Risk-free Debt Research Articles

Discounting in Natural Resource Damage Assessment

AbstractThe goal of natural resource damage assessment (NRDA) is to compensate the public for losses to natural resources from past or ongoing hazardous releases, including losses that may persist into the future. Compensation is delivered in the form of restoration projects. Resolving NRDA liability requires balancing losses and restoration benefits over multiple decades and converting them into a present value for calculating appropriate damages. For the past two decades, NRDA practitioners have used a real discount rate of 3 % to convert losses and benefits to a present value equivalent. That rate was based, in part, on real historical yields on risk-free debt (e.g., the real rate of return on 3-month Treasury bills). Declining interest rates on risk-free debt in recent years has led to suggestions to reexamine the historical consensus discount rate. This paper reviews two alternative conceptual paradigms for selecting a discount rate in NRDA cases: the social rate of time preference and discount rates for tort cases. We summarize historical data for empirically implementing the two paradigms and discuss the ramifications of the different options. Based on our review, we suggest maintaining the 3 % consensus as a practical solution to a range of empirical candidates within the two conceptual paradigms.

Optimal financing and investment strategies under asymmetric information on liquidation value

This study develops the real options model to explore how asymmetric information at the time of liquidation ex-post affects a firm’s financing (capital structure) and investment decisions ex-ante. Accordingly, it is found that asymmetric information at the time of liquidation delays investment and reduces the amount of debt issuance. When the degree of asymmetric information is high, the firm cannot take a mixed financing consisting of risky debt and equity. The firm with collateral takes a mixed financing consisting of risk-free debt and equity, whose debt issuance amount equals the collateral value, whereas the firm without collateral takes all-equity financing. This result contrasts with that under symmetric information, where the firm always issues a mix of risky debt and equity. Moreover, when the degree of asymmetric information is substantial, an increase in cash inflow volatility decreases debt issuance. This result also contrasts with that under symmetric information, where an increase in volatility increases debt issuance.

What Determines the Government’s Funding Costs when r=g? Unpleasant Fiscal Asset Pricing Arithmetic

Using MBA textbook finance, we look at three simple examples to illustrate why the r-g measure of the fiscal cost of deficits is incomplete. We start by considering the case of risky government debt. Second, we consider the case of risk-free debt. Third, we allow for convenience yields. In each of these cases, Blanchard’s gap is incomplete at best. Fundamentally, the government’s cost of funding is determined by the riskiness of its spending, its tax revenue and, if relevant, the seigniorage revenue.

Optimal Taxation with Endogenous Default under Incomplete Markets

How are the optimal tax and debt policies affected if the government has the option to default on its debt? We address this question from a normative perspective in an economy with noncontingent government debt, domestic default and labor taxes. On one hand, default prevents the government from incurring future tax distortions that would come along with the service of the debt. On the other hand, default risk gives rise to endogenous credit limits that hinder the government's ability to smooth taxes. We characterize the fiscal policy and show how the option to default alters the near-unit root component of taxes in the economy with risk-free borrowing. When we allow the government to default and calibrate the model to Spain, fiscal policies are more volatile, borrowing costs are higher, indebtness and welfare are both lower than in two alternatives economies, one with only risk-free debt available and the other with government's commitment to the default strategy.

The Impact of Financial Leverage on Shareholders’ Systematic Risk

This paper tests the degree to which a sustainable relationship exists between financial leverage and the systematic risk of shareholders under the following capital market imperfections: corporate and personal taxes as well as risky debt and bankruptcy costs. This beta-leverage relationship has not yet been examined empirically in prior studies nor compared with the theoretical parameter values implied by well-known formulations in the literature. Using data from publicly traded American industrial firms, we found that risky debt models, rather than their corresponding risk free debt models, are more sustainable and appropriate for describing the link between equity beta and financial leverage. Our findings imply that estimating betas or unlevering betas based on risk free debt models might lead to unsustainable and inaccurate estimates of key corporate parameters such as the cost of capital, and may consequently lead to inappropriate capital budgeting decisions. In this respect, the results of this study might have consequences to the recently growing area of sustainable finance in the sense that investment decisions made by different bodies and institutions in the country are more consistent with market imperfections that exist in the economy. In other words, our findings can be in line with a sustainable financial marketplace that contributes to the economic efficiency in the long run and can be related to social well-being.

CREDIT SPREAD AND LIQUIDATION VALUE-BASED DEBT FINANCING CONSTRAINT

This study examines the corporate credit spread of a firm that is constrained by an upper limit of debt issuance depending on the liquidation (collateral) value. We provide four important results. First, the upper limit of debt issuance may induce the firm to issue riskless (risk-free) debt. Second, the upper limit decreases the credit spread. Third, the credit spread increases with the liquidation value when the firm is financially constrained, while the credit spread decreases with the liquidation value when it is not. Fourth, the firm is likely to be financially constrained when cash flow volatility is high, the risk-free interest rate is low, corporate tax is high, and bankruptcy cost is high. Our results fit well with empirical studies.

