Dynamic Capital Structure Thesis

Dynamic Capital Structure
Nicolaj Hamann Christensen (20040574)

Supervisor: Professor dr.oecon. Peter Ove Christensen
School of Economics and Management, Aarhus University
March 12, 2010

This thesis may be disclosed
Abstract
All firms implicitly make a choice of how the optimal amount of debt is determined upon. In
a market with frictions this decision influences the value of the firm and the capital structure is
therefore not a trivial matter. Consequently, numerous attempts have been made throughout the
years to investigate the determinants of the optimal capital structure. Despite the relevance of
these classic papers it remains very complex to align the work and draw some general conclusions.
The main objective of this assignment is therefore to get around this issue by building a structural framework. Since debt and equity values solely depend on earnings and time they can be
regarded as contingent claims on the firm. One can thus use the pricing techniques known from
asset pricing, which proves very useful.
However, establishing how debt and equity can be priced does not provide an answer to why
firms should actually care about their capital structure. Within our framework the sole upside
consists of circumventing the double taxation issue faced by share holders. This must be balanced
against the risk of defaulting as well as the risk of share holders substituting the assets ex post.
We find that flexibility to adjust the capital structure helps to minimise the stakes to taxes
and default costs and thus increase firm value. Designing covenants that promote such flexibility
is therefore favourable. On the other hand asset substitution harms share holders in a rational
expectations model. Aligning the incentives of debt and equity by forming protective covenants
may therefore be value improving. Finally we argue that bias of an accounting report may have
real implications for the efficiency of these covenants1 .
1 I would like to thank my supervisor, Peter Ove Christensen, for many helpful comments and guidance throughout
the process. Furthermore, I am very grateful for the extremely useful lecture notes provided by Christian Riis Flor.
Including footnotes but ignoring appendices and bibliography the assignment is equivalent to about 89 standard
pages (we use the official definition of a standard page stated at the Schools homepage, which is 2500 characters
including spaces).
Contents
1 Introduction
1.1
Background . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
1.2
Motivation
. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
1.3
Delimitations . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
1.4
Way forward . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Foundation
2 Capital structure theory
2.1
Goal of the firm . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
2.2
The classic view
. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
2.3
Main assumptions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
11
3 Pricing the effects
II
13
3.1
Underlying assumptions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
14
3.2
State variable . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
16
3.3
Sources to claim value . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
19
3.4
Pricing a corporate claim . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
20
3.5
Smooth pasting . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
23
Modelling the trade-off
25
4 Static debt choice
26
4.1
Tax regime . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
27
4.2
An alternative approach . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
28
4.3
Distribution among claimants . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
30
4.4
Optimal default level . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
33
4.5
Optimal capital structure . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
34
5 Upward restructurings
36
5.1
Extending the model . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
36
5.2
Scalability . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
41
CONTENTS
5.3
Distributing restructuring value . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
45
5.4
Optimal capital structure . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
48
6 Downward restructurings and negotiation
53
6.1
Benchmark case . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
54
6.2
Renegotiations . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
57
6.3
Summary of trade-off models . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
61
III
Perspectives
63
7 Extensions
64
7.1
Modifications within the simple trade-off . . . . . . . . . . . . . . . . . . . . . . . .
64
7.2
Extended trade-off . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
68
7.3
Summing up
74
. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
8 Role of covenants
75
8.1
Covenants in general . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
75
8.2
Simple trade-off . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
77
8.3
Asset substitution . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
78
9 Imperfect information and accounting
82
9.1
Conservative accounting regime . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
82
9.2
Efficiency of debt contracts . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
84
9.3
Accounting bias and covenants . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
86
9.4
Conclusion
87
. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
10 Conclusion
89
A Static debt choice
91
A.1 Optimal default level . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
91
A.2 Closed forms . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
92
A.3 Optimal coupon level . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
93
A.4 Equilibrium values . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
94
B Dynamic restructurings
96
B.1 State prices . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
96
B.2 Scaling of state prices . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
97
B.3 Debt value . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
98
B.4 Restructuring costs . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
98
B.5 Unlevered firm value . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
98
B.6 Value of equity after debt is in place . . . . . . . . . . . . . . . . . . . . . . . . . .
99
B.7 Smooth-pasting . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 100
Chapter 1
Introduction
Normally a firm is more concerned with deciding which investments to take on rather than how
these are actually financed. This makes sense as the ability to choose a mix of favourable projects
that yield large pre-tax cash flows is definitely essential to the firm. At the end of the day, however,
what really matters to share holders is the amount of earnings that are left after taxes. So even
though pre-tax earnings may look promising an essential issue for the firm is how the share to the
government is reduced most efficiently.
A major component in this pursuit is how the relative amount of debt and equity is chosen
upon. In case dividends are taxed more heavily than coupon payments, one could argue that taking
on large amounts of debt would minimise taxes and thus resemble a safe profit. While determining
the optimal investment portfolio seems like a very risky project, on can argue that minimising the
gap between pre- and after-tax earnings seems less speculative. Consequently it does not appear
that abstract to enhance share holder value by minimising taxes rather than gambling on the most
profitable projects. In this assignment we therefore focus on how the capital structure can help to
make the most of some rather fixed pre-tax earnings faced by a firm.
In this introductory section we briefly outline the background and motivation for writing a
whole thesis on capital structure issues. This forms the natural basis for formulating the main
question to be answered in this paper.
1.1
Background
To start off with it seems natural to take a step back and clarify what is actually meant by the
term capital structure. One can claim that a firm is basically just the sum of some assets, which
must naturally belong to someone. These owners can be found in the right hand side of the balance
sheet and generally comprise debt and equity holders. By the structure we therefore refer to the
relative composition of these two groups of owners. In other words the capital structure relates to
the amount of debt relative to the amount of equity in a firm.
A natural question in this connection is how these two components should be measured. In
the balance sheet debt and equity are entered as book values. However, since the real value of
CHAPTER 1. INTRODUCTION
especially equity may deviate a great deal from its booked value, we shall only consider market
values of debt and equity in the following.
One can then proceed to questioning why it is actually relevant to discuss the composition of
debt and equity in a firm. The mere fact that all companies at some point in time make an implicit
choice of how its assets are optimally financed should be adequate motivation. First of all one has
to decide whether this choice is just random or actually influences firm value. In a frictionless
world Modigliani and Miller (1958) argue that the capital structure is irrelevant. The argument
is that no frictions imply that two identical firms only differing by their capital structure must be
worth the same. Although this setup is very unrealistic it proves a good starting point since it
identifies the potential reasons for capital structure to play a role. In other words, the potential
existence of taxes, transaction costs and asymmetric information makes the choice of debt and
equity non-trivial.
If capital structure can be argued to affect firm value, then one would probably be interested in
how the optimal structure is determined. Numerous attempts have been made within the literature
by introducing a friction, e.g. taxes. The main drawback of much of this work is that the models
used are highly contingent specific. For example one cannot easily interpret the asset substitution
issue presented by Jensen and Meckling (1976) by using the underinvestment model considered
by Myers (1977). Furthermore the conclusions in these and related papers are highly qualitative.
Despite their differences they nevertheless share the common view that the net effect is measured
on firm value.
An idea could therefore be to centre the analysis on the value of the firm and model the
various differences by adjusting observable variables such as growth rate and volatility. To arrive
at more quantitative conclusions one should furthermore be able to price the firm directly from
these observable variables. This was exactly the point in the seminal paper by Merton (1974),
who pointed out that that debt and equity are contingent claims on firm value and therefore can
be priced using the Black-Scholes-Merton framework. The main driver is that firm value can
be assumed to follow a stochastic process and that debt and equity only depend on this state
variable and time. This is the basic foundation for the structural models we shall consider in this
assignment.
The first generation of these structural models were chiefly concerned with developing a sufficiently flexible pricing framework that was able to handle real life debt contracts (in particular
Merton, 1974 and Black and Cox, 1976)1 . As a result they did not provide an answer to the
fundamental question why a firm should actually be concerned with its capital structure. This
exercise was the main focus of the second generation models, where especially the trade-off theory
has drawn a lot of attention (e.g. Leland, 1994 and Goldstein, Ju and Leland, 2001).
As one will soon realise the major differences between the various models basically come down to
the degree of flexibility at different levels of earnings (i.e. at the boundaries). When earnings rise to
a certain pre-specified level, one could imagine that existing debt is called and a new larger portion
1 We loosely refer to primarily Merton (1974) and Black and Cox (1976) as first generation models since they
did not give an explicit reason for debt have any relevance. This was the main focus of e.g. Leland (1994) and the
subsequent work. We term these as second generation models.
is issued (Goldstein et al., 2001). Moreover, when earnings dwindle share holders may refrain from
honouring the debt. Normally this would result in debt holders gaining control of the firm, but
one could also imagine that default is circumvented. Share holders may act strategically knowing
that debt holders prefer avoiding default (e.g. Anderson and Sundaresan, 1996; Mella-Barral and
Perraudin, 1997; Fan and Sundaresan, 2001 and Christensen et al., 2002). Furthermore, one could
also analyse the robustness of the results by altering the maturity (Leland and Toft, 1996) as well
as the type of debt (Hackbarth, Hennessy and Leland, 2007). Finally, the stochastic path of future
earnings may be determined endogenously as a function of the managements actions. An example
could be adverse behaviour from share holders (Mello and Parsons, 1992; Leland, 1998 and Flor,
2006). We now try to take all this into account and provide a motivation for digging further into
a few of these subjects.
1.2
Motivation
While all of these structural models are based on the stochastic process of an underlying variable,
they are not completely comparable from an overall point of view. In particular they vary with
respect to the choice of state variable, tax structure and flexibility at the boundaries. In order
to identify the direct effect of introducing e.g. upward restructurings it is crucial that one has
a common framework to analyse this from. We therefore devote much attention to aligning the
structural models to gain a general foundation. This is not an easy task since one has to examine
every little detail of the models used. The premise for designing our framework is the intuition
used in Goldstein et al (2001), but we also frequently draw upon the very useful work by Flor
(2009a).
Once such a general framework has been established and the optimal capital structure analysed,
one could naturally attempt to increase firm value by using other means. In case one finds that
asset substitution decreases tax benefits from debt, a natural action could involve introducing
covenants that minimise such adverse behaviour. This forms the first extension of the model.
The structural models assume that the state variable is perfectly observable, which seems
restrictive. Instead one could imagine that the primary information source arises from an imperfect
accounting report. Due to regulation these signals are conservative in their very nature and one
may wonder if this has an actual impact on firm value. This forms the second extension of the
model.
We stress that the main emphasis is on building a general framework and analysing capital
structure issues within this setup. To be more precise we therefore briefly state the research
question of this assignment.
Research question
Throughout this assignment we aim at examining the following question.
How can the choice of optimal capital structure be modelled and do covenants have a
role to play in that connection?

In other words our main interest is to analyse how one can model the optimal choice of debt
and equity in a convenient way. In connection with this issue it seems natural to wonder if the
actual design of the debt contract can help to increase value. This relates to analysing the effect
of covenants, which forms the first sub question. Another aspect is the role of accounting reports
when firm value is not perfectly observable. Our last sub question therefore explores the effect on
firm value from conservative accounting.
1.3
Delimitations
From the background in Section 1.1 it may appear that the literature within capital structure theory
is vast. Consequently we are only able to cover a limited branch of this field. In the following
we shall restrain ourselves to only discussing structural models and thereby ignore models using
a reduced form approach. We consider upward and downwards restructurings of the debt level,
but at the lower boundary only a complete restructuring of the debt is analysed (e.g. Christensen
et al., 2002). In other words pure strategic debt service models are ignored (e.g. Anderson and
Sundaresan, 1996).
We extend the simple trade-off to embody agency problems but only consider issues concerning
asset substitution. Furthermore, any principal-agent issues between share holders and the manager
are ignored. These two entities are thus assumed to act as a single unit. When treating the role of
accounting reports we only focus on the inherent bias and ignore issues concerning the precision
of the signal (e.g. Feltham, Robb and Zhang, 2007).
Throughout the assignment our approach will be theoretical. We provide a few numerical
results, but do not put further emphasis on such issues. Numerical examples may be a convenient
way to test ones model but as the choice of parameter value is rather subjective, the marginal
benefit from replicating the original results is negligible. As a result we feel that our time is spent
more wisely examining the theoretical foundation of the research field.
Finally, the field of structural models are becoming increasingly complex with respect to the
underlying mathematics. A formal approach is provided to some degree but we choose to trade
off some technicalities against a more intuitive approach. For example one could probably write
a whole thesis on the derivation of the smooth-pasting condition, but we shall only attempt to
provide an intuitive analysis of this matter.
1.4
Way forward
We determine the optimal structure of this assignment as a function of the research questions
posed above. Doing that we fell that the most appropriate way to investigate the optimal capital
structure is by dividing the assignment into three main parts.
First, we provide the building blocks that form the foundation for the entire analysis. This
includes a brief introduction to the classic work within the field of capital structure (Chapter 2).
A useful distinction is made with respect to the degree of independence between future pre-tax
earnings and choice of capital structure. We are then ready to form a basic structure under which
capital structure issues can be analysed and priced (Chapter 3).
Second, we turn to the question why capital structure issues actually matter. Staying within
a simple trade-off we spend considerable time examining how dynamics of restructurings influence
the conclusion for these models (Chapter 4, Chapter 5 and Chapter 6).
Third, we extend the simple trade-off to incorporate other issues such as asset substitution
and examine how firm value can be maximised using covenants (Chapter 7 and Chapter 8). To
finish off we rather briefly open up for firm value being imperfectly observable for both parties. In
that case accounting reports become essential and the inherent bias of these may in fact not be
irrelevant (Chapter 9).
Figure 1.1: General structure of assignment (own creation).
Part I
Foundation
Chapter 2
Capital structure theory

To make clear what is meant by firm value and optimal behaviour we start out by briefly establishing that the classic share holder view is adopted throughout the assignment. We then proceed
by looking in to the most notable work within capital structure literature and form a useful distinction of how the choice of debt can influence firm value. To round off we draw out the three
main assumptions that we feel prevail amongst the structural models.
2.1
Goal of the firm
Throughout this assignment we shall devote most of our time to discuss the optimal design of
capital structure. It therefore seems natural to very briefly make clear from which party this
optimality is assessed. In other words we take a step back and consider how the purpose of a firm
is actually defined. Within economics the traditional viewpoint has been that share holders return
on investment should be the sole foundation of a firm. In other words creation of economic profit
makes out the entire premise for a firm to exist1 . However, within the last couple of decades a
somewhat different view has emerged especially in the field of management. The saying is that
instead of a narrow share holder view one should also incorporate other stakeholders to the firm, e.g.
employees, local community and customers. On the surface this sounds very sensible since most
people agree that the future existence of a firm depends crucially on its ability to attract talented
people and maintain a satisfied customer base etc. However, we claim that such rationality already
exists within the share holder view. More specifically, a profit maximising firm can be argued to
embrace all critical externalities in its profit function (Tirole, 2001)2 .
max = f (y1 (xj ) + y2 (xj ) + . . .)
xj R
1 Economic profit could for example be measured by residual earnings, which are the leftovers when cost of capital
is adjusted for (see e.g. Penman, 2003). Determining this cost of capital is done by a weighted average cost of capital
(WACC) at many business schools. This approach, however, involves serious drawbacks. We do not go into further
details but Christensen and Feltham (2009) show that one should adjust for business risk (time) in the numeraire
(denominator).
2 We stress that this is just our own informal attempt of illustrating an extended profit function of a firm. An
outside stakeholder is given as y i . The possible actions that a firm can take, xj , influence the wellbeing of y i (xj )
and thereby also the profit of the firm.
CHAPTER 2. CAPITAL STRUCTURE THEORY
In other words, the share holder view does indeed take into account the wellbeing of other
stakeholders to the firm. If supporting an outside claimant is worth it, then share holders naturally
appreciate it. From this perspective one can redefine the increasingly popular stakeholder view
as one that promotes the wellbeing of customers, suppliers and government at the cost of share
holders. If building a new school does not have a positive net present value for share holders in
terms of goodwill, then such an action can be seen as imposing taxes on the formal owners of the
firm, i.e. the equity holders (Tirole, 2006). Not only does management impose taxes on share
holders, they also decide what to spend these taxes on! We shall not go into further details of
how the two views may meet at some point, but rather conclude that throughout this assignment
a rational profit maximising view is adopted, i.e. the traditional share holder view.
2.2
The classic view
In the theory of corporate finance the structure of how the firm is financed has attracted a vast
amount of attention for at least half a century. The general motivation has been to investigate
the link between capital structure and firm value. Doing that it proves useful to interpret the firm
as the aggregate sum of assets that have been put in place (i.e. the unlevered firm). These make
out the machine that generates earnings so to say. As will become clear later on, a convenient
distinction is to determine whether the size of these assets is influenced by the capital structure.
If this is unlikely then pre-tax earnings are given exogenously and capital structure only has a role
to play if it can alter the distributions of these earnings to the various claimants to the firm.
However, if one believes that the mere choice of debt and equity affects the expected growth
and volatility of earnings (i.e. the stochastic path), then the story gets more complicated. We
shall discuss the major lines within corporate finance theory from these two mutually exclusive
perspectives in the following. Due to space limits the analysis is restricted to a very general level.
2.2.1
Exogenous future earnings
The academic discussion on the relevance of capital structure can leastwise be dated back to
Modigliani and Miller (1958). In case the earnings stream is exogenously given then capital structure only has relevance if it can alter the cost of capital3 . We thus focus on how cost of capital
can be decreased by adjusting the relative portions of debt and equity. To help the interpretation in the following it may be helpful to recall the WACC formula despite its limitations,
E
D
F = E D+E
+ D D+E
.
Assuming no frictions in the form of transaction costs and taxes result in the well-known
irrelevance theorem (Modigliani and Miller, 1958). This irrelevance entails that merely adjusting
the relative size of debt and equity cannot alter the cost of capital. Consequently, the firm value
is invariant to the capital structure and thus not an issue for the management.
A counter argument may state that since cost of debt is usually lower than cost of equity,
3 Cost of capital can be thought of as representing the investors opportunity cost. We deduct these from nominal
earnings in order to measure economic profit (e.g. residual earnings).
the overall cost of capital must decrease when debt is taken on. However, such an argument
misinterprets the causality of determining the cost of capital for a firm. Debt and equity holders
require a competitive return on their investment as a function of the operational and financial risk
4
of the firm not the other way round, E = f (F , D
E ) . Increasing debt involves a larger financial
risk for share holders who therefore require a premium. The net effect of altering the relative
amount of debt and equity therefore cancels out.
This irrelevance theorem nevertheless hinges on the absence of frictions. In case payouts to
debt and equity are taxed differently, one may be able to influence the cost of capital by adjusting
the relative amount of leverage (Modigliani and Miller, 1963). What investors care about is their
after-tax return, so in case dividends are taxed harder than interest rates it will be cheaper for the
firm to use debt. In some way this corresponds to the government subsidising debt finance relative
to equity finance.
As a result, one may question why firms are not completely debt financed in order to maximise
the tax shield. When coupons have to be paid every period there is always a risk that these
payments cannot be met by current earnings. In that case debt holders gain control of the firm
and have the option to declare bankruptcy, which entails some restructuring and legal costs5 . The
expected size of these bankruptcy costs must be incorporated as a disadvantage of debt since these
could have been avoided in an all-equity financed firm6 .
Balancing the tax benefits against the costs of financial distress results in a trade-off theory.
From this perspective one can define the debt decision as a function of the following balancing
act7 .
Simple trade-off:
Tax benefits
vs.
Default costs
We shall devote most of our time to analysing this simple trade-off and only to a certain degree
open up for agency issues that are introduced below.
2.2.2
Endogenous future earnings
In general the separation of ownership and control may lead to misalignment of the incentives
between manager/owner and debt holders8 . Consequently, it seems a bit naive to believe that
future earnings are completely independent of the capital structure. In other words managements
decisions can very well be a function of the relative amount of debt and equity in place. The exis4 Rewriting WACC one can get the following expression for cost of equity,
E = F + (D/E)(F D ). The
second term shows the financial risk as a function of the relative amount of debt as well as the risk that taking on
debt is not beneficial. It is clear that cost of equity is increasing in the debt gearing. Besides this one should also
account for the utility of future dividends.
5 One usually distinguishes between Chapter 11 and Chapter 7 when defaulting. Normally a firm first enters
Chapter 11, where creditors are put on hold and business goes on. Liquidation happens later in the process when
Chapter 7 is filed. Unless mentioned in the following we mean liquidation and thus implicitly Chapter 7 bankruptcy
when discussing default.
6 The direct cost of financial distress refers to the cost of insolvency of a company. Once the proceedings of
insolvency starts, the assets of the firm may be needed to be sold at distress price, which is generally much lower
than the current values of the assets. Administrative and legal costs are also associated with the insolvency (Grinblatt
and Titman, 2001). Indirect costs refer to key employees leaving, bad image etc.
7 We term tax benefits as net of issuance costs.
8 Recall that we only consider agency issues between share holders and debt holders and thus use manager and
owner interchangeably.
10
tence of debt may therefore have some negative as well as positive consequences on the investment
choices made by share holders.
Beginning with the former, one problem could be that the CEO has increased incentives to enjoy
perks when debt is in place (Jensen and Meckling, 1976). The short story is that he enjoys the full
benefits from larger carpets but only pays a fraction due to his limited ownership. The authors
also show that due to the asymmetric payoff structure of debt and equity, the initial owner of the
firm favours risky projects. This leads to asset substitution where highly volatile investments are
taken on despite their negative net present value. A counter argument to this theory is provided
by Myers (1977). He argues that a debt overhang problem can lead to underinvestment. The
intuition is that profitable projects are ignored because the manager is too worried about meeting
next periods coupons.
Due to such potential agency problems several ways have been proposed to keep management
on their toes and refrain from taking adverse actions that exploit debt holders. Alignment of
interests can come about by introducing compensation schemes, monitoring and takeover threats
to name a few. Generally it all comes down to corporate governance, which is a way to assure that
the suppliers of finance to the firm get a return on their investment (Shleifer and Vishny, 1997).
On the other hand, debt may also have some disciplining effect on management. The wellknown free cash flow problem can be reduced when coupons have to be met every period (Jensen,
1986). Moreover, owners superior knowledge of true firm value can result in a lemons problem
when issuing new equity. Since debt has higher priority than equity this source of capital will be
favoured when outsiders do not know the true intrinsic value of the firm (i.e. a pecking order Myers and Majluf, 1984).
On top of the trade off theory one can therefore incorporate potential agency issues. As we
must be able to capture such effects in a structural model, it is essential that the particular effects
can be modelled in a convenient way. We basically want the choice of debt to directly influence
future earnings. These are determined by the growth rate, , and volatility, . We thus restrict the
analysis to only incorporate asset substitution, which will refer to higher volatility and potentially
lower growth as well. The extended trade-off will therefore look like the following.
Extended trade-off:
2.2.3
Tax benefits
vs.
Default costs + Asset sub.
Overview
Generally we distinguish between future earnings being given exogenously determined or a function
of the relative amount of debt and equity in place. In the former case the optimal capital structure
is given by a simple trade-off between tax gains and costs in connection with financial distress.
From that point of view one would probably expect rather high leverage ratios.
However, since this is seldom the case other explanations probably prevail. In particular one
can imagine that future earnings may be endogenously determined. For example, the asymmetric
payoff structure of debt and equity gives rise to substituting the assets in place. As a result more
volatile projects can be taken on even though they decrease value at an aggregate level. One
11
therefore has to balance tax benefits from debt against the costs of default and asset substitution,
which can be referred to as an extended trade-off.
The way to proceed is therefore to examine the simply trade-off using a range of structural
models and finish off by incorporating assets substitution explicitly. We do this by drawing out
a general framework in order to distinguish the different models from one another. The first step
would most appropriately be to break up the structural models we examine according to their main
assumptions.
2.3
Main assumptions
While all structural models assume perfect information about firm value, we take a step back
and break down the models from this very general perspective. This is primarily to allow for
the accounting report to have a role later on. Having done that we move on to consider the two
different trade-offs studied above. Simple trade-off models most strikingly differ with respect to the
restructuring flexibility of debt. Extended trade-off models incorporate asset substitution where
the major issue is whether this happens via financial engineering or by altering the real investment
portfolio.
2.3.1
Information about firm value
A fundamental distinction between structural and reduced form models is that the former assume
the state variable is perfectly observable. This has major relevance since owners main issue is to
decide when it is no longer profitable to honour the debt and thus declare bankruptcy. This of
course depends on future expected earnings, which are a direct function of earnings today. Perfect
information about current firm value thus simplifies the analysis considerably and removes any
uncertainty with regards to when bankruptcy should be triggered.
On the other hand an interesting issue arises if the true firm value cannot be monitored directly.
Equity holders still need to know when default should be declared, so some other signal of firm
value is needed. This is where the accounting report comes into play. In that connection Duffie and
Lando (2001) provide a neat link between the structural and reduced form models. One could also
leave the structural framework completely in order to emphasise the role of the accounting report.
Doing that one is able to study the effect of accounting bias on the efficiency of debt contracts
(Gigler et al., 2009).
2.3.2
Simple trade-off models
Structural models that only consider the simple trade-off primarily differ with respect to the degree
of flexibility at the upper and lower boundaries. The early literature (most notably Leland, 1994)
assumed a static capital structure to simplify the analysis, but more recent work incorporates
the possibility of dynamic restructuring. Such restructurings may occur when the state variable
reaches some upper boundary where more debt is being issued (e.g. Goldstein et al., 2001).
12
On the other hand, debt holders may be willing to negotiate with share holders if the firm is
about to enter financial distress. In order to avoid the deadweight loss in connection with default,
one could thus assume some negotiation at the lower boundary as well (e.g. Anderson and Sundaresan, 1996; Mella-Barral and Perraudin, 1997; Fan and Sundaresan, 2001 and Christensen et al.
2002;)9 . In our analysis the primary focus will be on static debt choice and upward restructurings.
Although the notable relevance of negotiations at default, this issue is only touched upon rather
briefly.
2.3.3
Extended trade-off models
In case owners of the firm feel tempted to increase the risk ex post, one has to be a bit careful
about how this actually comes about. If the risk can be increased by simply gearing the current
assets in place, one can argue that the only effect is a higher variance on future earnings. However,
if this is not possible asset substitution may come about by altering the investment portfolio. If
one assumes that all favourable projects have already been exploited then this would entail a lower
expected growth rate of future earnings. Leland (1998) considers the former case whereas Flor
(2006) deals with the latter case. No matter which approach is adopted the future path of the
state variable will depend on the relative size of debt and equity in these models.
2.3.4
Summing up
The key point of this chapter was to highlight that first of all one has to determine whether future
earnings are exogenous or determined within the model. In the former case one is left with a simple
trade-off between tax benefits and bankruptcy costs, which is the focus for most structural models.
On the other hand, share holders may be able to change the course of the firm ex post and thereby
influence future earnings. In that case one has to include asset substitution directly, which results
in an extended trade-off. We now leave this very general level of analysis and instead provide the
basis for pricing these effects.
9 As will be discussed later it proves useful to distinguish between strategic debt management and a complete
restructuring of the debt. Christensen et al. (2002) is the only one of the mentioned papers to do that.
Chapter 3
Pricing the effects

