Ebook Capital Structure, Credit Risk, and Macroeconomic Conditions
Since Modigliani and Miller (1958), economists have devoted much effort to understanding firms’ financing policies. While most of the early literature analyzes financing decisions within qualitative models, recent research tries to provide quantitative guidance as well. However, despite the substantial development of this literature, little attention has been paid to the effects of macroeconomic conditions on credit risk and capital structure choices. This is relatively surprising since economic intuition suggests that the position of the economy in the business cycle phase should be an important determinant of default risk, and thus, of financing decisions. For example, we know that during recessions, consumers are likely to cut back on luxuries, and thus firms in the consumer durable goods sector should see their credit risk increase. Moreover, there is considerable evidence that macroeconomic conditions impact the probability of default (see Fama (1986) or Duffie and Singleton (2003, pp45-47)). Yet, existing models of firms’ financing policies typically ignore this dimension.
In this paper we contend that macroeconomic conditions should have a large impact not only on credit risk but also on firms’ leverage ratios. Indeed, if one determines optimal leverage by balancing the tax benefit of debt and bankruptcy costs, then both the benefit and the cost of debt should depend on macroeconomic conditions. The tax benefit of debt obviously depends on the level of cash flows, which in turn should depend on whether the economy is in an expansion or a contraction. In addition, expected bankruptcy costs depend on the probability of default and the loss given default, both of which should depend on the current state of the economy. As a result, variations in macroeconomic conditions should induce variations in optimal leverage.
The purpose of this paper is to provide a first step towards the understanding of the quantitative impact of macroeconomic conditions on credit risk and capital structure decisions. For doing so, we develop a contingent claims model in which the firm’s cash flows depend on both an idiosyncratic shock and an aggregate shock that reflects the state of the economy. The analysis is developed within a standard model of capital structure decisions in the spirit of Mello and Parsons (1992). Specifically, we consider a firm having exclusive access to a project that yields a stochastic stream of cash flows. The firm is levered because debt allows it to shield part of its income from taxation. However, leverage is limited because debt financing increases the likelihood of costly financial distress. Once debt has been issued, shareholders have the option to default on their obligations. Based on this endogenous modeling of default, the paper derives valuation formulas for coupon-bearing debt with arbitrary maturity, equity, and levered firm value. These closed-form expressions are then used to analyze credit risk and determine optimal leverage.
The analysis shows that, when the value of the aggregate shock shifts between different states (boom or recession), shareholders’ default policy is characterized by a different threshold for each state. Under this policy the state space can be partitioned into various domains including a continuation region where no default occurs. Outside of this region, default can occur either because cash flows reach the default threshold in a given state or because of a change in the state of the aggregate shock. In other words, aggregate shocks generate some time-series variation in the present value of future cash flows to current cash flows that may induce the firm to default following a change in macroeconomic conditions. The paper also demonstrates that while these two ways to trigger default have the same firm-level implications (they essentially result in an exit decision), they have different implications for industry dynamics. Notably, we show that variations in idiosyncratic shocks are unlikely to explain the clustering of exit decisions observed in many markets whereas changes in macroeconomic conditions provide the ground for such phenomena.
Following the analysis of the shareholders’ default policy, we examine the implications of the model for optimal leverage. The leverage ratios generated by the model are in line with those observed in practice. In addition, the model predicts that leverage is counter-cyclical, consistent with the evidence reported by Korajczyk and Levy (2003). We also examine dynamic capital structure choice and relate both the pace and the size of capital structure changes to macroeconomic conditions. Another quantity of interest for corporations is the credit spread on corporate debt (the excess over risk-free interest rates at which corporate debt is priced in public markets). We show that the model generates a term structure of credit spreads which is in line with empirically observed credit spreads on corporate debt. The model generates strictly positive credit spreads for short term debt issues, thereby solving one of the major shortcomings of traditional contingent claims models.
Download
PDF Ebook Capital Structure, Credit Risk, and Macroeconomic Conditions
Posted in :