Valuing firm’s financial flexibility under default risk and bankruptcy costs: a WACC based approach

PurposeThe purpose of this paper is to present a model to value leveraged firms in the presence of default risk and bankruptcy costs under a flexible firm’s debt structure.Design/methodology/approachThe authors assume that the total debt of the firm is a combination of two debt components. The first component is an active debt component which is assumed to be proportional to the firm’s value. The second one is a passive predetermined risk-free debt component. The combination of the two debt categories makes the firm’s capital structure more realistic and allows us to include flexibility into the firm’s debt structure management. The firm’s valuation is performed using the discounted cash flow technique based on the weighted average cost of capital (WACC) method.FindingsThe model can be used to define active debt management strategies that can induce the firm to deviate from its capital structure target in order to preserve debt capacity for future funding needs. The firm’s valuation is performed by using the WACC method and a closed form valuation formula is provided. Such a formula can be used to value costs and benefits of financial flexibility.Research limitations/implicationsThe proposed approach provides a good compromise between mathematical complexity and model capability of interpreting the various economic and financial aspects involved in the firm’s debt structure puzzle.Practical implicationsThis model offers a realistic approach to practical applications where real financing decisions are characterized by a simultaneous use of these two debt categories. By comparing costs and benefits deriving from using unused debt capacity for future funding needs, the model provides a quantitative support to investigate if financial flexibility can add value to firms.Originality/valueTo the authors knowledge, the approach the authors propose is the first attempt to build a valuation scheme that accounts for firm’s financial flexibility under default risky debt and bankruptcy costs. Including financial flexibility, this model fills an important gap in the literature on this topic.

De and re-levering betas with risky debt

De- and re-levering betas is important to obtain discount rates for assets that are not publicly traded. A de- and re-levering procedure is around for the case of risk-free debt. The procedure for risky debt is much less clear even under very simplifying assumptions. In this paper, I concretize and extend the procedure for de- and re-levering of betas for companies with risky debt. I derive procedures for different assumptions on the taxation of a cancellation of debt (COD) and for different assumptions regarding the distribution of losses on interest and principal payments. With a tax on the COD I obtain known results. However, without taxes on a COD, the distribution of losses on interest and principal payments matters and equations differ markedly for different assumptions on the assignment of losses to interest and principal payments. Furthermore, using a procedure that does not fit the COD treatment is likely to lead to substantial deviations for de- and re-levered betas from their correct values.

Solving the Equity Risk Premium Puzzle and Inching Toward a Theory of Everything

The equity risk premium puzzle is that the return on equities has far exceeded the average return on short-term risk-free debt and cannot be explained by conventional representative-agent consumption based equilibrium models. We review a few attempts done over the years to explain this anomaly: 1. Inclusion of highly unlikely events with low probability (Ugly state along with Good and Bad), or market crashes / Black Swans. 2. Slow moving habit, or time-varying subsistence level, added to the basic power utility function. 3. A separation of the inter-temporal elasticity of substitution and risk aversion, combined with long run risks which captures time varying economic uncertainty. We explore whether a fusion of the above approaches supplemented with better methods to handle the below reservations would provide a more realistic and yet tractable framework to tackle the various conundrums in the social sciences: 1. Unlimited ability of individuals to invest as compared to their ability to consume. 2. Lack of an objective measuring stick of value 3. Unintended consequences due to the dynamic nature of social systems 4. Relaxation of the transversality condition to avoid the formation of asset price bubbles 5. How durable is durable? Accounting for durable goods since nothing lasts forever The world we live in produces fascinating phenomenon despite (or perhaps, due to) being a hotchpotch of varying doses of the above elements. The rationale for a unified theory is that beauty can emerge from chaos since the best test for a stew is its taste. Many long standing puzzles seem to have been resolved using different techniques. The various explanations need to stand the test of time before acceptance; but then unexpected outcomes set in and new puzzles emerge. As real analysis and limits tell us: We are getting Closer and Closer; Yet it seems we are still Far Far Away...

Regulatory Transformations. Rethinking Economy – Society Interactions. By Bettina Lange, Fiona Haines and Dania Thomas (eds.). Oñati International Series in Law and Society, Oxford: Hart Publishing, 2015. 272 pp. £60.00 hardcover.

