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Fitting the glass slipper: optimal capital structure in the face of liability

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  • van 't Veld, Klaas T.
  • Rausser, Gordon C.
  • Simon, Leo K.

Abstract

The model presented in this paper juxtaposes two theories for why a firm might offer creditors a security interest to back up a loan. One theory holds that issuing secured debt allows the firm's owners to reduce expected payments in the event of bankruptcy to so-called "non-adjusting" creditors, who cannot or do not adjust the size of their claims in response. An important class of such non-adjusting claims are liability claims on the firm. The other theory holds that issuing secured debt solves an underinvestment problem: the firm may only be able to finance a growth opportunity if it offers new investors a security interest. Recognizing that most real-world firms face both non-adjusting claims and growth opportunities, we combine the two theories in a single model. We find that firms generally choose an interior secured-debt ratio, and all firms smaller than a critical size choose a strictly higher secured-debt ratio than firms larger than the critical size. Moreover, the relationship between the optimal secured-debt ratio and firm size is highly nonlinear in ways consistent with the empirical evidence: the optimal ratio mayor may not initially increase in firm size, then tends to decrease, and then becomes constant.

Suggested Citation

  • van 't Veld, Klaas T. & Rausser, Gordon C. & Simon, Leo K., 2000. "Fitting the glass slipper: optimal capital structure in the face of liability," Department of Agricultural & Resource Economics, UC Berkeley, Working Paper Series qt5nb497vk, Department of Agricultural & Resource Economics, UC Berkeley.
    • Handle: RePEc:cdl:agrebk:qt5nb497vk
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    References listed on IDEAS

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    1. Barclay, Michael J & Smith, Clifford W, Jr, 1995. "The Priority Structure of Corporate Liabilities," Journal of Finance, American Finance Association, vol. 50(3), pages 899-917, July.
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    4. Alan Schwartz, 1997. "Priority Contracts and Priority in Bankruptcy," Yale School of Management Working Papers ysm72, Yale School of Management.
    5. Triantis, George G, 1992. "Secured Debt under Conditions of Imperfect Information," The Journal of Legal Studies, University of Chicago Press, vol. 21(1), pages 225-258, January.
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    Cited by:

    1. van 't Veld, Klaas, 2006. "Hazardous-industry restructuring to avoid liability for accidents," International Review of Law and Economics, Elsevier, vol. 26(3), pages 297-322, September.

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