Optimal Leverage Research Articles

Prudential Regulation under CECL

This study investigates prudential regulation under the current expected credit losses (CECL) model in accounting for loan loss provisioning. We highlight the dual role (valuation role and regulatory role) of the CECL accounting in deriving the optimal regulatory leverage ratios, which integrate (1) the dual role of banks (liquidity provision to households and credit supply to the real sector); (2) the reward and risk attributes of loan portfolio composition; and (3) procyclicality and countercyclicality.

Does Private Equity Systematically Over-Lever Portfolio Companies?

Detractors have warned that Private Equity (PE) funds tend to over-lever their portfolio companies because of an option-like payoff, building up debt overhang and widespread bankruptcy risks. Drawing on standard trade-off theory, this paper argues PE-ownership leads to higher levels of optimal (value-maximizing) leverage. I embed key features of PE-ownership into a model of firm value, leverage and credit risk. Using a large sample of PE-sponsored leveraged buyouts (LBO), the estimated model fully explains both the level and change in leverage ratios in the data following PE-takeover. Higher levels of optimal leverage arise endogenously from (i) lower asset volatility (ii) higher expected future return and (iii) lower deadweight bankruptcy costs. In equilibrium, tax benefit is greater and expected distress cost of debt is much lower since bankruptcy is both less likely and less costly. Counterfactual analysis reveals substantial loss in firm value if PE sub-optimally chose lower leverage. Post-LBO, I estimate Distance-to-Default increases by 28 percent and credit spreads narrow by 3.6 percentage points for the median firm, suggesting concerns about default risks may have been overstated. Additional tests show PE-backed firms receive equity injections from sponsoring funds if they fall into financial distress, corroborating the lower distress cost channel. My results suggest new policies regulating leveraged loans should focus on the borrower's optimal capital structure.

Maximizing Relative Wealth Using Leverage: The Role of Risk Aversion

Investors can use leverage to increase the returns and profit of an investment. The so-called Kelly criterion is traditionally used to determine the optimal leverage factor for maximizing an investor’s absolute wealth. However, using the Kelly criterion may lead to too risky decisions for rational investors without log utility, rendering it not applicable for risk averse investors. Further, investor success is more often than not evaluated as the relative performance against a benchmark, making the case for maximizing relative wealth rather than absolute wealth. We propose a risk-adjusted Kelly criterion based on quadratic utility for maximizing the investors’ wealth relative to a generic reference. Our model enables us to derive the optimal leverage decision for rational investors seeking to maximize relative wealth given investor risk aversion, thereby allowing risk averse investors to benefit from leverage. Quadratic utility also enables optimizing of leverage independent of the returns-density-function assumption so that the skewness and kurtosis of asset returns do not violate the assumptions of the model. Our findings demonstrate the rationale for risk averse investors to use leverage in maximizing relative wealth. Our study provides useful understanding of relative wealth accumulation using leverage and the role of risk aversion.

Impact of Financial Sector Opacity on the Capital Structure Choice of Asian Banks

This study investigates the role of market imperfections on the optimal capital structure choice of value maximizing banks, by investigating the impact of information asymmetry on bank liabilities. Random effects estimation (GLS) is used to test the effect of market imperfections on the capital structure of banks by employing 7 years of unbalanced panel data from the largest 15 countries of Asia based on GDP. The study finds evidence of specific individual characteristics impacting the capital structure of Asian banks. However, banking sector market imperfections are also found to play a major role in the capital structure choice of banks. In the presence of a high level of information asymmetry between the bank and the depositor, the bank retains a lower than optimal capital ratio. Transparent banks may be successful in achieving the optimal leverage, consequently lowering their capital cost. Evidence suggests a need to reduce banking sector opacity regarding their risk exposures. To ensure banking sector stability, stronger capital requirements need to be imposed on banks in those Asian countries where information asymmetry is high. The limitations of the study include limited data and the choice of information asymmetry proxies. Future research can address this limitation by employing additional proxies for information asymmetry and increasing the number of countries.