One of the main weaknesses of the literature preceding Merton (1974) was the lack of quantitative
arguments. There is little doubt that a trade-off between tax gains and bankruptcy costs exits
(Modigliani and Miller, 1963) and that bondholders should anticipate potential opportunistic behaviour from share holders (Jensen and Meckling, 1976). The problem, however, is that we need
to address the relative sizes of these effects in order to draw a more detailed conclusion of what
the optimal capital structure may look like.
The payoffs to debt and equity holders are fundamentally driven by how well the firm is performing. This relates to debt and equity being contingent claims on the development of firm value.
To highlight the intuition of this line of thought a simple example seems in place. Doing that it
becomes clear that the underlying assumptions of the standard option pricing framework play an
essential role. Having discussed these we turn to the state variable, which has a rather different
interpretation when pricing corporate claims. From that it is evident that we need to examine the
potential sources to claim value as well as how these components can be priced. We finish off by
looking at the essential lower boundary where control is being handed over to debt holders.
A simple example
Consider the setup in Merton (1974) where the firm issues a single class of debt that has the payoff
structure of a zero-coupon bond (i.e. no coupons). When the firm is liquidated at time T the
absolute priority is respected. In other words share holders only receive a gain in case firm value
exceeds principal of the debt, VT > P . The value of debt and equity at maturity can thus be
stated as follows: ET = max(VT P, 0) and DT = min(VT , P ) = P max(PT V, 0).
It is clear that equity resembles the nature of a European call option with strike price equal
to the principal of the debt. Debt can be reformulated as a bank account that pays the principal
and shorting a European put option on the firm (Flor, 2009a). Claim values can then be found by
using the standard Black-Scholes option pricing formulas.
This is a very convenient result as all input variables needed in the B-S model are usually
available straightaway (Hull, 2005). Moreover, the comparative statics of option pricing still has
intuitive appeal when analysing claim values. For example equity is increasing in volatility,
13
> 0,
CHAPTER 3. PRICING THE EFFECTS
14
Figure 3.1: Equity resembles the nature of a call option (own creation - inspired by Flor, 2009a).
which directly relates to asset substitution (Jensen and Meckling, 1976). However, all this hinges
crucially on the underlying assumptions being satisfied. It thus seems natural to start out by
looking at how these may vary when valuing corporate claims instead of financial options.
3.1
Underlying assumptions
In developing their option valuation framework Black and Scholes (1973) assume that the market
is characterised by what they call ideal conditions. These ideal conditions have been interpreted in
slightly various ways throughout the years, but one may be able to state them as the following1 .
Y Perfect markets: No transaction costs, no taxes, infinite short-selling and price taking behaviour
Y Trading: Continuous and completely divisible assets
Y Term structure: Non-stochastic and well-known
Y Underlying asset: Follows a random-walk process with constant variance and no payouts
The main implication following these assumptions is that the market is free of arbitrage. This is
the basic building block for obtaining the true market prices of the traded assets. In other words
a general equilibrium is obtained where asset prices are always correct (Merton, 1973). For this to
hold not all assumptions are essential. Markets need not to be completely frictionless, i.e. taxes
may very well exist. Moreover, the term structure can be stochastic without ruining the model
(Vasicek model in Hull, 2005). On the other side it is rather critical that the underlying variable
follows a random-walk process and that it is traded continuously. Since we are not pricing a typical
financial derivative but rather a claim to the firms capitalised earnings, we now look into how the
underlying assumptions may be affected by this matter.
3.1.1
Relation to corporate claims
When applying this framework to valuation of corporate claims four issues seem to motivate a
further discussion. These comprise perfect markets, credit risk, choice of the underlying variable
1 Especially
standard asset pricing textbooks have vaguely different interpretations, e.g. Hull (2005).
15
and its future path.

First, perfect markets imply the absence of frictions such as transaction costs and taxes. In
case the capital structure does not influence the investment choices of the firm (Modigliani-Miller
irrelevance), then one could naturally ask why debt should be taken on at all (Merton, 1974).
However, this was not the main focus of these first generation models as developing a framework
for valuing corporate claims was more urgent. One can therefore claim that frictions indeed have
to exist for this whole analysis to have any relevance.
Second, providing a loan to a firm entails a non-negligible risk of losing a part of ones principal,
which is usually not the case for standard government papers2 . Consequently, corporate bonds
cannot be valued merely using the general term structure, as this default risk must be identified
and priced explicitly. If one uses a non-stochastic and known term structure as a benchmark case,
then excess default risk is most easily identified. Just as in the general option pricing framework the
assumption of deterministic interest rates can be weakened without ruining the model. However,
only a few models have made this attempt within the capital structure literature (e.g. Shimko et
al., 1993).
Third, the underlying asset is no longer the price of a stock but some state variable that
depends on the value of the firm (normally unlevered asset value or EBIT). In the standard B-S
setup dividend payouts from stocks can easily be included, which must also be the case for the
corporate claims. In case the state variable used is firm value then any payouts to debt and equity
(coupons and dividends) must be reflected in the drift of the state variable (e.g. Merton, 1974).
Fourth and last, when valuing a stock it is rarely a relevant matter whether its value can
be affected by the action of a single investor. In other words the drift rate and volatility are
exogenously given. However, when analysing a firm these parameters may be a function of the
capital structure and thus determined endogenously (e.g. asset substitution). Consequently, the
actual structure of the state variable may thus be determined within the model.
Summing up we are aware that analysing corporate claims is not entirely identical to evaluating
financial derivatives. Whether the state variable can be regarded a traded asset is being dealt with
in section 3.2.3. In the following we implicitly assume that the standard assumptions are fulfilled,
but pay special attention to analysing the following two issues when mentioned.
Y Perfect markets: Taxes and transactions costs may exist
Y State variable: Drift and volatility may be endogenously determined
The former issue is related to including tax benefits from debt. The latter must be the case when
asset substitution is an issue. Since the underlying state variable is the main driver of the model,
we now look further into how this may be constructed.
2 In
this connection please ignore bonds issued by Greece, the state of California etc.
3.2
16
State variable
As the pricing of corporate claims depends on the development of (at least) one underlying variable,
special attention should be addressed to how this state variable is defined. In standard asset pricing
the choice of state variable is straightforward, but when pricing corporate claims this is not the
case. Generally, models have been using unlevered firm value and earnings before interest and
taxes. We first briefly look into the general stochastic process of the underlying variable. We then
move on to determining whether earnings or unlevered firm value is the most appropriate choice
of state variable. Finally, we quickly show the equivalence between the two alternatives.
3.2.1
Stochastic process
We briefly elaborate on the general diffusion process but focus on how it may be incorporated in
valuing corporate claims on the firm. For a more formal and thorough discussion Flor (2009b) is
very useful. A stochastic process can be thought of as an infinite series of stochastic events that
together form a random sample path. In other words, if every outcome of an event at any date in
time is non-deterministic, then combining all these random events together constitute an unknown
path in time. The structural models we consider all presume that the state variable follows a
geometric Brownian motion.
dt = t dt + t dWt
(3.1)
The two main components are a deterministic element (drift) and a stochastic element (diffusion). The former relates to the expected growth of the variable for every time increment, dt.
The nominal drift is thus a function of the drift rate, , and the actual level of the state variable, t . The diffusion is what makes the process random. This is modelled as the change of a
Wiener process (standard Brownian motion), which is a random variable with zero drift and some
standard variation, W (0, 2 )3 . Thus the nominal variation at every time interval is a function
of the change of a random variable, dW t , and a constant standard deviation, . Combining the
deterministic and stochastic parts, one arrives at the process of the underlying variable as given
in (3.1). Note that all this is defined under the risk neutral probability measure, Q (equivalent
martingale), so one can interpret as the risk neutral drift.
3.2.2
Drift of the state variable
We now take a closer look at how the drift rate of this underlying variable may be given. Until
recently firm value was used as the choice of state variable, which seemed obvious for various
reasons (e.g. Merton, 1974, Black and Cox, 1976 and Leland, 1994). The main motivation for
using firm value was probably that it can be argued to represent a traded asset (if listed on an
exchange) and risk neutral drift thus simplifies to the risk free interest rate, = r. Note in this
connection that one must adjust for any net payouts from the firm to claim holders. For example
3 Also,
the increments of the process, dWt , are independently distributed.
if coupons are financed internally then the drift of the firm is lowered by this amount, = r
17
(Merton, 1974). On the other hand Leland (1994) assumes that coupons are financed entirely by
new equity issues, so that no payout exists, = r.
Lately, however, there has been a switch towards using earnings before interest and taxes
(EBIT) instead. Earnings cannot be thought of as a traded asset and therefore the drift rate
does not simplify to the risk free rate, < r4 . Instead, the growth rate has to be determined
exogenously, which yields and extra parameter. In this connection it is noteworthy that Goldstein
et al. (2001) claim that the drift rate is determined endogenously as a function of coupon payments.
Nevertheless, they also assume at the same time that future earnings are independent of capital
structure, which seems contradicting.
With respect to payout policies, one usually assumes that all earnings are paid out, so that no
cash remains in the firm. If this was not the case then the drift rate of the firm had to incorporate
some compounded rate of retained earnings, which relates to cum-dividends in some way.
From this discussion firm value may seem the more attractive state variable since one avoids
specifying an exogenous parameter. However, using the typical levered firm value as state variable
makes it complicated to analyse the effects from leverage, which is one of our main objectives.
One therefore has to use the unlevered firm value instead. Whether this particular state variable
remains a traded asset is nevertheless somewhat unclear. If it is hard to believe that the allequity firm can be regarded a traded asset then one may probably be better off using EBIT as the
underlying variable.
3.2.3
Is unlevered firm value a traded asset?
In the static framework the main reason for taking on debt is that the firm obtains a tax benefit.
In other words an unlevered firm becomes worth more when being levered. A potential arbitrage
question thus arises in case the unlevered firm is a traded asset and debt issuance is not too costly.
In that case a rational strategy would be to buy the unlevered firm, lever it optimally and then
sell it off at a higher price (Flor, 2009a). If this seems like a realistic strategy then no arbitrage
would imply that the unlevered firm value should incorporate all potential benefits from leverage.
In other words the unlevered firm already incorporates all net benefits from leverage and thus there
is no reason to actually take on debt! Another way of stating this is that tax gains equal expected
default costs for all debt levels and leverage thus plays no role5 . However, one may challenge this
line of thought.
First, investors are unlikely to bid up the price of an unlevered firm, as they are not receiving
the tax benefits yet and some uncertainty prevails whether this will actually happen in the near
future. In other words the unlevered firm must entail some risk premium that debt will actually
be undertaken6 .
4 In
case risk neutral drift exceeds the risk free rate firm value explodes when t
statement is clarified if one assumes that firm value must fulfil the following relation: Firm value (levered
firm value) = assets in place (unlevered firm value) + Tax gains expected bankruptcy costs. The two last terms
must be equivalent for unlevered and levered firm value to be the same (Flor, 2009a).
6 One normally uses the case of Microsoft (no debt) to state that it is irrational to bid up the price of this stock
just because potential tax benefits prevail. On the home turf one can refer to Novo Nordisk A/S, which has a
5 This
18
Second, one could also argue that taking over an entire firm includes paying a premium to
existing share holders that offsets potential tax gains (Goldstein et al., 2001). Both arguments
seem to have some validity, so it remains an open question whether unlevered firm can reasonably
be regarded a traded asset.
An additional issue also arises when using unlevered firm value. Tax gains are modelled as an
inflow of funds rather than a payment to the government, which would be more correct (Goldstein
et al., 2001). Consequently equity value is increasing in the tax rate, which does not make economic
sense7 .
Using EBIT as state variable instead solves these matters in a convenient way. Distribution
among claimants does not affect the pure nature of the EBIT process and taxes are thus treated
the same way as dividends and coupon payments, namely as payouts from the firm. The EBIT
process should also be reasonably invariant to issuance of debt, so we avoid the problem of whether
the state variable remains a traded asset as well as the potential arbitrage issue.
Throughout our examination of different structural models it would be handy to use the same
state variable. We thus briefly analyse whether unlevered firm value can be swapped with EBIT
in a convenient way.
3.2.4
Equivalence of EBIT and unlevered firm value
Basically, the unlevered firm value must be made up of future earnings. Absent tax issues the
intuitive guess would be that firm value must equal the present value of all future EBIT. When
using physical probabilities such an operation involves some tricky issues of discounting for risk
as well as time. However, such matters are circumvented when staying under the Q-measure.
Intuitively it must be the case here that the firm value equals future earnings accounted for risk
neutral growth as well as discounting8 .
V (0 ) = 0
1
r
(3.2)
As the risk neutral drift, , and interest rates, r, are exogenously given, the relationship between
firm value and earnings is just a constant factor (actually the price-earnings ratio). If we know
the stochastic process for either firm value or earnings then it must be possible to substitute in
without causing any trouble. No matter which state variable is used the drift rate, , and standard
variation, , will therefore remain the same, which was the conclusion we were looking for. In other
words unlevered firm value and EBIT can be used interchangeably in the following.
This can of course be shown in a much more formal way, which Goldstein et al. (2001) and
Flor (2009a) do. The basic idea is that all deflated processes under the risk neutral measure
are martingales themselves. By interpreting firm value as a function of earnings one can then
show that the two processes share the same characteristics. Incorporating taxes do not alter this
conclusion either, as we just consider after-tax earnings flows instead. We now know the process
negative debt ratio (money in the bank). It is unlikely that the market price incorporates full benefits from debt.
7 See comparative statistics in Leland (1994).
8 Some resemblance appears with Gordons growth model. One could interpret as being prior earnings scaled
0
up by factor , which is the usual numeraire in the model.
19
of the underlying variable and one could move on to determining how the claim process is given
(Its Lemma). However, an intermediate step proves useful in order to highlight the sources of
claim value.
3.3
Sources to claim value
As illustrated in the beginning one can use the standard formulas for option pricing when valuing
debt and equity for a very simple setup. Unfortunately capital structure in reality is of a much
more complex structure. For example, debt normally receives coupon payments at every time
interval and sometimes has a protective covenant as well. In such cases one needs a more general
setup, which was first provided by Black and Cox (1976).
In order to develop a more general framework of valuing corporate claims it proves useful to
take a step back and briefly consider what actually makes up the value of a claim. As with a
standard European option there is normally a payoff at maturity. As mentioned above the claim
holder may also receive a payment flow during the lifetime (e.g. coupons). Moreover, the claim
may not survive until maturity in case a covenant is broken (e.g. default occurs). This is the main
intuition of the approach used by Black and Cox (1976), which has become the main foundation
for most structural models. The key point is that value of a corporate claim can be argued to
consist of the following four building blocks.
Y Value at maturity
Y Value when state variable hits a lower boundary
Y Value when state variable hits an upper boundary
Y Value added through the lifetime
Any corporate claim can therefore be valued by analysing these four value components. Informally
one can think of each debt contract as having four degrees of freedom that need to be specified
ex ante. Consequently any difference between two claims can also be addressed by these four
elements. For example the simple debt contract described in Section 3 only has value stemming
from the first component (value at maturity). Briefly, we make some general distinctions between
the different models in the literature from this basis.
First, one would probably assume debt to have finite maturity, which is also the in Merton
(1974) and Leland and Toft (1996). However, one could also imagine that the principal is never
due, which resembles perpetual debt. For reasons that will become clear in not too long this is
what the second generation models assume. As a result these models only have three components
to investigate (value at maturity vanishes).
Second, design of debt covenants is the main driver of claim values at the lower boundary. A
protective covenant could prescribe that in case the state variable hits some pre-specified lower
value then control of the firm is being handed over to debt holders (considered in Leland, 1994).
Even if such a level is not contracted out ex ante this does not imply that a lower boundary is
20
never hit. Due to share holders limited liability they may choose to cease coupon payments when
future prospects are particularly dull. This particular point is determined endogenously by the
smooth-pasting condition, which will be analysed further below. Such a setup has become common
in structural models now.
Third, a covenant could also state that the issuer can redeem the bond at a fixed price if the
state variable hits some upper boundary. More specifically, a callability provision is often assumed
in order to restructure the firm. Goldstein et al. (2001) assume this happens at par value but a
call premium, , can easily be included as done in Christensen et al. (2002).
Fourth and last, choice of payout policy influences how much value is added throughout lifetime
of the individual claim. Debt can only receive non-negative payments but equity holders may choose
to infuse additional capital if earnings are not sufficient to meet coupon payments and bankruptcy
would be called otherwise. Constant coupon payments are generally assumed and since residual
earnings are paid out to share holders no cash remains in the firm.
Summarising, one can argue that all corporate claims can be evaluated by addressing each of
these four components. When going through the different structural models we therefore need to
pay special attention to whether debt is perpetual, how covenants are constructed and the specific
payout policy. Once this has been established, one must quantify each of these value components.
We therefore proceed by discussing how this may come about.
3.4
Pricing a corporate claim
There seems to be two general approaches to solve for the claim value. Some models use a partial
differential equation (pde), which has the price of the contingent claim as the solution. Others use
the probabilistic approach, which states the price as an expectation under the risk neutral measure
(Flor, 2009a). Of the models considered in this assignment only Black and Cox (1976) and Leland
and Toft (1996) use the latter approach.
Despite its moderate popularity the intuition behind the probabilistic method may be a slightly
more clear than using a pde. As stated in Black and Cox (1976) one can treat the value sources
stemming from boundaries and maturity as being mutually exclusive. For example, when the lower
boundary is triggered by some protective covenant, control may be handed over to debt holders
and the story ends, so to say. Following this line of reasoning it thus seems intuitive to value each
of the four value sources explicitly. This is exactly the intuition behind the probabilistic approach.
However, when debt is perpetual the pde approach has some clear advantages, which is the reason
why most of the structural models prefer this method. We shall stay loyal to this approach and
thus only value the claims by partial differential equations in the following. Before one can value
a claim we need to know the stochastic process of this particular asset, which is outlined next.
3.4.1
Process of the claim
Consider some traded security whose market value, F , can be written solely as a function of time,
t, and the state variable, F = F (, t). For example one could be interested in finding the value of
21
equity, F , which can be stated as a function depending solely on earnings, , and time, t. The first
step in deriving the price of equity must be to write up the stochastic path for this variable. In
that connection a standard result from asset pricing theory proves very useful. Its Lemma shows
how to calculate the process of a security, which is merely a function of another process and time
(Hull, 2005).

F (t , t)
F (t , t) 1 2 F (t , t) 2 2
F (t , t)
t +
+
dt +
t dWt
t
t
t
2
t2
t
F (t , t)
= F dt +
t dWt
t

dF (t , t)
(3.3)
One could then be interested in how the drift rate of this process is constructed in more details.
As the security, F , only depends on time, t, and the underlying variable, , we can form a risk free
portfolio consisting of the state variable, the security and some bank account. Given perfect capital
markets this portfolio must earn the riskless rate in order to avoid any arbitrage possibilities. In
case the claim receives no payouts its nominal drift must equal the risk free return, F = rF 9 .
However, since the claims we want to examine often produce payouts during their lifetime,
some flexibility should be included. Generally, it must hold that total benefits of holding a claim
that satisfies the above criteria must yield no abnormal payoff. In case the claim holder receives
some intermediate payout, then the price of the claim must decrease all else equal. In other words
the drift rate of the claim is negatively related to payouts to the claim holder. More specifically, a
payout to the claim holder, , must result in a lower risk neutral drift of the claim, F = rF 10 .
How the particular payout structure may actually look like is on the other hand hard to call.
Dividends can possibly be argued to consist of a fixed component as well as a variable part that
is positively correlated with current earnings, Et = a + bt 11 . For the models considered in this
assignment the payout to debt is fixed, C, and all remaining cash is handed out to share holders,
Dt = C and Et = t C.
Having determined the stochastic process of the claim one can then derive a general price
equation that must be satisfied in the absence of arbitrage. More specifically this relates to deriving
the pde, which is discussed next.
3.4.2
The partial differential equation
Once the diffusion processes of the underlying asset and the claim have been determined, one can
form a portfolio that is risk free for an infinitesimally short time interval. The main trigger is that
the instantaneous returns on the claim and the state variable are perfectly correlated (Merton,
1973). This portfolio must then earn the risk free rate. In the language of normal asset pricing
9 Formally, one implicitly assumes that a unique equivalent martingale measure so that the financial markets are
complete and free of arbitrage (Flor, 2009a)
10 Dividends and coupons are normally paid only at specific time periods, so we here consider a converted continuous payment to claim holders.
11 Several dividend studies have shown a positive however somewhat weak relation between earnings and size of
dividends (e.g. Hedensted and Raaballe, 2007). Note that if payments to equity holders are directly proportional
to the state variable, then one could use the standard result for options on a dividend-paying stock (Hull, 2005).
22
our particular setup with payouts to the claim holder can relate to a stock paying a known yield.
One can then arrive at the following pde by setting the drift in (3.3) equal to F = rF + 12 .
1
F 2 2 + F + Ft rF + = 0
2
(3.4)
The only addition to the standard B-S-M original differential equation is that we allow for
some fixed payout, , to the specific claim holder at every time period, which implies that the risk
neutral drift of the claim must be reduced by this factor. The equation in (3.4) is a parabolic
partial differential equation (pde) and must hold for any security that can be written solely as a
function of time and the state variable. This process is a function of earnings, time, business risk
(), interest rates, payouts to claim holder and net payout from the underlying variable. Note that
the investors risk profiles do play any role, which is a major advantage of the Black-Scholes-Merton
differential equation. Thus, one can without hesitation make the assumption that all agents in the
economy are risk neutral.
One could then take a step further and analyse what will happen in case time does not affect
the value of the claim. Equity does not have a finite expiry date. Debt on the other hand may
terminate at some future point and thus also influence the value of equity. In the structural models
we consider one simplifies the analysis by assuming perpetual debt, which results in the two claims
being independent on time. This simplifies the result considerably as the F t vanishes and the pde
becomes an ordinary differential equation (ode).
1
F 2 2 + F rF + = 0
2
(3.5)
Note that the pde only states the relation that must be fulfilled by the market price. We
therefore proceed by briefly discussing how the particular solution can be found.
3.4.3
Finding the solution
The price that fulfils a pde is basically determined by the claim value at the three boundaries as
well as value added through life time. The former relates to the general solution and the latter
refers to the particular solution (Sydsaetter and Hammond, 1995). The combination of these two
make up the price of the claim.
F = FGS + FP S
(3.6)
Alas, this overall solution is contingent dependent and no general formula therefore exists.
However, when the problem reduces to solving an ode an exact solution luckily prevails. According
to Goldstein et al. (2001) the general solution is determined as the following, where the boundary
12 Subscripts denote the partial derivative with respect to that particular variable. F (, t) is indeed still a function
of the underlying variable and time but we leave out the full definition to simplify.
23
conditions determine the constants, A1 + A2 .

