Valuation Of Corporate Debt Research Articles

Valuation of Corporate Debt and Equity in Uncertain Markets

In practice, financial decisions are made in the context of indeterminacy. Randomness, uncertainty, and fuzziness are three basic types of indeterminacy. A multiplicity of differential equations have been designed to depict various processes powered by different kinds of indeterminacy. Among others, these differential equations include uncertain differential equations, stochastic differential equations, and fuzzy differential equations. In this study, we propose that the value of a firm can be described by an uncertain differential equation powered by a geometric canonical Liu process. Uncertain differential equations describe processes driven by uncertainty. Implementing the uncertain Liu option pricing theory, we develop and analyse a framework for valuing debt and equity for a levered firm in uncertain markets. Numerical calculations are demonstrated.

Insider ownership, governance mechanisms, and corporate bond pricing around the world

We investigate the effect of insider ownership on corporate bond yield spreads from 2003 to 2014 using a sample of 10,460 bonds issued by 1,222 non-financial firms from 44 countries. Using this sample, we find on average that greater insider ownership is associated with a higher yield spread. We consider consumption of private benefits as an economic channel through which insider ownership hurts bondholders. Using a global index of shareholder rights, we observe that the positive association between insider ownership and the spread decreases for firms with relatively stronger shareholder rights in which consumption of private benefits is less likely to occur. Furthermore, we report that in firms with more insider ownership the probability of related-party transactions is larger whereas their accounting return on assets is weaker, ceteris paribus. Taken together, the results indicate that bondholders anticipate that greater insider ownership facilitates consumption of private benefits, with implications for the valuation of corporate debt.

Insider Ownership, Governance Mechanisms, and Corporate Bond Pricing Around the World

We investigate the effect of insider ownership on corporate bond yield spreads from 2003 to 2014 using a sample of 10,470 bonds issued by 1,222 non-financial firms from 48 countries. We find that greater insider ownership is associated with higher yield spreads. This positive relationship holds after controlling for measures of risk-taking, which suggests that bondholders price-protect against greater insider ownership for reasons beyond insiders’ heightened incentives to take risk. We consider consumption of private benefits as another economic channel through which insider ownership hurts bondholders. Using a global index of shareholder rights, we show that the positive association between insider ownership and the spread decreases for firms with relatively stronger shareholder rights, in which consumption of private benefits is less likely to occur. Furthermore, we present evidence that the probability of tunnelling, through related-party transactions, is larger in firms with more insider ownership. The positive relation between insider ownership holds even after excluding firms that deviate from the one-share-one-vote principle and firms with cross-ownership. We conclude that bondholders anticipate that greater insider ownership facilitates consumption of private benefits, with implications for the valuation of corporate debt around the world.

Optimal Capital Structure, Corporate Debt Valuation and Credit Spreads under State-Dependent Volatility and Jump Process Asset Dynamics

Optimal Capital Structure, Corporate Debt Valuation and Credit Spreads under State-Dependent Volatility and Jump Process Asset Dynamics

Belief updating, debt pricing and financial decisions under asymmetric information

Abstract This paper studies debt holders’ belief updating, valuation of corporate debt, and equity owners’ financing decisions during financial distress under asymmetric information. This is done within a continuous-time framework, where the relevant state variable is assumed to follow an Arithmetic Brownian motion (ABM). ABM can take negative values and has very realistic feature compared with Geometric Brownian motion (GBM). Using Chapter 11 of U.S. Bankruptcy Code as a costly screening device, we can characterize which firm will choose private workouts (in the form of strategic debt service) and which will choose to file for the Chapter 11 Bankruptcy procedure (in the form of debt–equity swap) when the firm is in financial distress. Using arguments similar to equilibrium refinements, we give a clear picture of how debt holders’ beliefs about the firm’s types are updated according to the state variable and the firm’s default behavior, and describe optimal strategies of both parties under those beliefs. We also provide an approximate solution to the debt pricing problem under asymmetric information.

