Fitting the glass slipper: optimal capital structure in the face of liability
AbstractThe model presented in this paper juxtaposes two theories for why a firm might offer creditors a security interest to back up a loan. One theory holds that issuing secured debt allows the firm's owners to reduce expected payments in the event of bankruptcy to so-called "non-adjusting" creditors, who cannot or do not adjust the size of their claims in response. An important class of such non-adjusting claims are liability claims on the firm. The other theory holds that issuing secured debt solves an underinvestment problem: the firm may only be able to finance a growth opportunity if it offers new investors a security interest. Recognizing that most real-world firms face both non-adjusting claims and growth opportunities, we combine the two theories in a single model. We find that firms generally choose an interior secured-debt ratio, and all firms smaller than a critical size choose a strictly higher secured-debt ratio than firms larger than the critical size. Moreover, the relationship between the optimal secured-debt ratio and firm size is highly nonlinear in ways consistent with the empirical evidence: the optimal ratio mayor may not initially increase in firm size, then tends to decrease, and then becomes constant.
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Bibliographic InfoPaper provided by Department of Agricultural & Resource Economics, UC Berkeley in its series Department of Agricultural & Resource Economics, UC Berkeley, Working Paper Series with number qt5nb497vk.
Date of creation: 01 Oct 2000
Date of revision:
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bankruptcy; businesses; credit; debt; mathematical models; Social and Behavioral Sciences;
Other versions of this item:
- Veld, Klaas T. van 't & Rausser, Gordon C. & Simon, Leo K, 2000. "Fitting the glass slipper: optimal capital structure in the face of liability," CUDARE Working Paper Series 917, University of California at Berkeley, Department of Agricultural and Resource Economics and Policy.
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- Alan Schwartz, 1997. "Priority Contracts and Priority in Bankruptcy," Yale School of Management Working Papers ysm72, Yale School of Management.
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- van 't Veld, Klaas, 2006. "Hazardous-industry restructuring to avoid liability for accidents," International Review of Law and Economics, Elsevier, vol. 26(3), pages 297-322, September.
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