1. Regulatory Transformations: An Introduction Bettina Lange and Fiona Haines Part I: Theoretical Resources for Thinking about how to Harness the Regulatory Capacity of a Social Sphere 2. The Regulation of Markets: Polanyian Perspectives Alexander Ebner 3. Economics and Transnational Risk Regulation Christopher Decker Part II: Harnessing the Capacity of a Social Sphere for Regulating Corporate Actors 4. Export Credit Agencies and Human Rights Abuses: Flux and Friction in Regulation Fiona Haines and Samantha Balaton-Chrimes 5. Transnational Business and the Politics of Social Risk: Re-Embedding Transnational Supply Chains Through Private Governance Kate Macdonald and Shelley Marshall Part III: Regulating Trade in Fictitious and Risky Commodities 6. Making Sense of the WTO Sanitary and Phytosanitary Agreement: An Essay about Scholarly Expertise Elizabeth Fisher 7. Regulating Economic Activity Through Performative Discourses: A Case Study of the EU Carbon Market Bettina Lange 8. (Dis)embeddedness and the Management of Transnational Risk: The Case of Blood Regulation Anne-Maree Farrell 9. Double Movements in the Regulation of New Technologies: The Case of Nanotechnology Elen Stokes 10. Risk-Free Debt: The Distorting Promissory Narratives in Sovereign Debt Law and Policy Dania Thomas

Debt Collateralization, Capital Structure, and Maximal Leverage

Many capital structures implicitly or explicitly give agents the ability to use debt contracts as collateral for other financial promises. We study the effects of allowing debt to be used as collateral in a general equilibrium model with heterogeneous agents, collateralized financial contracts, and multiple states of uncertainty. When agents cannot use debt contracts as collateral, some agents borrow using risky debt and others borrow with risk-free debt. With debt collateralization, agents switch to high-leverage contracts, margin requirements decrease, and risk premia decrease. We provide testable implications regarding how funding markets affect capital structure, economy-wide margins, and price volatility.

Solving the Equity Risk Premium Puzzle and Inching Towards a Theory of Everything -- Visual Version

The equity risk premium puzzle is that the return on equities has far exceeded the average return on short-term risk-free debt and cannot be explained by conventional representative-agent consumption based equilibrium models. We review a few attempts done over the years to explain this anomaly:1. Inclusion of highly unlikely events with low probability (Ugly state along with Good and Bad), or market crashes, recently also termed as Black Swans.2. Slow moving habit, or time-varying subsistence level, added to the basic power utility function.3. Allowing for a separation of the inter-temporal elasticity of substitution and risk aversion, combined with consumption and dividend growth rates modeled as containing a small persistent expected growth rate component and a fluctuating volatility which captures time varying economic uncertainty.We explore whether a fusion of the above approaches supplemented with better methods to handle the below reservations would provide a more realistic and yet tractable framework to tackle the various conundrums in the social sciences:1. Unlimited ability of individuals to invest as compared to their ability to consume.2. Lack of an objective measuring stick of value which gives rise to heterogeneous preferences and beliefs.3. Unintended consequences due to the dynamic nature of social systems, where changes can be observed and decisions effected by participants to influence the system.4. Relaxation of the transversality condition to avoid the formation of asset price bubbles.5. How durable is durable? Since nothing lasts forever, accounting for durable goods to create a comprehensive measure of consumption volatility .The world we live in produces fascinating phenomenon despite (or perhaps, due to) being a hotchpotch of varying doses of the above elements. The rationale for a unified theory is that beauty can emerge from chaos since the best test for a stew is its taste.

Solving the Equity Risk Premium Puzzle and Inching Towards a Theory of Everything

The equity risk premium puzzle is that the return on equities has far exceeded the average return on short-term risk-free debt and cannot be explained by conventional representative-agent consumption based equilibrium models. We review a few attempts done over the years to explain this anomaly:1. Inclusion of highly unlikely events with low probability (Ugly state along with Good and Bad), or market crashes, recently also termed as Black Swans.2. Slow moving habit, or time-varying subsistence level, added to the basic power utility function.3. Allowing for a separation of the inter-temporal elasticity of substitution and risk aversion, combined with consumption and dividend growth rates modeled as containing a small persistent expected growth rate component and a fluctuating volatility which captures time varying economic uncertainty.We explore whether a fusion of the above approaches supplemented with better methods to handle the below reservations would provide a more realistic and yet tractable framework to tackle the various conundrums in the social sciences:1. Unlimited ability of individuals to invest as compared to their ability to consume.2. Lack of an objective measuring stick of value which gives rise to heterogeneous preferences and beliefs.3. Unintended consequences due to the dynamic nature of social systems, where changes can be observed and decisions effected by participants to influence the system.4. Relaxation of the transversality condition to avoid the formation of asset price bubbles.5. How durable is durable? Since nothing lasts forever, accounting for durable goods to create a comprehensive measure of consumption volatility.The world we live in produces fascinating phenomenon despite (or perhaps, due to) being a hotchpotch of varying doses of the above elements. The rationale for a unified theory is that beauty can emerge from chaos since the best test for a stew is its taste. Many long standing puzzles seem to have been resolved using different techniques. The various explanations need to stand the test of time before acceptance; but then unexpected outcomes set in and new puzzles emerge. As real analysis and limits tell us: we are getting Closer and Closer; Yet it seems we are still Far Far Away...

