Simple Capital Structure Research Articles

Dominant Currency Debt

We propose a to explain the international role of the dollar and provide broad empirical support for it. Within a simple capital structure model in which firms optimally choose the currency composition of their debt, we derive conditions under which all firms issue debt in a single, dominant currency. Theoretically, it is the currency that (1) depreciates in global downturns over horizons of typical debt maturity of firms and (2) has the steepest nominal yield curve. Both forward-looking and historical measures suggest that the dollar fits this description better than all major currencies. The debt view can jointly explain the fall and the rise of the dollar in international debt markets over the last two decades. It also offers insights into the future of the dominance of the dollar in the aftermath of the Covid-19 crisis.

Revisiting Structural Modeling of Credit Risk—Evidence from the Credit Default Swap (CDS) Market

The ground-breaking Black-Scholes-Merton model has brought about a generation of derivative pricing models that have been successfully applied in the financial industry. It has been a long standing puzzle that the structural models of credit risk, as an application of the same modeling paradigm, do not perform well empirically. We argue that the ability to accurately compute and dynamically update hedge ratios to facilitate a capital structure arbitrage is a distinctive strength of the Black-Scholes-Merton’s modeling paradigm which could be utilized in credit risk models as well. Our evidence is economically significant: We improve the implementation of a simple structural model so that it is more suitable for our application and then devise a simple capital structure arbitrage strategy based on the model. We show that the trading strategy persistently produced substantial risk-adjusted profit.

Cost-of-Capital Exercises

These cost-of-capital exercises stress the weighted-average cost of capital, beginning with a simple capital structure and extending to a company with a complete balance sheet, including four separate debt issues. The problems demand that several different estimates of cost of equity be computed using the CAPM, earnings capitalization, and the dividend-growth model.

Discussion of “Optimal Debt Service: Straight vs. Convertible Debt”

Corporate bond default plays a signifi cant role in today's business environment. According to Moody's, a leading provider of credit ratings, corporate bond issuers that it rated as of January 1, 2004, defaulted on a total of US $16 billion in 2004. Credit default not only affects the equity investors of a firm, but also the debt holders, who may loose part of their credit. Default can also have dramatic consequences for a firm's future operations. Therefore, the decision of if and when to default is important for both the firm and its stakeholders. There is a substantial body of literature on the determination of optimal default points as a strategic decision by the owners of a firm. According to this view, optimal default occurs when the continuation value of the firm, less the discounted value of all future tax-adjusted coupon payments, falls below zero. However, some studies on optimal default points are limited, since these studies usually assume a simple capital structure with only equity and straight debt. Christian Koziol extends this literature by relaxing the assumption of a simple capital structure and by allowing for convertible debt. Th e main objectives of his paper are (i) to determine optimal default and conversion strategies, when debt is convertible; and (ii) to highlight the differences between this strategy and the strategy for straight debt. Since convertible debt plays a significant role in corporate finance decisions, Koziol's approach seems to be both important and of wide interest. To analyze these problems, the author uses a widely accepted time-independent model with a perpetual bond that pays a continual coupon in the presence of both bankruptcy costs and tax deductibility. My discussion is organized as follows. In section 2, I relate Koziol's paper to previous literature and provide an intuitive explanation for the results. Section 3 discusses an application in the area of real option games.

Structural Models of Corporate Bond Pricing: An Empirical Analysis

This article empirically tests five structural models of corporate bond pricing: those of Merton (1974), Geske (1977), Longstaff and Schwartz (1995), Leland and Toft (1996), and Collin-Dufresne and Goldstein (2001). We implement the models using a sample of 182 bond prices from firms with simple capital structures during the period 1986–1997. The conventional wisdom is that structural models do not generate spreads as high as those seen in the bond market, and true to expectations, we find that the predicted spreads in our implementation of the Merton model are too low. However, most of the other structural models predict spreads that are too high on average. Nevertheless, accuracy is a problem, as the newer models tend to severely overstate the credit risk of firms with high leverage or volatility and yet suffer from a spread underprediction problem with safer bonds. The Leland and Toft model is an exception in that it overpredicts spreads on most bonds, particularly those with high coupons. More accurate structural models must avoid features that increase the credit risk on the riskier bonds while scarcely affecting the spreads of the safest bonds. The seminal work of Black and Scholes (1973) and Merton (1974) in the area of corporate bond pricing has spawned an enormous theoretical literature on risky debt pricing. One motivating factor for this burgeoning literature is the perception that the Merton model cannot generate sufficiently high-yield spreads to match those observed in the market. Thus the recent theoretical literature includes a variety of extensions and

