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

• Published date: 01 February 2016
• Author: Palani‐Rajan Kadapakkam,John K. Wald,Alex Meisami
• Date: 01 February 2016
• DOI: http://doi.org/10.1111/fire.12096

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

Abstract

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

choices.

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: ameisami@iusb.edu.

We would like to thank Onur Bayar, Karan Bhanot, Tim Carpenter, Adam Usman, and an anonymous

referee for comments on earlier drafts.

C2016The 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,

2010).

1Consistent with this theory, investment-grade firmsissue debt more often than equity while junk-grade

firms issue equity more often.