Research Paper Presentation on Asset Redeployability, Liquidation Value, and Endogenous Capital Structure Heterogeneity
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The paper discusses how asset redeployability and capital structure heterogeneity influence bankruptcy and financial distress in firms. It presents two models—the opportunistic-acquisition channel and the distress-reorganization channel—demonstrating how debt levels affect asset demand and supply during financial distress. Key takeaways include the non-isomorphic effects of leverage choices on firm strategy and the complex relationship between debt benefits, asset redeployability, and firm value.
Research Paper Presentation on Asset Redeployability, Liquidation Value, and Endogenous Capital Structure Heterogeneity
- 1. Asset Redeployability, Liquidation Value, and Endogenous Capital Structure Heterogeneity Paper by Antonio E. Bernardo, Alex Fabisiak, and Ivo Welch Presentation by Michael-Paul James 1
- 2. Table of contents Introduction O-A Channel The Opportunistic-Acquisition Channel, Model Setup and Assumptions, Equilibrium, Solution, Implications Story, Questions, Context, Issues Literature Related Literature, Shleifer and Vishny Discussion Welfare, Generalizations 01 02 04 05 D-R Channel Distress-Reorganization Channel, Setup & Assumptions, Access to Infinite Financing/Eliminating the Acquisition Channel, Equilibrium with Acquisitions & Financial Distress Channels, Implications Conclusion Key Points and Takeaways 03 06 2 Michael-Paul James
- 3. Introduction 01 Story, Questions, Context, Issues 3 Michael-Paul James
- 4. Bankruptcy and Financial Distress ● Firms with more leverage increase the chance of future financial distress. ○ More firm leverage, higher bankruptcy costs ○ More industry leverage, higher bankruptcy costs ■ Due to more limited capital of potential buyers (peers) to buy distressed assets. ■ Fire-sale discounts become steeper in relation to fundamental assets. ● During bankruptcy, creditors must choose to liquidate or reorganize. ○ Liquidate: creditors receive market price. ○ Reorganize: assets maintained, but strained relationships with stakeholders. 4 Michael-Paul James
- 5. High Leverage ● Benefits ○ Signaling benefits (credit worthy, higher expected return) ○ Incentive enhancements (agency costs; restrict free cash flow) ○ Tax shields ● Costs ○ Distress costs. ● Characteristics ○ More likely to sell assets ○ Less likely to buy assets 5 Michael-Paul James
- 6. High Leverage Implications ● Aggressive debt policies ○ Increases future supply ○ Reduces demand for liquidated assets ○ Lowers equilibrium price. ● Lower price ○ Competitive firms fear financial distress more ○ Motivated to reduce debt to take advantage of future fire-sales. ● Best response ○ If firms adopt aggressive debt strategies, competitors best response is to lower debt. 6 Michael-Paul James
- 7. Low Leverage Implications ● Conservative debt policies ○ Decreases future supply ○ Increases demand for liquidated assets ○ Increases equilibrium price. ● Higher price ○ Competitive firms fear financial distress less ○ Motivated to increase debt to take advantage of high prices. ● Best response ○ If assets are more redeployable, firms are better off assuming more debt due to lower distress costs. 7 Michael-Paul James
- 8. Leverage Feedback Loop (Best Response) Competitor Increases Leverage Why? Increase distressed asset pricing / Decrease bankruptcy costs Higher market price / Higher return on assets 8 Michael-Paul James Supply Increases Liquidated Asset Demand Decreases Equilibrium Price Falls Competitor Decreases Leverage Why? Decrease distressed asset pricing / Increase bankruptcy costs Lower market price / Lower return on assets Future fire-sale opportunities in the future Supply Decreases Liquidated Asset Demand Increases Equilibrium Price Rises
- 9. O-A Channel 02 The Opportunistic-Acquisition Channel, Model Setup and Assumptions, Equilibrium, Solution, Implications 9 Michael-Paul James
- 11. Model Assumptions ● Risk neutral competitive firms ● Manager maximizes firm value ● Assets and Type (Asset productivity- vi , Asset Price- P) ○ Firms identical at t0 , productivity revealed at t1 , payoff t2 . ● Financing: Each firm finances asset purchase with debt or equity ○ No discounting. Rate of return on debt is zero. Debt has benefits (𝜏) ● Liquidation ○ Learn productivity. Choose to sell asset (vi <P) or continue operation. ● Acquisition ○ Cost to redeployment (η x vj , vi <vj ). Must be positive NPV (vj >P/η) ● Other assumptions: uniform distribution on values; linearity in τ, η, and φ; stark integration limits; limited liability; free disposal; limited capital; uncorrelated shocks; no further countervailing important omitted effects 11 Michael-Paul James
