Ebook When Does Strategic Debt Service Matter?
Since its introduction by Hart and Moore, the notion of strategic debt-service has received considerable attention in the finance literature. At its core, strategic debt-service involves a simple idea: when liquidation is costly, it may be possible for equity holders to under-perform on their debt servicing obligations without triggering liquidation, since rejecting the offer and liquidating the firm may leave debt holders even worse off. The idea is an attractive one; it indicates that default may occur not just because the firm lacks adequate cash (“liquidity defaults”), but also because of opportunistic behavior by equity holders (“strategic defaults”).
These observations suggest that strategic debt-service makes debt “more” risky and should result in a widening of yield spreads. Recent work in a valuation setting by Anderson and Sundaresan and Mella-Barral and Perraudin appears to confirm this point. The papers each develop cash-flow based extensions of the Merton risky-debt pricing model. Comparing outcomes under strategic and non-strategic debt service using numerical techniques, they find that equilibrium yield spreads are substantially wider in the former case. This leads both papers to conclude, in particular, that strategic debt-service can resolve the widely-documented problem of the underpricing of risky debt associated with the traditional Merton framework.
Two conflating factors, however, mask the exact role played by strategic debt-service in the Anderson/Sundaresan and Mella-Barral/Perraudin analyses. First, neither paper investigates the optimal management of the periodic cash flows generated by the firm. Rather, both require that all cash flows generated in each period be paid out completely to claim holders, either as debt-service to creditors or as dividends to equity holders. In particular, the option to maintain cash reserves to meet future debt-service obligations is unavailable to firms. Second, with regard to raising cash via issue of new equity, the papers make assumptions at opposite ends of the spectrum. Anderson/Sundaresan effectively assume this option is infinitely costly: they prohibit new equity issuance altogether. In contrast, Mella-Barral/Perraudin take it to be costless.
From a theoretical standpoint, these restrictions do not appear to be innocuous; they are also at odds with empirical evidence. Firms in practice often hold substantial reserves of cash; a prohibition on their doing so in the model might overstate liquidity defaults and inflate spreads. Secondly, while an assumption that new equity issuance is infinitely costly appears somewhat excessive, an assumption that it is costless is also questionable. Empirical documentation suggests that such costs are substantial; ignoring them would tend to delay liquidation and bias the value of equity upwards. All of this leads one naturally to ask: When and how much does strategic debt-service really matter? How does its impact depend on cash management policy and equity issuance costs? These questions form the basis for our analysis in this paper.
We examine a cash-flow based model of firm value akin to that of Anderson and Sundaresan and others. Our model retains the features of earlier work that liquidation is costly and strategic debt-service is allowed, but adds two important generalizations. First, it allows the firm to hold cash reserves and carry these forward from one period to the next. Second, it allows for the issuance of new equity to be costly; this cost, like the cost of liquidation, is a model parameter. Taking these costs as given, and anticipating rationally the acceptance/rejection decisions of debt holders in the event of under performance of debt-service obligations, the firm chooses cash reserve, debt-service, dividend, and equity-issuance policies to maximize equity value.
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