Prudential Policy with Distorted Beliefs

This paper studies leverage regulation and monetary policy when equity investors and/or creditors have distorted beliefs relative to a planner. We characterize how the optimal leverage regulation responds to arbitrary changes in investors' and creditors' beliefs and relate our results to practical scenarios. We show that the optimal regulation depends on the type and magnitude of such changes. Optimism by investors calls for looser leverage regulation, while optimism by creditors, or jointly by both investors and creditors, calls for tighter leverage regulation. Monetary policy should be tightened (loosened) in response to either investors' or creditors' optimism (pessimism).

The COVID-19 Impact on Corporate Leverage and Financial Fragility

We study the impact of the COVID-19 recession on capital structure of publicly listed U.S. firms. Our estimates suggest leverage (Net Debt/Asset) decreased by 5.3 percentage points from the pre-shock mean of 19.6 percent, while debt maturity increased moderately. This de-leveraging effect is stronger for firms exposed to significant rollover risk, while firms whose businesses were most vulnerable to social distancing did not de-lever relative to less vulnerable companies. We rationalize our evidence through a structural model of firm value that shows lower expected growth rate and higher volatility of cash flows following COVID-19 reduced optimal levels of corporate leverage. Model-implied optimal leverage indicates firms severely affected by lockdowns became over-leveraged. We find default probability deteriorates most in large, over-leveraged firms and those that were stressed pre-COVID. Additional stress tests predict value of these firms will be less than one standard deviation away from default if cash flows decline by 20 percent.

Bail-in vs bail-out: Bank resolution and liability structure

What is the joint impact of different resolution regimes and capital requirements on the optimal liability structure of a bank holding insured deposits and issuing non-bail-inable debt and bail-inable Tier1-capital debt? We address this novel question and find that: (1) a credible bail-in resolution regime rules out extreme leverage and creates value by postponing default; (2) a positive probability of bail-out destroys credibility with dramatic effects on financial risk-taking, to the point of reversing the classical positive link between optimal leverage and growth prospects; and (3) a strict enforcement of the Basel III CET1 capital requirement strongly mitigates the impact of a non-credible resolution regime.

Agency Conflicts and Investment: Evidence from a Structural Estimation

We develop a dynamic capital structure model to study how manager-shareholders agency conflicts affect the joint determination of financing and investment decisions. We show that the consumption of private benefits channel leads managers not only to choose a lower optimal leverage, but also to underinvest. We fit the model to the data and show that the average firm underinvests, younger CEOs underinvest less than older ones and firms with low institutional ownership underinvest less than those with high institutional ownership. Firms with compensation that is more closely related to the company's size exhibit overinvestment.

Investment and financing decisions with learning-curve technology

The learning curve has a significant impact on production cost (hence corporate profit) in a number of industries. While the learning curve is well recognized in the Economics literature and its effect on operating costs and production decisions widely studied, its effect on corporate investment has been largely unexplored. To our knowledge, there is one paper that examines this issue, but it is limited to unlevered firms. We therefore examine a levered firm's optimal investment and financing choices when using learning-curve technology. The main findings are as follows. The effect of leverage on the investment decision depends on the level of debt. Using the optimal debt level will result in earlier and larger investment. Thus, leverage has a positive effect on investment overall, and the difference between levered and unlevered firm is an increasing function of learning speed. The optimal leverage ratio (without a borrowing constraint) is an increasing function of learning speed. With a borrowing constraint, the investment decision is similar to the unconstrained-borrowing case, but the leverage ratio is initially increasing and subsequently decreasing in learning speed. Moreover, it is a decreasing function over a wider range for a more stringent borrowing constraint, for decreasing-returns-to-scale technology and for a less volatile product market.

Optimal capital requirements with noisy signals on banking risk

We analyze the optimal capital requirement in a model of banks with heterogeneous investment risks and asymmetric information. Asymmetric information prevents depositors from charging an actuarially fair interest rate and leads to cross-subsidization across banks. A leverage constraint reduces the investment of riskier banks, mitigating the pecuniary externality on deposit rates. When policymakers lack information about banking risk, the optimal leverage constraint is tighter than the first-best leverage ratio. When policymakers observe a noisy signal of banking risk, the optimal signal-based leverage constraint is tighter when the signal has worse precision, rather than a larger level of expected risk.

