This study seeks to empirically test whether equity value reflects gains and losses associated with changes in debt value that arise from changes in credit risk. Merton (1974) establishes this effect theoretically. However, direct empirical evidence is lacking. The question relates to the implications of using fair value accounting for liabilities, which would include recognizing in income what some view as anomalous effects on equity value of changes in credit risk.
In particular, we test whether increases (decreases) in credit risk are associated with increases (decreases) in equity value. Because fair value accounting for liabilities, if adopted, would apply to all firms, we conduct our tests on a broad sample of primarily solvent firms. We also calculate and provide descriptive evidence relating to the effects on firms financial statements of recognizing changes in debt value.
Changes in credit risk arise when either the value or the risk of the firm's assets changes. Merton (1974) shows that changes in equity value occasioned by changes in asset risk can be characterized into two countervailing effects. The direct effect comprises the one-to-one mapping between asset value and equity value that exists in the absence of debt. The direct effect on equity value of increases in asset risk is negative or zero. The indirect effect comprises the amount of any asset value change that is absorbed by debt holders, plus the change in debt value associated with changes in asset risk.
Merton (1974) predicts that despite assuming debt has priority over equity, debt value changes with asset value. This is true even for solvent firms because priority at liquidation of the debt does not imply that debt holders have first claim on asset value before liquidation. Thus, debt holders participate in changes in asset value, even when asset value is more than sufficient to liquidate the debt. Merton (1974) also predicts that debt value decreases with unanticipated increases in asset risk. Because equity value equals asset value minus debt value, decreases in debt value result in increases in equity value. Therefore, the indirect effect on equity value of increases in asset risk is positive.
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Fair Value Accounting for Liabilities and Own Credit Risk