FGS = A1 y + A2 x
(3.7)
where
(

2
+
2
(

2
1

2
2
1
2
2
2
2
2
+ 2r
+ 2r 2
1/2 )
>0
1/2 )
<0
(3.8)
The particular solution is the value of all intertemporal cash flows to the claim. This is of course
completely contingent dependent. Suppose the relevant payout is total earnings every period, = ,
then the present value is given as F P S =
r .
In general we must be able to state the particular
solution as the present value of payouts to the claim,
FP S =
13
t (1 + r)t
(3.9)
t=1
What we have shown here is that differences between the individual claims can be identified
by the general and particular solution to the ode. Due to the different design of various corporate
claims it is the actual setting of these boundary conditions and value at maturity that distinguishes
equity and debt values. Especially the lower boundary is essential since debt holders normally gain
control of the firm here. We thus finish off the general framework by considering the mechanisms
at the lower boundary point.
3.5
Smooth pasting
As we shall realise later a major determinant of debt and equity value is how the bankruptcy level
is decided upon. First of all one has to make clear whether debt and equity holders can credibly
commit to a specific default level ex ante. If this is the case equity holders may agree to improve
protection of debt in exchange for lower coupons (Gigler et al., 2009). One can thus arrive at some
socially optimal default level, which maximises joint debt and equity value ex ante14 .
However, the structural models considered here assume that pre-contracting is not an option.
Share holders then have a degree of freedom with respect to honouring the debt. Due to their
limited liability initial owners of the firm have the right to cease coupon payments at any point in
time. However, when this happens an implicit covenant in the model implies that control of the
firm shifts to debt holders. The question then arises when it is optimal for share holders to pull
the plug and leave the firm.
Generally, rational equity holders want to maximise the value of their investment at any point
13 Note
that t is not necessarily a constant hence the subscript.

is a general statement. In the trade-off models the socially optimal default level is actually lower than the
one chosen endogenously by share holders.
14 This
24
in time. As pre-contracting on default level is not possible share holders gain nothing by acting
in favour of debt holders ex post15 . Consequently, leaving the firm simply becomes a question of
whether the expected value of equity from continuation is positive or negative. This involves trading
off additional contributions from share holders needed to keep the firm afloat against expected
appreciation of equity (Leland and Toft, 1996). Informally, this could relate to a situation where
current earnings fall below coupon payments and equity owners therefore have to decide whether to
infuse new capital, or pull the plug and leave the firm to debt holders16 . The optimal bankruptcy
level must therefore be chosen so that share holders are indifferent about staying in control.
Formally, this refers to the smooth-pasting condition also known as the high contact point or
the optimal stopping point in real option theory (Dixit and Pindyck, 1994). Basically, we need
to find the point where share holders are indifferent between continuation and terminating their
ownership in the firm. An intuitive approach could be to simply find the derivative of equity with
respect to the lower boundary and set it equal to zero,
= 0. However this is not always sufficient.
In addition to reassuring that payoffs from stopping and continuation are equal, one also has to
make sure that these two payoffs behave alike around the stopping time. This corresponds to the
effect from a marginal increase in the underlying state variable having the same effect on the two
payoffs. In other words their slope coefficients must not differ as one then makes a mistake of being
too soon or to late (Flor, 2009b). A different interpretation is that any current advantages of
stopping or continuing should not be reversed in the very near future (Dixit and Pindyck, 1994).
It can then be shown that share holders find their optimal point to cease coupons as the following.

E(, )
=0
=
(3.10)
The technicalities behind this result are quite rigorous and beyond the scope of this assignment,
so we shall leave the discussion with that (see e.g. Brekke and ksendal, 1991).
Summary
In the preceding section we have laid out a general discussion of i) the underlying assumptions of
the pricing framework, ii) interpretation of the state variable, iii) pricing a corporate claim and
iv) the smooth-pasting condition. One would now be able to derive explicit expressions for debt
and equity values under various setups. However, this would leave us at the same level as the first
generation models since we are still not able to answer the essential question why debt should be
taken on in the first place. In other words we need to model the benefits and drawbacks of debt in
order to gain a meaningful premise for pricing debt and equity. A natural way to proceed is thus
to look a the work of Leland (1994).
15 Of course, a rational expectations model implies that debt holders anticipate such self-maximising behaviour
from share holders, which ex ante debt prices reflect.
16 We here assume that a covenant prevent share holders from selling off assets to meet coupon payments, which
is also the case in all of the models examined in this assignment.
Part II
Modelling the trade-off
25
Chapter 4
Static debt choice

Until now we have ignored how the tax advantage of debt and bankruptcy costs are actually valued.
Our motivation for analysing the size of these variables more explicitly is to address their effect
on firm value and thereby determining the optimal capital structure. We therefore now relax the
assumption of no frictions in the market by introducing taxes.
Throughout this assignment we shall adopt a somewhat alternative approach when evaluating
the claims to the firm, which is explained below. In this chapter we study the most simple case
with a static debt choice. This is extended to upward restructurings in Chapter 5 and we round
off the simple trade-off models by disucssin negotiations at the lower boundary in Chapter 6.
To start out with it proves useful to analyse the most simple setup with no restructurings of
debt. In other words the capital structure is static and the choice of debt thus becomes a one-shot
game, which is decided upon ex ante1 . We adjust the setup used by Leland (1994) to incorporate
EBIT as the state variable to avoid the issues concerning the unlevered firm value as discussed in
Section 3.2.3. Furthermore, a more realistic tax structure is embraced in the framework, which
is presented in Section 4.1. As the issued debt never matures the four potential sources to claim
value simplify to value added through lifetime and value at the lower boundary (i.e. default). All
this entails that the price of debt and equity must fulfil the ode found in equation (3.5).
1
F 2 2 + F rF + = 0
2
(4.1)
The most direct approach of valuing debt and equity would be to solve the ode in equation
(4.1) straightaway. Doing that one can interpret the particular solution, F P S , as dealing with
value added through lifetime. The general solution, F GS , adjusts for the expected value loss in
case the lower boundary is hit. In other words we adjust the continuation value of a specific claim
for the probability of hitting a boundary level and the corresponding payoff loss hereof. This is
the approach used by Christensen et al. (2002) and Flor (2009a), which is convenient since claim
values appear straight away in a neat fashion.
However, if one is not completely confident with the interpretation of how claim value emerges,
a slightly different procedure may be useful. Recall that a strength of the probabilistic approach is
1 One
can think of this as a financial covenant being in place that prevents any new issues, see Chapter 8
26
CHAPTER 4. STATIC DEBT CHOICE
27
that one is able to identify claim value directly from each of the four possible sources. This involves
a good intuition and one could try to incorporate this feature into the framework of solving the ode.
In other words we would like to identify value stemming from default (value at lower boundary)
and staying solvent (value added through lifetime). No matter which procedure is used the same
claim values will emerge, so it is merely a question of ones favoured technique. Before explaining
this alternative approach we briefly draw out the tax structure used throughout the assignment.
4.1
Tax regime
In case the state variable is invariant to changes in the capital structure (simple trade-off), debt
only has a role to play in case it can reduce a firms cost of capital (see Chapter 2). This cost of
capital is a function of equity and debt holders after-tax opportunity costs. In other words there
must be a divergence in the tax rates faced by the two groups of claim holders.
In real life a double taxation issue normally arises when the firm is all equity financed. This
means that corporate taxes are paid on EBIT and the residual amount is paid out as dividends to
share holders, who also face a personal tax rate on these capital gains. The total or effective tax
rate faced by share holders must therefore be given as te = tc + td (1 tc ) (Grinblatt and Titman,
2001). On the other hand if the firm takes on debt the company taxes are reduced, as interest
payments are deductible (can be subtracted in taxable earnings).
Consequently, the effective tax rate on dividends must be higher than tax on interest income
for debt to have a tax advantage, te > ti . All else equal maximum tax benefits accrue when
coupon payments exactly offset EBIT every period resulting in no corporate taxes, C t = t . This
is illustrated in Table 4.1.
All equity financed

Debt and equity financed
Condition for tax gains
Company taxes
tc
tc ( C)
Dividend taxes
td (1 tc )
td (1 tc )( C)
Coupon taxes
0
ti C
Total
te
te ( C) + ti C
te > ti
Table 4.1: Criteria for debt having a tax benefit. Inspired by Flor (2009a)
So when dividends are taxed effectively harder than coupon payments it is possible to transfer
value from the government to share holders by taking on debt. As this calls for very high debt ratios
there has to be some offsetting issue that limits the upside of debt. As touched upon in Chapter
2 various downsides of debt exist, but we shall only consider costs in connection with default and
new issues, i.e. a simple trade-off exists. Note that in the following the risk free interest rate, r, is
denoted as the after tax rate, r = (1 ti )
r. Before moving on to evaluating debt and equity values
we take a step back and form an alternative way to analyse firm value, which is used throughout
the paper.
4.2
28
An alternative approach
Recall that our simple trade-off model implies that assets in place are invariant to the choice of
capital structure. As a result the unlevered firm value is a fixed size, and one can focus solely on
the division of this pie among the claimants to the firm. Besides debt and equity one could also
include the government (taxes) and bankruptcy costs to have a formal stake in the firm2 . The main
purpose of thinking of the firm in this way is to arrive at a modified irrelevance theorem. In other
words the total pie to be spilt among these four claimants is invariant to the capital structure3 .
Figure 4.1: Assets in place can be interpreted as being shared by four claimants to the firm (own
creation).
The next question that arises is probably how the firm is divided among these four claim
holders. We know that two main sources of value exist in the static model; namely value added
through lifetime and value at the lower boundary. One may conjecture that this must also be
the case for the overall unlevered firm value. In other words the firm can either be solvent where
business goes on as usual, or it can go bankrupt where all business in our model ceases. These two
states must therefore make out the entire probability space for the firm. Consequently, assets in
place must be no different from the aggregate value of the overall solvency and default claims4 .
V () =
= v sol () + v def ()
r
(4.2)
Note that even though value of total claims are invariant to the capital structure, the proper
choice of debt and equity still serves a purpose in minimising the stakes to the government and
default costs. In other words, the focus is still on making the most of the potential tax gains from
debt, so the distribution of the total pie is still as relevant as before. Applying the approach above
thus loses no details in relation the original framework by Leland (1994).
4.2.1
Splitting up the assets in place
As a next step one probably wants to derive the explicit expressions for overall firm value in the
two mutual states. For now assume that the point where share holders find it optimal to stop
2 Issuing and restructuring costs of debt could also be included to have a formal stake, but we model these as an
outflow from the proceeds from debt issuance.
3 Goldstein et al. (2001), p. 493.
4 Leland (1994) interprets tax benefits and bankruptcy costs to make out the difference between the levered and
the unlevered firm. Tax benefits can be seen as a reduction in the transfer from share holders to the government,
and including default costs as an explicit claim makes the term redundant compared to the original setting. TB
and BC thus cancel out compared to the original setting.
29
honouring the debt is exogenously given, which refers to some lower earnings level, 5 . This relates
to pricing two claims that have payoffs only in case of solvency and default, respectively. We thus
apply the ode in equation (3.5) and solve for the general and particular solution where relevant.
Bankruptcy only has a payoff in case default occurs, . Expected value must then be given
as the payoff when this happens relative to the likelihood. In other words we are valuing a claim
that pays off an amount equal to firm value at default and nothing in all other instances6 .
Solvency, on the other hand, is equivalent to the entire firm value as long as no boundaries are
hit. Value added through lifetime is thus total asset value (particular solution), but one has to
adjust for lost value at the lower boundary (general solution).
v def () = pB
v sol () =
pB
r
r
(4.3)
We here introduce a state price, pB (), that indicates the present value of a claim that pays 1
only in case the lower boundary is hit7 . If this present value is high then hitting the boundary is
likely.
Due to the limited upside of debt it proves useful to take an intermediate step when dealing
with the division of v sol . Solvency is fundamentally defined by debt being honoured, which entails
debt holders receiving coupons of C every period. Debt holders thus receive a fixed fraction of the
solvency claim and it seems intuitive to dole out this part and leave the residual to equity (and
taxes). We therefore find the expected value (or price) of a claim that pays C whenever the firm
stays solvent and nothing in case default is hit. Note that this is just a convenient subdivision of
the overall solvency claim.
v int () =
C
C
C
pB = (1 pB )
r
r
r
(4.4)
As stated earlier the joint value of v sol and v def obviously makes out the value of the assets in
place,
0
r .
Recall that the primary motivation for adopting this approach is that sources of claim
value become more evident. However, in addition to this we also feel that the inherent scaling
feature becomes more pronounced, which proves useful when upward restructurings are allowed
for8 . One can now proceed to doling out the stakes of the four claimants for each of the claims
above.
5 If the state variable is unlevered firm value then this is just a capitalised value of the particular EBIT level,
V B = /(r ).
6 Since bankruptcy costs are treated as a specific claim they can be ignored as it is merely treated as a transfer
from debt holders to the holders of this claim (e.g. lawyers).
7 This claim can be valued just like all other claims on the firm by evaluating the general solution for this particular
case, pB () = (/)x . In the following we just write pB for simplicity, but will keep in mind that the state price
is indeed a function of the state variable. See B.1 for derivation of state prices in the dynamic setup.
8 One may wonder why the complete framework is not extended immediately to incorporate upward restructurings
and potential bargaining at the lower level. However, we take this step-by-step in order to motivate the inherent
intuition and link between the different frameworks.
4.3
30
Distribution among claimants
As share holders leave the firm when it is no longer fruitful to stay on board, one can make the
simplifying assumption that equity holders only have a claim in the firm if default is avoided. On
the other hand bankruptcy costs only have relevance when the lower boundary is hit. Debt and
taxes have stakes in the firm for both solvency and default, so one can outline the division of assets
in place as follows.
Figure 4.2: Solvency and default are both split among three claimants (own creation).
We proceed by distributing the solvency and default claim of the assets in place. Note that
the expressions found in (4.3) express the claim price ex ante, so the probability adjustment has
already been done. As a result one just needs to determine the proper division of these two claims.
4.3.1
Debt value
Debt value stems from receiving coupons through solvency and taking over the firm in case of
default, i.e. two sources to claim value. At the lower boundary some fraction of firm value, , is
lost due to market frictions in the default process. Incorporating the tax structure presented in
Table 4.1 results in the following debt value9 .
D()
= Dsol () + Ddef ()
(1 ti )v int + (1 te )(1 )v def
C
= (1 ti ) (1 pB ) + (1 te )(1 )pB
r
r
(4.5)
When given control of the firm at bankruptcy, debt holders become proper owners and must
therefore face an effective tax rate similar to the former owners, te . Alternatively, one could also
assume that the firm is sold off immediately to new investors. However, this creates an issue of
whether tax benefits still prevail, which will be discussed when analysing the model of Christensen
et al. (2001)10 .
9 For simplicity we leave out writing the specific claim values as a function of the state variable even though that
is still the case. E.g. v sol () reduces to v sol and the same yields for the state prices.
10 Goldstein et al. (2001), note 15, consider a rather similar case but they just take the perspective of the
government and state that they have a stake in case of default, i.e. tax payments will still be received.
4.3.2
31
Equity value
Share holders are left with nothing in case default occurs, so they only gain as long as the firm
stays solvent. When this is the case they have unlimited upside as they receive all that is left when
debt has been honoured, (1 te )(v sol v int ).
E()
Esol () + Edef ()
(1 te )(v sol v int ) + 0

C
(1 te )
pB
(1 te )(1 pB )
r
r
r
(4.6)
The first term gives the expected after tax value of the assets in place. The last term shows
the expected after tax expenditures of honouring the debt. Note that bankruptcy costs do not
appear directly in the expression for equity value, which is because debt holders bear all the costs
of defaulting. However, as will be shown below, these costs influence the optimal debt level and
thus implicitly firm and equity values. Note that this approach of determining equity value is
rather different from the one employed in Leland (1994). Here equity is found as a residual of
levered firm value less debt.
4.3.3
Bankruptcy costs
The claim on costs in connection with default only becomes relevant in case the lower boundary
is hit. In that case a fraction of the assets in place are paid to the owner of this claim. It remains
an open question whether to include tax issues. Goldstein et al. (2001) and Leland (1994) ignore
this issue, whereas Flor (2009a) incorporates it explicitly11 .
At a general level, however, this issue is rather irrelevant as it is merely a transfer between
default costs and taxes. Share holders only focus on the aggregate size of these two claims and
thus either approach will do. Perhaps one could argue that holders of the bankruptcy claim (e.g.
lawyers) face a double taxation issue, which must be reflected in the claim price. In that case the
bankruptcy claim must be given as the following.
BC()
= BCsol () + BCdef ()
=
(1 te )v def
(1 te )pB
(4.7)
Expected bankruptcy costs must be the actual size when default happens adjusted for the
probability that this becomes the case.
11 Goldstein et al. (2001) focus on whether the government has a part in the bankruptcy at an overall level (note
15). However, they ignore tax issues in relation with bankruptcy costs and only provide a a brief comment for this
decision (note 16).
4.3.4
32
Taxes
Turning the focus towards the government it must be the case that it has a stake in solvency as well
as when bankruptcy is triggered. When no boundaries are hit the government receives taxes on
the coupon payments received by debt holders as well as double taxation of the residual earnings
paid out to equity. In case the firm is declared bankrupt debt holders pay taxes on the capital
gains resulting from selling off the firm. Additionally, it was assumed in Section 4.3.3 that holders
of the bankruptcy claim face a double taxation issue when receiving their slice of the pie.
G()
= Gsol () + Gdef ()
= ti v int + te (v sol v int ) + te (1 )v def + te v def
C
= te
(te ti )(1 pB )
r
r
(4.8)
Another interpretation is that prior to the first debt issuance the government is entitled to
. However, share holders take on debt in order

double taxation on the entire assets in place, te r
to minimise the gains of the government. These benefits can thus be thought of as a loss for
the government compared to the all equity case. The expected value of this loss must equal the
expected tax benefits, (1 pB ) (te ti ) Cr (this is also the case in Leland, 1994). As expected, the
proportions of tax benefits are a direct function of how severe the double taxation issue is, te ti ,
and the amount of debt, C. If one assumed that the firm could be sold off as a going concern tax
benefits would remain even when the lower boundary is hit, which would relate to setting pB = 0
in equation (4.8) (Christensen et al., 2002).
Finally, one could probably argue that full tax benefits seem unrealistic when firm is just about
to be liquidated, = + . To embrace such a feature some higher level of earnings can be stated
for full tax benefits to prevail12 .
4.3.5
Summing up
To complete the picture one could also include issuing costs as a part of the total pie. However,
we refrain from doing this as these costs are modelled as an outflow before share holders receive
the proceeds from selling off debt. Nevertheless, they still play a role as share holders choose the
optimal debt level partly as a function of the costs of issuing debt. Again an issue arises as to
whether these costs are tax deductible. None of models treat this in depth, so one can just think
of q as representing the after tax unit cost13 . The nominal size of costs in connection with selling
off debt is proportional to the size of the new issue.
C
RC() = qD() = q (1 ti )(1 pB ) + (1 te )(1 )pB
r
r

(4.9)
Finally, it may prove useful just to sum up how the different claims are expressed. As the
12 Most models open up for this feature but we shall ignore this issue in order to keep track on more essential
issues.
13 Goldstein et al. (2001), note 16.
33
division of the restructuring claim has been left out of the analysis, it is clear that the claims below
must sum to the assets in place and thus also v sol + vdef . Levered firm value is thus given by the
joint value of debt and equity.
D()
(1 ti )v int + (1 te )(1 )v def
(4.10)
E()
(1 te )(v sol v int )
(4.11)
BC()
(1 te )v def
(4.12)
G()
= ti v int + te (v sol v int ) + te v def
(4.13)
Recall that share holders have two degrees of freedom in this setup. They decide on the amount
of debt to be taken on initially as well as when violation of the debt contract is optimal ex post.
We proceed by analysing the latter issue first.
4.4
Optimal default level
Until now we have just assumed some exogenously given default level, , which seems restrictive in
the absence of ex ante contracting. Leland (1994) assumes that pre-contracting is not possible, so
share holders just find the optimal stopping point as to where equity value is maximised. Due to
the absolute priority it does not seem too restrictive to assume that share holders receive nothing
in case of default14 . The optimal default level then relies solely on whether staying solvent is
beneficial for equity holders. By introducing the smooth-pasting condition one is able to find this
point analytically (see Section A.1).

E()

=0
=
x C
C
=
=
r
1+x r
r
(4.14)
This procedure takes into account that expected equity value must always be positive for share
holders still being willing to infuse funds. Optimal default level therefore cannot be arbitrarily low,
which is ensured in the above derivation. In Leland (1994) new equity issues finance coupons, which
entail that these new issues must have a positive net present value if default is to be circumvented.
In the EBIT models share holders only have to infuse funds in case earnings fall below coupon
payments. Note that the only endogenous parameter left is coupon payments. Further note that
the optimal default level is proportional to the debt level, which highlights that some scaling feature
is already inherent in the static model.
Suppose that increasing the default level can be seen as providing better protection of debt.
Two contradicting effects exist when evaluating net effect on debt value. A higher bankruptcy
level implies that bondholders receive a larger amount when taking over the firm. However, debt
holders incur larger expected bankruptcy costs since costly default is triggered more often,
PB
14 Actually, Leland and Toft (1996) find that when debt is just about to mature share holders may find it profitable
to leave even though the firm is worth more than its obligations.
x
34
1 > 0. In general the net effect is ambiguous, so improved protection is not an advantage
to debt holders per se15 .

