DETERMINANTS OF DEBT CAPACITY

1st set of transparencies for ToCF

 I. INTRODUCTION

Adam Smith (1776) - Berle-Means (1932)

Agency problem

Principal outsiders/investors/lenders

Agent insiders/managers/entrepreneur

1. Insufficient ‘‘effort’’
2. Inefficient investment
3. Entrenchment strategies
4. Private benefits

Good governance: (1) selects most able managers

(2) makes them accountable to investors
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 OUTLINE
Approach: controlled experiment

Topics:

1. Micro
– Basics: (a) one-stage financing: fixed and variable investment models;
(b) applications: debt overhang, diversification, collateral
pledging, redeployability of assets.
– Multistage financing: liquidity ratios, soft budget constraint, free cash
flow.
– Financing under asymmetric information.
– Exit and voice in corporate governance.
– Control rights.

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2. Macro
– Dual role of assets and multiple equilibria.
– Credit crunch.
– Liquidity shortages.
– Liquidity premia and pricing of assets.
– Political economy of corporate finance.

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II. BASICS OF CREDIT RATIONING: FIXED INVESTMENT
MODEL

Lenders / investors /outsiders

Project costs I.
Entrepreneur / borrower / insider
Has cash A < I.

Key question: Can lenders recoup their

investment?

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 TYPICAL MODEL
• Risk neutral entrepreneur has one project, needs outside financing.

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Want to induce good behavior:

and

Contract: Success:Rb + R =R.

Failure: 0 each (optimal).

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Reward Rb in case of success

Necessary and sufficient condition for financing

or
PLEDGEABLE INCOME  INVESTORS’ OUTLAY

Minimum equity:

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Remarks
(1) Entrepreneur receives NPV

Will always be the case with competitive financial market.

(2) Reputational capital / scope for diversion (shortcut)
A increases with B.
Note : Courts can help reduce B
(3) Investors’ claim: debt or equity?
(At least) two interpretations:
– inside equity + outside debt (R to be reimbursed);
– all-equity firm: shares
No longer true if leftover value in case of failure. In any case:
no need for multiple outside claims.
weakness, 9
strength (focus on fundamentals).
DEBT OVERHANG

Definition: (project would always be financed in absence of previous

claim).
Example:
A < 0 new investment cannot be financed solely because renegotiation
with initial investors infeasible.

Previous claim is senior.

Borrower no longer has cash (A =0).

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a) Bargaining with initial investors, who have cash
Noone receives anything if no investment.
Investment: Choose Rb such that

and

Feasible since

b) Initial investors don’t have funds to invest. Bargaining with new

investors only.
Income that can be pledged to new investors:
by assumption.

cannot raise funds.

DEBT OVERHANG 11
c) Initial investors don’t have funds to invest. Bargaining with new and
initial investors.

Debt forgiveness: where

That is

When is debt overhang an issue?

– Many creditors. Examples:

corporate bonds
(nomination of bond trustee, exchange offers)
interbank market/derivatives/guarantees,..

– Asymmetric information (not in this model).

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III. BASICS OF CREDIT RATIONING/ VARIABLE INVESTMENT
MODEL

1. EQUITY MULTIPLIER / DEBT CAPACITY

Implicit (perfect) correlation hypothesis: specialization, voluntary

correlation, macro shocks.

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Notation:
income per unit of investment

pledgeable income per unit of

investment

Assumption

First inequality: finite investment

Second inequality: positive NPV (otherwise no investment).

Constraints:

and

Borrower’s utility (=NPV)

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wants to maximize I.
DEBT CAPACITY

Utility

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DEBT OR EQUITY? THE MAXIMAL INCENTIVE PRINCIPLE

Extension: RSI in case of success

RFI in case of failure (salvage value of assets)

Generalization of

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Optimal sharing rule:

s.t.

and

Breakeven constraint binding (otherwise ).

wants to maximize I.

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Incentive constraint binding (otherwise debt capacity)
Suppose Then

relaxes incentive constraint.

Outside debt maximizes inside incentives

Generalization: Innes (1990).

Discussion: risk taking,

 broader notion of insiders,
 risk aversion.

