We demonstrate that in the absence of debt covenants and agency costs, optimal debt maturity is a monotonic function of leverage. However, debt is often issued with restrictive covenants in order to reduce debt-equity agency costs. Utilising covenants in this way introduces owner-manager agency costs that results in shorter term debt than would otherwise be optimal. In the presence of debt-covenants, agency costs drive a concave functional relationship between maturity and leverage. This concave relationship is empirically confirmed with a large sample of industrial firms for the period 1992-2005. We also show that the alignment of managers and owners interests, as proxied by future levels of managerial ownership and executive stock options, significantly reduces the effect of manager-owner agency costs on maturity decisions. These insights provide a sound explanation for a variety of competing empirical observations in the capital structure and corporate governance literature.
Once a firm’s managers decide to issue debt, they must determine a suitable maturity for the debt issue. Owners and managers have a strong incentive to choose a maturity that minimizes the cost of debt in order to maximise firm value. One method of reducing the cost of debt is to incorporate debt covenants with the debt issue. Debt costs are reduced by incorporating covenants because debt holders are able to mitigate the agency costs arising from debt-equity conflicts. However restrictive debt covenants introduce an alternative agency cost arising from owner-manager conflicts. Restrictive debt covenants increase the likelihood of managers losing control of the firm (Chava and Roberts, 2008; Ozelge, 2007), so managers have a stronger incentive to minimize the probability of covenant violation than to lower the cost of debt. We investigate the role played by the trade off between the competing agency costs in debt maturity decisions.
A secondary aim of this study is to better understand the interaction between leverage, debt covenants and debt maturity and how this interaction affects the value of the firm. Corporate leverage and debt maturity are often treated independently in traditional examinations of capital structure. In a perfect capital market, the cost of debt will not affect the capital structure as the optimal leverage ratio is invariant to various costs of debt (Modigliani and Miller, 1958). In the presence of market imperfections, optimal leverage and hence firm value, will vary with yield as the yield curve is rarely flat. Essentially, market imperfections are driving the optimal capital structure problem into three dimensions. Firms need to choose not only an optimal leverage ratio but also optimal debt maturities to achieve an optimal capital structure. Naively, one might expect the default risk premium to be a monotonic function of maturity and hence the optimal maturity, in a frictionless market, will be extreme short-term debt. Recent empirical findings by Barclay and Smith (1995) suggest that maturity and leverage may act as substitutes. Hamson (1992) and A lcock, Finn, and Tan (2008) demonstrate that default risk, and hence the risk premium for debt, is not a monotonic function of debt ratio but a function of both leverage and debt maturity. Accordingly, maturity is neither a substitute for leverage nor is optimal maturity simply short term debt. Rather, they illustrate that optimal maturity, in the absence of debt covenants, is a monotonic function of everage.
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