Maximising the joint value of debt and equity (levered firm value) can be seen as minimising
the stakes belonging to taxes and default costs. For a given coupon level it is clear that this comes
about by keeping the firm afloat no matter what. The reason is that at default tax benefits are
lost and a sunk cost has to be incurred. Even if the firm can be sold off as a going concern it is still
profitable at an overall level to avoid default. As a result there seems to be potential for enhancing
firm value by opening up for pre-contracting on the default level, which we shall return to later.
Of course all this hinges on an implicit assumption that the assets in place have a non-negative
value, 0 > 0.
4.5
Optimal capital structure
In contrast to the optimal stopping time, the decision concerning debt level is made ex ante. Share
holders therefore want to maximise the joint value of debt and equity16 . When an expression for
the optimal default level has been found the only endogenous parameter influencing equity value
is coupon payments, C. It is therefore straightforward to analyse what the optimal level of debt
may look like. Doing that we use the size of coupon payments as a measure of the amount of debt
in place.
Increasing the debt level influences the firm in two ways. First, tax benefits are bigger as long as
the firm stays solvent, (te ti ) C. Second, the optimal default level increases and bankruptcy thus
becomes more likely, which is clear from equation (4.14),
pB
C
> 0. Determining the optimal
debt level thus becomes a balancing act of these two effects. As noted earlier owners incur some
sunk costs in connection with issuing debt, which is proportional to the amount of debt issued,
qD ().
[E() + (1 q)D()]
=0
C
C0? () = 0 c?
(4.15)
The explicit expression is given in Section A.3 but the main thing to note is that the optimal
coupon level is proportional to current earnings given some exogenous parameters. Just like to
optimal default level this stems from the inherent scaling feature of the model.
It appears that more debt is taken on when value of assets in place is high, interest rate is high
and default costs are low (comparative statics in Leland, 1994). First, high firm value means that
bankruptcy becomes less likely and the firm wants to make better use of the tax shield. Second,
higher interest rates imply that leverage becomes more expensive in this framework but greater
tax savings more than offset this effect17 . Finally, default costs are a measure of the deadweight
15 For the setup used in Leland (1994) protected debt is more valuable than unprotected debt if bankruptcy costs
are not too high ( = 0.5). However, one should not interpret this as firm value also increases. We shall return to
this issue.
16 Implicitly, one assumes that debt holders just receive some fair return on their investment and share holders
thus want to maximise firm value net of issuing costs.
17 As the risk neutral drift of debt and equity claims are equivalent, the risk free interest rate can only influence
the capital structure (relative size of debt and equity) if some tax savings of debt are possible.
35
loss in case of bankruptcy, and it seems intuitive that the firm wants to lower the risk of incurring
these if is large. Using the above expression for optimal coupon amount we can also evaluate
equilibrium values for the default level and claim values (see Section A.4). Again the inherent
scaling feature shows up as the three claim values as well as the default level are merely functions
of some exogenous parameters and the state variable.
v ? (, , C ? )
= A0
(4.16)
E ? (, , C ? )
= AE 0
(4.17)
D? (, , C ? )
= AD 0
(4.18)
= d0
(4.19)
? (, , C ? )
For some realistic parameter values Leland (1994) finds that the optimal leverage is around
80% and is able to increase firm value with about 25-40%. These leverage ratios seem way in
excess to what is observed in real life, which is partly due to the lack of restructuring possibilities
in the model. If the amount of debt can never be altered it induces the firm to take on more
debt compared to the case where restructuring is possible. Hence, paving the way for upward
restructurings one would expect to find lower debt levels that are more in line with empirical real
life debt-equity ratios.
Chapter 5
Upward restructurings
In real life a company is not restricted to a one-shot game when deciding how much debt it wants
to take on. As earnings increase it naturally follows that management wants to issue more debt
in order to exploit the tax shield more efficiently. When considering a static framework as above,
one would assume that too much debt is put in place compared to the case where restructurings
are possible. The intuition can be that the owners in a static framework anticipate future higher
earnings and want to have some debt in stock to better exploit the corresponding tax advantages1 .
Even though being the optimal decision in a one-shot game, the disadvantage of this aggressive
behaviour is that default becomes more likely. By giving management the opportunity to rebalance
the capital structure more frequently one would therefore anticipate a lower initial debt level to be
the optimal choice.
In order to incorporate the restructuring feature in the current framework we use the model
of Goldstein et al. (2001). In our discussion we shall provide a thorough discussion of the scaling
feature, which is the cornerstone in understanding how the model works. Just like in the static case
our main focus is to examine how the optimal capital structure may be altered when restructurings
are possible.
We start out by discussing how the static model can be extended to incorporate upwards
restructurings. Thereafter we basically want to study how debt and equity prices change when
future restructurings are possible. Two main issues have to be clarified in order to answer this.
First, overall firm value stemming from restructurings must be determined in a neat fashion. The
inherent scaling feature plays a vital role in that pursuit. Second, one has to dole out the value to
debt and equity from this overall claim. This is more contingent specific and is chiefly determined
by the pure nature of the debt contract.
5.1
Extending the model
A natural starting point is to make clear whether restructurings can actually happen in the first
place. This seems relevant as Leland (1994) argues that current debt holders will oppose any
1 This must indeed be the case when the state variable is assumed to have a positive drift, which is the case in
the present framework.
36
CHAPTER 5. UPWARD RESTRUCTURINGS
37
new issues since these dilute the value of their investment. Increasing the coupon payments result
in a higher optimal default level as shown in equation (4.14). This makes existing debt more
insecure without offering a counterbalancing premium. However, one could state that rational
debt holders would just anticipate such behaviour and thus require a discount ex ante on the
debt they buy. Generally, it seems a little hypothetical to conclude anything about the realism of
potential restructurings using a static model as background like Leland (1994) does.
Implicitly Goldstein et al. (2001) also criticise the argumentation used in Leland (1994) by
stating that callability is not an essential feature for their framework to hold. In other words, the
dynamic model also works when debt is just issued on top of the existing debt. The general idea
is that when the new issue is identical to the debt already in place then the risk is unchanged for
existing debt holders compared to the last restructuring date since earnings have increased2 . So
restructurings can indeed be argued to come about but the main trigger is whether the model is
flexible enough to incorporate such issues.
In order to extend the static framework we discuss how the restructuring actually comes about
and then proceed to show how the unlevered firm value now consists of three different parts. From
this one can easily derive some general expressions for debt and equity, which allows us to look
further into the restructuring part.
5.1.1
Restructuring process
The amount of debt can be altered in various ways. New issues that are junior to existing debt
could be one option. Mixing bank debt with market debt is also often a scenario in real life
(Hackbarth et al., 2007). Moreover, management may want to change the maturity or the coupon
rate on the new issues as well (Leland and Toft, 1996). In spite of how realistic such arrangements
may be we shall restrict ourselves to only dealing with perpetual debt that has the same coupon
rate as the existing debt. In other words only debt similar to the type already in place can be
issued by the owners at each restructuring point.
Then a natural question arises with regards to how the restructuring is actually carried through.
Basically two scenarios seem likely. All the models we consider assume that restructurings come
about by calling all existing debt and then issue a whole new and larger portion. A different and
maybe more realistic approach entails that new debt is merely issued on top of what is already
in place. Despite the intuition of this line of reasoning at least two problematic issues arise when
debt is not callable.
First, in the absence of any fixed costs in the restructuring process it would probably prove
fruitful for the owners to restructure very frequently, which would resemble continuous adjustments.
This makes the model less tractable, so one would have to include a fixed cost to circumvent this
issue3 .
Second, the very first debt issuance will be much larger than the following restructurings if
2 The argument goes like this: Callable debt can be redeemed at par value, D . When debt is not callable
0
new debt is issued (same priority) so that the value of the existing debt drops to the initial value, D0 . Whether
restructuring is done by calling all debt or just issuing new portions is irrelevant for this result to hold.
3 Goldstein et al. (2001), note 27.
38
debt is not callable. Expressing total restructuring costs using the inherent scaling feature thus
becomes problematic. To summarise one can state that callability is not a critical assumption but
relaxing this issue will just result in needless complexities. Having clarified this we now consider
how restructurings may fit in to the alternative approach presented earlier.
5.1.2
Relation to static framework
Introducing the possibility of taking on more debt when earnings increase can be seen as including
a third possible state. This seems reasonable as the restructuring is carried through by calling
existing debt and issue a new portion. As a result an upper boundary also figures in the model
now. The solvency state now only occurs when the state variable moves between the lower and
the upper boundary. In case the upper (lower) boundary is hit claims to default (restructurings)
and solvency become worthless. Hence the three states are mutually exclusive and value of assets
in place can be written in form of these three claims. The relation to Black and Cox (1974) is that
three of the four sources to claim value are activated now. Only value at maturity is inactive, as
the firm still does not have any finite expiry date4 .
V0 () =
0
= v0sol () + v0def () + v0res ()
r
(5.1)
Note that the new part stemming from restructuring is not just a subdivision of the old solvency
claim, as one may hesitate to conclude. This is due to a new set of state prices, which modifies
the expected value of default and solvency compared to the static case (see Section B.1). Further
note that future earnings are still exogenously determined, so the three claims in equation (5.1)
sum to the solvency and default claim in the static model, equation (4.3). What may have change
now, however, is the distribution among the claimants and more specifically to what extent claims
to taxes and bankruptcy costs can be reduced.
Figure 5.1: Breakup of future earnings as a function of dynamics (own creation).
5.1.3
Splitting up the firm value
We now briefly determine how firm value is given at points of default, restructuring and in-between.
For the static case the motivation and intuition of taking such an intermediate step were provided,
4 As
the setup becomes more dynamic now it is convenient to add time subscripts to keep things clear.
39
so we just focus on changes from introducing an upper boundary. What we find is that the two
state prices make out the key difference in relation to the old framework.
At time 0 we start out by valuing a claim that has a payoff only in case bankruptcy is called
upon. In case restructuring is hit the claim has no future potential payoffs and is thus worthless. It
is true that default can happen after the first restructuring has taken place but that particular claim
is hidden in the restructuring part now. If not clear at the moment the convenience behind such
an approach shall prove useful in the later modelling phases. The default claim is thus identical to
the static case only with a modified lower state price5 . The inherent feature here is that all value
is lost in case restructuring is hit first. One should therefore not confuse this expression with the
claim to default in the static case as they are not equivalent.
v0def () = pB
0
r
(5.2)
In the same manner we want to assess the expected value in case the restructuring point is hit
before bankruptcy. As touched upon earlier, this expression can be seen as containing a new set
of claims to the next round, so to say, which will be examined in more detail later. Again the
expected value of the restructuring claim must be a probability-weighted measure of the firm value
at that specific point. Just like the bankruptcy case the upper state price accounts for the risk
that the lower boundary is hit first.
v0res () = pU
0
r
(5.3)
To complete the analysis of total firm value one also has to study the expected value arising
from staying in-between these two boundaries. This is equivalent to study a claim that is worth
the entire firm value as long as no boundaries are hit. One therefore needs to adjust the present
asset value for the expected value loss in case a boundary is hit.
v0sol () =
0
pB 0 pU 0
r
r
r
(5.4)
Just like in the static case, value through solvency is split between debt, equity and taxes
(illustrated in Figure 4.2). Debt cannot receive more than the agreed coupon payment and thus
has a limited upside. It therefore proves useful to define how much of the solvency claim that
belongs to debt holders (and taxes). The only adjustment to the static case is that we adjust for
the probability of hitting an upper boundary now. Expected value of receiving coupon payments
as long as the firm stays in-between the two boundaries must thus have a value as follows.
v0int () =
C0
C0
C0
pB
pU
r
r
r
(5.5)
Our primary interest, however, is not these overall subdivisions of assets in place, but rather
the relative distribution among the claim holders. As mentioned earlier three sources of value now
5 The lower (upper) state price now has the interpretation that it pays off $1 only in case the lower (upper)
boundary is hit first.
40
accrue to debt and equity. The following gives the value of debt
D0 ()
D0sol + D0def + D0res
(1 ti )v0int + (1 te )(1 )v0def + D0res
(5.6)
and equity
E0 ()
= E0sol + E0def + E0res

=
(1 te )(v0sol v0int ) + E0res
(5.7)
Note that debt and equity values with regards to default and solvency must have the same
structural form as in the static case, but the actual values will be different due to the changes in
the state prices. What remains unclear, however, is how the restructuring claim, v0res , is to be
divided6 . The main question in this chapter is therefore to decide the actual nature of E0res and
Dres
0 . The answer may not be straightforward, so it seems beneficial to derive some intuition of
what this restructuring claim actually consists of.
5.1.4
Break-down of restructuring claim
Hitting the upper boundary entails that the game starts over again and a new set of claims to
default, solvency and restructuring arise. In that way some future potential restructuring claim
will always remain but the analysis may be simplified by the following informal discussion. For a
(large) finite number of time periods the whole game can be thought of as consisting entirely of
default and solvency claims. In other words one can reformulate a game only consisting of solvency
and default claims.
Figure 5.2: Informal break-down of the restructuring claim (own creation).

For an infinite number of periods, however, there will always be a possible future restructuring
period and one cannot use the argument for the finite case directly. However, periods far out in
the future have little value, so if one uses a finite case with a long horizon then the residual value
must go towards zero7 . The whole idea of taking such an approach is that we would like to limit
the analysis to something familiar and thereby reduce the dimensions of the model. For the static
6 Note that one can easily dole out the total value of v res as we know the two other claims as well as the aggregate
0
firm value. However, this does not necessarily give us the answer to the distribution of this particular claim.
7 In some way this relates to discounting future residual earnings by using a known cut-off point and setting
continuation value to zero. We later show that restructurings far away have decreasing value when pU < 1.
41
framework we were left with determining claims to solvency and default for one specific period.
Now we just have to do this for an unlimited number of periods so to say. More specifically, one
can state claim value stemming from restructurings as the following.
E0res ()
D0res ()
E0res
D0res
v1sol
v1sol
v1def , . . .
v1def , . . .
=E
=D
X
t=0
!
vtsol
vtdef
vtdef
(5.8)
!
vtsol
(5.9)
t=0
From this a two-sided problem prevails when evaluating debt and equity in a dynamic framework. First, one has to determine what future claims to default and solvency may look like, i.e.
the nature of v sol
and v def
t . Second, one must analyse how these future claims are to be split
t
and D.
The first question
among debt and equity, i.e. the functional forms of debt and equity, E
relates to investigating the potential scaling feature of the model, whereas the latter issue concerns
doling out value to equity and debt. This makes out the two next sections and we start out by
determining the future solvency and default claims.
Figure 5.3: Two main obstacles need to be solved in order to find debt and equity value stemming
from future restructurings (own creation).
5.2
Scalability
In some way we would like to reduce the dimensions of the model so that all future claims have
some relation to the well-known initial state. In other words one would like to determine future
claims as functions of the initial claim value. Informally, we hope that debt and equity value
originating from future restructurings can be simplified to something similar to the following.
E0res ()
=E
D0res () = D
X
t=0
!
+
vtdef
vtsol +
vtdef
vtsol

v sol + v def
E
0
0
(5.10)

v0sol + v def
D
0
(5.11)
t=0
This hypothesis hinges on future claims to solvency and default being functions of current
values, v sol
= f (v0sol ) and v def
= g(v0def ). If that is the case then each individual restructuring
t
t
period will be identical to the initial one just scaled by some factor. This is not just a wild guess
since the static model exhibited some degree of scalability. In order to investigate whether this is
42
actually the case, one has to look further into how future claims to solvency and default are given.
int
Considering the structural forms of v sol
and v def
from Section 5.1.3 it is clear that one
0 , v0
0
has to look further into the behaviour of the restructuring level, , the default level, , the coupon
payments, C and the state prices, pB and pU when the upper boundary is hit8 . For our hypothesis
to hold the three initial claims must scale upwards by the same factor at restructuring. In other
words we look to identify the potential scaling feature of the model.
At the risk of jumping to conclusions the log-normal behaviour of the state variable might
give a hint of what is going on. Log-normality implies that the drift rate and standard variation
of a variable is constant no matter the nominal level9 . After each restructuring date nothing
fundamental has thus changed in the firm. In case the parameters mentioned above only depend
on the state variable then one may convince oneself that all future periods basically look like the
initial one. Flor (2009a) and Christensen et al. (2002) refer to this as the model featuring positive
homogeneity of degree one. By taking this approach they present the scaling feature in a compact
and neat fashion, but in the following we shall take a more informal approach in order to highlight
the intuition in a more direct manner. We therefore investigate the potential scalability of the four
components that determine the structure of v sol , v int and v def .
5.2.1
Restructuring level
In order to systematise the way restructurings can happen it does not seem too harsh to assume
that management wants to increase debt levels every time firm value is increased by some fraction.
For example, firm owners may find it optimal to increase debt levels when initial earnings are
up by 10%. All else equal, one would in that case expect the same strategy to be followed once
earnings increase by 10% again meaning that earnings would be worth 1.12 0 10 . This corresponds
to restructurings being carried through every time the state variable is scaled upward by some
constant factor, u > 1. The restructuring point at time t can thus be established solely as a
function of the scaling factor and initial earnings.
0 = u0
t = ut 0 = ut+1 0
(5.12)
Goldstein et al. (2001) assume that the scaling factor is contracted upon ex ante and thus given
exogenously in the model. At the same time, however, they still assume that the owners determine
the lower boundary condition endogenously (i.e. the smooth-pasting condition). Even though the
authors state that one could easily incorporate the restructuring decision as an endogenous one, it
seems rather strange to have this sort of inconsistency between the two boundary conditions (Flor,
2009a). Actually, if debt holders were given the choice, one would maybe assume that clarification
about the default level rather than the upward restructuring level would be preferred when writing
8 Of course earnings also play a role but as this variable is the state variable it equals the restructuring level by
definition when the upper boundary is hit.
9 The change of a log-normal variable is given as 4 log(x ) = log x log x
t
t
t1 = log(xt /xt1 ). For some constant
drift, , the log-normal change must be given as log(xt /xt1 ) = log(xt1 /xt1 ) = log , which is a constant xt .
10 Of course this means that the nominal change of the upward restructuring level grows over time but the scale
or factor is constant, u.
43
the debt contract.

In case the restructuring decision becomes an endogenous one, management faces a similar
problem as with determining the default level. Invoking a smooth-pasting condition at the upper
level would generally entail a balancing act between expected default and issuance costs of new
debt and additional tax gains on the other hand. This is exactly what Christensen et al. (2002)
do. In that connection one could ask whether the restructuring factor can become infinitely small
relating to continuous restructurings. Absent fixed costs in the restructuring process this can be the
case when debt is not callable. In the present framework, however, we have assumed that all debt
is called in case of restructuring, so restructuring costs are non-negligible and thus infinitely small
adjustments will not occur. Nevertheless, one may argue that ignoring endogenous smooth-pasting
at the upper boundary does not change the sign of our conclusions.
5.2.2
Coupon level
The main reason for assuming that all existing debt is called when restructuring is triggered is that
this particular procedure neatly fits the framework we have built so far. Share holders become the
sole owners of the firm after debt is called, so at any restructuring date the initial owners want to
maximise the firm value by taking on the optimal amount of debt. At every restructuring point
management therefore faces a problem similar to the very first period with the only difference
being that the firm is now worth more than it initially was (by a factor equal to u).
Recall that in the static case the optimal coupon level was found to be directly proportional
to initial earnings and thus scalable in firm value, see equation (4.15). Intuitively, one could think
of earnings at the first restructuring, u0 , as being worth the initial value, 0 , just with a different
numeraire, namely u. Management therefore faces a problem similar to the initial debt issuance
just in a different currency so to say11 . It naturally follows that the optimal coupon level must be
equal to the initial coupon just scaled by this new numeraire.
C0? (0 ) = c? 0
5.2.3
Ct? (ut 0 ) = ut C0? = ut (c? 0 )
(5.13)
Default level
In addition to evaluating how the upward restructuring point can be determined, one also has to
assess how the lower boundary is altered when more debt is put in place. By using the results from
the static model it immediately follows that the optimal bankruptcy level is a direct function of
coupon payments and thus initial earnings, see equation (4.14).
0 = d? 0
11 This
t = ut 0 = ut (d? 0 )
line of argumentation is adapted from Goldstein et al. (2001), appendix B.
(5.14)
5.2.4
44
Summing up
To summarise, we have shown that incorporating restructurings do not remove the inherent scalability found in the static case, which simplifies the analysis considerably. At each restructuring
point the intuition is that the whole story starts over again. This is the case since default level,
restructuring point as well as coupon payments are scalable in the state variable.
t = ut+1 0
t = ut (d? 0 )
Ct? = ut (c? 0 )
(5.15)
In order for v sol , v def and v int to scale upwards by the same factor as earnings increase (i.e.
to be proportional to the state variable) one only needs to make sure that the state prices are
invariant to changes in the state variable. Goldstein et al. (2001) only consider this issue very
briefly, but we show in B.2 that it is indeed the case. In other words the initial problem resembles
the static case just scaled upwards by some constant. We now find this scaling factor explicitly.
Figure 5.4: Monte Carlo simulation shows the inherent scaling feature of the upper and lower
boundaries. Parameters: = 0.03, = 0.15, 0 = 100, 0 = 60, 0 = 110, u = 1.15, 4t = 0.01
(own creation - inspired by Goldstein et al., 2001).
5.2.5
Scaling factor
Recall that we posed two main questions earlier on, which must be answered in order to find an
intuitive expression for debt and equity value. We are just about to answer the first one, namely
how the overall restructuring claim can be expressed in terms of the initially well-known claim
values. The inherent scaling feature just found implies that v res
is a linear function of future
0
scaled versions of v sol
and v def
0
0 . This entails that we can state firm value in terms of these two
variables. Doing that one should bear in mind that future restructurings only come about in case
earnings stay free of the lower boundary. We use the upper state price to deal with this matter
since this parameter incorporates risk and time of reaching the next restructuring period. Firm
value can thus be reduced to the following expression12 .
12 Goldstein et al. (2001) find this scaling factor in a slightly different way but we feel that the intuition follows
more directly by using the procedure presented here.
0
r
=
=
45
v0sol + v0def + v0res

h
i
v0sol + v0def + upU v0sol + upU v0def + . . . =
The capitalising factor,
1
1upU
(5.16)

1
v0sol + v0def
1 upU
(5.17)
, is a firm way to represent the scaling feature. It basically
means that the numeraire is capitalised with a growth rate, u, adjusted for time and risk, pU .
The intuition is that more distant periods are less likely to occur since default has to be avoided
for a longer period of time. However, when they do occur earnings have risen quite a bit. We
use this knowledge to answer the second main question, namely how this restructuring value is
and D
divided among debt and equity. In other words we study how the functional forms of E
from equation (5.6) and (5.7) are given.
5.3
Distributing restructuring value
We have shown that the dimensions of the model can be reduced to merely consist of the initial
claims to solvency and default. Since the scaling feature implies that the story just repeats itself
at every restructuring, one would naturally expect that debt, equity, taxes and bankruptcy costs
just increase by the scaling factor found in equation (5.16). The main trigger is that all four claim
def
values are linear in v sol
0 and v 0 , which again have been shown to be linear in initial earnings, 0 .
However, the ex ante split between equity and debt holders are determined by the pure structure
of the debt contract. One can therefore take an even broader perspective and consider joint debt
and equity value relative to taxes and bankruptcy costs. This relationship must remain constant
when distributing the value from restructuring.
E0sol
E0
def
E0
+ D0
+
D0sol
D0def
G0
Gsol
0
Gdef
0
BC0
BC0sol
BC0def
1
1 upU
(5.18)
Until now we have ignored the exact construction of the debt contract in order to provide a
general framework. We now become more detailed and contingent specific in order to derive the
proper debt and equity values. We first consider the unlevered firm value, which provides a useful
base case to dole out debt and equity values afterwards.
5.3.1
Unlevered firm value
Recall that initial owners of the firm focus on maximising the joint value of debt and equity ex
ante. This is also the case at each restructuring dates since the firm basically becomes unlevered
when debt is called. At these stages of the game share holders have the right to all future debt
issues, which must be reflected in the value of their investment in some way. Goldstein et al. (2001)
argue that unlevered firm value prior to the first debt issuance completely reflects the net gains
from all future debt issues (see Section B.5 for an explicit expression).
v0 () = E0 () + D0 () RC () =
46
E0sol + E0def + D0sol + D0def

RC
1 upU
(5.19)
Another way of interpreting this is that all tax savings from potential future debt issues must be
included in the unlevered equity value. Recall that a discussion was put forward in Section 3.2.3 of
whether the unlevered firm value used in Leland (1994) could possibly deviate from the optimally
leveraged firm value. This is basically a matter of how realistic it is to take over an unlevered firm
without having to pay a premium. If such an action is likely then a no arbitrage argument implies
that the levered and unlevered firm values can only deviate by the amount of restructuring costs.
The model thus becomes self-fulfilling in some way since the owners of an unlevered firm do not
gain from actually taking on debt as the value of their investment already incorporates such gains.
To circumvent this circularity Goldstein et al. (2001) argue that the acquirer always has to pay a
premium meaning that debt indeed plays a role in the framework of Leland (1994).
At first glance it may seem like the authors are contradicting themselves. However, one has to
note that the present framework uses a different state variable compared to Leland (1994). In other
words the tricky issue whether the unlevered firm remains a traded asset is eluded here. In order
to enhance the intuition one could think of the owners having made some credible commitment
to issue debt and the market value of equity thus reflects this. Goldstein et al. (2001) do not go
into such discussions, so the above treatment only serves to highlight the potential issue of stating
unlevered equity value in the way it is done. Having determined the overall firm value we now
proceed to dividing this between debt and equity holders.
5.3.2
Debt value
We have assumed that share holders can call debt at par value when the upper boundary is hit.
Informally this implies that debt holders have no bargaining power when dealing with share holders
about selling their debt back to firm owners. The value of their investment has to reflect this issue,
which implies that initial debt holders are not entitled to gains from future potential restructurings.
Since debt is called at par value, debt holders simply receive an amount equal to the initial claim
value when the upper boundary is hit, Dres
0 () = pU D0 . When the state variable stays between
the two boundaries or hits the lower level, claim value is given according to the benchmark case.
Combining this implies that the expected value of the debt issued in period 0 can be stated as the
following (see Section B.3 for an explicit expression).
D0 ()
D0sol + D0def + pU D0 =
D0sol + D0def
1 pU
(5.20)
Note that true debt value is indeed still scalable in the state variable even though the scaling
factor from above is not used explicitly in this particular matter. The callability provision in the
debt contract simply entails that claims to future debt issues are currently owned by equity and
47
restructuring costs13 . Informally, share holders thus have some part in the overall cash flows to
debt, so to say.
In this connection one may note that this could have been predicted on beforehand. This is
true for callable debt but in case a more complex setup was being studied the general approach
adopted here would prove useful. Moreover, analysing the real equity value involves restructuring
costs, where the scaling feature proves useful. The whole exercise of finding the inherent scaling
factor in the model has therefore not just been an academic one!
From a more general point of view one would presumably ask the question why debt holders are
willing to include such a call indenture in the contract. The option to call debt at par is equivalent
to handing over a right but not an obligation to share holders, which always has a positive value
for the holder14 . For the debt holder such a contract is thus less valuable and rational expectations
imply that ex ante debt prices reflect this matter.
However, including such a provision in the debt contract may nonetheless have real implications
for ex ante firm value in this specific setup since issuing costs are proportional to initial debt value.
Holding tax benefits of debt constant but reducing ex ante value of debt by including a call provision
thus lowers the issuance costs.
The particular value of expected future restructuring costs of debt can be found using the
inherent scaling feature. Doing that one accounts for larger issuing costs in the future, u, but also
that these may not be realised, pU (see Section B.4 for an explicit expression).
RC()
5.3.3
qD0 + qpU D1 + . . . = qD0 (1 + upU + . . .) = qD0
1
1 upU
(5.21)
Equity value
We know that equity value stems from two components, namely solvency and hitting the upper
boundary. Our main focus has been on determining the latter in an intuitive way and not just by
solving the ode directly. When the upper boundary is hit share holders become the sole firm owners
again by calling all existing debt. This freedom is gained by paying debt holders par value of their
debt. Their motivation for doing this is that some unexploited tax benefits implicitly prevail in
the firm when earnings have increased. This option can be exercised by issuing a larger amount of
debt. We basically just want to measure the size of this option now. Net value of calling the debt
at the upper boundary must then be given by the scaled unlevered firm value in equation (5.19)
less the price of calling the debt, D0 . Also, since it is uncertain whether restructurings actually do
occur one has to account for this matter using the state price, pU (see Section B.6 for an explicit
expression)
E0 () = E0sol + E0def + E0res = E0sol + pU (uv0 D0 )
13 Goldstein
(5.22)
et al. (2001), note 26.