- 15. Maximization ● At time 0, each firm chooses a debt level Fi to maximize their ex-ante value 15 Payoff if asset is liquidated (vi ≤P) Payoff if firm continues to operate (P<vi ≤1) Expected surplus from acquisition Requires capital (P+Fi ≤vi ) to purchase Only positive NPV (P/η ≤vi ) Debt benefit Michael-Paul James If financing constraint binds:
- 18. Solution 18 ● Maximize ex ante firm value from first equation produces the optimal debt face value of F* ● Maximize firm value
- 20. Figure 2 Figure 2 shows a contour plot with the fraction of heterogeneous firms as the dependent variable. The shaded area contains the two-type equilibria (as defined in Theorem 1). The area above the diagonal is uninteresting because all firms choose Fi = 1, and the price is 0. The area on the bottom right has all firms act alike. Interpretation: Heterogeneity arises unless redeployability is high and debt benefits are low. It is common for intermediate values of redeployabilities and direct debt benefits. Implication 1. When assets are indivisible, ex ante identical firms may specialize: Low-debt firms coexist with high-debt firms. The region with endogenous heterogeneity is characterized by intermediate levels of redeployability and debt benefits. 20 Michael-Paul James
- 21. Figure 3 Figure 3 shows contour plots for the acquisition-only model. The shaded area contains the two-type equilibria (as defined in Theorem 1). Patterns that have ∩ or ∪ shapes indicate ambiguous comparative statics in redeployability. ⊂ or ⊃ shapes indicate ambiguous comparative statics in direct debt benefits. Interpretation: Graphs A, B, D, and E: The face value F* and current market value of debt (D*) increase (everywhere for the industry, almost everywhere for the low-debt firm) monotonically in debt benefits and decrease monotonically in redeployability η. Graphs C and F: The debt-to-value ratio is ambiguous in debt benefits and decreasing monotonically in redeployability η. Implication 2. Because firm value is also endogenous, comparative statics on debt levels need not be the same as comparative statics on debt-to-value ratios. 21 Michael-Paul James
- 22. Peer Effects on Debt Choice 22 ● Optimal interior debt choice Michael-Paul James
- 23. Figure 4 Figure 4 shows equilibrium prices and debt choices when η=1/2. Interpretation: For high τ, some firms choose a high- debt strategy (FH =1). Therefore, industry debt (FInd ) is higher, and the equilibrium price (P) is lower, than what would have occurred if all firms had chosen a low-debt strategy (represented by the dashed lines). Other firms recognize that more valuable buying opportunities will become available and have an incentive to choose debt (FL ) below what is optimal if industry debt is lower. Implication 3. Holding parameters constant, with endogenous liquidation values, firms’ equilibrium debt choices are negatively influenced by those they conjecture for their peers. 23 Michael-Paul James
- 24. D-R Channel 03 Distress-Reorganization Channel, Setup & Assumptions, Access to Infinite Financing/Eliminating the Acquisition Channel, Equilibrium with Acquisitions & Financial Distress Channels, Implications 24 Michael-Paul James
- 25. Both Channels Working in Tandem ● Opportunistic-acquisition channel ○ Debt reduces the demand for liquidated assets ● Financial-distress channel ○ Debt increases the supply of liquidated assets. 25 Michael-Paul James
- 26. Model Assumptions ● Risk neutral competitive firms ● Manager maximizes firm value ● Limited liability ● Assets and Type (Asset productivity- vi , Asset Price- P) ○ Firms identical at t0 , productivity revealed at t1 , payoff t2 . ● Financing: Each firm finances asset purchase with debt or equity ○ No discounting. Rate of return on debt is zero. Debt has benefits (𝜏) ● Impairment: (Chapter 11 or informal) ○ Dissipative cost when reorganizing & continuing in default (vi < Fi ). ● Other assumptions: uniform distribution on values; linearity in τ, η, and φ; stark integration limits; limited liability; free disposal; limited capital; uncorrelated shocks; no further countervailing important omitted effects 26 Michael-Paul James
- 27. Model Assumptions ● Liquidation ○ Learn productivity. Choose to sell or reorganize asset (vi <F) and continue operation. ○ Firm optimally liquidates for all values below critical value ● Acquisition ○ Cost to redeployment (η x vj , vi <vj ). Must be positive NPV (vj >P/η) ○ Firm must have sufficient capital (vi -Fi ≥ P) 27 Michael-Paul James
- 28. Figure 5: Full Model Game Tree 28 Figure 5 illustrates the timing of the manager's choices and the resulting payoffs in the full model. The manager first chooses a debt level. The value of the asset is then realized, and the manager decides whether or not to default and whether or not to acquire another asset. In the event of default, the manager also chooses between liquidation and reorganization. The assets then pay off according to the previous decisions. Michael-Paul James
