal companies to increase debt capacity beyond the limitations imposed by the fiscal debt rules. The article presents corporate governance and agency problems on the example of relations between local government units and affiliated companies. We review and link literature on corporate finance, in particular capital structure, and public finance - debt liabilities of municipalities. We analyse a sample of 2,019 observations of municipalities and their municipal companies using the Ordinary Least Squares (OLS) method, where explanatory variables were taken from the public and corporate finance (leverage and its determinants). Results show that long-term debt of municipalities is positively associated with the leverage and size of municipal companies, but it is negatively related to their profitability.

How Do Laws and Institutions Affect Recovery Rates for Collateral?

Abstract Using unique internal bank data on ex ante appraised liquidation and market values of assets pledged as collateral in sixteen countries, we show that laws and institutions that strengthen creditor protection increase expected recovery rates for collateral. Stronger creditor protection increases expected recovery rates for movable collateral relative to immovable collateral and shifts the composition of collateral toward movable assets, thereby increasing debt capacity through both higher loan-to-values and attenuating the creditor’s liquidation bias. Our results suggest that the recovery rate for collateral is an important first-stage mechanism through which creditor protection can improve contracting efficiency and enhance access to credit. Received September 17, 2018; editorial decision July 9, 2019 by Editor Andrew Ellul.

How do firms value debt capacity? Evidence from mergers and acquisitions

Abstract We examine how capital structure considerations affect acquisition pricing and valuation. We find that debt capacity improvement is value-enhancing for all acquirers when they gradually reveal their growth opportunities to the market. This is reflected in the long-run stock market returns, both 12- and 24-months after acquisition announcement. While both overlevered and underlevered acquirers benefit from an increase in debt capacity resulting from the merger, only overlevered acquirers pay higher premiums to increase debt capacity. Underlevered acquirers do not pay a premium for it; instead they consider market timing opportunities. Results are robust for alternative definitions of leverage and debt capacity improvement.

How Do Firms Value Debt Capacity? Evidence from Mergers and Acquisitions

We examine how capital structure considerations affect acquisition pricing and valuation. We find that debt capacity improvement is value-enhancing for all acquirers when they gradually reveal their growth opportunities to the market. This is reflected in the long-run stock market returns, both 12- and 24-months after acquisition announcement. While both overlevered and underlevered acquirers benefit from an increase in debt capacity resulting from the merger, only overlevered acquirers pay higher premiums to increase debt capacity. Underlevered acquirers do not pay a premium for it; instead they consider market timing opportunities. Results are robust for alternative definitions of leverage and debt capacity improvement.

Debt retirement at IPO and firm growth

This paper examines whether debt retirement at the time of initial public offering (IPO) can stimulate firm growth. Our findings demonstrate that highly leveraged firms tend to use the proceeds of IPOs to repay more existing debt. Then, increased debt capacity and reduced interest burden enable firms to expand their businesses. Firms that retire more debt also present better performance in the long-term. These results indicate that firms that have previously been labeled low-growth firms can achieve high growth in the post-IPO period by conducting debt retirement.

Debt Retirement at IPO and Firm Growth

This paper examines whether debt retirement at the time of initial public offering (IPO) can stimulate firm growth. Our findings reveal that highly leveraged firms tend to use proceeds of IPOs to repay more existing debt. Then, increased debt capacity and reduced interest burden enable firms to expand their businesses. Firms retiring more debt also present better long-term operating performance. These results indicate that firms conducting debt retirement, which have been labeled as low-growth firms by previous IPO literature, actually can achieve high growth during the post-IPO period due to the alleviation of potential debt-overhang problems.

Bank Bailouts, Bail-Ins, or No Regulatory Intervention? A Dynamic Model and Empirical Tests of Optimal Regulation

We model dynamic bank capital structure under three optimally-designed regulatory regimes dealing with potential default: bailout, where government provides capital; bail-in, using private-sector funds; and no regulatory intervention, allowing failure. Only under optimally designed bail-in do banks recapitalize during distress. Their pre-commitment to recapitalize reduces debt costs and increases debt capacity. No regulatory intervention is suboptimal for all agents. Optimal bailouts and bail-ins generate no asset substitution-moral hazard behavior because regulators intervene at early stages of distress with sufficient capital remaining. Empirical tests of changes in capital behavior from the pre-crisis bailout period to the post-crisis bail-in period corroborate model predictions.

Is Earnings Yield a Security Return Model Anomaly?

This paper supplements the traditional security return model, by adding earnings yield to the risk-free rate, market risk, size, and book-to-market equity as predictors of security returns. Earnings yield is the ratio of net income to market price, so that it represents the segment of market price that depends upon operating performance of the firm, rather than market perception. This paper establishes a theoretical framework for the earnings yield construct, describing it as a predictor of return on assets, return on equity, economic value added, and the equity multiplier. Earnings yield, therefore, predicts the ability to purchase productive assets, achieve a positive return for shareholders, and increase debt capacity. Then, earnings yield is subjected to empirical testing through a regression of its impact on security returns, with the finding that it explained a significant amount of the variance in security returns beyond size and book-to-market equity.

Credit Default Swaps, Financial Distress and Corporate Acquisitions

This study shows that credit default swap (CDS) reference firms are more likely to conduct acquisitions. In economic terms, CDS reference firms have a 5% higher acquisition propensity than non-CDS firms. Additionally, CDS reference acquirers experience higher announcement returns. This is driven by CDS reference acquirers with high credit risk, who are also associated with a lower probability of default. The positive effect of CDS on acquisition outcomes is attributable to the empty creditor threat posed by CDS-protected creditors. Finally, consistent with CDS increasing debt capacity, cash is more likely to be used as the payment method.

Optimal cash holdings under heterogeneous beliefs

AbstractThis paper explores a one‐period model for a firm that finances its operations through debt provided by heterogeneous creditors. Creditors differ in their beliefs about the firm's investment outcomes. We show the existence of Stackelberg equilibria in which the firm holds cash reserves in order to provide incentives for pessimistic creditors to invest in the firm. We find interest rates and cash holdings to be complementary tools for increasing debt capacity. In markets with a high concentration of capital across a small interval of pessimistic creditors or by a few large creditors, cash holdings is the preferred tool to increase the debt capacity of the firm.

Liquidation Values, Claim Priority, and Productivity

Pledgeable assets with higher liquidation values are often thought to increase debt capacity by being collateralized in loan contracts. Contrary to this intuition, we find that higher liquidation values are associated with less collateralization, using plausibly exogenous shocks to local real estate markets as quasi-experiments. We argue that creditors require collateral to compensate for shortfalls in expected liquidation proceeds due to low asset redeployability or competing claims. Consistent with this idea, we find evidence that collateralization is more likely when a firm has other secured creditors and that liquidation values decrease super senior claims.

Buyer Power in Conglomerate Acquisitions

In this paper, we take a broad product markets approach to examine the sources of value creation in diversifying acquisitions. We find that our proxies for the merging firms’ change in purchasing concentration are positively related to the combined wealth effect of merging firms, negatively related to the change in cogs-to-sales of merging firms, and negatively related to the wealth effects of common supplier industry firms and rival firms. Furthermore, we document post-acquisition decreases in output prices for the main common supplier industry. The above results cannot be explained by negative demand shocks in acquiring firm industries. These results highlight the benefits of pooled purchasing in diversifying acquisitions. Additionally, greater asset complementarities and increased debt capacity also generate larger gains for the merging firms.