debt value is increasing in earnings. As debt is only called when times are good (i.e. at the upper
boundary) it must therefore be the case that callability always is to the benefit of the share holder.
14 Generally
48
The intuition is that equity value stemming from future restructurings features the nature of
a call option to restructure the firm15 . Exercising this option involves calling the debt, which
happens at a strike price equivalent to par value, D0 . Value of the underlying variable at exercise
date is the scaled unlevered firm value, uv0 . Expected gain from this restructuring option arises
when adjusting for the likelihood of this option becoming in the money so to say, pU .
Further insight may be obtained by briefly looking at the case just before the first restructuring.
At this point it is almost certain that restructuring will happen and the upper state price must go
towards 1. On the other hand the claims to cash flow in period 0 are worthless as this very state
is just about to end. When earnings approach the upper boundary level, equity must thus have a
value in the limit that demonstrates the option-like feature of the model.
lim E0 () = E0res = uv0 D0
0 u0
(5.23)
It is exactly this part of the equity value that is the new stuff compared to the static case
and the part we have tried to identify in a rational manner. Knowing the expressions for firm and
equity value one would naturally proceed to investigate how that affects the behaviour of a rational
share holder.
5.4
Optimal capital structure
The whole idea of analysing the inherent scaling structure of the model was to arrive at some
useful expressions for debt and equity value. When share holders know these they obviously want
maximise the value of their investment by exercising the degrees of freedom that are available to
them. In the static model these comprised size of debt, C, and when to stop honouring the debt,
.
Introducing dynamics into the model a new variable emerged, namely the upper boundary level.
To keep the resemblance with the static framework we treat the restructuring level as exogenously
given, so that the same two degrees of freedom still exist. The only difference now is therefore
that the expression for levered firm value has changed. One can thus proceed by using the same
approach as in the static framework when determining the optimal values of coupon payments and
default level.
5.4.1
Closed form solutions
Generally, one would probably begin by invoking the smooth-pasting condition, 0 (C0 ), followed
by deriving a closed form solution for the optimal coupon level, C ?0 (0 ). For the static case this
worked fine but this may not be as straightforward now due to the complex nature of the functions
in the dynamic framework. When evaluating the smooth-pasting condition, one has to bear in
mind that the state prices are a function of earnings and the chosen default level.
15 This interpretation is only informal in the very nature and a slight reformulation of the expression (equation 72)
used in Goldstein et al. (2001). They do not take this approach explicitly but we feel the interpretation becomes
more pronounced this way.
49
A natural starting point could therefore be to invoke the smooth-pasting condition on the
two state prices. Doing that one realises the surge in complexity for these first order expressions
compared to the static case (see Section B.7). This generally prevails for the relevant equations
and we have actually come a cropper when trying to derive a closed form solution for the optimal
default level16 . Contrary to the static case this does not seem possible here, and the literature does
not provide much help in this relation either. Needless to say, optimal debt level is not possible to
derive analytically either. Instead it appears as Goldstein et al. (2001) apply a numerical method.
Nevertheless, we may still be able to say something qualitative about the solutions one will arrive
at.
Recall that in the static framework equilibrium values of coupon payments and default level
were given by the state variable and some exogenous parameters (explicit expressions given in
Section A.4). Consequently, debt and equity values in equilibrium were linearly dependent on the
state variable and thus scalable. Even though we are not able to derive such expressions analytically
for the dynamic framework, this general setup must still prevail. The main argument is that all
relevant variables have been shown to be scalable in the state variable. More specifically, coupon
payments, default and restructuring levels are directly proportional to earnings. This must imply
that at every restructuring the owners maximise firm value by implementing the same general
capital structure. In other words we argue that the functional form, so to say, of the optimisation
problem is identical since the only difference between each restructuring is that the state variable
have increased by a factor u. As a result equilibrium values for debt and equity must also be
scalable in the state variable.
v ? ()
= At
(5.24)
D? ()
= AD t
(5.25)
E ? ()
= AE t
(5.26)
The constants show the optimally after-tax levered claim value per unit of earnings17 . The
interpretation is that at every point in time one can maximise firm value by scaling the initial
optimal coupon rate and default level according to the current level of the state variable. From
this follows that the marginal effect on claim values from larger earnings is constant18 .
One could now proceed with replicating the numerical results produced by the authors. This
would include maximising the explicit expression for firm value with respect to 0 and C simultaneously (i.e. the expression in B.6). Our main interest, however, is not whether the default and
coupon levels are x or y given some slightly random parameter values, but rather how they change
compared to the static case. In the following we thus provide a qualitative reasoning instead.
16 By closed-form solution we here mean an expression depending only on known parameters and the coupon
payment, which is to be found afterwards.
17 Flor (2009a) uses this procedure for the firm value. We claim that the same intuition must yield for debt and
equity value due to scalability. AD (AE ) thus shows debt (equity) value per unit of earnings for an optimally levered
firm.
18 Figure 3.1 in Flor (2009a) illustrates this, which is equivalent to figure 1 in Christensen et al. (2002).
5.4.2
50
Recall that share holders find it optimal to leave the firm when the expected payoff from keeping
it afloat becomes negative. Analysing how this optimal stopping point may change when incorporating restructurings can thus be done by looking at expected payoff from continuation.
Figure 5.5: Break-down of expected payoff from default decision (own creation).
Generally, continuation entails benefits to the owners in form of future dividends and net tax
benefits. The former is invariant to the capital structure and thus a fixed size no matter the
dynamics of the setup. On the other hand future upward restructurings can only be an advantage
to the owners since the tax shield is exploited in a more efficient way. This was not prevalent in
the static case, so because of larger expected tax gains, one can argue that equity must be more
valuable in the dynamic framework all else equal.
A counter argument could state that absent restructuring options, owners could just scale up
the initial debt level in order to exploit tax gains from future increases in earnings. However, the
optimal debt level derived in the static model exactly balances this potential upside against the
larger risk of defaulting. One can thus interpret the restructuring possibility as an option to exploit
future potential tax gains without enduring the downside of a larger default risk today. Such an
option must have a non-negative value and share holders must benefit from the possibility of future
restructurings.
The relation to whether the optimal default level is altered in the dynamic framework then
follows naturally. As the upside potential from keeping the firm afloat when the future looks gloomy
(i.e. low earnings) is bigger in the dynamic framework, share holders will choose a lower default
level. This is also what the authors find for some realistic set of parameter values, ?dynamic <
?static . Note that the optimal default level is a direct function of the debt level, so the above
conclusion is thus an all else equal.
5.4.3
Optimal debt level
It proves useful to recall that taking on debt is basically a matter of balancing tax gains over
expected bankruptcy costs (and issuing costs). An interpretation is that the owners have to assess
how much the current and future earnings can bear in form of coupon payments. Since the future
path of the state variable is uncertain, taking on debt as a function of future expected earnings can
seen as some kind of gamble. How much emphasis to put on this gamble depends on the existence
of future restructuring options.
51
If issuing debt is a one-shot game, one could argue that an optimal strategy includes taking
on an aggressive amount of debt relative to current earnings. This is efficient for the firm in case
future earnings are expected to grow, > 0, as the firm is just balancing expected tax gains over
expected default costs. In some way this relates to the firm gambling on future earnings growth.
On the other hand the firm can be argued to placing less emphasis on expected future earnings
growth in case the firm has the option to restructure at some latter stages of the game. In other
words the firm is less willing to gamble on earnings growth. This seems intuitive since a firm in the
dynamic framework can be thought of as holding an option to exploit future tax gains from more
debt. Such an option is exercised if it goes in the money resulting in owners being less willing to
gamble on future earnings growth.
Figure 5.6: Initial debt decision is a function of how much current and future earnings can bear
in terms of coupon payments. Future restructurings imply a more conservative gamble on future
earnings growth, 1 > 2 (own creation).
These considerations are illustrated in Figure 5.6, where the focus is to show that owners place
less emphasis on future earnings growth when restructurings are possible, 1 > 2 . Due to the
higher degree of flexibility with regards to the capital structure, one can thus conclude that initial
debt level in the dynamic case is reduced compared to the static case all else equal. These results
are confirmed by the findings in Goldstein et al. (2001), which are also more on line with real life
leverage.
Figure 5.7: Initial debt level is lower when future restructurings are possible (own creation).
We have now discussed how share holders alter the optimal default level as well as initial debt
level when restructurings are possible. We end this chapter by combining these two effects to
determine the effect on firm value.
5.4.4
52
Firm value
Recall that maximising firm value can be seen as minimising the stakes to taxes and default costs.
The potential tax shield is exploited most efficiently in case coupons equal earnings every period,
Ct = t . However a high debt level has an adverse effect on expected bankruptcy costs as the
optimal stopping time increases, /C > 0. At a general level the net effect from altering the
debt level is thus ambiguous.
In the present setup we have found that initial debt is lower than in the static framework.
As a result the present tax shield is exploited less efficiently, but this may be balanced by lower
expected bankruptcy costs. Informally, one may argue that the initial debt level chosen in a
dynamic framework fits current earnings in a more efficient way than the larger debt level taken
on in a one-shot game. The reason is that share holders do not have to gamble on future earnings
growth and thereby incur unwanted default risk when debt can be adjusted in the future. An
intuitive way to conclude that equity is worth more when future restructurings are possible, is that
such a firm can always choose a debt level equal to the static one and will still have an option on
top of this.
Figure 5.8: Equity value in dynamic framework can be interpreted as the static counterpart topped
with an option (own creation).
Flor (2009a) models the tax advantage to debt and finds that restructurings increase firm
value only relatively moderately19 . Following the line of reasoning above one can interpret this
difference between the tax advantage for the two frameworks as making out the extra value from
restructurings.
We have spent considerable energy on analysing what happens when the upper boundary is hit
and the inherent scaling feature. One could naturally continue this line of reasoning to the lower
boundary and how negotiations can potentially come about. As we would also like to discuss issues
such as asset substitution and imperfect information, the discussion of downward renegotiations
will not be as thorough as the one just presented.
19 Tax advantage is modelled as the ratio of the optimally levered firm relative to the unlevered firm value. It is
argued that the tax benefit would be larger if the coupon rate did not enter the drift of the firm negatively (note
15).
Chapter 6
Downward restructurings and

negotiation
Within the simple trade-off we started out by discussing a situation with a one-shot debt choice
(Leland 1994). The limited flexibility within this setup implied that the debt level could not be
increased in order to match higher earnings. Neither could share holders and debt holders find
a way out in case earnings dropped below some critical level where costly default was called.
Goldstein et al. (2001) make up for the former matter, so we now turn our focus towards the
latter issue and how default can possibly be circumvented within the framework. In our pursuit
of providing a suitable discussion within the framework used so far, the main foundation will be
Christensen, Flor, Lando and Miltersen (2002). In some way this model is a straight extension of
the dynamic model in Goldstein et al. (2001). Generally two limitations arise in the latter model,
which Christensen et al. (2002) make up for.
First, the upper boundary level is for some reason exogenously given in the debt contract. One
could easily imagine a situation where owners of the firm decide to alter the capital structure
whenever this seems profitable. This would relate to invoking the smooth-pasting condition at the
upper level.
Second, no flexibility exists at the lower boundary, so there is no way default can possibly be
avoided. Relaxing this strict assumption is the main contribution from Christensen et al. (2002),
which will also be the focus in the following analysis. The empirical motivation for incorporating
such a feature could be that a firm normally enters Chapter 11 bankruptcy before being liquidated,
which relates to Chapter 7 default. One could thus interpret negotiations as part of Chapter 11
default and if these break down Chapter 7 bankruptcy is called upon. As a result we now have a
more realistic setup at the lower boundary.
The intuitive way to proceed is to briefly explore how the setup of the model is altered when
negotiations at the lower boundary are introduced. In order to simplify the analysis a benchmark
case is then presented with only one option to negotiate. Since liquidation is not always a credible
threat, it seems realistic to extend the model to a larger finite number of possible lower restructuring
options. The main focus throughout this section is to analyse how downward restructurings may
53
CHAPTER 6. DOWNWARD RESTRUCTURINGS AND NEGOTIATION
54
alter the conclusions found so far concerning capital structure and firm value.
6.1
Benchmark case
Instead of simply leaving the firm to debt holders and incurring a deadweight loss in connection
with bankruptcy, share holders are now given the option to negotiate with debt holders. This
happens as a bargaining process because debt holders do not have any contractual obligation to
accept any of these proposals. The main driver for the relevance of negotiations is that the firm
incurs a deadweight loss in connection with entering financial distress (equal to a factor ). Debt
and equity holders thus have a common interest in avoiding these default costs, as initial claim
values must reflect such issues in a rational expectations model.
What remains unclear at the moment, however, is how gains from avoiding costly default are
to be split among claim holders. One could claim that debt holders should receive all proceeds,
as share holders do not have any contractual claim on the firm in case of default. On the other
hand share holders are the ones who must take the initiative and put together a Pareto-optimal
solution. They have no incentive doing this if debt holders are the sole beneficiaries from avoiding
a harmful default. One can thus make a qualified guess that no corner solutions, so to say, will be
the outcome of the sharing process.
To round off this introductory section, one could raise the question whether the literature on
strategic debt service does not cover the issues raised above. However, these models (e.g. Anderson
and Sundaresan, 1996; Mella-Barral and Perraudin, 1997; and Fan and Sundaresan, 2001) are more
concerned with the marginal coupon payment than restructuring the entire capital structure as
done in Christensen et al. (2002). The latter paper thus provides new insight and also fits the
framework presented so far more properly. We proceed by discussing how the increased flexibility
can be incorporated in the current framework. Then we are ready to set up our benchmark case
of a single negotiation round.
6.1.1
Relation to old framework
It seems that some differences exist between the general setup in Christensen et al. (2002) compared
to the one already considered. Ideally, we would prefer the two setups to be identical, so that the
clean effect of introducing renegotiations in the model can be identified directly. In other words
one cannot be sure that ones conclusions are not flawed by the slightly different setup used here.
It thus proves worthwhile to briefly and informally consider how the different setup in Christensen
et al. (2002) may influence the potential conclusions and the choice of debt level1 .
First, the drift of the state variable is completely exogenously given in Christensen et al. (2002),
so it does not depend on the coupon rate at all, which is argued to be the case in Goldstein et
al. (2001). In that way one avoids the potential problem of a downward biased expected earnings
1 If a closed form expression for the optimal coupon level prevailed, a more correct way to proceed would involve
finding the first derivative with respect to the parameter in question. E.g. how does optimal leverage change when
a call premium is in place.
55
path as mentioned in Flor (2009a, n. 15). All else equal, the capitalised value of current earnings
will be larger, which motivates more debt and thereby larger tax gains.
Second, the upper boundary is determined endogenously, so one has to invoke the smoothpasting condition for this limit as well. Doing that one avoids the rather arbitrary restructuring
point used in Goldstein et al. (2001). The debt level is increased exactly when this becomes
fruitful, so larger gains from tax must prevail all else equal.
Third, when debt is called this happens at a premium (factor ) on top of par value. One can
interpret this as a higher strike price of exercising the restructuring option illustrated in equation
(5.22). Generally, this implies that the option has a smaller exercise region resulting in fewer
restructurings. Lower tax gains thus exist from debt compared to the case without call premiums.
Fourth and last, it is assumed that tax benefits are not lost when the firm defaults, as the
debt holders can lever the firm after gaining control. This means that the firm is more valuable
at the lower boundary, which motivates share holders to continue operations to a larger degree.
Consequently, the smooth-pasting condition is lower, which allows more debt to be put in place.
Summarising, one can conclude that only the call premium may imply a downward bias of
the optimal debt level. Exogenous drift, an efficient upward restructuring point and tax gains at
default all call for more debt in place and thus better use of the potential tax shield. Recall that our
primary focus is to examine the direct effect of allowing negotiations. In order to do that we carry
on with the framework presented in Goldstein et al. (2001) and extend this with the negotiation
feature from Christensen et al. (2002). Of the four differences stated above, we only incorporate
tax gains at default. The reason is that gains from negotiations simplifies to only being a function
of saved costs in connection with financial distress2 . Before setting out the one-shot negotiation
game, we briefly recapitulate the situation from Goldstein et al. (2001) when tax gains prevail at
default.
6.1.2
No restructuring
We now turn our focus towards claim values at the lower boundary level. To start with it seems
intuitive to sketch out the case where no negotiations are possible, i.e. the situation in Goldstein
et al. (2001). The absolute priority rule implies that debt holders are first in line when the firm
is split at default and we assume nothing is left to share holders. Tax gains at default imply that
the firm can be sold off as a going concern. In other words, debt holders take over the firm and
enforce a new optimal capital structure. Alternatively, one can imagine debt holders selling off the
firm immediately to some new owners who implement an optimal capital structure. Either way
the firm value at default must reflect this inherent value. Basically, this means that there is more
left than just value of assets when default is triggered. In fact one has the value of an optimally
levered company as in the initial period, but with the modification that it is a function of lower
earnings. The difference in value to the Goldstein et al (2001) case must then be net tax gains from
debt at the lower boundary. As stated in equation (5.24) we argue that the optimally levered firm
2 If tax gains were lost in case of default an extra dimension from saving the firm would prevail. In addition to
saved bankruptcy costs also saved tax shield would make out potential gains from restructuring the firm, which just
makes the model less tractable.
56
is scalable in the level of earnings. Christensen et al. (2002) use an approach somewhat similar to
this3 .
def
Dneg
() = (1 )A
def
Eneg
() = 0
(6.1)
The main motivation for looking at potential negotiations is that it must be in the common
interests of debt and equity holders to avoid default as this entails a deadweight loss. When
considering the potential gains from avoiding default one has to compare the situation in equation
(6.1) with a state that includes negotiations.
6.1.3
One-shot negotiation
Imagine now that claim holders can come together and save the firm from costly default. If this
comes about the old debt is retired and a new smaller portion is issued, which maximises firm
value as a function of current earnings, d0 . Furthermore, assume that share holders can somehow
convince debt holders that liquidation will be the inevitable outcome in case the proposal is rejected.
Whether the firm is saved or not does not influence the size of tax gains and restructuring costs,
so the only difference is that costs in connection with financial distress are avoided. In other words
the potential aggregate gain from negotiation is equivalent to the bankruptcy costs.
Gneg () = A
(6.2)
Then the question arises how these potential gains will be shared between the two groups of
claim holders. Since debt holders always have the right to refuse any restructuring at the lower
boundary, they must be better off in order for negotiations to be feasible. In other words they
must receive a non-negative part of the gains. We assume that the bargaining game is exogenously
determined and can be expressed as share holders (debt holders) receiving a fraction of (1 )
of the gain4 . If one likes to relate this to the total firm value at default the following must hold,
where = .
Dneg ()
A A = (1 )A
(6.3)
Eneg ()
A = A
(6.4)
The direct effect is that equity now has a positive value when the lower boundary is hit. As
just mentioned debt holders must receive a positive share of the gain, < 1, in order to be better
off, which is also equivalent to > . In other words, the proportion of the firm lost to bankruptcy
costs must thus exceed the fraction of the restructured firm that is transferred to share holders.
What we have done here is merely just defining a new set of claim values at the lower boundary.
One could then proceed as before and solve numerically for the optimal restructuring levels and
3 Note
that tax issues are hidden in the constant, A, so these do not figure explicitly any longer.
that our main focus is whether such negotiations can actually be put into force rather than analysing the
exact division of a potential gain.
4 Note
57
amount of debt. What seems interesting, however, is the sign of the potential changes in claim
values and debt levels when negotiations are possible at the lower boundary. The direct effect from
allowing negotiations is that more debt is put in place. Recall that the debt decision is merely a
balancing act between tax gains and costs in connection with financial distress and restructuring.
Negotiation implies that bankruptcy costs can be circumvented and thus the downside of taking
on debt is reduced. All else equal it will be optimal to implement a higher level of debt.
Maximising firm value is equivalent to minimising the joint stakes to taxes and default costs.
The latter part actually vanishes because negotiations are always preferred in the setup above. Ex
post negotiations are always efficient so bankruptcy is always avoided, which in some way refers to
the Coase Theorem (Hackbarth et al., 2007)5 . The firm becomes more valuable and both equity
and debt holders must benefit in order to encourage negotiations.
Further note that the absolute priority rule is not respected when negotiations are introduced.
Debt holders are fine with this, however, as they receive more now than by becoming the sole
owners of a firm in financial distress. Finally note that while allowing for negotiation when things
go bad, we ignore any adverse effect this issue would have on managements behaviour. The
potential gains in this simple one-shot game depend crucially on share holders being able to make
debt holders believe that the firm will indeed be liquidated in case negotiations break down. We
now turn to relaxing this rather unrealistic assumption.
6.2
Renegotiations
Until now share holders have been assumed to make a take-it-or-leave-it offer to debt holders, who
would force the firm into liquidation by rejecting the offer. An implicit assumption here is that
the debt holders are convinced that the owners of the firm will cease coupon payments in case
negotiations fall through. Another way of stating this is that liquidation must be the best strategy
for share holders in case restructurings are impossible. This seems unrealistic since share holders
seldom run away with anything in case of default. If the future looks reasonably promising one may
thus expect that owners would keep honouring the debt in case a negotiation offer was rejected6 .
The main implication is that the potential gains from restructuring have to be modified compared
to the simple case considered above.
It seems obvious that share holders have an interest in making debt holders believe that the
only alternative to a collapsed negotiation is costly default. In that way their reservation wage, so
to say, becomes as low as possible making it easier to propose a restructuring deal. In case debt
holders believe share holders will carry on honouring the debt after a collapsed negotiation, they
will have a higher reservation wage in connection with the bargaining process since bankruptcy
5 Informally what we mean is that no matter which party has the bargaining right (property right) the two claim
holders will always find it optimal to come together and make a Pareto-optimal deal . This naturally hinges on the
absence of transaction costs. We return to this when discussing finite restructuring possibilities. See for example
standard microeconomics textbooks as Schotter (2000) or Gruber (2004)
6 One may question this since the smooth-pasting condition indeed shows the optimal point to leave the firm
to debt holders. However, it is not this specific issue that is being addressed here but rather how the gains from
negotiation are given in a more realistic setup. Having found this one can proceed to analysing the new optimal
default level as a function of this modified firm value at bankruptcy.
58
costs are not accounted for explicitly. One must therefore introduce a more comprehensive and
realistic setup in the negotiation process.
6.2.1
Setup
We now try to clarify the more realistic negotiation process presented above. Compared to the
simple benchmark share holders are now given an alternative to liquidating the firm if negotiations
break down.
Figure 6.1: Payoff structure from extended negotiation setup (own creation).
In case debt holders agree to restructure the firm, the situation from the benchmark case
prevails where the two groups of claim holders split the saved bankruptcy costs between themselves.
What remains unclear, however, is how share holders decide to act when negotiations break down.
Generally they must consider equity value from liquidating the firm as well as keeping the firm
afloat. The absolute priority rule implies that share holders only receive something from default
if net firm value exceeds par value of debt. When operations are continued without restructuring
the firm, equity has the same value as prior to the negotiation due to the value matching property
(Flor, 2009a). As share holders are the ones who choose the course of action, debt holders just
stand by the line and observe the end result of the game7 . Using Figure 6.1 a compact form of the
situation where debt holders refuse the offer can be presented as follows8 .
E nr ()
Dnr ()

max E con (), E def ()

max (AE (0 ), max A(0 ) 0 AD (0 ), 0
1con Dcon + 1def Ddef

1con AD (0 ) + 1def min (1 )A(0 ), AD (0 )
(6.5)
(6.6)
What has been stated above is the alternative situation to restructuring the firm. In other words
when debt holders reject the restructuring offer the outcome is decided according to E nr and Dnr .
Gains from restructuring must thus be given as the difference between an optimal restructured
71
indicator variables. If share
con and 1def are two mutually exclusive

holders choose to continue coupon
payments (liquidate) 1con = 1 1def = 1 and otherwise 1con = 0 1def = 0
8 We earlier argued that A denotes the optimally levered firm value per unit of EBIT. In case the capital structure
is suboptimal to the current level of earnings we denote this in a parenthesis, A(0 ). In other words A (0 ) implies
that the capital structure fits the initial earnings level and not the current lower level, .
59
firm and the joint claim values from above.
Gneg () = A (E nr + Dnr )
(6.7)
There is a clear divergence to the benchmark case since the alternative to restructuring now is
not necessarily given by claim values at default, see equation (6.1). Potential gains are therefore
lower on average now. We still asumme that gains are split according to some exogenously given
bargaining power, so debt and equity values at default must be given as the following.
E()
= Gneg () + E nr
D()
(1 )Gneg () + Dnr
(6.8)
(6.9)
The implicit assumption is that negotiation is somewhat realistic so that potential gains are
incorporated in the claim prices. If gains from negotiation are non-negative both players will be
better off by deciding on restructuring the firm. The new stuff compared to the benchmark case
is that negotiations come about in a more voluntarily fashion now. What still remains unclear,
however, is how the model can actually be solved.
6.2.2
Solving the game
When the share holders best response to a rejected negotiation is liquidation we arrive at the
the benchmark. It thus seems more interesting to look at the case where they want to continue
operations. This is done with a suboptimal capital structure since this is determined as a function
of the initial earnings level, < 0 . One could therefore rush to concluding that the firm value
would be lower than the perfectly restructured one. However, we have no limitations on how often
negotiations can be started. So in case the first negotiation breaks down and share holders decide
to continue, they will have incentives to start a new negotiation a brief moment later. This will
continue until the claim holders reach an agreement. As complete information is assumed, claim
prices before the first negotiation must reflect that gains from negotiation will be realised for sure.
E con () + Dcon () = A
(6.10)
So in case continuation is the optimal strategy for share holders, gains from negotiation become
empty in equation (6.7) as claim prices already reflect this. In other words one cannot say anything
about how the gain is actually split. This is basically because we are currently walking along the
equilibrium path where the model is fulfilling by its very nature. In order to derive any new
knowledge about how gains will be divided, one has to analyse the off-the-equilibrium-path as put
by the authors. In other words one has to moderate the implicit assumption in the model that
gains from negotiation will always be realised.
A different interpretation is that one has to include a risk that the deadweight loss in connection
with default will be realised to some extent. Such a risk could possibly prevail in case some direct or
60
indirect costs exist in connection with negotiation (Flor, 2009a). Various ways exist to incorporate
such a feature. One alternative is to put a limit on the number of potential negotiations. By and
large this implies that share holders have n number of rights to ask the debt holders to restructure
the firm. Whenever these have been spoiled the only option is to default and incur the costs in
connection with financial distress. In relation to the Coase Theorem this implies that transaction
costs are non-zero and one cannot be sure that the Pareto-optimal outcome will be reached. More
generally, it is just another way of implementing an iterative approach to solve the problem.
In order to solve the model it seems appropriate to start out with the case where the very last
restructuring proposal is put forward. This must be identical to the benchmark case, where the
only alternative to restructuring is default. One then proceeds to the case where one option is left.
In case debt holders reject the negotiation, we know that the benchmark case will prevail. Thus
one knows how the alternative state is modelled. This procedure is continued until the very first
restructuring period is hit. Gains from negotiations at time t are thus given as the following.
G0

