We examine the financing and debt maturity choices made by undiversified large shareholders or owner-managers. The interplay between the objective of the undiversified, self-interested owner-manager who controls the firm and the valuation of the firm’s marketed claims by well-diversified outside investors, has a major impact on leverage and debt maturity choices as well as credit spreads. The effect of this interplay is particularly significant in a world where the representative investor (who determines asset prices in the economy) is risk-averse leading to nonzero market prices of systematic risk and risk premia of the firm’s investment opportunities. In a perfect information framework with no taxes or bankruptcy costs, we show that, the owner-manager could, depending on the projects’ characteristics, finance them exclusively with debt, exclusively with equity, or with a combination of equity and debt. Ceteris paribus, leverage increases with the expected growth rate of firmvalue under its investment opportunities, and decreases with its volatility. Debt maturity varies non-monotonically in a U-shaped manner with the expected growth rate, and decreases with the volatility.
Our results reconcile empirical evidence on the variation of financing choices with firm characteristics that is not completely consistent with previous theories. The significant impact of the expected returns (therefore, risk premia) of firms’ investment opportunities on their leverage ratios, debt maturities, and credit spreads are important implications of our theory that cannot be obtained in these models or in models in which all agents are risk-neutral so that risk premia are zero. We empirically test the implications of our theory for the relationships among firms’ financing and debt maturity choices and the expected growth rate and volatility of their asset values. Controlling for all the significant determinants of firms’ financing and debt maturity choices identified by earlier studies, we show significant empirical support for our predictions.
The whole dissertation is organized as follows. In Chapter I, we present our theory in a parsimonious two-time period model, which highlights the key analytical results and economic intuition on the variation of financing and debt maturity vis-à-vis the quality of underlying project. In Chapter II, we recast our theory with a more sophisticated continuous-time structural model under rational expectations. The results obtained from the two-period model are confirmed and enriched along new dimensions of project drift, volatility and credit spreads. Furthermore, the continuous-time model yields a set of empirical implications that can be readily tested with corporate finance and debt maturity data. We present our empirical analysis in Chapter III, where we test our model predictions using data from COMPUSTAT, CRSP and FISD databases.
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Financing and Debt Maturity Choices by Undiversified Owner-Managers: Theory and Evidence
