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Working Paper
Reorganization or Liquidation: Bankruptcy Choice and Firm Dynamics
In this paper, we ask how bankruptcy law affects the financial decisions of corporations and its implications for firm dynamics. According to current U.S. law, firms have two bankruptcy options: Chapter 7 liquidation and Chapter 11 reorganization. Using Compustat data, we first document capital structure and investment decisions of non-bankrupt, Chapter 11, and Chapter 7 firms. Using those data moments, we then estimate parameters of a general equilibrium firm dynamics model with endogenous entry and exit to include both bankruptcy options. Finally, we evaluate a bankruptcy policy change ...
Working Paper
Options, Equity Risks, and the Value of Capital Structure Adjustments
We use exchange-traded options to identify risks relevant to capital structure adjustments in firms. These forward-looking market-based risk measures provide significant explanatory power in predicting net leverage changes in excess of accounting data. They matter most during contractionary periods and for growth firms. We form market-based indices that capture firms' magnitudes of, and propensity for, net leverage increases. Firms with larger predicted leverage increases outperform firms with lower predicted increases by 3.1% to 3.9% per year in buy-and-hold abnormal returns. Finally, ...
Report
The cost of capital of the financial sector
Standard factor pricing models do not capture well the common time-series or cross-sectional variation in average returns of financial stocks. We propose a five-factor asset pricing model that complements the standard Fama and French (1993) three-factor model with a financial sector ROE factor (FROE) and the spread between the financial sector and the market return (SPREAD). This five-factor model helps to alleviate the pricing anomalies for financial sector stocks and also performs well for nonfinancial sector stocks compared with the Fama and French (2014) five-factor model or the Hou, Xue, ...
Working Paper
Asymmetric Information, Dynamic Debt Issuance, and the Term Structure of Credit Spreads
We propose a tractable model of a firm?s dynamic debt and equity issuance policies in the presence of asymmetric information. Because ?investment-grade? firms can access debt markets, managers who observe a bad private signal can both conceal this information and shield shareholders from infusing capital into the firm by issuing new debt to service existing debt, thus avoiding default. The implication is that the ?asymmetric information channel? can generate jumps to default (from the creditors? perspective) only for those "high-yield" firms that have exhausted their ability to borrow. ...
Working Paper
Secondary Market Liquidity and the Optimal Capital Structure
We present a model where endogenous liquidity generates a feedback loop between secondary market liquidity and firms' financing decisions in primary markets. The model features two key frictions: a costly state verification problem in primary markets, and search frictions in over-the-counter secondary markets. Our concept of liquidity depends endogenously on illiquid assets put up for sale relative to the resources available for buying those assets in the secondary market. Liquidity determines the liquidity premium, which affects issuance in the primary market, and this effect feeds back into ...
Working Paper
Does Private Equity 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 default risk and debt overhang. This paper argues PE-ownership leads to substantially higher levels of optimal (value-maximizing) leverage, by reducing the expected cost of financial distress. Using data from a large sample of PE buyouts, I estimate a dynamic trade-off model where leverage is chosen by the PE investor. The model is able to explain both the level and change in leverage documented empirically following buyouts. The increase in optimal ...
Working Paper
Capital Constraints and Risk Shifting: An Instrumental Approach
When firms approach distress, whether they engage in asset substitution (risk shifting) or rebuild equity (risk management) may depend on their access to capital markets. The property-casualty insurance industry has two features that make it ideal for testing this hypothesis: (1) the main losses for insurers are exogenous events like hurricanes that provide a strong instrument for financial distress; and (2) many insurers are organized as mutual companies, which cannot issue stock. Consistent with the importance of capital constraints, stock companies issue new equity following a negative ...
Working Paper
Optimal Design of Contingent Capital
This paper proposes a parsimonious framework for designing contingent capital contracts (CoCos). CoCos designed this way (i) are either optimal or incentive compatible for equity holders, (ii) implement a unique equilibrium, and (iii) result in an optimal capital structure for the firm. We consider CoCos with equity conversion and write-down modalities. Equity conversion CoCos are optimal; write-down CoCos are incentive-compatible. Both types of CoCos can be implemented by exogenously specifying a capital ratio rule that triggers conversion and, hence, qualify as additional tier 1 (AT1) ...
Working Paper
Debt Overhang and the Retail Apocalypse
Debt overhang is central for theories of capital structure, yet credible empirical estimates of its effects remain elusive. We study the consequences and mechanisms of debt overhang using exogenous changes in the leverage of commercial retail properties. Identification comes from changes in property values occurring after pre-determined debt rollover dates. We show that debt reduces profitability by impairing property owners' response to negative shocks, reducing the business activity of their remaining retail tenants. For the median property, a 10 percentage point leverage increase causes ...
Working Paper
Contingent Debt and Performance Pricing in an Optimal Capital Structure Model with Financial Distress and Reorganization
Building on the trade-off between agency costs and monitoring costs, we develop a dynamic theory of optimal capital structure with financial distress and reorganization. Costly monitoring eliminates the agency friction and thus the risk of inefficient liquidation. Our key assumption is that monitoring cannot be applied instantaneously. Rather, transitions between agency and monitoring are subject to search frictions. In the optimal contract, the firm seeks a monitoring opportunity whenever it is financially distressed, i.e., when the risk of liquidation is high. If a monitoring opportunity ...