Guarantor and Liquidity Risk: Effects on Bank Capital Structure, and Regulatory and Insurance Policy

We develop a structural model that accounts for guarantor risk and state-dependent withdrawals that induce liquidity funding costs for the bank. The severity of these costs increases near the default barrier, where depositors run on the bank for fear of a costly recovery. The introduced frictions reduce the bank charter value and lead to lower levels of optimal leverage. Our model provides a tool for examining the effectiveness of different regulatory and deposit insurance policies. Minimum capital requirements successfully mitigate asset substitution and moral hazard problems, even in regimes with capital forbearance and mispriced deposit insurance. We introduce a new measure, the reservation price of deposit insurance, defined as the highest premium that makes deposit insurance irrelevant to the bank. The reservation price is significantly low when the guarantee fund provides limited coverage and has not prevented bank runs, thus forcing the guarantee fund to levy a lower assessment rate.

The Leland\u2013Toft optimal capital structure model under Poisson observations

This paper revisits the optimal capital structure model with endogenous bankruptcy, first studied by Leland (J. Finance 49:1213–1252, 1994) and Leland and Toft (J. Finance 51:987–1019, 1996). Unlike in the standard case where shareholders continuously observe the asset value and bankruptcy is executed instantaneously without delay, the information of the asset value is assumed to be updated periodically at the jump times of an independent Poisson process. Under a spectrally negative Lévy model, we obtain the optimal bankruptcy strategy and the corresponding capital structure. A series of numerical studies provide an analysis of the sensitivity, with respect to the observation frequency, of the optimal strategies, optimal leverage and credit spreads.

M&A Activity and the Capital Structure of Target Firms

Using a large sample of European acquisitions, we find that acquired firms substantially close the gap between their actual and optimal leverage ratios. The bulk of this adjustment occurs quite rapidly â?? within a year of the acquisition. The typical over-levered firm adjusts its debt-to-assets ratio from 34.4% in the year before acquisition to 20% in the year after. (The adjustment is smaller, but still quite rapid, for targets that had been under-leveraged.) These adjustments occur primarily through debt issuances or retirements. We also investigate whether target firms' pre-merger leverage contributes to the probability of them being acquired. We find that firms further away from their optimal leverage are more likely to be acquired: for an average firm, an increase in the absolute leverage deviation from 1% to 10% of total assets increases the probability of being acquired by 4.1% to 5.6% (The larger effect applies to over-leveraged firms.) Overall, our results provide support for the trade-off theory of capital structure and suggest that financial synergies have a significant role in the typical European acquisition decision.

Investment and financing decisions in the presence of time-to-build

We study a firm’s optimal decisions on investment, default, and financing when the amount of time and the running costs for project completion are uncertain. In the presence of time-to-build, a firm makes conservative investment and financing decisions; investment is delayed, and the optimal leverage ratio is inverted U-shaped with respect to the size of the lag. Although equity holders can choose to default before the project has been completed, the default probability in the presence of time-to-build is lower than that in the absence of a lag in most cases because of the conservative investment and financing decisions. Given the lower default probability, equity holders may benefit more from debt financing in the presence of time-to-build than they would in the absence of a lag. When firms can shorten their expected time-to-build by bearing more costs, unlevered firms strive to reduce the lag more than optimally levered firms do. However, highly levered firms utilize more resources to reduce the lag than all-equity firms do because equity holders are more concerned about the possibility of default before the project’s completion.

Asset Variance Risk Premium and Capital Structure

AbstractThis article investigates how the asset-return variance risk premium changes leverage. I find that the premium reduces leverage by increasing risk-neutral bankruptcy probability and costs in a model where asset returns have stochastic variance with the risk premium. Empirically, the model calibrations verify a significant reduction in optimal leverage, closer to observed leverage than the model without the premium. In model-free regressions, I document that leverage correlates negatively with the variance premium. The highest negative correlation is among investment-grade firms with low asset beta and historical variance but high variance premiums because their assets have high exposure to the market’s variance premium.

