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

Klaas van 't Veld (), Gordon Rausser and Leo Simon

Department of Agricultural & Resource Economics, UC Berkeley, Working Paper Series from Department of Agricultural & Resource Economics, UC Berkeley

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.

Keywords: bankruptcy; businesses; credit; debt; mathematical models; Social and Behavioral Sciences (search for similar items in EconPapers)
Date: 2000-10-01
References: View references in EconPapers View complete reference list from CitEc
Citations: View citations in EconPapers (1)

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