This paper examines the agency problem caused by credit risk. In particular, it looks at the problem where the debt holders are taken advantage of by the shareholders in the situation where the firm should have been default but the shareholders still have the control of the firm.
The dazzling observation by Black and Scholes (1973) and Merton (1974) that the equity resembles a call option is widely applied in the finance literature. When debts are issued, equity holders are effectively selling the assets of the firm to the debt holders in return for cash and a call option. When the debts are due (so is the call option), the equity holders will face the choice whether to buy the assets back from the debt holders (whether to exercise the call option) and will do so only if the value of the assets exceed the redemption value of the debts. Under the situation where the equity holders are unwilling or unable to redeem the assets of the firm, the debt holders must takeover the firm. This method lays also the foundation of the structural credit risk models, such as all kinds of default barrier models and compound option models.
The implication of option pricing method for capital structure is the debt holder wealth expropriation hypothesis. If the equity is thought as a call option, the optimal choice for the equity holders is to support as many risky projects as possible no matter whether the NPV of the projects is positive or not since the option value is positively correlated with the variance of returns of firm assets. Obviously, this is not of the debt holders interest and an agency problem emerges from this framework. Under no asymmetric information, the debt holders are fully informed of this agency problem and consequently will lower their loan to the equity holders at the time of debt issuance.
Barnea, Haugen, and Senbet (1980) demonstrate that it is then not at the best interest of the equity holders to take on risky projects. They conclude that the agency problem will only exist under asymmetric information. However, this result, as we shall see shortly, will not hold in a multi-period setup.