= A (E0nr + D0nr ) = A E0def + D0def
G1
= A (E1nr + D1nr ) = A (E1nr (E0nr ) + D1nr (D1nr ))
..
.
Gn
..
.
..
.
= A (Ennr + Dnnr ) = A
n1
X
Ennr
j=0
n1
X
Ejnr + Dnnr
j=0
Djnr
(6.11)
This relates to solving the game using some sort of a forward induction argument as well as the
well-known benchmark case. The number of possible negotiation options is determined so that a
fixed point is reached. In other words the marginal effect on debt and equity value from an extra
option must go towards zero, which the authors carry out numerically. We choose not to devote
more space to this issue, as we would like to turn our focus towards other issues in this assignment
as well. Instead we briefly study the implications from a more realistic bargaining setup.
6.2.3
Results
When going through the benchmark case we emphasised the effects from disobeying the absolute
priority rule by introducing a one-shot negotiation. We therefore limit ourselves to discussing how
this conclusion may change when extending the number of remaining renegotiations from 0 to n.
The short story is that the optimal debt level increases when multiple negotiation options
exist. Even though this benefits the firm at an aggregate level, share holders actually prefer that
negotiation is just a one-shot game. In other words equity is worth less when the number of
remaining restructuring options goes from 0 to n9 . The reason is that the bargaining process
becomes endogenous when we leave the benchmark case. Informally, share holders have to come
up with a good restructuring offer when they are not able to make the debt holders believe that
the firm will be liquidated in case the offer is turned down. An alternative way to interpret this is
9 Figure
5.b in Christensen et al. (2002)
61
that debt holders reservation wage increases when future negotiations are possible. Share holders
are thus forced to leave more on the table. As a result the explicitly given bargaining power plays
a smaller role now, since the division of the gains from restructurings are determined endogenously
in the model. Nevertheless, the absolute priority rule is still not respected as debt holders only get
around 58% of their principal back.
At a more general level one could naturally ask why firms actually go bust in real life if it is
always in their common interests to avoid default. The model does not open for such considerations
explicitly, but the authors mention two ways to incorporate this. One can either introduce an
exogenous risk that agreement cannot be reached or a second state variable can be included to
measure the outside value of the assets in place.
We end this section by briefly summing up how the conclusions from Goldstein et al. (2001)
change when the more rigorous framework used in Christensen et al. (2002) is implemented10 .
The main motivation for circumventing bankruptcy is to avoid the deadweight loss in connection
with financial distress. Restructuring the firm and thereby breaking the absolute priority rule
thus seems like a Pareto-optimal outcome11 . As neither group of claim holders have a formal
obligation to support negotiations it is clear that both claimants must benefit from participating
in a restructuring. In other words debt and equity values increase when default can be avoided.
Negotiations can be seen as decreasing the risk of default and thereby lowering the expected
default costs12 . This in turn favours a larger amount of debt to be taken on and thus more efficient
exploitation of the tax shield. When share holders cannot credibly commit to liquidating the firm
in case debt holders turn down the negotiation proposal, the bargaining power becomes endogenous
forcing equity holders to leave a larger chunk of the restructuring gain on the table. This implicitly
provides better protection of debt holders, which again promotes more debt to be put in place and
thus larger tax gains. We now finish off the simple trade-off part of the assignment by summing
up the general results found so far.
6.3
Summary of trade-off models
The initial starting point of this assignment was that firm value may depend on the capital structure. More specifically we would like to examine how much debt should optimally be taken on
and its effect on firm value. Assuming perfect information about the underlying state variable and
no agency costs this question merely boiled down to balancing net tax benefits against expected
bankruptcy costs. Within this simple trade-off context we have now focused on how the conclusions
may vary when altering one specific dimension, namely the degree of flexibility at the upper and
lower boundaries. To use the language of Black and Cox (1976) these make out two of the main
components to claim value.
Recall that the absence of agency issues implies that pre-tax future earnings are independent of
10 Note
that we have actually only considered the changes from allowing tax gains at default as well as restructurings
of the firm.
11 Note that we are not arguing that breaking the absolute priority rule per se is beneficial to the firm. Actually
Leland (1994) shows that if this is contracted upon ex ante the debt capacity is reduced.
12 In the model default will always be circumvented so default costs actually vanish.
62
the capital structure and thus a fixed, exogenous size. One can thus focus solely on how these are
to be split among debt, equity, bankruptcy costs and taxes. Maximising firm value then becomes
a matter of minimising the joint stakes to government and bankruptcy costs. In other words share
holders ideally want to maximise the tax shield and eliminate expected default costs. The former
can come about if coupon payments would exactly cover earnings in every period, Ct = t . The
latter basically entails that default must never occur13 . This ideal scenario is useful as a point of
reference when evaluating the conclusions in the different models.
Upward restructurings
Deciding on the optimal debt level is principally a choice of determining how much current and
future earnings can bear in terms of coupon payments. Generally, one can argue that owners
put rather heavy emphasis on future earnings when the debt choice is static14 . Informally, one
can interpret this as current earnings being exposed to an excessive level of coupon payments15 .
Introducing options to restructure the firm in the future basically imply that future tax benefits can
be exercised when these actually occur. In other words one does not have to impose unnecessary
bankruptcy risk upon current earnings. The direct implication is that initial debt level is lower than
in the static case. Consequently, firm owners decide to stay longer with the firm in case earnings
decrease (i.e. default level is lower). All in all it was argued that government and bankruptcy
costs have a lower stake in the firm when upward restructurings are possible resulting in larger
firm value.
Downward restructurings
One could then turn ones head to the lower boundary and look for potential improvements. As
default costs can be regarded as a deadweight loss it seems intuitive that both debt and equity have
an interest in minimising the expected size of these. This can come about by breaking the absolute
priority rule by allowing renegotiations of the capital structure. On average default becomes less
likely and thus the downside of debt is reduced16 . As a result more debt is taken on initially and
the joint values of debt and equity increases. Obviously, one can think of many potential agency
problems when share holders know this ex ante.
To sum up we have found that increased flexibility at the two boundary levels implies that the
owners are able to capture some of the stakes initially belonging to government and bankruptcy
costs. We now proceed with modifying three assumptions of the current framework as well as
extending the simple trade-off to incorporate potential adverse behaviour from share holders.
13 Of course if = 0 then default never entails a deadweight loss and thus becomes irrelevant at an overall level.
We ignore this trivial case.
14 In the specific model the state variable has a positive drift, so owners decide to take on an aggressive amount
of debt when no future restructurings are possible
15 We stress that we are not contradicting that the chosen debt level is the optimal one, but rather compare the
situation to the case where restructurings are possible.
16 For the specific setup default is actually never called upon but this is not critical for the sign of the conclusion
to hold.
Part III
Perspectives
63
Chapter 7
Extensions
One could think of numerous ways to extend the framework presented so far. Basically we want
to distinguish between staying within the simple trade-off and extending the model to incorporate
other issues. We shall restrict ourselves to limit these other issues to matters of asset substitution.
Before investigating this extended trade-off, we briefly modify three assumptions within the simple
trade-off framework used so far.
7.1
Modifications within the simple trade-off
Determining the optimal capital structure is not just a matter of choosing the right amount, but
also the maturity as well as type of debt. Furthermore, debt holders may not have access to the
same information as share holders. We thus proceed with relaxing the implicit assumptions of
perpetual debt, single structure of debt as well as symmetric information. We stress that this is
done under the simple trade-off and only after this analysis we shall extend the model to incorporate
asset substitution in Section 7.2.
7.1.1
Maturity of debt
The realism of perpetual debt seems a bit hypothetical although some empirical support may be
available. For example Leland (1994) argues that in case debt has long maturity the principal plays
a minor role and thus resembles perpetual debt. Alternatively, one could interpret the assumption
of time independence as debt being rolled over very frequently at a fixed interest rate. Nevertheless
it seems interesting to regard the debt choice as a matter of size as well as maturity.
Leland and Toft (1996) address this particular issue using the same general setup as Leland
(1994). In order to simplify the model the debt contracts are modelled in a way so that the
aggregate coupon payment, C, is constant at every time interval. However, the claim values are
no longer independent of time, so the partial differential equation does not simplify to the usual
ordinary one. As a result closed form expressions of debt values are hard to derive, so one normally
has to do this numerically using a probabilistic approach as done in Black and Cox (1976). The
main driver is that the optimal default level now also depends on maturity of the debt issued. For
64
CHAPTER 7. EXTENSIONS
65
a given coupon level share holders find it optimal to cease honouring the debt at a higher level of
firm value when debt has shorter maturity. In other words the smooth-pasting condition is lowered
when maturity of debt, T , increases.
!
E()
<0
=
(7.1)
This in turn implies that the debt capacity is reduced for short-term debt resulting in the tax
shield being exploited less efficiently. All else equal owners choose to issue debt with very long
maturities, which can resemble the perpetual case used in the framework above. For short-term
debt to have any relevance the authors introduce agency issues, which we shall come back to in a
brief moment.
Summing up one can argue that assuming perpetual debt results in the most desirable maturity
feature when staying in the static trade-off paradigm. In other words the advantages to debt found
in the models are over estimated if the firm has non-perpetual debt all else equal. Having discussed
the dimension relating to maturity of debt, one could naturally proceed with the assumption of a
single class debt structure.
7.1.2
Single class debt structure
In real life numerous of different debt contracts seem to be available in the market. A natural
way to distinguish one class of debt from another is how it influences the way a firm can behave.
At an overall level it seems reasonable to classify a contract as being market based or bank debt.
A main difference in this connection is the dispersed ownership structure of market debt (i.e.
many different claim holders)1 . As a result it is widely believed that bank debt entails superior
monitoring of the firm management (e.g. Datta, Iskandar-Datta and Patel, 1999). Despite the
relevance of this approach one needs to adopt a different view in order to stay within the simple
trade-off paradigm, where monitoring does not have an effect due to share holders non-adverse
behaviour..
The models considered so far do not explicitly state the class of debt but one can maybe
deduce something from the existence of renegotiation at the lower boundary. For the models with
no negotiation options this can result from debt holders weak incentives to organise themselves.
One could therefore relate this to the use of market debt. On the other hand when negotiation
is possible this must entail that debt holders can make quick and unambiguous decisions when
chapter 7 bankruptcy is just around the corner. Such a scenario is likely to come about when just
a few groups of debt holders are in place, which can resemble bank debt.
So even though a single class of debt has been assumed so far, one could argue that it is not
necessarily the same type that is being used implicitly. In this connection it seems relevant to make
an attempt to get around the strict assumption that two types of debt cannot exist simultaneously.
As bank debt provides superior flexibility at the lower boundary, one could argue that there must
1 If the firm decides to issue corporate bonds on the market, the different investors normally do not know each
other and will be unlikely to get together. Furthermore the usual free-rider problem arises when they only hold
limited positions in the firm.
66
Figure 7.1: Succesful renegotiation at the lower boundary is more likely when bank debt is in place
(own creation).
be some restrictions on the supply of this type of funding all else equal.
Hackbarth, Hennessy and Leland (2007) consider such issues and distinguish between a strong
and a weak firm as the decisive factor2 . The main driver is that a strong firm has bargaining
power and thus able to capture the gains from avoiding costly default, which relates to a high
in Christensen et al. (2002). As a result banks are somewhat reluctant to engage in transactions
with these strong bargainers as they can do better business elsewhere. Accordingly, banks can
only provide a fraction of the financial needs of a strong firm, so the remaining portion has to
be dealt with in the market. On the other hand weak firms have limited bargaining power and
thus unlimited access to bank debt. Consequently, strong firms take on a hybrid debt structure
consisting of bank debt placed as senior topped up with market debt. Weak firms only use one
class of debt, namely bank debt.
For the purpose of our discussion this paper brings in some intuition behind the negotiation
game when default is triggered. Strong firms can be seen as large and mature companies, who only
have limited prospect of being saved from costly default due to the dispersed ownership of its debt
holders. Oppositely, weak firms can resemble young and small entities that are always saved by
their assembled group of debt holders. Whether this is in line with reality seems rather doubtful.
To incorporate this issue explicitly one could for example introduce a firm size variable in
Christensen et al. (2002), which would express the probability that negotiation would come about.
As a result the expected gains from negotiation would be lowered, as some non-zero probability
exists that negotiations will never come about. All else equal the value of debt decreases and
thereby turning the optimal capital structure towards more equity.
7.1.3
Asymmetric information
We now rather briefly evaluate what happens if only share holders hold perfect information about
the state variable, which is being dealt with in Duffie and Lando (2001). At the end of the
assignment we extend this to the case where both parties are unaware of the exact value of the
state variable. Until now both set of claimants have been able to observe true earnings without
uncertainty. Consequently there has been no doubt whether default is about to be called or not.
Due to the very nature of a diffusion process without jumps the next movement is known when
the time interval converges to 0 (Hull, 2005). In other words the risk of defaulting for a solvent
firm becomes zero in the limit.
2 In their setup the owners want to balance tax gains against bankruptcy costs. However, the firm needs outside
funding to get started so debt has to be taken on for the assets to come in place. No upward restructurings are
possible.
67
lim
h0
Q (|t+h t | )
=0
h
> 0
(7.2)
This has a relation to the pricing of debt. As discussed in Section 3.1 debt value can be seen as
depending on the classic term structure and some risk that future coupons will not be met (Merton,
1974). The latter component determines the credit spread, which refers to the yield spread between
a corporate bond and a risk free government bond. When debt holders are perfectly informed the
risk that future payments will not be met can be calculated straightforward and thus resembles
some true credit risk. Moreover, this credit risk must converge to 0 for an infinitely small time
interval and corporate debt thus becomes risk free. This is indeed what the structural models
above conclude (e.g. fig. 3 and 4 in Leland and Toft, 1996). However, this is not what is generally
observed in real life, which motivates incorporating a positive probability of default at every time
interval. This can come about by including a jump process for the state variable (Flor, 2001), but
one could also use economic intuition to address this issue in a more intuitive way.
The fact that corporate bonds never become totally risk free indicates that debt holders do not
posses perfect information and thus require a risk premium. This is exactly the point of departure
taken by Duffie and Lando (2001), who attempt to incorporate information asymmetries. They
assume that debt holders only observe true value of the firm right before the game begins. At
every point in time hereafter they form an expectation of the true state variable upon some noisy
accounting signal. All they know is that given default has not yet occurred the state variable
must exceed the default level, t (d0 , ). For this setup the conditional probability of default
occurring is still zero in the limit as before.
h
i
lim Pr t+h > d0 | t > d0 = 0
h0
This seems intuitive as the underlying process of the state variable is left untouched. However,
what has changed is the speed of how this probability measure converges to zero when imperfect
information exists. The key result in the article is that an element of the probability measure does
not converge to zero and thus a non-zero limit exists. Using the language of survival models this
limit is actually the hazard rate, which can be interpreted as the default intensity for this specific
setup (see e.g. Heij et al., 2004)3 . In other words one can never disregard the threat of bankruptcy
when the accounting report is imperfect.
Due to debt holders risk averse nature it naturally follows that they prefer knowing the true
value of earnings rather than an unbiased but imperfect signal of this. Consequently, the fair value
of debt in this environment requires a larger risk premium and thus a wider credit spread. Due to
the hazard rate this credit spread will have a non-zero limit for an infinitely small time interval.
In other words introducing informational asymmetries can circumvent the unrealistic behaviour of
yield spreads in the standard structural models.
To end this section one could ask how the existence of imperfect information influences the
optimal amount of debt and thus firm value. Recall that debt holders are fully aware of the value
3 This
is the main distinction between the reduced-form models and the structural models.
68
of assets in place prior to buying the debt issue, and one could claim that nothing has changed at
this stage of game. However, as we move on in time debt holders require a premium for holding
the debt due to their risk aversion. This basically stems from debts limited upside as it is concave
in the state variable (i.e. a Jensen effect). Initially, potential investors will anticipate such future
value declines and pay less for buying the debt. All else equal optimal debt level will be lower
resulting in a less efficient exploitation of the tax shield and thus lower firm value. The three issues
just discussed merely served to bring in some perspective in the simple trade-off model, and we
shall now proceed to incorporating asset substitution explicitly.
7.2
Extended trade-off
Until now it has been assumed that the choice of capital structure does not influence the decisions
made by the management. In other words they take on the same investments as would have been
done in an all-equity firm. Due to the asymmetric payoffs of debt and equity claims, such a setup
is unlikely to be realistic. We thus now open up for including matters concerning asset substitution
and how this may influence the optimal amount of debt and thus firm value. We first attempt
to interpret the nature of asset substitution within the framework used so far and finish off by
analysing the effects from two specific types of adverse behaviour.
7.2.1
Introduction
Recall that the share holders claim on the firm resembles the nature of a call option to some
degree4 . From standard asset pricing it is well-known that the value of a call option is increasing
in the volatility of the underlying asset due to the limited downside. This relates to share holders
capturing the full gains from increases in the state variable once coupons have been honoured.
More specifically, this must relate to equity (debt) being convex (concave) in the state variable
(see e.g. comparative statics in Leland, 1994).
Figure 7.2: Equity (debt) may be seen as an increasing convex (concave) function of earnings (own
creation).
One could easily interpret this as illustrating the risk profile of the two groups of claim holders.
As a result share holders (debt holders) can be seen as risk loving (risk averse) and thus preferring
(avoiding) a gamble to the expected value of that particular gamble5 . In case owners of the firm
4 Tax issues and default costs imply that other factors than the underlying asset determines the value of the
option, so the connection is not completely clear-cut.
5 Using utilities, U and a stochastic variable, x, risk loving preferences imply that U [E (x)] < U [x].
69
have the flexibility to alter the course of the firm in a riskier fashion one can argue that this will
come about. However due to the nature of their risk profile debt holders will feel ill-treated and
thus begrudge such actions, which can be expressed as follows.
E()
>0
D()
<0
(7.3)
From asset pricing we also know that increasing the risk of the underlying variable is particularly
tempting when the option is just about to be in the money. This relates to the fact that share
holders do not care how much the firm defaults if this should happen. Thus asset substitution can
be argued as being more likely at lower level of earnings and not when the option is deep in the
money (i.e. at high level of earnings).
E()

<0
(7.4)
Fundamentally, share holders are only concerned with the value of equity, but they must also
take into account that debt holders cannot be fooled. In a rational expectation model debt holders
will anticipate such adverse behaviour and require a discount on their investment. Recall that we
implicitly assume that the cash from debt issues are paid out immediately as dividends. Ex ante
share holders thus want to maximise the joint size of debt and equity. So the interesting issue
concerning asset substitution is whether the increase in equity exceeds the reduction in debt value.
Using the all-equity firm as benchmark, one can argue that the owners choose the most
favourable projects here, which must relate to a first best choice. Altering this strategy just
because debt is taken on must thus involve a lower aggregate value. In other words the existence
of potential future asset substitution thus decreases the current values of debt and equity. In the
following we define agency costs in relation to asset substitution, , as the difference in firm value
arising from divergence from the first best investment strategy.
(, ) = {E (F B ) + D (F B )} {E (
) + D (
)}
(7.5)
One could also interpret the benchmark case as a firm, where asset substitution can be contracted out perfectly ex ante so it never becomes an issue. We now study how these thoughts can
be modelled within the setup used so far.
7.2.2
Framework
So far the optimal debt level has been determined merely as a balancing act between tax gains and
costs in connection with financial distress. Implicitly one has thus assumed that the chosen debt
size did not influence the firm in any other way. We have just argued that this is unlikely to be
the case since share holders will choose to alter the riskiness of the firm when debt has been taken
on. In turn this matter influences the optimal amount of debt to be employed ex ante, so one can
extend the balancing act as follows6 .
6 Tax
benefits are considered net gains here so that issuing and restructuring costs of debt are included implicitly.
Extended trade-off:
Tax benefits
70
vs.
Default costs + Asset sub.
One may note that we have argued throughout the assignment that the firm can be considered as
being split among four claim holders and that a modified irrelevance theorem applies here. It thus
seems natural to study how the existence of asset substitution costs can fit into this framework.
Above it was argued that the joint size of debt and equity is lower when asset substitution is a
future option. Staying within the framework this can be either due to larger stakes to taxes and
default costs or that the total pie (unlevered firm) has dwindled. In other words we want to model
asset substitution as either resulting in a less efficient tax shield and/or as lowering the value of
capitalised pre-tax earnings.
Figure 7.3: Value loss in connection with asset substitution can basically stem from a transfer to
government (option A - increased taxes) or/and lower future earnings (option B - smaller total
pie) (own creation).
In order to provide some intuition it seems natural to look further into how the variance of the
state variable can actually be altered. If the state variable is highly correlated with some financial
derivative then the EBIT-generating machine can be geared relatively easily7 . E.g. the market
value of assets belonging to an oil company must be quite dependent on the oil price8 . Since
future investments are not directly altered one can argue that the growth rate of earnings is left
untouched.
However, the nature of assets in place may often be of such complex nature that financial
engineering at most becomes a reasonable approximation. In that case owners probably have to
change the firms portfolio of real investments in order to increase volatility. If one assumes that
the initial investment strategy is the optimal one, then diverging from this must be suboptimal.
As a result one could argue that the expected growth rate of the state variable becomes lower.
To sum up we have claimed that the way asset substitution is effectuated determines how it
can be interpreted in the old framework. If one assumes financial engineering to be most realistic,
then the capitalised pre-tax earnings are unaffected and the value loss solely stems from lost tax
benefits. The modified irrelevance theorem thus still applies. On the other hand if asset substitution
comes about by altering the actual choice of real investments then the irrelevance theorem breaks
down. In other words the value of assets in place now depends directly on the capital structure.
Consequently the total pie to be shared by the four claimants thus dwindles in size due to a lower
7 Alternatively,
one could construct some replicating portfolio as known in standard asset pricing theory.
though the beta risk may be replicated perfectly, one still needs to capture the firm specific risk in order
for the drift rate of the state variable to be unaffected. Outside investors do not care about firm specific risk but
what we try do here is increasing the volatility of earnings leaving all other parameters in the model constant.
8 Even
71
growth rate.
We now move on to analyse whether share holders actually find it beneficial to change the
course of the firm ex post.
Figure 7.4: The total pie to be shared declines in size when asset substitution is done by altering
0
0
> r
the real investments, r
0 (own creation).
7.2.3
Optimal debt level and firm value
In the literature it seems as asset substitution has dragged a lot of attention for many decades
(e.g. Jensen and Meckling, 1976). Despite the relevance of these papers no successful attempt was
made to quantify the effects stemming from adverse behaviour. With the emergence of contingent
claim analysis it seemed natural to try modelling these agency issues explicitly. As a result there
seems to be a substantial amount of work suitable for our discussion (e.g. Mello and Parsons,
1992 and Mauer and Triantis, 1994). However we shall restrict our discussion to work that uses
the same framework as above in order to simplify the analysis. More specifically our premise is
how the risk is actually increased, where we shall focus on Leland (1998) and Flor (2006). The
former paper can be argued to use financial engineering, whereas the latter believes changing the
real investments is a more realistic setup.
Financial engineering
If one assumes financial engineering is used to enhance the risk of the firm, the model proposed by
Leland (1998) seems suitable. Here the static framework developed in Leland (1994) is extended
to incorporate asset substitution as well as upward restructurings of debt (although exogenously
given). The interesting issue is how the modelling of asset substitution comes about. The main
driver in this connection is an endogenously determined switching point, S , where share holders
choose to decrease the risk of the firm from H to L . The intuition behind this setup is that asset
substitution is believed to be most tempting when earnings are not too far away from default level,
which was highlighted in equation (7.4). Implicitly it is thus assumed that only one switching point
exists, which may seem a bit speculative9 . A benchmark case is modelled where the switching point
is determined ex ante to maximise joint value of debt and equity. This is compared to the state
9 For example Leland and Toft (1996) show that the partial derivative of equity with respect to volatility depends
on the maturity of debt. For short term debt a unique switching point may not exist (fig. 8). However for long
term debt the assumption in Leland (1998) does not seem to be harsh.
72
where the point to decrease volatility is determined ex post, which resembles asset substitution.
The difference in firm value can be seen as an expression for agency costs in relation to non-credible
pre-commitment of risk structure.