Testing Merton's Model for Credit Spreads on Zero-Coupon Bonds

Structural models for valuing corporate bonds (beginning with Merton (1974)) have been criticised for giving spreads which are (a) too small and (b) have a term structure in which spreads diminish with extra time to maturity. Empirical tests of models are hampered by the complexity of real-world bonds, which have coupons, calls and sinking funds, and also by the complicated and changing capital structures adopted by companies. This paper exploits a new database of zero-coupon bonds issued by closed-end funds in the UK. These companies have very simple capital structures and transparent values for both assets and liabilities. Between 20 and 78 bonds are observable over the period February 1992 to April 2001. Counter to previous research, we find that model and market spreads are on average of similar magnitude. Similar to previous research, market spreads are high (relative to model spreads) for bonds which have low risk and for bonds which are near to maturity. While the observed term-structure of credit spreads is upward-sloping, this may be explained by a predictable drift in leverage over time. On the whole, the results are surprisingly supportive of Merton's model and suggest that it is important to allow for expected changes in leverage when computing credit spreads.

Limited Liability Rules, Financial Innovation and Capital Structure Complexity

During the course of the nineteenth century, many countries abolished debtors' prisons and imposed legal limits on borrowers' maximum liability. The same period saw the emergence of equity warrants. This paper shows how limited liability rules make warrants a critical part of firms' capital structure. We use a standard agency model of investment financing under moral hazard and risk aversion in which it is optimal for active shareholders to have unlimited liability. When the legal environment does not constrain active shareholders' choice of liability regime, it is found that they can finance investment with a simple combination of straight debt and limited-liability external equity as long as they themselves retain unlimited liability. That is, a simple capital structure suffices because harsh penalties can be imposed and outside investors can recover a significant fraction of their investment in case of default. In contrast, when legal rules exogenously limit entrepreneurs' maximum liability, a warrant issue becomes a key additional element of the optimal capital structure. The warrants optimally compensate outside investors for higher expected losses in the event of default.

Structural Models of Corporate Bond Pricing: An Empirical Analysis

This paper empirically tests five structural models of corporate bond pricing: Those of Merton (1974), Geske (1977), Leland and Toft (1996), Longstaff and Schwartz (1995), and Collin-Dufresne and Goldstein (2001). We implement the models using a sample of 182 bond prices from firms with simple capital structures during the period 1986-1997. The conventional wisdom is that structural models do not generate spreads as high as those seen in the bond market, and true to expectations we find that the predicted spreads in our implementation of the Merton model are too low. The compound option approach of Geske comes much closer to the spreads observed in the market, on average, but still underpredicts spreads. In contrast, the Leland and Toft model substantially overestimates credit risk on most bonds, and especially so for high coupon bonds. The Longstaff and Schwartz model modifies Merton to incorporate a stochastic interest rate and a correlation between interest rates and firm value. While the correlation and the level of interest rates have little effect, higher interest rate volatility leads to higher predicted spreads. However, this and other features of this model result in spreads that are often too high for risky bonds and too low for safe bonds. The target leverage ratio model of Collin-Dufresne and Goldstein helps to raise the spreads on the bonds that were considered very safe by the Longstaff and Schwartz model, but overall tends toward overestimation of credit risk. We conclude that structural models do not systematically underpredict spreads, as the previous literature implies, but accuracy is a problem. Moreover, some of the simplifications made to date lead to overestimation of credit risk on the riskier bonds while scarcely affecting the spreads of the safest bonds.

Toward a capabilities perspective of the small firm

This paper attempts to explain the competitive advantages of the small firm in the capabilities perspective. It begins by identifying the kinds of strategic assets possessed by small firms. It argues that entrepreneurship and a simple capital structure are the sources of dynamism for small firms. The relationship between the small firm's resources and its capabilities are then critically examined. In particular, the analysis focuses on the influences of strategic assets on the organizational flexibility – a significant source of competitive advantage enjoyed by small firms. The competitive attributes of small firms are further discussed in terms of firm's internal and external capabilities. Finally, the relationship between the small firm's capabilities and the choice of technology strategies is examined.