Costly Financing, Optimal Payout Policies and the Valuation of Corporate Debt

We present a cash-flow based model of corporate debt valuation that incorporates two novel features. First, we allow for the separation and optimal determination of the firm's debt-service and dividend policies; in particular, the firm is allowed to maintain cash reserves to meet future debt obligations. Second, our model admits the possibility that raising resources through issuance of new equity could be a costly procedure. In contrast, much of the previous literature has considered only dividend polices that are the consequences of debt-service policy, and has assumed new equity issuance costs are either zero or infinite. We provide an analytical characterization of equilibrium behavior in our model. Numerical analysis of the equilibrium reveals that our model predicts substantially higher yield spread than the canonical Merton-type model. More importantly, we find that the two novel features of our model are crucial determinants of not only the overall spread that result but also of the marginal impact of allowing for debt-service to be strategic. Specifically: (a) assuming residual rather than optimal dividend policies can result in a significant upward bias in the yield spread predicted by the model; (b) the size of this bias depends in a central way on the costs of equity issuance; (c) the marginal impact of strategic debt-service is substantial, in general, only for low equity-issuance costs, and (d) under optimally-determined dividends, strategic debt-service can actually result in a narrowing of yield spreads. In summary, our results indicate that endogenizing dividend policy and allowing for equity-issuance costs can enhance the model's content substantially, while ignoring these factors could introduce non-trivial biases into the valuation.

The Valuation of Corporate Debt With Default Risk

This article values equity and corporate debt by taking into account the fact that in practice the default point differs from the liquidation point and that it might be in the creditors' interest to delay liquidation. The article develops a continuous time asset pricing model of debt restructuring which explicitly considers the inalienability of human capital. The study finds that even though in general the creditors will not liquidate the firm on the incidence of default, but nevertheless would liquidate the firm prematurely relative to the first best threshold. This agency problem leads to the breakdown of the capital structure irrelevance result. 1. Theoretical Foundation The literature on the pricing of defaultable bonds started with Merton (1974) who applied the contingent claims valuation insight of Black and Scholes (1973) to the pricing of corporate bonds. He obtained closed form valuation expressions for (zero-coupon) risky bonds, by taking the lower reorganization boundary as given. Thus in his model, default occurred at maturity if the value of the firm was less than the payment promised to the bondholders. Furthermore, at maturity the compensation received by the creditors is fixed and they receive the minimum of the value of the firm or the contracted payment. In the event of a default, the control of the firm is transferred to the creditors and this default point can also be interpreted as a liquidation point with zero bankruptcy costs. Thus, in Merton's model, both the lower reorganization boundary and the compensation received by the bondholders is taken to be exogenous. In practice, however, the compensation received by the creditors may vary continuously with the value of the firm if the firm is in financial distress. Furthermore, Merton does not make the distinction between default and liquidation. There have been a number of extensions of the Merton model. Black and Cox (1976) incorporate bond indenture provisions. Jones, Mason and Rosenfeld (1984) consider mul- tiple issue of callable coupon debt. In both of these models however the induced lower boundary at which the firm is liquidated is taken to be exogenous. Further, default is again tantamount to bankruptcy in these models. Leland (1993) and Leland and Toft (1996) extend Merton's analysis by endogenising the lower reorganization boundary. By assuming that the equityholders will always issue equity to prevent a default, they obtain expressions for the values of risky debt via the smooth-pasting condition. Thus in their models, the equityholders keep on issuing equity (when necessary) to avoid a default until the value of equity falls to zero. Thus default occurs when the value of equity falls to zero and this default point is again synonymous

Towards a Realistic Model of Corporate Debt Valuation

Structural models of corporate debt valuation still commit significant errors. A recent paper (Ericsson and Reneby 2003) finds average errors that range between 3.8% and 7.7%. An aspect that has been overlooked in previous works is the irrealisticness of the assumptions considered, which tend to overestimate debt value. We develop a simplified debt valuation model that avoids the most frequent irrealistic features. Based on a simulated case, we applied our model and Ericsson and Reneby's one and compare the results. When valuing long term debt calibrated as low rated or speculative grade issues, our model, to a great extent, removes the average errors found by Ericsson and Reneby. In the case of high rated debt, the results may also be affected by the risk of 'asset substitution'. The irrealisticness of the structural models may be responsible for their persistent errors. This paper shows the need to reexamine them and to formulate more realistic assumptions.

Debt and Equity Valuation of IT companies: A Real Option Approach

We attempt in this study to estimate the fundamental equity value of a firm by combining two separate capital valuation techniques, namely the corporate debt valuation of Merton (1974) and the rational pricing technique of internet companies of Schwartz and Moon (2000). We use the Black Scholes (1973) approach proposed by Merton (1974) to infer an estimate of the value of the debt of the firm, and the pricing methodology of internet companies pioneered by Schwartz and Moon (2000) to estimate the total value of the firm. Making use of the fact that firm value is made up of debt and equity, we first derive a closed-form solution for the value of the debt and then back out implied fundamental equity values for three firms in the Information Technology sector, and show how in two cases out of three the share price is actually undervalued. We also provide inferences on the debt risk premium.