(S , ) = E SF B + D SF B {E (
S ) + D (
S )}
(7.6)
The asset substitution problem can in this case be interpreted as share holders maintaining a
risky strategy for too long time.
Figure 7.5: First order derivative with respect to volatility shows that the switching point is too
high when equity ignores debt holders, E ? > F B (own creation).
This is inefficient at an aggregate level as less debt is taken on. In other words the tax shield is
exploited less efficiently when the switching point cannot be contracted out ex ante10 . In relation
to the old setup the stakes to government (taxes) are thus increased at the expense of joint debt
and equity values. Note that the risk switching strategy does not influence the growth rate of the
state variable, so capitalised pre-tax earnings are constant. We now turn to a setup where this is
no longer the case.
Real investment
One could now turn to a more realistic setup where the riskiness of the firm is increased by choosing
a new portfolio of real investments. These have more variance but entail a lower net present value.
Asset substitution thus results in a more direct cost than above since the drift rate of the state
variable also decreases. This harms both debt and equity holders because the total pie to be shared
now declines. In contrast to Leland (1998) and others this direct cost of asset substitution may
nevertheless have a disciplining effect on share holders.
Flor (2008) uses the same general setup as Christensen et al. (2002) and incorporates potential
asset substitution explicitly11 . As discussed earlier, share holders find it more attractive to increase
risk when the level of the underlying variable is low, see equation (7.4). In order to keep the model
simple the author thus assumes that asset substitution can only come about when the lower
boundary is hit, d0 . In other words the initial owners can decide to implement a risky strategy
instead of renegotiating the debt, which results in a new expected path for the state variable
10 The author also uses the state where asset substitution is not possible at all (no switching point). It is found that
debt levels are higher when the risk can be altered ex post, which the author finds surprising. However, increased
flexibility is always preferable and may motivate more debt as the firm becomes more valuable.
11 In addition to analysing how asset substitution affects firm value it is also being examined how negotiation of
debt influences the threat of adverse behaviour. We shall come back to the latter point when dealing with covenants.
73
dt = S t dt + S t dWt
(7.7)
In case the lower boundary is hit the claim values thus change compared to the original framework, where S < but S > . Valuing debt and equity must therefore incorporate this matter.
In other words we can just use the approach from the framework presented in this assignment with
a slight modification. Numerical results highlight a very interesting point. Changing the course
of the firm results in a suboptimal earnings process with lower drift, so share holders will actually
refrain from substituting the assets in some cases. Asset substitution thus involves a trade-off for
share holders between more volatility, which they always prefer, and lower earnings growth, which
they dislike. In other words what matters is how much volatility increases relative to the decrease
in earnings growth rate. Increasing riskiness of the firm thus only becomes an issue if share holders
face a positive net gain from such actions.
Figure 7.6: Asset substitution now involves trading off increased volatility for lower earnings growth
(own creation).
Another way of interpreting this is that the direct loss from lower earnings growth can work as
a disciplining device on equity holders. From this follows that expected agency costs are positively
related to the growth rate of the suboptimal earnings process (given some volatility),
> 0. In
other words, if changing the course of the firm entails some very unprofitable projects (low drift),
then such a strategy becomes unlikely resulting in a lower expected cost12 .
To finish off with one could relate the results to a situation where assets are substituted by
using financial engineering (e.g. Leland, 1998). The main difference in this case is that there is
no direct cost of changing the course of the firm as earnings continue with the same growth rate.
Using the setup from Flor (2008) this can be modelled by setting = S . Following the line of
reasoning from above this results in larger expected agency costs for some given volatility level13 .
In other words treating the asset substitution as altering the choice of real investments rather than
pure financial engineering results in lower expected agency costs all else equal.
One can now sum up the various extensions studied in this chapter.
12 One could claim that once asset substitution takes place it is really harmful but the former effect dominates
(fig. 1.a in Flor, 2006)
13 We are not claiming that agency costs in Flor (2006) are strictly dominated in size by their counterparts in
Leland (1998) per se. What is meant is that the qualitative setup in Leland (1998) can be incorporated in Flor
(2006) by using a constant drift for the alternative earnings process.
7.3
74
Summing up
Before moving on to discussing how covenants may increase firm value, it seems appropriate to
sum up the various extensions of the framework considered so far. Recall that our general ambition
is to minimise the earnings stakes belonging to taxes and bankruptcy costs.
Staying within the simple trade-off framework we first considered how easing the assumption
of infinite maturity affected the model (Leland and Toft, 1996). Short term debt makes default
more likely, which promotes a lower optimal debt level. Consequently the tax shield is exploited
less efficiently and absent asset substitution long term debt is always preferred.
A single class of debt is assumed in most models, but nevertheless these models may implicitly
differ with respect to the particular type of debt that is being used. Likelihood of renegotiations
at the lower boundary can be seen as a function of the concentration of the debt holder group
(Hackbarth et al., 2007). In case debt holders are made up of a few big (many small) members,
renegotiations are more likely (unlikely), which approximates to bank debt (market debt).
In case the state variable is not perfectly observable to debt holders, they must form expectations about the state of the firm (Duffie and Lando, 2001). For an infinitely small time interval
uncertainty still prevails, which results in a risk premium due to debt holders risk averse nature.
In contrast to the case with perfect information the debt never becomes risk free in the limit. Debt
is therefore less valuable and the tax shield is exploited less efficiently, which is rather surprising
as no agency problems exist in this setup. Increasing the precision of accounting information will
therefore reduce the problem.
One could then leave the simple trade-off setup and include potential agency issues in the model.
Due to the call option nature of equity, share holders will be tempted to increase the variance of the
state variable ex post. However, debt holders anticipate such behaviour and demands a discount
for buying the debt ex ante. If financial engineering is used to increase the variance, the related
value loss only stems from missed tax benefits (Leland, 1998). On the other hand switching to
some inferior real investment portfolio also causes future earnings to dwindle (Flor, 2006). This
may have some disciplining effect on the initial owners.
From all this it seems like debt and equity holders can benefit if they can commit to acting
like one unit. As a result it seems interesting to discuss how covenants can play a role in this
connection.
Chapter 8
Role of covenants
It has been argued that equity value is generally determined by two factors; the total size of
capitalised earnings and how these are to be split among the four claimants to the firm. Initially
share holders therefore want to minimise the stakes to taxes and default costs as well as maintaining
the current (optimal) growth rate of earnings. What we look for in this section is whether it is
possible to come closer to this hypothetical point by modifying the design of the debt contract. In
other words we look further into the covenants of the debt contract.
8.1
Covenants in general
First, we briefly argue why share holders will actually allow for improved protection of debt holders
as well as defining different types of covenants. Second, we examine the role of covenants when
share holders cannot expropriate debt holders ex post (i.e. staying within the simple trade-off).
Finally, it seems useful to ease this assumption and allow directly for asset substitution and the
potential role of covenants (i.e. the extended trade-off).
8.1.1
Will owners allow better protection?
One may wonder why share holders should voluntarily offer debt holders better protection or
flexibility than what is required by law. The main trigger is that a rational expectations model
implies that initial debt prices perfectly reflect the true value of their investment. Share holders
can thus obtain better initial debt prices by improving protection and general conditions for debt
holders. If debt holders value such covenants more than it costs share holders to provide it, then
firm value is increased. This is basically the balancing act that determines the profitability of a
potential covenant. Of course the underlying assumption here is that the initial debt inflow is
being paid out immediately as dividends1 .
1 Note, however, that most of the structural models are not completely clear with regards to how the funds infused
by debt holders are actually distributed.
75
CHAPTER 8. ROLE OF COVENANTS
8.1.2
76
Covenants
A covenant basically refers to the construction of a contract, where one can think of countless
potential variations. Generally, covenants can be either affirmative or negative (Smith, 1993). The
former refers to the firm maintaining a specified level of accounting-based ratios, whereas the latter
directly puts a limit on certain actions within the firm. We shall focus on negative covenants, where
four convenient distinctions can be made (Smith and Warner, 1979).
First, investment covenants can serve to limit the variety of new projects management are
allowed to take on. This naturally relates to asset substitution in our framework. Moreover, one
may also want to regulate the scope of potential downsizing by selling off the assets in place. In
the framework considered so far there is actually an implicit covenant that blocks selling off assets
to meet coupon payments2 .
Second, dividend covenants primarily relate to putting a limit on payouts to share holders. The
underlying motivation is probably debt holders fear of being left with an empty shell as pointed
out in Black (1976)3 . Thus there seems to be some overlap with the investment covenant of limited
downsizing. In our framework only residual earnings can (and must) be paid out to share holders.
Third, financing covenants can be in place to protect existing debt holders from new issues that
may dilute the value of the old debt. In restrictive circumstances this type of covenant can block
all future debt issues, which indirectly relates to the static setup in Leland (1994).
Fourth, bonding covenants relate to convertibility and callability of the debt contract. For the
models with upward restructurings a callability provision is in place, which secures that debt can
be redeemed. Furthermore, bonding covenants can include specifications of how the principal is to
be amortised through its life time (sinking fund provisions).
Finally, one may also include an indirect covenant that specifies how the firm should report to
the external environment. Such accounting covenants become relevant when information is imperfect. In the following chapter we shall deal with the dimension relating to bias of an accounting
signal.
Figure 8.1: Grouping of covenants and an example of a provision (own creation).

In order to avoid losing track of what is going on we must be able to model such covenants
within the framework in order to say something useful. Recall that at an overall level the reason
for using covenants is to get closer to the first-best state. We start out by exploring this when
share holders refrain from taking advantage of debt holders ex post.
2 Leland
(1994) states this explicitly in note 12.

debt issuance share holders could sell off all assets in place and make a huge dividend payout. No
EBIT-generating machine would then be in place to support future coupon payments making debt worthless.
3 After
8.2
77
Simple trade-off
One may think that covenants have no role when asset substitution or something similar is not an
issue. However, frictions are still present in the form of taxes and default costs, so covenants may
serve to minimise the sizes of these two factors. We first consider the standard case where true
earnings are perfectly observable for everyone and finish off by relaxing this assumption.
8.2.1
Symmetric information
Maximising tax benefits can be interpreted as paying coupons that equal earnings every period,
Ct = t . Absent fixed issuing costs one would then increase debt levels every time earnings
increased marginally, which resembles continuous restructurings. However, to keep the structural
models tractable all existing debt is called before new portions are issued, which is an indirect way
of introducing a fixed cost. Staying loyal to this approach the analytical way to solve for the optimal
restructuring policy involves invoking the smooth-pasting condition for the upper boundary.

E()
=0
=u
(8.1)
Doing this one arrives at the point of earnings where net gains from increasing debt have just
become positive. With regards to covenants share holders should thus be fully allowed to issue
new debt every time the earnings increase enough to make this profitable. Financing covenants
that restrict new issues should thus be discouraged.
One could then look into how expected bankruptcy costs can be minimised for any given debt
level. The easy answer is that default should never be called as this involves a sunk cost. However,
share holders only focus on future expected dividends and when these are negative it is rational
for them to cease coupon payments. In other words the problem basically comes down to share
holders self-maximising behaviour. This relates to the smooth-pasting condition invoked by the
initial owners being too high compared to the socially optimal one.

E()
=d
>

[E() + D()]

(8.2)
=d
One way to circumvent costly default is renegotiation of debt, which in some way could relate
to debt holders bribing equity holders to stay on board. Including renegotiation of debt in a
covenant thus appears rational, but one should contemplate the adverse behaviour of share holders
this can result in.
An alternative way of getting around this tricky issue could involve allowing debt holders to
convert their claim to equity when the lower boundary is hit. If they are being given a larger share
than (1 ) Ad0 then this is preferable. The new all-equity firm would then maximise firm value
by issuing a new smaller portion of debt, where the proceeds would be split among all the new
share holders. Of course this can be seen as indirect renegotiation, but with respect to covenants
it may seem more realistic with such a convertible feature than stating the renegotiation option
explicitly.
78
To keep the discussion within the framework one can thus argue that the lower smooth-pasting
condition should be fixed to a lower level ex ante in order to minimise expected default costs.
This would benefit share holders through a more valuable initial debt issue, which can be paid
out immediately. On the other hand share holders should be given full flexibility of the upper
smooth-pasting level in order to exploit the tax shield when earnings increase. Note that better
protection of debt holders is not by any means welfare maximising per se as the popular press
postulates now and then. For example a protective covenant specifying a higher default level than
the endogenously determined one, would result in larger expected bankruptcy costs and thus an
aggregate loss to debt and equity ex ante (Leland, 1994).
8.2.2
Asymmetric information
When only share holders are fully aware of the true value of the firm, debt holders require a
premium even though no asset substitution takes place. This is due to their limited upside, which
can be interpreted as risk aversion. Initial debt issues thus have a lower value, which harms the
share holders. Duffie and Lando (2001) find that the risk premium is decreasing in the precision
of the accounting report. Improving accounting precision therefore becomes a trade-off between
obtaining better prices of debt and the costs of working out these reports.
In that connection it seems appropriate to consider how the maturity dimension influences this
matter. When debt is just about to expire, accounting precision plays a crucial role in lowering the
credit spread, but for long maturities the effect of superior accounting information goes towards
zero4 . With regards to covenants one could therefore argue that it would be in the share holders
interest to specify a high level of accounting transparency in the contract if debt has a finite
maturity date. On the other hand one can ignore such issues if debt is perpetual.
Finally, one may consider potential bias of the accounting reports. Duffie and Lando (2001)
do not touch upon this issue since it is a common assumption in the literature that signals can
be transformed to being unbiased. In that case bias becomes irrelevant. We shall come back to
the realism of this assumption in the final section of this assignment. We now study the role of
covenants when share holders are tempted to substitute the assets after debt is in place.
8.3
Asset substitution
Rational debt holders anticipate share holders adverse behaviour and thus demand a discount
on their initial investment in the firm. Share holders are therefore punished by their potential
opportunistic actions through a higher implicit interest rate. As a result they want to design a
guarantee that assures debt holders that asset substitution will not take place by any means. The
obvious answer would probably be to construct a bulletproof contract, which explicitly specifies
that only positive net present value investments can be undertaken. However, such investment
covenants are presumably extremely costly to design and monitor. Instead one would like to look
for an indirect way to align the interests of debt and equity. In other words we want to design a
4 Fig.
8 in Duffie and Lando (2001).
79
covenant, which makes it optimal for share holders to behave in the interests of debt holders ex
post. As stated earlier the main reason for asset substitution is the call option nature of equity. If
one can circumvent this feature then asset substitution may be overcome.
E()
<0
(8.3)
The critical question, however, is how this can come about in the present framework. Three
different propositions may provide an explanation; a net worth covenant, short term debt and
renegotiation options.
8.3.1
Net worth covenant
Even though share holders do not have any liability when the firm defaults, they obviously prefer
that it stays solvent. When deciding to increase the risk of the firm they therefore take into account
the negative effects of default becoming more pronounced. A way to align the interests of the two
claimants could then be to make this downside even greater. A possible solution could entail that
share holders commit to leave the firm at a higher earnings level than what the smooth-pasting
originally condition dictated.
(d0 )
E()

<0
(8.4)
In that way the drawback of substituting the assets become more pronounced and can actually
remove the adverse incentive completely (Leland, 1994). Another interpretation is that the share
holders are forced to leave the firm when equity is still in the money. In other words the higher
default level can be seen as a net-worth covenant. One naturally has to balance these lower agency
costs against the suboptimal leverage resulting from a higher default level.
8.3.2
Short term debt
It has long been believed that shorter maturities of debt may help to reduce share holders incentive
to increase risk5 . The intuition is that the prospect of being obliged to pay the principal within
a brief time interval makes the share holder conservative. The trigger is that in case earnings fall
considerably there is little time to get back on foot.
E()

>0
(8.5)
Leland and Toft (1996) show numerically that for debt with 6 months maturity it is only when
bankruptcy is just around the corner that share holders want to increase risk. However, when
maturity is increased share holders are not that disciplined and want to incraese risk for a wider
range of earnings interval. Recall that long term debt exploits the tax shield most efficiently,
so one should only decrease maturity in case agency issues are severe. A debt contract always
5 Table 1 in Merton (1974) has this interpretation. Informally, the debt overhang issue in Myers (1977) has a
somewhat similar interpretation.
80
entails standard specifications on coupon rate, maturity and so on. Switching to shorter maturity
is therefore not an explicit protective covenant but more a choice of debt variety.
8.3.3
Renegotiation
Finally, one may change the focus slightly and consider the possibility of renegotiations of debt as
a measure to minimise agency costs (Flor, 2006). Recall that altering the real investments resulted
in lower earnings growth. Consequently, share holders only favoured substituting the assets when
volatility could be increased sufficiently. One could then extend the prior analysis to allow asset
substitution to be used as a threat directly in the negotiation process. The new detail is that
in case the negotiations break down the debt holders face a firm with higher volatility and not
liquidation as before.
G = Ad0 (DS + ES )
(8.6)
Negotiations are in the common interests of both claim holders since asset substitution is value
decreasing at an aggregate level. As a result minimising agency costs through negotiations entail
that the tax shield is exploited more efficiently and thus more debt is taken on ex ante. However,
there seem to be a somewhat circularity arising in this connection. As more debt is in place
share holders incentive to gamble with the firm increases again. Rational debt holders anticipate
this and the net effect on ex ante agency costs is thus ambiguous. This is a rather unexpected
conclusion.
More specifically, it must be the case that negotiations create an adverse (favourable) effect
when potential volatility increases are small (large). With respect to covenants one can therefore
argue that renegotiations should be promoted (discouraged) when modifying real investments results in large (small) increases in volatility. As touched upon earlier a way to come around this
would be to make debt convertible at the lower boundary if renegotiations should be enforced.
Obviously one could also just use bank debt, which promotes negotiations as pointed out by Flor
(2006) as well as Hackbarth et al. (2007).
8.3.4
Summing up
The starting point in this section was that covenants might serve to increase firm value. More
specifically we wanted to include provisions in the debt contract that would enhance tax benefits
and help avoiding costly default. The former is partly achieved by giving the owners full flexibility
with respect to new issues (limited financing covenants). Risk of default can be reduced by making
debt convertible at the lower boundary in order to promote negotiations.
In case owners are believed to increase firm risk ex post, it is in the mutual benefits of the
claimants to come up with credible safeguards against such adverse behaviour. Perfect investment
covenants are unattainable, so share holders incentives have to be indirectly aligned with debt
holders. Provisions such as net worth covenants, short term debt and renegotiation options can
be useful in that matter. Nevertheless, one always has to bear in mind that for a covenant to
81
be welfare increasing, debt holders must attach more value to it than the costs faced by share
holders. We now finish off this assignment by leaving the structural framework in order to study
the possible effect from accounting bias on the efficiency of debt covenants.
Chapter 9
Imperfect information and