Optimal Capital Structure and Speed of Adjustment under Hyperinflation and Dollarization

Economic challenges in Zimbabwe have resulted in firms being pushed out of their optimal leverage. Firms are faced with the need to move back to the optimal level of financing to improve their value. They tend to adjust quickly to the optimal level whenever failing to do so is costlier. This study employs a dynamic capital structure model to examine the determinants of optimal leverage and the speed of adjustment under a hyperinflation and dollarization period (2000–2016). The study shows that firms have an optimal leverage and there are costs of adjusting to this level of capital. Findings are consistent with theoretical predictions of the static trade-off theory (STT) and agency theory. The adjustment factors for all the models were found to be at least 0.475 and are higher under hyperinflation than under dollarization. Both firm and macroeconomic factors explain the optimal capital structure while the former also explains the speed of adjustment. Policies focusing on improving access to and reducing costs for finance will assist firms to maximize value as they adjust to the desired financing mix. The policies adopted may vary in response to the economic environment.

Determinan Leverage Optimal Di Bursa Efek Indonesia

Research on capital structure, recently characterized by the use of dynamic capital structure. The use of dynamic capital structure basically wants to know the existence of optimal leverage as hypothesized by Trade-Off Theory and Speed off Adjustment (SOA) to optimal leverage. This research tries to overcome this problem, by using dynamic panel data by using company characteristics and macroeconomic factors. The use of General Method of Moment (GMM) to overcome the problem of econometrics due to the use of dynamic models. Samples taken from manufacturing companies listing on the Indonesia Stock Exchange 2009-2015. The inference model and the determinant behavior of capital structure can be explained by Trade-Off Theory and Pecking Order Theory. The variable characteristics of the company and macro economy are significant and are marked according to the hypothesis. The findings of this study include: the influence of profitability, size, tangibility, growth opportunity and business risk. In addition, on average companies in Indonesia can increase their debt to utilize tax shields

Determinants of the Capital Structure of Nigerian Listed firms: A Dynamic Panel Model

Firms in developing countries face high transaction costs and information asymmetric due to the undeveloped capital market conditions. This situation makes it difficult for the firms operating in the region to make a timely adjustment to the optimal leverage to enhance their value. Thus, the firms have to incur costs in their attempt to converge to their target debt ratio. Given this, it is imperative to examine the capital structure determinants using the dynamic model from the perspective of a developing country such as Nigeria. Therefore, this study examines the determinants of the capital structure of the Nigerian non-financial listed firms. The sample size of this research comprised of the 71 firms listed on the floor of the Nigerian Stock Exchange during the year 2012 to 2018. The data for the study was obtained from the annual reports and accounts of the sampled companies and analysed using the Generalised Method of Moments (GMM) estimator. The results of the study suggest that the Nigerian listed firms make a dynamic adjustment to attain optimal leverage ratio. Also, the research suggests that firm size, tangibility, liquidity and return on assets explain the attainment of target leverage of the Nigerian listed firms. The evidence that emerged from this research has a policy implication on the part of managers and investors in making their informed decisions. Managers should strive to operate at the optimum debt-equity level by taking adjustment costs into account when setting their capital structure.

Corporate investment and financing with uncertain growth opportunities

AbstractThis paper develops a continuous‐time model of a firm's sequential investments. The firm has an option to expand revenue after the initial investment. However, the timing of exercising the growth option depends not only on the underlying cash flows but also on the uncertainty of the growth opportunity. We show that the uncertainty of growth opportunity has a positive effect on the initial investment. In particular, the investment threshold has a nonmonotonic (U‐shaped) relation with the arrival rate of the growth opportunity, in that it starts to decrease and then increase with the arrival rate. The outcome is driven by the tradeoff between benefit and cost of the prospective expansion, and the magnitude of that rests on the level of arrival rate. For optimally levered firm, the financial leverage ratio displays a U‐shaped relation with the arrival rate. It is caused by the interaction between future growth uncertainty and debt overhang problem. Furthermore, we show that the optimal leverage, depending on the level of growth uncertainty, may or may not display inverse relation with the growth size. Our results shed valuable light on the empirical implication of testing the existence of debt overhang.

Investment and financing for cash flow discounted with group diversity

AbstractWe consider a firm's investment and financing decisions made by a group of agents on behalf of shareholders, of which each individual utilizes a different discount rate following a given probability distribution for the valuation of equity. We measure group diversity by the variance of the distribution. The price of debt is determined by an equilibrium method in a competitive market. We show that a greater group diversity increases the project value, accelerates investment and postpones default. The value of the investment option increases but the optimal leverage decrease with the group diversity. The inefficiency from asset substitution increases but that from debt overhang decreases with the group diversity. Our predictions are documented by empirical evidences.