The impact of debt restructuring on dynamic investment and financing policies

Highlights

• We develop a unified model of firm dynamics with debt restructuring.

• Firms with more uncertainty on cash flows prefer private debt to public debt.

• Debt restructuring is an effective way to mitigate agency problem.

• Policymakers can adopt debt restructuring to improve financial decisions efficiency.

Abstract

This paper explores the impacts of debt restructuring on investment and financing decisions and agency problem between shareholders and creditors. Notably, a critical feature in our model is that the renegotiation in debt restructuring is credible. To do so, we develop a unified model of dynamic investment, financing and agency problem for firms with renegotiable private debt, thereby highlight the significance of debt restructuring for corporate decisions. We find that firms with lower renegotiation costs and more uncertainty on cash flows are more likely to issue private debt than public debt. Interestingly, we also discover that debt restructuring can alleviate underinvestment and weaken sharesholders’ asset substitution motives, thereby reducing the agency costs of debt. The above results provide practical implications for policymakers about improving investment and financing efficiency and avoiding the deadweight loss of social welfare.

Introduction

In corporate finance, the question about investment and financing decisions has long been a concern (see in Mauer and Ott (2000),Mauer and Sarkar (2005), Hackbarth et al. (2007), Hackbarth and Mauer (2012), Lyandres and Zhdanov (2014), and Luo et al. (2020), among others). However, much of literature focuses on the interaction between public (market) debt financing and investment. The public debt can be difficult (or even impossible) to renegotiate,¹ and it leads to inefficient bankruptcy liquidation. Whereas private debt is easy to renegotiate when firms are in financial distress.²

Indeed, debt renegotiation is an efficient solution to resolve firms’ distress and avoid costly bankruptcy. As shown in Corbae and Derasmo (2017), the U.S. bankruptcy court system received nearly 38,000 commercial bankruptcy filings in 2016. For publicly traded firms, 80% of bankruptcies are handled under Chapter 11 (debt restructuring), while only 20% are Chapter 7 (liquidations). Additionally, the Chinese government recently implements a series of policies and documents to encourage market-oriented debt restructuring (i.e., partial debt-to-equity swaps) between firms (shareholders) and banks (creditors). Until November 2020, the total implemented amount has already reached 1600 billion RMB.³ Given the significance of debt restructuring, firms would consider the possible contingency of a future reorganization when they make optimal investment and financing decisions. However, there are few papers that explore how debt renegotiation (private debt financing) influences investment and financing decisions and agency problem between shareholders and creditors in a unified dynamic model. We aim to address these issues in this paper.

To this end, we build a dynamic model of investment, financing and debt restructuring decisions, which are endogenously and jointly determined. We consider a firm with assets in place financed by equity and private debt (renegotiable debt, e.g., bank loans) and a growth option financed by internal equity. The private debt can, if possible, be partially renegotiated when the firm is in financial distress. Thus it can defer inefficient liquidation. Naturally, the firm has two options: The first is the growth option to expand operations when the firm is performing well; the second is the debt renegotiation option to restructure in periods of financial distress. A critical feature of our model is that the debt renegotiation is credible, which is different from the strategic debt service in Sundaresan and Wang (2007) and Pawlina (2010). Credible debt restructuring here means that the creditors holding private debt have an option to decide whether to accept or reject debt restructuring offers proposed by shareholders. If the value received by the creditors in debt renegotiation is less than that upon formal bankruptcy, the restructuring offers will be rejected. Thus the credible debt renegotiation can success only if it benefit both creditors and shareholders. We further assume the firm not only decides on both optimal investment and debt restructuring policies, but also determines financing ways for restructuring funds in different scenarios (before and after investment), i.e., taking on new debt, issuing equity, or a combination of them.

We provide some novel results as follows. First, firms with lower renegotiation costs, i.e., lower buyback premium costs, transaction costs and equity issuance costs, are more likely to implement debt restructuring comparing with formal liquidation. Because the gains from debt restructuring can more easily to cover the total restructuring costs for firms with low renegotiation costs, and thus both shareholders and creditors are easier to profit from it. In addition, firms with growth options can much more easily engage in debt restructuring relative to ones without growth options. The intuition is that, for a promising firm with growth options, both the shareholders and initial creditors are more likely to benefit from it since the firm's debt restructuring is more profitable owing to including the contingent claims of exercising growth options in future.

