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Fitting the glass slipper: optimal capital structure in the face of liability

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  • van 't Veld, Klaas T.
  • Rausser, Gordon C.
  • Simon, Leo K.

Abstract

The 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 Info

Paper 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.

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Date of creation: 01 Oct 2000
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Handle: RePEc:cdl:agrebk:qt5nb497vk

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Keywords: bankruptcy; businesses; credit; debt; mathematical models; Social and Behavioral Sciences;

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References

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  1. Stulz, ReneM. & Johnson, Herb, 1985. "An analysis of secured debt," Journal of Financial Economics, Elsevier, vol. 14(4), pages 501-521, December.
  2. Schwartz, Alan, 1989. "A Theory of Loan Priorities," The Journal of Legal Studies, University of Chicago Press, University of Chicago Press, vol. 18(2), pages 209-61, June.
  3. Myers, Stewart C., 1977. "Determinants of corporate borrowing," Journal of Financial Economics, Elsevier, vol. 5(2), pages 147-175, November.
  4. Triantis, George G, 1992. "Secured Debt under Conditions of Imperfect Information," The Journal of Legal Studies, University of Chicago Press, University of Chicago Press, vol. 21(1), pages 225-58, January.
  5. Alan Schwartz, 1997. "Priority Contracts and Priority in Bankruptcy," Yale School of Management Working Papers, Yale School of Management ysm72, Yale School of Management.
  6. Barclay, Michael J & Smith, Clifford W, Jr, 1995. " The Priority Structure of Corporate Liabilities," Journal of Finance, American Finance Association, vol. 50(3), pages 899-917, July.
  7. Hudson, John, 1995. "The case against secured lending," International Review of Law and Economics, Elsevier, vol. 15(1), pages 47-63, January.
  8. Berkovitch, Elazar & Kim, E Han, 1990. " Financial Contracting and Leverage Induced Over- and Under-Investment Incentives," Journal of Finance, American Finance Association, vol. 45(3), pages 765-94, July.
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Cited by:
  1. 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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