Ebook Debt Capacity of Tangible Assets: What is Collateralizable in the Debt Market?
Many corporate capital structure studies have documented a positive relationship between collateral (measured as the fraction of property, plant, and equipment to total assets) and firm leverage (see, e.g., Titman and Wessels, 1988, Rajan and Zingales, 1995, MacKay and Phillips, 2005, Bharath, Pasquariello and Wu, 2006, Faulkender and Petersen, 2006; and very recently Wald and Long, 2007, Kale and Shahrur, 2007, Lemmon and Zender, 2007 just to cite some). This is largely explained by the fact that tangible assets can be pledged as collateral to lenders and thus allow companies to raise debt.
The empirical approach followed in aforementioned studies consists of including as explanatory variable an aggregate measure of tangibility in a leverage regression for large samples of public companies. This approach implicitly assumes that all types of tangible assets (e.g., land, buildings, and machineries & equipments) posses the same degree of debt capacity with no loss of information associated with the use of an aggregate measure of tangibility (that does not distinguish among the different types of tangible assets).
More importantly, by conducting the analysis on the "average" U.S. public firm, these studies miss to explain that tangible assets are not important to create debt capacity for firms that have otherwise already wide access to the debt market e.g., credit unconstrained firms while a direct positive link between leverage and tangible assets is likely to exist only for firms with limited access to the debt market (e.g., credit constrained firms).
This distinction between firms based on whether or not they face credit constraints raises another salient issue, which has not been uncovered in previous empirical studies. In fact, we cannot rule out the possibility that, confronted with limited access to the debt market, firms might endogenously choose an investment structure with more tangible assets to increase their debt capacity. This argument relies on the assumption that the proportion of tangible assets is not exclusively dictated by the type of business but is a “discretionary” decision variable for each firm within an industry at least to some extent.
The aim of this paper is to address each of these issues. We depart empirically from previous studies in that we use a different tangibility ratio for each different type of tangible assets. This allows us to test whether different assets posses the same propensity to generate collateral in the financing process. We tackle the potential endogeneity of the tangibility ratio in the leverage regression by modelling the tangibility ratio of the different types of tangible assets as a function of several carefully identified exogenous instruments. Finally, we develop a theoretical model showing that a strict positive relation between tangibility and leverage exists only for firms that do not have otherwise access to the debt market (e.g., credit constrained) while tangibility and leverage are separate decisions for credit unconstrained firms. We provide strong empirical support for this prediction.
Our paper closely relates to a recent study by Faulkender and Petersen (2006). The argument underlying their paper is that firms might be "rationed by their lenders" when trying to raise debt financing. The source of capital (in their study, whether or not a firm has access to the public debt market), as they show, can mitigate these frictions in the debt market. We follow a similar approach to theirs in that we also explicitly recognize that frictions in the supply-side of the credit market might create credit rationing. We focus however on the role of collateral as a means for firms to increase their debt capacity.
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