Asset Substitution and Debt Renegotiation

Abstract

In a dynamic capital structure model we study whether asset substitution implies agency costs when the firm initially takes the substitution option into account. Asset substitution affects earnings in two directions: volatility increases and growth rate decreases. We show that substitution implies agency costs if volatility increases enough. In this case, debt renegotiation to avoid substitution mitigates the ex ante costs. However, debt renegotiation decreases the equity holders' ex post costs. Thus, with a modest volatility increase, debt renegotiation allows equity holders to extract concessions from creditors albeit asset substitution was not chosen for non-renegotiable debt. Hence, debt renegotiation need not improve ex ante firm value if asset substitution is allowed for.

Debt Maturity Structure and Accounting Conservatism

“…Conservative financial reporting forces revelation of information regarding losses and provides not only ‘hard’ sources of information on current performance but also ‘soft’ information on current and future performance (Watts, ). Flor () finds that firms with high likelihood of asset substitution imply higher agency costs, and debt renegotiation can be one mechanism to mitigate these costs. Thus, in the presence of high default risk, lenders exhibit greater demand to monitor management and exert contingent allocation of control rights (Smith and Warner, ).…”

Agency cost of debt overhang with optimal investment timing and size

“…Agency problems and the associated agency cost are central problems in corporate finance (Flor, ). The two major shareholder‐bondholder agency problems are asset substitution and underinvestment.…”

“…The two major shareholder‐bondholder agency problems are asset substitution and underinvestment. The former has been studied by Eisdorfer (), Flor (), Jensen and Meckling (), Leland () and others. Our paper focuses on the latter – underinvestment or debt overhang.…”

Stock‐bond return co‐movement and accounting information

“…Shareholders may expropriate wealth from bondholders by switching from safe to risky investment strategies (i.e., asset substitution). If risky investments perform well, shareholders get most of the gains (the value of their call option increases), whereas bondholders bear most of the cost because of their limited upside potential (Fama & Miller, ; Flor, ; Parrino & Weisbach, ). Similarly, if bonds are priced under the assumption that no additional debt securities will be issued by the firm, bondholders may be expropriated if additional bonds of equal or higher priority are issued (i.e., claim dilution).…”