- 29. Maximization ● At t0 , each firm chooses a debt level Fi to maximize their ex-ante value 29 Payoff if asset is liquidated (vi ≤P) Payoff if firm continues to operate (P<vi ≤1) Expected surplus from acquisition Requires capital (P+Fi ≤vi ) to purchase Only positive NPV (P/η ≤vi ) Debt benefit Michael-Paul James Payoff if distressed firm reorganizes and continues (P<vi ≤1)
- 35. Costly Debt ● Reduces future purchasing opportunities ● Increases expected costs of financial distress. 35 Michael-Paul James
- 36. Figure 6 Figure 6 shows a contour plot with the fraction of heterogeneous firms as the dependent variable in the full model with distress costs. The shaded area contains the two-type equilibria (as defined in Theorem 2 and the Supplementary Material). Patterns that have ∩ or ∪ shapes indicate ambiguous comparative statics in redeployability. ⊂ or ⊃ shapes indicate ambiguous comparative statics in direct debt benefits. Interpretation: Heterogeneity still arises for intermediate values of debt benefits and large values of redeployability. However, the heterogeneity region is now smaller than it was when φ=0 in Figure 2. 36 Michael-Paul James
- 37. Figure 7 37 Figure 7 shows contour plots for the full model with distress costs. The shaded area contains the two-type equilibria (as defined in Theorem 2 and the Supplementary Material; industry face leverage is F*Ind = h* x 1 + (1 - h*) x FL *). Patterns that have ∩ or ∪ shapes indicate ambiguous comparative statics in redeployability. ⊂ or ⊃ shapes indicate ambiguous comparative statics in direct debt benefits. Interpretation: Industry debt increases monotonically with direct debt benefits τ. However, it can first increase and then decrease in redeployability η. Not shown, the low-debt firm (rather than industry debt) shows a very similar pattern, with only small changes in the shaded region. Implication 4. For low debt benefits and low asset redeployability η, the financial distress channel dominates. Firms take on more debt when assets become more redeployable. For higher debt benefits τ and higher asset redeployability η, the opportunistic-acquisition channel dominates. Firms take on less debt when assets become more redeployable. Implication 5. Debt face values and leverage ratios can have different comparative statics. One may go up when the other goes down, and vice versa. This is because parameters affect not only the debt but also the firm value.
- 38. Figure 8 Figure 8 shows contour plots for the full model with distress costs. The shaded area contains the two-type equilibria (as defined in Theorem 2 and the Supplementary Material). Patterns that have ∩ or ∪ shapes indicate ambiguous comparative statics in redeployability. ⊂ or ⊃ shapes indicate ambiguous comparative statics in direct debt benefits. Credit spreads increase when debt benefits are higher. Higher τ encourages more debt, higher expected creditor loss. Higher η increases recovery rates, thus higher debt. Crest spreads are indifferent between funding and not funding to the low type when: 38
- 40. Tax Effects ● How do corporate income taxes, one component of τ, influence reallocational efficiency? ● Implication 6. Increases in the benefits of debt, as can be effectuated by tax-code changes, can result in socially less or more efficient redeployment activity. ○ Low τ, firms choose low leverage, increasing demand for liquidated assets. Raising debt benefits, would reduce expected transfers. ○ High τ, firms choose high leverage, decreasing demand for liquidated assets. Supply of liquidated assets is low. ○ Government tax policy might moderate other debt benefits. 40 Michael-Paul James
- 41. Figure 9 Figure 9 shows contour plots for varying levels of distress costs. The shaded area contains the two-type equilibria (as defined in Theorem 2 and the Supplementary Material). The thick line shows the parameters for τ and η where equilibrium results in first-best redeployment. Interpretation: The area to the left of the thick line has too much transfer activity (Q*).The area to the right of the thick line has too little transfer activity. If there are no reorganization costs (φ = 0), there is always too little redeployment. 41 Michael-Paul James
- 42. Takeaways of the Model ● Firms’ leverage choices are affected by their peers through the equilibrium price of liquidated assets. ● Indivisibility of assets may result in heterogeneity in leverage strategies. ● Leverage-level effects are not isomorphic to leverage-ratio effects. ● The acquisition channel means that increased asset redeployability can also have a negative effect on leverage, especially when debt benefits and redeployability are high to begin with. ● Tax policy and non-tax-related debt benefits can have ambiguous effects on reallocational efficiency, firm value, and tax receipts. For example, for some large tax rates, a further increase in tax rates can increase both firm value and tax revenues. 42 Michael-Paul James