DETERMINANTS OF THE RATINGS AND YIELDS ON CORPORATE BONDS: TESTS OF THE CONTINGENT CLAIMS MODEL

AbstractA contingent claims model for corporate bonds is tested on newly issued bonds of firms with very simple capital structures. Two default risk measures derived from the model — firm return standard deviation (σ) and leverage (D/V) — explain approximately 78 percent of the variation in the agency ratings on the bonds, based on a probit analysis. Model yield premiums explain almost 60 percent of the variation in market yield premiums. In both analyses, however, firm size is a significant additional variable, suggesting that the contingent claims model is not robust to changes in scale. The assumption of nonstochastic interest rates also appears to be an important misspecification. Institutional restrictions on investments in speculative grade bonds, however, do not affect market yield premiums on such bonds, and thus do not appear to represent a serious misspecification.

A Note on the Information Content of Primary and Fully Diluted Earnings Per Share

Past research has demonstrated that security prices and returns are associated with earnings changes.' One study has even stated, Of all the information about an individual firm which becomes available during a year, one-half or more is captured in that year's income number.2 Firms with complex capital structures report earnings differently from firms with simple capital structures. Does their earnings per share reporting provide more information to the capital market? Accounting Principles Board Opinion No. 15, Earnings Per Share, provides guidelines for the calculation and reporting of earnings per common share (EPS) when potentially dilutive securities (PDS) are outstanding. PDS include convertible bonds, convertible preferred, stock options, warrants and rights that could in the aggregate, if exercised, result in a dilution of earnings per share. Firms with PDS are said to have complex capital structures. APB No. 15 requires that these firms report primary earnings per share (P) and fully diluted earnings per share (D), rather than the normally recorded actual earnings per share (i.e., earnings available to common stockholders divided by actual average outstanding common shares), hereafter referred to as simple EPS. When a company's capital structure contains PDS, P is based on all securities, treating those deemed to be common stock equivalents and dilutive as if the purchase or conversion option had been exercised. The effective at the time of issuance of the convertible security determines whether it is classified as a common stock equivalent. If the interest yield to maturity is equal to or greater than two-thirds of the average yield to maturity on Aa-related corporate bonds at the time of issuance, the security is considered to have been sold on the basis of its bond characteristics and is accounted for as debt. If the yield is less than two-thirds of that rate, it is considered to have been sold for its equity characteristics and is accounted for as a common stock equivalent. For warrants, rights and other options whose exercise would involve a receipt of cash, a stock is used to compute the number of shares of common stock used in the computation of P and D. This method assumes that the proceeds that would be received if PDS options were exercised would be used to purchase up to 20 per cent of the outstanding common shares in order to partially satisfy the exercise. If the presumed receipts exceed the market value of 20 per cent of the outstanding common shares, the excess is assumed to be used first to reduce short and long-term debt and then for investments in U. S. government securities, thereby reducing interest expense and increasing interest income. This hypothetical earnings number becomes the basis for reported earnings. Several studies have criticized APB No. 15 because of its arbitrariness, because it introduces an exogenous factor (i.e., interest rates) into the EPS computation, because of the impossibility of predicting conversion, and because the Treasury stock method may be used even if the exercise price exceeds the market price of the stock.3 This note examines a sample of firms that reported both primary and fully diluted earnings per share. We compute a simple EPS-the figure that would be reported if APB No. 15 were not applied-and two cash EPS values. We compare the degree of association of each of these earnings definitions with stock returns. We find that simple EPS and one of the flow definitions exhibit significantly higher correlations than primary and fully diluted EPS. Neither the simple nor the flow EPS is reported in the annual reports of firms required to report according to APB No. 15.

THE EFFECTS OF COMPLEX CAPITAL STRUCTURE ON THE MARKET VALUES OF FIRMS

AbstractThe familiar Modigliani and Miller risk class model is the basis of a test for differences in value between simple and complex capital structure groups of firms. Cluster analysis, using market risk measures and debt‐equity ratio as input, provides the method for obtaining the risk class sample of firms. Crosssectional tests at three annual dates are made on twenty‐six simple and twentysix complex capital structure firms. For all periods examined, the complex capital structure firms are valued lower than the simple capital structure firms. Possible explanations for the results include failure of the arbitrage mechanism and the presence of certain costs associated with different types of capital structures.