accounting
Throughout the entire assignment it has been assumed that the state variable was perfectly observable1 . This simplifies the analysis considerably allowing the authors to focus on other interesting
issues. However, it seems interesting to ease this rather strict assumption to finalise the analysis.
Doing that we cannot stay within the structural framework, so this chapter mainly serves as a
more informal perspective of the discussion.
Since claimants to the firms still need to know the state of their investment they now use
accounting reports to form their beliefs. In connection with accounting reports there seem to be
two major issues to study, namely precision and bias. Feltham, Robb and Zhang (2007) examine
the influence from leverage on accounting precision. Gigler, Kanodia, Sapra and Venugopalan
(2009) explore how accounting bias influences efficiency of covenants. Due to finite space limits we
only study the latter area to finish off the assignment.
We first develop a way to link accounting bias and information content of a specific accounting
signal. Then we briefly set up a model where share holders do not act in a welfare maximising way,
which motivates the construction of a covenant. We finish off by showing that accounting bias has
real implications for the efficiency of this covenant.
9.1
Conservative accounting regime
Conservatism in accounting can be defined as the differential verifiability required for recognition
of profits and losses (Watts, 2001). In other words the well-known feature that the firm must
recognise future expenditures more aggressively than future revenues. The immediate effect is
that the accounting numbers of a firm become a downward estimate of true future profits, all else
equal. An implication hereof is that substantial market-to-book values often prevail. Many interesting issues arise in connection with accounting conservatism, but we shall refrain from spending
1 Duffie and Lando (2001) only assume asymmetric information, so share holders are still aware of the true value
of the underlying variable.
82
CHAPTER 9. IMPERFECT INFORMATION AND ACCOUNTING
83
time on general discussions of this matter. What seems more interesting, though, is how the
accounting conservatism can be modelled in a simple manner. Gigler et al. (2009) provide a statistical interpretation that proves useful when analysing the informativeness of different degrees of
conservatism.
9.1.1
Likelihood ratio
Following the line of reasoning in Watts (2001) one can interpret conservatism as a concept of
measurement. Ideally, one would probably like to formulate a model that quantifies the information
effects stemming from conservatism. However, this seems very complicated, so one may want to
adapt a more qualitative stance to highlight this matter.
Accounting reports often entail information about future cash flows, as there seem to be some
interconnection between periods. In other words, an encouraging half year statement is likely to
result in high total earnings for the entire year. More specifically, suppose that earnings for the
entire year can be either high, , or low, , and that a half year statement exists, y (0, y)2 .
What we have claimed here is simply that in case a good report shows up then this signal is
more likely to have been drawn from high earnings. As the report is not perfect, one has to make
a conditional guess on the signal stemming from high or low future earnings, (y | ). In order to
have some kind of measurement of the informativeness of the signal one can use a likelihood ratio3 .
LR =
(y | )
(y | )
(9.1)
If a signal is able to revise the probabilities to a large extent then it is very informative. On the
other hand a likelihood ratio around 1 corresponds to a more or less useless report. It is assumed
that the likelihood ratio is increasing in y and thus the monotone likelihood ratio property prevails.
9.1.2
Information content
An interesting next step could be to study how conservatism influences informativeness of the
accounting signal. A high (low) degree of conservative accounting is measured by a low (high) ,
which leads to a new conditional probability distribution, (y |, ). One can then evaluate the
likelihood ratio when changing the degree of conservatism.
Intuitively, it may be possible to say something useful by using the fact that conservatism can
be seen as a downward bias of the accounting reports. If a high signal (LR>1) is observed in
a very strict accounting regime, then it is very likely to have been drawn from the distribution
of high earnings. Oppositely, low signals (LR<1) occur frequently when accounting is downward
biased, so they can stem from either distribution. In other words high signals entail a high degree
of information whereas low signals are more dubious when the accounting regime is conservative4 .
2 We change the setup in Gigler et al. (2009) slightly to enhance the economic intuition as well as the notation
used so forth. This setup can naturally be extended to continuous time, which is demonstrated in the article.
3 Lecture notes: Accounting for Decision and Control, Peter Ove Christensen, 2008, Aarhus University, Denmark.
4 The authors use an example of a lecturer grading exam papers. A conservative regime relates to very few papers
getting a good grade. One can then be pretty sure that students receiving high grades are indeed top students.
However a low grade does not necessarily imply that the student is a low performer. A high (low) grade is thus
highly (slightly) informative.
84
In terms of the likelihood ratio the numerator increases globally and the denominator decreases
globally. As a result the LR is increasing in conservatism (i.e. decreasing in ),
LR
< 0. One can
also interpret this as a leftward shift of the individual conditional probabilities when conservatism
increases. Increasing conservatism thus results in decreased (increased) information content of low
(high) signals now.
Figure 9.1: A higher degree of conservatism implies that the LR shifts outwards (own creation inspired by Gigler et al., 2009).
This is a rather striking conclusion as accounting bias then has real implications for the information content of the accounting reports. Normally in the literature one assumes that potential
bias can always be eliminated through transformations (e.g. Feltham et al., 2007). For the result
in this section to hold, one has therefore implicitly assumed that no such transformation function
exists. Whether this is too strong an assumption is hard to call. However, the mere complexity
of constructing a financial report may oppose the notion that one can just take the inverse to the
conservative auditing technique and get an unbiased result! Nevertheless, we shall stay loyal to
the result just found and proceed to investigating how the efficiency of debt covenants may be
influenced.
9.2
Efficiency of debt contracts
Above it was shown that altering the degree of bias has real implications for the information content
of an accounting report. We now try to use this knowledge in discussing how the efficiency of a
detb covenant may be influenced by this result. To keep things straight we first set up a simple
model. Then the agency problem is underlined, which leads to stating a socially optimal covenant.
9.2.1
Model
We leave the structural framework for a moment and set up a much simpler model in order to
keep focused on the accounting dimension. Debt is no longer motivated by tax benefits but rather
the need of outside funding to finance a favourable project. The cost of the project is K, which
at time 2 yields a payoff, (, ), with probabilities, (pL , pH )5 . However, after the first period
5 The
authors use a continuous model but simplifying to a binary case loses no details.
85
share holders have the right to liquidate the project, which generates a fixed payment, M , where
< M < . This decision is based on the accounting report mentioned above, y.
Figure 9.2: Timing of the model. The key point is the stop decision after receiving accounting
report at time 1 (own creation).
As liquidation value cannot cover the principal of the debt, share holders gain nothing in that
case. It is therefore pretty clear that a potential conflict exists between the two claimants due to
their asymmetric payoffs.
E() > K(1 + R) > M
(9.2)
Share holders always want to continue the project, but debt holders find it optimal to liquidate
for low accounting reports. This relates to share holders having a smooth-pasting condition at 0 (or
), which would also be the case in the structural framework with no coupons. Recall that we
are interested in maximising firm value ex ante, so there seems to be room for including a covenant
before the game begins. In other words one could look for the socially optimal smooth-pasting
condition.
9.2.2
Optimal covenant
Suppose the claim holders agree to writing a covenant based on the observed accounting report,
y. This signal gives an indication of the earnings that will be realised in case the project is not
terminated. Intuitively, one should therefore only continue in case the future prospects are superior
to the fixed liquidation value, E( |y ) > M 6 . It must therefore be possible to find the accounting
report where one should be indifferent between liquidating and continuation.
E( | y) = M
y = yc
(9.3)
Designing a covenant that hands over control rights to debt holders when the accounting report
is below y c maximises joint welfare7 . Nevertheless, this does not by any means imply that the
project is always optimally terminated. As the signal is imperfect a false alarm entails that a
favourable project is terminated (y < y c > M ), which can be referred to as a Type I error. On
the other hand, missing alarms result in unfavourable projects being continued (y > y c < M ),
which can be referred to as Type II errors. The sum of Type I+II costs can be used as a form of
efficiency metric for the covenant.
6 One
can assume that all values stated are present values so discounting can be ignored explicitly.
can be shown that debt holders have a higher smooth-pasting condition than the socially optimal one, so
they will terminate the project once given control at a signal y c .
7 It
86
One could finish off by wondering how such a covenant could actually be put in place. As there
are gains from trade one can argue that from a modified Coase-point-of-view the two parties will
always come together no matter where the initial control right lies8 . One may rush to concluding
that accounting bias cannot influence the efficiency of debt contracts since the two claimants would
just change the optimal covenant level as a function of bias. We shall now analyse whether this
seems realistic.
9.3
Accounting bias and covenants
Normally one would believe that a change in conservatism could be perfectly offset by a switch
in the optimal covenant level leaving efficiency unaltered. For example, increasing conservatism
results in more low signals but fewer high signals for a constant covenant level, y c . False alarms
thus become more frequent (Type II errors) but risk of leaving a favourable project becomes less
severe (Type I errors). The natural action would be to lower the covenant in order to to minimise
the sum of the two error types, y c / > 0. Whether this operation can completely restore the
risk of making Type I+II errors may however not be that obvious.
9.3.1
Efficiency
Recall that changing the accounting regime has real implications for the information content of all
signals (shift in LR). More specifically, conservatism provides more information for high signals (LR
increases) at the cost of unreliable low signals (LR decreases). Even though the optimal covenant is
adjusted to a new optimal level it cannot in general make up for change in information content9 . As
a result the risk of false alarms (undue optimism) increases (decreases) when accounting becomes
more conservative even though the optimal covenant is altered.
(T ype I errors)
<0
(T ype II errors)
>0
(9.4)
However, this feature does not directly say anything about the effect on social efficiency. In order
to do that we have to investigate which error type is most costly to endure. In case false alarms
entail smaller (larger) opportunity costs than continuing an unfavourable project then accounting
conservatism (liberalism) is favoured. In other words we want to investigate the relation between
total costs from suboptimal decisions and accounting regime, (C1 + C2 )/ 0.
In case of a false alarm high earnings are missed out, which must yield an opportunity loss of
( M ). On the other hand unjustified optimism results in lower earnings than what could have
been gained by leaving the project, (M ). For this specific model we have that initially the
project has a higher expected value than the liquidation gain, E() > M . As a result opportunity
costs from false alarms are more severe than undue optimism10 .
8 Of course this hinges on the absence of transaction costs. Property rights are probably clearly defined since
share holders are the ones in charge of the firm.
9 The authors show this by minimising the sum of opportunity costs subject to a optimising the covenant. Using
the Envelope Theorem and the fact that the conditional probability is strictly increasing in accounting liberalism
are the underlying conditions.
10 From 9.2 follows that p + p > M p ( M ) > p ( M )
H
L
H
L
pH ( M ) > pL (M )
pH + pL = 1
87
(9.5)
This is a key result in determining whether accounting conservatism is favourable or not. What
expression (9.5) states is that minimising false alarms is more important than avoiding undue
optimism11 . As conservative accounting switches the types of errors made towards false alarms, a
liberal accounting regime is preferred when the project has a positive net present value.
(C1 + C2 )
<0
9.4
(9.6)
Conclusion
The intuition is that changes in the accounting regime affect the likelihood ratio for all signals.
Altering the covenant level is therefore not able to completely restore the informativeness of the
individual signals. On average the firm is better off by continuing the project than liquidating, so
one has to be pretty sure about abandoning the investment. In other words credible signals at the
lower end are thus paramount in our pursuit of maximising total welfare, which promotes a more
liberal accounting.
Two critical features form the basis for this conclusion. First, no backward transformation of
the accounting regime must be possible. In other words the auditing process has to be sufficiently
complex leaving outsiders no chance of deducting the related unbiased accounting signal. Absent
this feature informativeness of each signal would not be a function of the accounting regime.
Second, on average the project entails higher value when continued than liquidated, E() > M .
This seems very well when management behaves in the overall interest of the firm. However, as
touched upon earlier share holders may have incentive to increase the risk unnecessarily. This could
relate to choosing a project with a higher but very low probability, pH , resulting in E() < M .
In that case the model predicts that undue optimism is most costly, which promotes a conservative
accounting regime.
Nevertheless, if one believes that the bias cannot be removed by a simple transformation the
accounting regime has real implications for the efficiency of a debt contract no matter the expected
value of the project, E () M .
9.4.1
Relation to old framework
In the structural framework the share holders basically had two degrees of freedom, namely when
to leave the firm and amount of debt. In the present setup the simple trade-off of using debt is
completely ignored and the debt decision is thus not treated explicitly. On the other hand the
decision of when to leave the firm is the main driver in the accounting model. A potential link
11 Strictly speaking one should also examine the expected opportunity costs as a function of the accounting signal.
The authors do this and implicitly show that the striking point is the one discussed above.
88
therefore prevails to the structural framework. However, a difference is that share holders in the
structural models must pay coupons to keep the firm afloat and thus do not stay on board at any
price (d0 > 0). One may then wonder how the insight just gained can be modelled within the
structural framework, which must relate to relaxing the assumption of perfect information.
Suppose an accounting report was to be received between coupon payments. Moreover, in
connection with this report outside investors might propose some well-known liquidation value.
At the risk of blabbering, including such features in a structural model could in a very informal
way resemble the situation in Gigler et al (2009). Share holders would always wait till the next
coupon date before deciding to liquidate. Debt holders, however, might be better off by liquidating
immediately if the prospects were particularly dull.
In general, liberal accounting would probably be preferred for the static trade-off models of
Goldstein et al. (2001) and Christensen et al. (2002) since only favourable projects are in place
here. On the other hand Leland (1998) and Flor (2006) anticipate welfare decreasing behaviour
from share holders, which would probably promote a more conservative accounting regime. Of
course numerous critical dissimilarities exist, so this is just a naive attempt of linking the conclusion
just found to the structural models considered in this assignment. This forms the end of our journey
and we briefly recapitulate on our main findings.
Chapter 10
Conclusion
The main objective of this assignment was to investigate how the choice of capital structure can
be modelled in a coherent manner. This seems relevant since the classic corporate finance texts
are very contingent specific and thus difficult to align to one another. Contingent claims analysis
proves a very useful tool in that connection since debt and equity are claims on future earnings of
the firm and thus resemble financial options in some way (Merton, 1974).
For the capital structure to have any relevance it must be able to affect the value of debt and
equity. We have argued that this can happen in two distinct ways. Future pre-tax earnings can
be argued to be a fixed size and the choice of debt then only plays a role in minimising taxes and
default costs. On the other hand one can argue that the investment portfolio is a function of the
capital structure, which results in future earnings being determined endogenously in the model.
Within the simple trade-off setup we spent considerable time analysing the degree of flexibility
at the two boundaries. Future options to increase debt levels imply that initial coupon payments
dropped (Goldstein et al., 2001). The intuition is that the firm does not have to gamble on
future earnings growth and thereby suffer unnecessary bankruptcy risk. At the lower boundary
claim holders may come together and restructure the firm rather than declaring costly default
(Christensen et al., 2002). Although breaking the absolute priority rule this is Pareto-efficient since
the main objective is to minimise the stakes to bankruptcy costs. Overall, increased flexibility at
the two boundaries results in a larger share of future earnings going to debt and equity. With
respect to covenants one should therefore aim at making upward restructurings likely by adding a
callable provision. Moreover, negotiations at the lower boundary can be promoted by using bank
debt or adding a convertibility provision.
We then carried on to allow for potential adverse behaviour from share holders. This extended
trade-off implies that future earnings are determined within the model, so the total pie to be
shared may no longer be a fixed size. In case volatility can be increased via financial engineering
one can argue that asset substitution does not decrease the growth rate of earnings (Leland, 1998).
However, if altering the actual investment portfolio is the only way to increase riskiness, then net
present value of the firm decreases (Flor, 2006). Rational debt holders require a discount when
share holders act selfishly ex post, so there may be room for increasing firm value by aligning
89
CHAPTER 10. CONCLUSION
90
their interests. This basically comes about if equity is decreasing in volatility of the underlying
asset. Net-worth covenants, short term debt and negotiation at the lower boundary may all serve
to promote this objective. Nevertheless, one always has to balance the reduced agency problems
against the lost tax benefits from introducing such covenants.
Leaving the structural models we finally studied the relevance of accounting bias. If bias cannot
be removed by a simple transformation it actually has real implications for the informativeness
of a given signal (Gigler et al., 2009). The favoured accounting regime thus becomes a matter of
which error type is most costly to make. In case share holders do not take on unfavourable projects
a liberal accounting is beneficial. On the other hand the usual conservative approach is probably
welfare increasing in case asset substitution is pronounced.
Summarising, we have demonstrated that contingent claims analysis is a very useful tool in
modelling the optimal capital structure. Minimising future earnings stakes belonging to taxes and
default costs are the main objective and covenants play an essential role in this connection.
Linking the structural framework with information issues concerning the underlying variable
seems to be rather unexplored within the literature and thus proves a very interesting future
research field.
Appendix A
Static debt choice

A.1
We first find the derivative of equity value with respect to the state variable and afterwards
evaluate this expression at the lower boundary, = . In other words we invoke the smoothpasting condition.
Rewriting equation (4.6) simplifies the differentiation.
C
pB
(1 te )(1 pB )
r
r
r

C
C
= (1 te )
pB (1 te )
r
r
r
r

x

C
= (1 te )
(1 te )
r
r
r
r

E()
(1 te )
(A.1)
Taking the first derivative we find the increase in equity value from a marginal change in
earnings.
E()
1
= (1 te )
+ x x1 x (1 te )
r
r
Setting the first order equal to zero and evaluating for = we find the following.

E()

=
=

1
C
+ x x1 x (1 te )
=0
r
r
r

1
C
(1 te )
+ x(1 te )
=0
r
r
r
(1 te )
One can now isolate for the capitalised default level, which must be the firm value, V B , at the
lower boundary in Leland (1994).
91
APPENDIX A. STATIC DEBT CHOICE
1
(1 te )
+ x(1 te )
r
A.2
92
r
r
x C
C
=
1+x r
r
(A.2)
Closed forms
Once the optimal default level has been found we can use this knowledge to reduce the number of
variables in the expressions for debt, equity and firm value. This becomes useful when the optimal
debt value is derived.
A.2.1
State price
Knowing the optimal default level in Section A.1we can start out by substituting that into the
expression for the state price.
x
x x
x

x
C
C
C
x
=
=a
=
(r )
pB () =
r
(r )
r
r
A.2.2
(A.3)
Debt value
Rewriting the original expression for debt value and plugging in for the modified state price found
in (A.3) and the optimal default level in Section A.1 a simplified expression follows.
C
(1 ti )(1 pB ) + (1 te )(1 )pB
r
r

C
C
= (1 ti ) pB (1 ti ) (1 te )(1 )
r
r
r
x+1
C
C
= (1 ti ) a
[(1 ti ) (1 te )(1 )]
r
r
D ()
A.2.3
(A.4)
Equity value
Using the simplified expression for equity in (A.1) and plugging in for the optimal default level the
following yields.
x

C
(1 te )
r
r

x

C
C
C
C
= (1 te )
a
(1 te )
r
r
r
r
r

x+1
C
C
= (1 te )
a
(1 te ) ( 1)
r
r
r

E ()
(1 te )
r
r
(A.5)
A.2.4
93
Firm value
The sum of debt and equity give an expression for firm value, where one only has to adjust for
issuing costs of debt.
C
E () + D () = (1 te )
+ (te ti ) a
r
r
A.2.5
C
r
x+1
[(te ti ) + (1 te )]
(A.6)
Summary
x+1
C
C
[(1 ti ) (1 te )(1 )]
a
r
r

x+1
C
C
E() = (1 te )
(1 te ) ( 1)
a
r
r
r
x+1
C
C
E () + D () = (1 te )
[(te ti ) + (1 te )]
+ (te ti ) a
r
r
r
D ()
A.3
(1 ti )
Optimal coupon level
Finding the optimal debt level we have to take into account that the owners incur some sunk costs
in connection with issuing debt. In particular we assume that these costs are proportional to the
amount of debt issued (i.e. with factor q). Ex ante the owners must therefore focus on maximising
net firm value when deciding on the amount of debt.
max
C
{E () + D () qD ()}
Evaluating the derivatives of the firm value and issue costs separately may simplify the analysis.
FOC for joint value of debt and equity is given as
(E + D)
te ti
=
(x + 1)a
C
r
C
r
x
r1 [(te ti ) (1 te )]
and FOC for issuing costs are given as

x

(qD)
C
1
= q 1 ti (x + 1)a
r [(1 ti ) (1 te )(1 )]
C
r
Subtracting the issue cost part from firm value and setting equal to 0 yields the following
(E + D) (qD)
C
C
Plugging in for the relevant expressions we find.

x1
r
1
(1 ti )(1 q) (1 te )
C () =
r x + 1 (1 ti )(1 q) (1 te ) + (1 te ) (1 (1 q) (1 ))
?
94
We have a particular interest in determining when debt will be taken on and reducing the above
expression may help clarifying this issue.

x1
r
1
A
C () =
r x+1A+B
where
A.4
(1 ti )(1 q) (1 te )
(1 ti )(1 q) (1 te ) + (1 te ) (1 (1 q) (1 ))
Equilibrium values
Having found the optimal default and debt level we a now able to derive a closed form expression
for debt, equity and the firm value. The advantage is that explicit debt and equity values can be
found for some specific parameter values as the solution now only depends on exogenous variables.
We rewrite the optimal coupon payment and the extended state price for later use.

x1
1
A
C?
=
r
r x+1A+B
and

a
C?
r
x+1
A.4.1
x
1
x+1
rx+1 (x+1) r(x+1)
1
A
1+xA+B
1
A
1+xA+B
1+x
x
1+x
x
Debt value
Plugging in for the optimal coupons and default level in (A.4) one finds the following.
1
D(, , C ) =
r
?
A.4.2
1
A
(1 ti )
1+xA+B
x1
1 )
1
A
[(1 ti ) (1 te )(1 )]
1+xA+B
(A.7)

Equity value
Following the same procedure for equity we find.
1
E(, , C ) = (1 te )
r
?
1
A
1+xA+B
x1
A
1
+ (1 )
1+xA+B
1 )
(A.8)
A.4.3
95
Firm value
Joint value of debt and equity less issuing costs must then make out the firm value in equilibrium.
[E ? + (1 q)D? ]
(
"

x1 #
1
1
A
=
(te ti )
r
1+xA+B

)
1
A
[(te ti ) + (1 te )]
1+xA+B
(A.9)
Appendix B
Dynamic restructurings
B.1
State prices
Two boundaries now exist so one has to evaluate each individual claim at these specific points.
The upper state price pays off $1 in case the restructuring level is hit and zero when bankruptcy is
called. Using that info in equation (3.5) with the fact that no dividend is paid, such a claim must
be worth.
pU () =
x y
y x
+
(B.1)
where
= y
(B.2)
One would perhaps be tempted to rush to concluding that the state price for the lower boundary
is left unchanged compared to the static framework. In that connection one should note that we
are valuing a claim that pays $1 in case default is hit before any other boundary (i.e. the upper
level). So we are not valuing a claim that pays $1 whenever the firm goes bust, but rather a claim
that pays $1 in case default happens before the next restructuring. This is consistent with the
whole idea of splitting the value of the firm into the three mutually exclusive parts in expression
(5.1). It must therefore be the case that the original state price for the lower boundary is no longer
valid and the following must hold instead.
pB () =
x y
y x
(B.3)
Just like in the static case a state price can be seen as a probability measure. For example if
the lower state price is close to 1 then the value of receiving $1 in case default happens before the
next restructuring is relatively high. In other words default is likely to happen in the future. It is
this probability property that is useful when writing up the value of the claims.
96
APPENDIX B. DYNAMIC RESTRUCTURINGS
B.2
97
Scaling of state prices
The state prices are a function of endogenous variables (earnings, default and restructuring level)
and some exogenous parameters (volatility, risk free interest rate and growth rate). We must show
that these are constant at every restructuring level. Goldstein et al. (2001) simply state that this
follows from the definitions of the state prices. The state prices for the initial earnings level are
given as the following.
pU (0 ) =
x
0y
0
0
y
0x
0
(B.4)
and
x
pB (0 ) =
0 0y
x
+ 0 0
0
0
(B.5)
Then an interesting issue would be whether the state prices may change when the state variable
hits some boundary condition. A natural starting point would be to compare the state prices for
the initial debt issuance case (relating to 0 ) and the first restructuring point, 1 = u0 . We only
do this for the upper state price but the lower state price can be analysed in the very same way.
Due to the scaling feature of the default and restructuring level the upper state price at the first
restructuring can be expressed as follows.
pU (1 )
= pU (u0 )

x

y
y
x
u 0
(u0 )
u 0
(u0 )
=
+
1
1
x y
y x
0
0
= uxy 0
+ uxy 0
1
1
(B.6)
(B.7)
(B.8)
where the denominator must be given as the following
u 0
y
u 0
x

x
y
u 0
u 0
(B.9)
= uyx y
0 uyx x
0
0
0
(B.10)
= uyx 0
(B.11)
Substituting for this denominator in (B.6) yields the following
pU (1 ) = uyx
x
0y
0
uyx 0
+ uyx
y
0x
0
uyx 0
x
0y
0
y
0x
0
0
= pU (0 )
(B.12)
It shows that the upper state price at the first restructuring point is equal to the initial state
price as one would probably have expected. This easily extends to any two different periods and
also for the lower state price.
B.3
98
pU (t )
= pU (j )
t, j R
pB (t )
= pB (j )
t, j R
Debt value
We know that value of debt is simply given as the following due to callability. Note that the scaling
factor, u, does not enter the equation.
D0 ()
=
=
B.4
i
D0sol + D0def
1 h
=
(1 ti )v0int + (1 te )(1 )v0def
1 pU
1 pU

1
C
(1 ti ) (1 pB pU ) + (1 te )(1 )pB
1 pU
r
r
(B.13)
Restructuring costs
In order to find net firm value we just need to adjust for restructuring costs.
RC()
B.5
1
qD0
1 upU
q
1
1 upU 1 pU
1
q
1 upU 1 pU
i
(1 ti )v0int + (1 te )(1 )v0def

C
(B.14)
(1 ti ) (1 pB pU ) + (1 te )(1 )pB
r
r
We now want an expression for the unlevered firm. Normally we find this as the sum of after tax
value of debt and equity less restructuring costs. As we do not know equity yet, we use the sum
of cash flows to debt and equity instead.
Cash flows to equity
e0 ()
=
=
def

esol
1 te
0 + e0
=
v0sol v0int
1 upU
1 upU

1 te
C
0
(1 dpB upU ) (1 pB pU )
1 upU r
r
(B.15)
99
Cash flows to debt
d0 ()
i
h
sol
dsol
1
0 + d0
=
(1 ti )v0int + (1 te )(1 )v0def
1 upU
1 upU

1
C
(1 ti ) (1 pB pU ) + (1 te )(1 )pB
1 upU
r
r
=
=
(B.16)
Aggregate cash flows

Evaluating the aggregate value of cash flow claims to debt and equity is useful for later use. Adding
debt and equity the tax benefit springs in mind as well as the expected bankruptcy costs.
e0 () + d0 ()
h
i
1
(1 te )v0sol + (te ti )v0int + (1 te )(1 )v0def
1 upU
(
1
0
=
(1 te )
(1 dpB upU )
1 upU
r
)
C
+(te ti ) (1 pB pU ) + (1 te )(1 )pB
r
r
=
(B.17)
v0 ()
B.6
= e0 () + d0 () RC()
h
i
1
=
(1 te )v0sol + (te ti )v0int + (1 te )(1 )v0def
1 upU
h
i
q
1
(1 ti )v0int + (1 te )(1 )v0def
1 upU 1 pU
(

q
1
sol
(1 te )v0 + (te ti )
=
(1 ti ) v0int
1 upU
1 pU
)

q
def
(1 )v0
+ (1 te )
1 pU
(B.18)
Value of equity after debt is in place
Now we are able to find a more explicit expression for equity value after debt has been issued. The
starting point is equation (5.22), where the option-like feature gives a good intuition as discussed
in the main text.
E0 () = E0sol + pU (uv0 D0 )
In rewriting this expression the intuition becomes a bit blurred so our main focus is to arrive
at a compact term that is easy to work with later on. Plugging in for the expressions for debt and
equity cash flow claims found earlier, true value of equity can be stated as the following.
100

q
E0 () = e0 + d0 pU u(1 q)
1 pU
(
1
(1 te )(v0sol v0def )
=
1 upU
)
q
+ (1
+ (1 te )(1
1 pU
(

1 te
0
C
=
(1 dpB upU ) (1 pB pU )
1 upU
r
r

)
C
q
+ (1 ti ) (1 pB pU ) + (1 te )(1 )pB
pU u(1 q)
r
r
1 pU
h
B.7
)v0def
ti )v0int

pU u(1 q)
Smooth-pasting
The state prices are more complex than in the static case so the first derivatives are not as straightforward any longer. Invoking the smooth-pasting condition the first derivative with regards to
earnings is evaluated when these earnings equal the default level. For the upper state price this
must be given as the following.

pU ()
=
1 y x y1 x y x1
1 (y x) yx1
(y x)
yx1
x
y x
x y 1
>0
(y x)
We know that y<0 and x>0 and that the default level is lower than the restructuring level of
earnings. It must therefore be the case that the derivative is positive.
The lower state price only differs with regards to the numerator, which is now a function of the
upper boundary level. Following the same procedure as right above one can find that the lower
state price is negatively related to increases in earnings, as one would expect.

pB ()
=

x
y
1 y y1 + x x1
y
1
x
1
1 x x+1
1 y y+1
" xy
#1
"
(xy) #1
= x
y +
" xy
"
#1
(xy) #1
1
1
= x
1
y
1+
<0
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Dynamic Capital Structure Thesis

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Dynamic Capital Structure

Nicolaj Hamann Christensen (20040574)

March 12, 2010

2 Capital structure theory

Goal of the firm . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

The classic view

3 Pricing the effects

Sources to claim value . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

Pricing a corporate claim . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

Modelling the trade-off

4 Static debt choice

Distribution among claimants . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

Optimal default level . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

Optimal capital structure . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

Extending the model . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

Distributing restructuring value . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

Optimal capital structure . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

6 Downward restructurings and negotiation

Summary of trade-off models . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

Modifications within the simple trade-off . . . . . . . . . . . . . . . . . . . . . . . .

9 Imperfect information and accounting

Conservative accounting regime . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

Efficiency of debt contracts . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

Accounting bias and covenants . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

A Static debt choice

A.1 Optimal default level . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

A.2 Closed forms . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

A.3 Optimal coupon level . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

A.4 Equilibrium values . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

B.1 State prices . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

B.2 Scaling of state prices . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

B.3 Debt value . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

B.4 Restructuring costs . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

B.5 Unlevered firm value . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

B.6 Value of equity after debt is in place . . . . . . . . . . . . . . . . . . . . . . . . . .

B.7 Smooth-pasting . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 100

role to play in that connection?

Figure 1.1: General structure of assignment (own creation).

Capital structure theory

Goal of the firm

max = f (y1 (xj ) + y2 (xj ) + . . .)

CHAPTER 2. CAPITAL STRUCTURE THEORY

The classic view

Exogenous future earnings

CHAPTER 2. CAPITAL STRUCTURE THEORY

Endogenous future earnings

CHAPTER 2. CAPITAL STRUCTURE THEORY

Default costs + Asset sub.

CHAPTER 2. CAPITAL STRUCTURE THEORY

Information about firm value

Simple trade-off models

CHAPTER 2. CAPITAL STRUCTURE THEORY

Extended trade-off models

Pricing the effects

CHAPTER 3. PRICING THE EFFECTS

Relation to corporate claims

CHAPTER 3. PRICING THE EFFECTS

and its future path.

CHAPTER 3. PRICING THE EFFECTS

Drift of the state variable

the increments of the process, dWt , are independently distributed.

CHAPTER 3. PRICING THE EFFECTS

Is unlevered firm value a traded asset?

CHAPTER 3. PRICING THE EFFECTS