- 43. Assumption Discussion ● Outside buyers ○ Increase liquidity values and lessen the desire to lower debt to save for buying opportunities. ● Correlated shocks ○ All assets are simultaneously shocked (recession) resulting in higher highs and lower lows, motivating lower debt. ● Agency conflicts ○ If managers are heavily incentivized to avoid declaring bankruptcy and not liquidate, firms are less likely to liquidate simultaneously, given equal debt, which may impact optimal debt levels. 43 Michael-Paul James
- 44. Literature 05 Related Literature, Shleifer and Vishny 44 Michael-Paul James
- 45. Known effects ● Fundamental trade offs between taxes and financial distress. ● Costs of financial distress have distinct components, such as debt overhang, the damaged relationships with key stakeholders, and reduced market share. ● When assets are indivisible, there may be mixed equilibria. ○ Some firms adopt high-debt strategies to access tax benefits ○ Others adopt low-debt strategies to take advantage of fire-sales. ● Debt is an optimal choice and fire-sale prices are endogenous. ○ Debt benefits increase debt levels, inducing price reduction. ● Financially distressed firms liquidate at discounts to fundamental value. ● Firms take on more debt when assets are easier to redeploy 45 Michael-Paul James
- 46. Shleifer-Vishny ● Research agenda for corporate behavior ○ Asset prices may be depressed when many firms need to sell simultaneously, thus resulting in fire-sale liquidations. ● Model setup ○ 3-period model with one outsider and two industry firms plus. ○ Firms value each other to determine to have debt to avoid agency costs or not to have debt to avoid costly liquidation. ○ Opportunistic buying limited by enough debt to be the acquirer if the other firm falls into financial distress. ○ Heterogeneity is exogenous; model cannot employ identical firms. ○ No comparative analysis. 46 Michael-Paul James
- 47. Differences ● Our model offers a negative comparative static with respect to redeployability. ● Our model generates endogenous heterogeneity among firms that are ex ante homogeneous, with an important link to asset indivisibility. ● Our model offers comparative statics on leverage (D/V), not just on debt levels. ● It is among very few models in which prices are endogenous. 47 Michael-Paul James
- 49. Table 3 Table 3 Notes: a. When debt is simpler to implement, more firms choose debt over equity (cf. pp. 579-581). b. Equity complexity is necessary for specific hard-to-transfer assets. Firms prefer debt when assets are easy to liquidate (cf. pp. 579-581). c. The benefits of debt are that payment/nonpayment and audits in default provide signals of asset quality (cf. p. 329). d. Only one firm. Redeployability is a discount in liquidation relative to fundamental value (cf. p. 340). e. Debt helps avoid negative net present value (NPV) investment and is firm specific. (Own) debt decreases within and increases between equilibrium regions (cf. p. 1354). f. Discussed only informally relative to Williamson (1988) (cf. p. 1359). g. Endogenous decision to sell to insider/outsider. Only when sold to the outsider is the price dependent on debt levels. Otherwise exogenous (maybe cf. p. 1353). h. The model cannot accommodate identical firms. i. They investigate responses to increases in the good asset's expected quality (not relative to bad investment) and show that it decreases debt levels on the intensive margin but increases on the extensive margin (cf. p. 120, para. 4). j. Measured as net (parameter ). The value continues to increase even though firms begin to max out leverage. 49 Michael-Paul James
- 50. Conclusion 06 Key Points and Takeaways 50 Michael-Paul James
- 51. Results ● Modeling firm anticipation and participation in industry asset sales, with more levered firms as sellers and less levered firms as buyers. ● Prices become mediators of industry leverage interactions ● Prices ambiguates the role of asset redeployability. ○ When redeployability is low, an increase in price induces firms to take on more debt in order to take advantage of higher fire-sale prices as potential sellers. ○ When redeployability is high, an increase in price induces firms to take on less debt in order to take advantage of fire sales as potential buyers. 51 Michael-Paul James
- 52. You are Amazing Ask me all the questions you desire. I will do my best to answer honestly and strive to grasp your intent and creativity. 52 Michael-Paul James