The Debt Trap: Wealth Transfers and Debt‐Equity Choices of Junk‐Grade Firms

Published date01 February 2016
Date01 February 2016
The Financial Review 51 (2016) 5–35
The Debt Trap: Wealth Transfers and
Debt-Equity Choices of Junk-Grade Firms
Palani-Rajan Kadapakkam
University of Texasat San Antonio
Alex Meisami
Indiana University South Bend
John K. Wald
University of Texasat San Antonio
If outstanding debt is risky, issuing equity transfers wealth from equity holders to debt
holders. If existing leverage is high and bankruptcy costs are small, this wealth transfer effect
outweighs the gains to stockholders from optimizing firm value. Empirically, we find that
for investment-grade firms, higher leverage implies a greater likelihood of issuing equity, as
expected in a standard tradeoff model. However, consistent with the impact of wealth transfer
effects, for junk-grade firms, higher leverage implies a greater likelihood of issuing debt. The
analysis implies an additional route through which historical shocks determine firms’ financing
Keywords: capital structure, wealth transfer effects, junk bond issues
JEL Classification:G32
Corresponding author: Department of Finance, Judd Leighton School of Business & Economics,
Indiana University South Bend, 1700 Mishawaka Avenue,P.O. Box 7111, South Bend, IN 46634-7111;
Phone: (574) 520-4355; Fax: (574) 520-4866; E-mail:
We would like to thank Onur Bayar, Karan Bhanot, Tim Carpenter, Adam Usman, and an anonymous
referee for comments on earlier drafts.
C2016The Eastern Finance Association 5
6P.-R.Kadapakkam et al./ The FinancialReview 51 (2016) 5–35
1. Introduction
The traditional tradeoff theory of capital structure suggests that firms optimize
their value by choosing a leverage that weighs the tax benefits of debt against the
deadweight costs of financial distress.1More recent papers analyze the dynamics of
capital structure decisions taking into account the firm’s existing leverage, tax status,
and issuance costs (see, for instance, Hennessy and Whited, 2005, or DeAngelo,
DeAngelo and Whited, 2011). In this paper, we add to the existing literature by
showing how the choice between debt and equity issuance is affected by wealth
transfers from existing equity holders to debt holders. Specifically, stockholders of
highly levered firms have an incentive to avoid secondary equity issuances as these
imply a transfer of wealth to bondholders. While additional equity could increase
total firm value, this increase in wealth is not always sufficientto offset the loss faced
by existing equity holders. Myers (1977) shows that this wealth transfer implies that
firms do not undertake some positive net present value projects, and here, we show
that it also creates an asymmetry in the way firms adjust their capital structures. While
most firms rebalance to an optimal capital structure, junk-grade firms with high debt
will more frequently choose additional debt rather than rebalancing by issuing equity.
We begin by providing a theoretical model of the firm’s decision to use debt or
equity financing. We show that the wealth transfer effect implies that riskier firms
are more likely to use additional debt financing. We test this theoretical proposition
and find confirming evidence. For investment-grade firms, the probability of using
debt decreases with existing leverage, suggesting adjustment toward target capital
structure ratios. In contrast, junk-grade firms with a higher leverage ratio are more
likely to issue debt than those with a lower leverage ratio. This finding is consistent
with Lemmon, Roberts and Zender (2008) who note that while leverage ratios exhibit
some mean reversion, there is a clear tendency for highly levered firms to remain
highly levered.
Our model additionally implies that the wealth transfer effect would be larger if
the financing need is greater (a larger issue size relative to existing firmvalue) and if
more of the outstanding debt is long-term. We find support for both the relative size
effect and the effect of debt maturity in our analysis of financing choice.
These results add to the literature on the importance of historical shocks in
determining capital structure. In particular, they suggest the existence of a “debt trap”
wherein firms with high leverageratios have insufficient incentives to reduce leverage
back to levels that maximize firm value. Thus, a negative shock can have longer term
consequences, as some firms choose to retain high leverage ratios after a sufficiently
negative shock, and this can reduce firm value (for estimates of expected bankruptcy
costs and other costs associated with debt, see van Binsbergen, Graham and Yang,
1Consistent with this theory, investment-grade firmsissue debt more often than equity while junk-grade
firms issue equity more often.

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