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2. DIVERSIFICATION

Diamond (1984)’s diversification argument.

n projects.

Basic idea: IRS due to the possibility of cross-pledging.

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TWO IDENTICAL PROJECTS

Rewards R0 , R1 , R2
Risk neutrality R0 = R1 =0.

Other IC constraint is then satisfied

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Nonpledgeable income

Financing condition. Entrepreneur’s equity= 2A.

PROJECT FINANCE IS NOT OPTIMAL

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Continuum of independent projects

Two cases: pHR - B - I < 0 : net worth still plays a role

pHR - B - I > 0 : unlimited size

Second case: continuum of projects, mass 1.

Debt contract: D=I
Work on all: pHR - D = pHR- I > 0
Work on y % of the projects:
either y pH R + (1-y) pLR < I then y=0 better, but dominated

or y pH R + (1-y) pLR  I
payoff increases with y ((p )R > B)
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LIMITS TO DIVERSIFICATION
• limited attention,
• core competency,
• endogenous correlation (asset substitution, VaR)

continuum:

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3. LIQUIDITY NEEDS

In case of "liquidity shock", rb invested yields :  rb > rb to

entrepreneur (none of which is pledgeable to investors).

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Two issues:
• imperfect performance measurement at date 1
• strategic exit (if liquidity shock unobservable, 2 dimensions of MH:
effort, truthful announcement of liquidity need).

Contract (can show: no loss of generality)

Menu:
• Rb in case of success at date 2, or
• rb at date 1.

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Benchmark: Liquidity shock observable

or

Independent of rb!
Pledgeable income (for given rb) :

Must exceed I-A  rb cannot be too large!

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Case 2: Possibility of strategic exit

Assume pL=0 (or, more generally, small)  wants to exit if shirks.

or

pL = 0  (2) is more constraining than (1).

Must also have

Pledgeable income: (for given rb)

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when rb >0. And:

Lower pledgeable income, same NPV. *

* for a given rb. But rb is smaller!

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Benefit from speculative monitoring at date 1.
Signal: good or bad. Good signal has probability qH or qL.
Incentive constraint:

Disciplines entrepreneur.
Same if active monitor as well.
 In practice
– sale to a buyer,
– IPO.
VC exit is carefully planned.
 Reversed pecking-order logic: want risky claim to encourage
speculative monitoring.

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4. COLLATERAL / REDEPLOYABILITY OF ASSETS

 Pledging collateral: – increases pledgeable income,

– boosts incentives if state-contingent pledges.
Cost of collateralization: – transaction cost,
– suboptimal maintenance,
– lower value for lender.

Redeployability of assets boosts debt capacity

Proper credit analysis:

relevant value of collateral  average value:
– low maintenance near distress,
– aggregate shocks.

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Assumption: 0  P  1
Previously: x = 1.
 Positive NPV:
 Breakeven condition:

I grows with P.

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(grows with P, for two reasons).
5. ENDOGENEIZATION OF P: SHLEIFER-VISHNY (1992)

(chapter 14 in book)
Idea : P endogenous, depends on existence of other firms able to
purchase asset.
Model : 2 firms in industry (do not compete on product market). "Local
liquidity": only other firm can buy asset.

Entrepreneur i : cash Ai , borrows Ii -Ai.

If j in distress and i not in distress, i (with the help of lender i) can buy
j’s assets.

assets I1+I2
potential private benefit B(I1 + I2)
income in case of success R(I1 + I2)
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As usual

and

Lender i and entrepreneur i sign (secret) loan agreement {Ii , Rbi},

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LIQUIDATION VALUES

Both firms in distress: no revenue for anyone.

None in distress: standard model.
Firm 1 in distress, firm 2 is not:
Assumption: lender 1 makes take-it-or-leave-it offer to lender 2.

Lender 2 must adjust incentive scheme:

becomes

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Discount since 0 < 1.

Extra rent for entrepreneur 2:

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Entrepreneur’s expected utility:

where

and

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Debt capacity decreases with correlation between  shocks.

Ii = kAi where

Ii  1 (minimum scale) and  < 0

multiple equilibria (complementarity).

 Financial muscle: do potential acquirers build too much or too little

financial muscle for M & As? See chapter 14.

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