An Ex Ante Approach to Excessive State Debt

The recent recession has shone a very public spotlight on the perilous financial condition of many American states. At the same time, it has renewed academic interest in the question of excessive state debt — its causes and possible cures. Scholars who see risk externalization as a primary driver of systematic over-borrowing have proposed bankruptcy legislation for the states as one solution. Advocates argue that a formal debt-adjustment mechanism could reduce the appeal of federal bailouts and thereby curtail the moral hazard leading to excessive debt. But given the states’ unilateral power to set the terms of default, it is hard to see why an opportunistic state would be inclined voluntarily to invoke an ex post debt-adjustment mechanism — and indeed this Article shows that even under existing law states could effectively opt into Chapter 9 if they so desired. An ex ante approach is needed. This Article identifies one such approach, “tax-credit borrowing,” as an alternative solution, and argues that with minimal changes to federal tax policy it could reduce risk externalization more effectively than bankruptcy legislation can. The advantage of tax-credit borrowing in this context stems from its capacity to preclude default by toggling the plaintiff-defendant distinction that lies at the heart of modern sovereign-immunity doctrine. Without a credible threat of default, a state’s leverage in bailout negotiations and, with it, the concomitant moral hazard would be greatly reduced. But tax-credit borrowing would have important implications for state fiscal policy even if agency problems rather than risk externalization best explain state borrowing habits. This Article shows how the availability of risk-free debt could reduce borrowing costs and improve the monitoring of state political actors.

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Lending, Lying, and Costly Auditing

In this paper, we describe a bankruptcy game played in a pure-exchange, perfectly competitive economy, and establish the existence of competitive equilibria. The game admits of lying by borrowers and costly auditing by lenders. The equilibria are characterized by (endogenously determined) equilibrium probabilities of default, loan quantities, interest rates, and default risk premia, and by equilibria simultaneously determined in risk-free debt markets. We nd that the optimal debt contract is the standard debt contract, and that the risk-free debt market may be inactive, as all parties may strictly prefer risky debt contracts to risk-free debt.

Financial Leverage, Corporate Investment, and Stock Returns

This paper presents a dynamic model of the firm with risk-free debt contracts, investment irreversibility, and debt restructuring costs. The model fits several stylized facts of corporate finance and asset pricing: First, book leverage is constant across different book-to-market portfolios, whereas market leverage differs significantly. Second, changes in market leverage are mainly caused by changes in stock prices rather than by changes in debt. Third, when the model is calibrated to fit the cross-sectional distribution of book-to-market ratios, it explains the return differences across different firms. The model also shows that investment irreversibility alone cannot generate the cross-sectional patterns observed in stock returns and that leverage is the main source of the value premium.

Taxes and the choice between risky and risk-free debt: on the neutrality of credit default taxation

Shareholders can decide if their corporation issues risky or risk-free debt. We identify tax systems in which the choice between risky and risk-free debt is not distorted by taxes. These credit default neutral tax systems make it possible to make capital structure decisions and firm valuations neglecting credit default risk, even after taxes. Thus credit default neutrality is a characteristic of a tax system that helps to reduce planning costs. Moreover, credit default neutrality is a necessary condition for financial neutrality of taxation. We find one class of credit default neutral taxes that preserves and another class that modifies the expected tax distribution between creditors and debtor firm. Finally, we show the influence of personal taxation on credit default neutrality.

The social value of risk-free government debt

The social value of risk-free government debt

Cost of Equity and Leverage Under 'Fair' Rate-of-Return Regulation

A rate-of-return regime characterized by fairness satisfies two criteria: the total allowed return on the rate base is equal to the cost of capital, and the regulated firm should be able to raise capital without either gain or loss to existing equity holders. Assuming a monopoly firm with a single product, a single-period state-preference world, risk-free debt, corporate (but not personal) tax, and perfectly price inelastic demand; this paper shows that in such a regime the tariff of a regulated firm will have to be reset with leverage. This resetting arises because unlike in a Modigliani-Miller world where firm (and equity) value is enhanced by the leverage (because of interest tax shields), fairness implies that interest tax shield benefits accrue to consumers, after ensuring equity holders receive a return on equity commensurate with systematic risk. If demand is not perfectly inelastic, a change in tariff consequent upon change in leverage will also lead to a change in equilibrium output. With the assumption that there is a single driver of systematic risk (that of output), the cost of equity-leverage relationship obtained with perfectly inelastic demand is shown to still hold.