A comparison of Merton's option pricing model of corporate debt valuation to the use of book values

Many studies use the book value of debt as a proxy for its market value because most corporate debt does not trade. I call this practice the book value of debt (BVD) approximation, and it appears to be justified by the observation that the average market value of debt is close to its book value. Many corporate bonds, however, trade at values significantly different from their book values, and consequently the BVD approximation can create important biases. I compare the accuracy of the BVD approximation to Merton's option pricing (OPT) model of corporate debt valuation, and find consistent evidence that the Merton model provides more accurate estimates. I also show that this model is an easily estimated alternative to the BVD approximation. In short, the BVD approximation not only creates significant biases, but it is also an unnecessary simplification.

Quantifying Credit Risk II: Debt Valuation

“Quantifying Credit Risk I” (in the January/February 2003 Financial Analysts Journal) presented evidence on the effectiveness of using the information in market equity prices to predict corporate default. This Part II links those results to the valuation of corporate debt and shows that, contrary to previous negative results, the approach pioneered by Fischer Black, Myron Scholes, and Robert Merton provides superior explanations of secondary-market debt prices.

Factors Affecting the Valuation of Corporate Bonds

The valuation of corporate debt is an important issue in asset pricing. While there has been an enormous amount of theoretical modeling of corporate bond prices, there has been relatively little empirical testing of these models. Recently there has been extensive development of rating based models as a type of reduced form model. These models take as a premise that groups of bonds can be identified which are homogeneous with respect to risk. For each risk group the models require estimates of several characteristics such as the spot yield curve, the default probabilities and the recovery rate. These estimates are then used to compute the theoretical price for each bond in the group. The purpose of this article is to clarify some of the differences among these models, to examine how well they explain prices, and to examine how to group bonds to most effectively estimate prices.

Valuation of International Corporate Debt Issues

When a corporation makes debt issues denominated in different currencies, their default risk and also their yield rates are influenced by the exchange rate process between those currencies. This paper presents a model of corporate debt valuation that captures this influence, effectively extending the default risk analysis of Merton (1974) to a two currency world. We obtain the corporate yield in each of the currencies, and show the credit risk effect of foreign currency exposure on claim's value. We found a closed form valuation equation for corporate debt, when the debt value depends on two lognormal risk factors, company value and exchange rate. This determination of a closed form solution of Merton's problem with two risk factors is one of this paper's main contributions. The valuation equation provides the yield rates that the firm should pay in each of the currencies in which it issues debt, as a function of the company's value and the exchange rate process.

Implementation of an Option Pricing-Based Bond Valuation Model for Corporate Debt and Its Components

INTRODUCTION This paper describes the binomial option pricing-based bond value estimation procedure used in our study, “Option Pricing-Based Bond Value Estimates and a Fundamental Components Approach to Account for Corporate Debt,” (Barth et al. 1998). That study provides evidence on the relevance and reliability of option pricing-based value estimates for bonds and their components, i.e., conversion, call, put, and sinking fund provisions. Although the prior study provides a brief overview of the model’s implementation, i.e., how to estimate total bond and component values, the objective of this paper is to provide a fuller set of details to permit the model’s implementation by others, including other researchers and financial statement preparers. We also aim to enhance their understanding of option pricing-based debt and component valuation. To achieve our objective, we present several examples based on the binomial or twostate option pricing model of Cox et al. (1979) and Rendleman and Bartter (1979) to illustrate accounting issues associated with the valuation of corporate debt and its components. In contrast to the Black and Scholes (1973) (hereafter the Black-Scholes model) and related option pricing models derived using the mathematics of stochastic calculus,

RISK‐ADJUSTED DISCOUNT RATES‐EXTENSIONS FROM THE AVERAGE‐RISK CASE

AbstractThis paper provides an approach for developing risk‐adjusted discount rates that follows naturally from the standard presentation of the weighted average cost of capital. In addition to examining the implied assumptions about the valuation of corporate debt, the paper shows the pedagogic advantages of the proposed approach.