Abstract: In this paper, we demonstrate that demandable debt provides an effective solution to the leverage ratchet effect without requiring any additional information beyond that assumed in the existing literature. Demandable debt-holders have an option to request full repayment of debt at any time. If the firm’s leverage exceeds its target debt ratio, debt-holders will exercise their option and sell this excess debt back to the firm. This mechanism efficiently disciplines the firm to maintain the target debt ratio, except under extreme negative shocks leading to inevitable bankruptcy. Furthermore, we show that as the model’s time intervals shorten, the firm can asymptotically achieve the full tax shield benefits without incurring any bankruptcy risk.
Discussant: Hongda Zhong, University of Texas-Dallas
Abstract: This paper analyzes optimal leverage dynamics with personal and corporate taxes and financial distress costs. Key to the analysis, the marginal tax benefit of debt depends on whether the debt is used for financing real investment or financial restructuring. The theory features continuous leverage adjustments and no security issuance costs. There are two local leverage targets for firms with leverage above or below a threshold. The model generates a leverage distribution that matches the data, including many zero-leverage firms. Policymakers can reduce distress costs without losing tax revenue by raising the personal tax rate and lowering the corporate tax rate.
Walter N. Torous, Massachusetts Institute of Technology
Abstract: We investigate the dynamic game between equity and debt holders in a trade-off model with proportional debt issuance costs. Both with and without ex ante commitment there is an optimal capital structure and debt maturity. In equilibrium the firm only issues debt infrequently and in a lumpy fashion. Even without issuance costs, the firm retains positive tax benefits because creditors observe when the firm issues debt and therefore discipline equity holders not to deviate to more aggressive policies. High credit risk firms cannot always issue debt without commitment whereas low credit risk firms are practically indifferent between committing or not.
Discussant: Chao Ying, Chinese University of Hong Kong
Abstract: Secured lenders have recently demanded a new condition in distressed debt restructurings: competing secured lenders must lose priority. We model the implications of this "creditor-on-creditor violence'' trend. In our dynamic model, secured lenders enjoy higher priority in default. However, secured lenders take value-destroying actions to boost their own recovery: they sell assets inefficiently early. We show that this creates an ex-ante tradeoff between secured and unsecured debt that matches recent empirical evidence. Introducing the recent creditor-conflict trend in this model endogenously increases secured credit spreads. Importantly, it also increases ex-ante total surplus: restructurings endogenously introduce efficient state-contingent debt reduction.
