Repurchasing debt

In this paper we build a theoretical model of corporate debt repurchases. First, we find that the firm that buys back its own debt from a creditor must pay a premium over the price at which the same creditor is willing to trade with third parties. This is because the repurchase by a firm leads to a dollar-for-dollar reduction in the amount of cash or assets available to pay the remaining debt. Second, the repurchase price is lower when there are multiple bondholders because of cross-creditor externalities. Therefore, we challenge the view that restructuring more dispersed debt is always more costly to implement. Third, when bankruptcy costs are significant, there is a range of prices below face value at which debt can be repurchased. Fourth, we show that repurchases contribute to flexibility in firms capital structure and increase ex-ante firm value, but have limited power to mitigate debt overhang

Can real options explain financing behavior?

Trade-off models commonly invoke financial transaction costs in order to explain observed leverage fluctuations. This paper offers an alternative explanation based on real options. The model is frictionless on the financing side but incorporates irreversibility and fixed costs of investment. Results obtained from Simulating the model are broadly consistent with observed financing patterns. Market leverage ratios are negatively related to profitability, mean-reverting, and depend on past stock returns. The gradual and lumpy leverage adjustments can occur in the absence of financial transaction costs. This evidence shows that incorporating real frictions into structural models increases their explanatory power. (C) 2008 Elsevier B.V. All rights reserved

A Dynamic Model of the Firm: Structural Explanations of Key Empirical Findings

SSRN-id28380957We derive a dynamic model of the rm in the spirit of the trade-o¤ theory of capital structure that explains rm behavior in terms of rm characteristics. We show our model is consistent with many important ndings about the cross-section of rms, including the negative relations between pro tability and leverage, and between dividends and investment-cash ow sensitivities. The model also explains the existence of zero-debt rms and their observed characteristics. These results have been used to challenge the trade-o¤ theory and the assumption of perfect capital markets. We revisit these critiques and provide structural explanations for the regularities we replicate

Can real options explain financing behavior?

Trade-off models commonly invoke financial transaction costs in order to explain observed leverage fluctuations. This paper offers an alternative explanation based on real options. The model is frictionless on the financing side but incorporates irreversibility and fixed costs of investment. Results obtained from simulating the model are broadly consistent with observed financing patterns. Market leverage ratios are negatively related to profitability, mean-reverting, and depend on past stock returns. The gradual and lumpy leverage adjustments can occur in the absence of financial transaction costs. This evidence shows that incorporating real frictions into structural models increases their explanatory power.