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CFGT-2: Capital Structure: Theory
Conflicting Priorities: A Theory of Covenants and Collateral
1Washington University in St Louis; 2HEC Paris; 3Columbia University, United States of America
Debt secured by collateral has absolute priority in the event of default—it is paid ahead of unsecured debt, even if unsecured debt is protected by negative pledge covenants prohibiting new secured debt. We develop a model of how this priority rule leads to conflicts among creditors, but can be optimal nonetheless: borrowers’ option to use collateral in violation of covenants allows for the dilution of existing debt, and hence prevents under-investment, whereas creditors’ option to accelerate debt following a covenant violation deters dilution, and hence prevents over-investment. The optimal investment policy is implementable via a mix of different types of debt, including secured and unsecured debt with tight and loose covenants. The model is consistent with a number of stylized facts about debt structure, covenants, and their violations.
Optimal leverage, transparency and the decision to go public
University of Rochester, United States of America
I introduce variable and heterogeneous degrees of informational asymmetries between a firm's insiders and its outside investors in an otherwise standard costly-state-verification model. I find that the optimal capital structure can be implemented by a simple mixture of debt and equity, and the optimal leverage ratio falls with a firm's profitability -- consistently with the evidence but unlike the prediction of existing theories. This framework yields a set of highly profitable zero-leverage firms, and can account for the low-leverage anomaly. When firms are allowed to increase their transparency by incurring an upfront cost, the model delivers a new theory about the decision to go public or stay private based purely on the optimal allocation of cash flow rights. Public firms have lower flotation cost, higher bankruptcy costs and lower transparency relative to private ones. Consistently with the empirical evidence, firms are more likely to go public when interest rates are low, when they need to raise larger external capital and when equity market analysts generate better information about firm performance.
Equity Issuance Methods and Dilution
London School of Economics and Political Science
We analyze rights offerings and public offerings in a setting where better informed current shareholders strategically choose to subscribe. When all current shareholders have wealth to participate, rights offerings achieve the full information outcome and dominate public offerings. When some current shareholders are wealth constrained, rights offerings lead to more dilution of their stakes and lower payoffs, despite the extra income from selling these rights. When firms can choose the floatation method, either all firms choose the same offer method or high and low quality firms opt for rights offerings while firms of intermediate quality select public offerings.
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