Second, firms with lower renegotiation costs have an incentive to restructure with creditors by taking on new debt and buying back old debt, i.e., through debt-to-debt swaps, and vice versa, firms tend to restructure by issuing a combination of new debt and equity. Moreover, since debt restructuring can significantly reduce bankruptcy risk and enhance the tax shield benefits, firms take a higher debt coupon, a larger leverage ratio, and thus bear higher credit spread and delay the exercise of the growth option. In addition, firms with greater cash flow uncertainty and lower renegotiation costs prefer private debt to public debt under the optimal capital structure. The economic intuition is that, in contrast to public debt without restructuring option, renegotiable private debt not only can reduce bankruptcy loss costs and increase tax benefits by avoiding premature liquidation, but also reduce agency conflicts regarding underinvestment and asset substitution. The value of debt restructuring option is more profitable with lower renegotiation costs and more uncertainty on cash flows since the value of buffering firms against bankruptcy increases with the volatility of cash flows rising.

Last, debt restructuring (private debt financing) can alleviate agency conflicts regarding underinvestment and asset substitution between shareholders and creditors. The Myers's (1977) underinvestment problem arises since the irreversible investment cost is undertaken by shareholders, while the part of the project's NPV is captured by the creditors. The presence of debt leads to the higher investment threshold and makes the shareholders willing to wait longer until the project's NPV becomes higher to offset the investment cost. In fact, if the firm exercises the growth option too early, it will be exposed to greater bankruptcy risk. However, debt restructuring can reduce the firm’ bankruptcy risk after investment. Because the firm with renegotiable private debt can continue to operate by implementing debt restructuring in financial distress. Thus, firms with debt restructuring have an incentive to accelerate investment relative to ones without debt restructuring, which implies that debt restructuring can alleviate underinvestment problem. The asset substitution problem caused by shareholders' risk-taking incentives. Shareholders transfer wealth from creditors to themselves via increasing the riskiness of firm. Debt restructuring in our model reduces the shareholder's wealth from asset substitution, since an increase in business risk leads to a significant decrease in firm value after restructuring. Thus, debt restructuring can mitigate asset substitution problem.

Literature review. Our research is related to a strand of the literature that uses structural models to examine debt renegotiation between shareholders and creditors. These works address issues ranging from debt renegotiation for temporary debt reduction (e.g. Anderson and Sundaresan (1996), Mella-Barral (1997) and Sundaresan and Wang (2007)) to permanent debt reduction for debt-to-equity swaps (Fan and Sundaresan (2000) and Sarkar (2013)) and pure debt-to-debt swaps (Mella-Barral (1999), Lambrecht (2001) and Moraux and Silaghi (2014)). They consider the investigation of how debt renegotiation depicted by a Nash bargaining game affects the capital structure and business behavior of firms. However, the above literature does not address the possibility of debt renegotiation, i.e., creditors may reject it ex post in the absence of a credible threat, and discuss the financing means available to obtain restructuring funds at renegotiation, i.e., whether to take on new debt or equity or a combination of both. Nishihara and Shibata (2016) and Silaghi (2018) consider this problem and analyze the use of equity financing, debt financing and asset sales in renegotiation. Both works consider debt restructuring with a credible threat developed through an exogenously given debt repayment premium. In addition, incorporating renegotiation frictions, debt renegotiation may fail with a certain probability and lead to early default, as discussed by Favara et al. (2012), Morellec et al. (2015), and Antill and Grenadie (2019). Last, the empirical literature also explores the impact of debt restructuring on firms’ investment decision. Such as Jiang et al. (2019) use the panel data of listed companies in China from 2005 to 2016, and then find the debt restructuring has a significant effect on investment efficiency. The empirical findings is line with the theoretical results in our model, which implies that we provide an potential economical explanation for the empirical findings.

My paper is also related to the literature exploring the interactions of investment and capital structure, such as Mauer and Ott (2000), Mauer and Sarkar (2005), Titman and Tsyplako (2007), Hackbarth and Mauer (2012), Sundaresan et al. (2015), Tan and Yang (2017) and Luo et al. (2020), among others. However, these studies mainly focus on the interaction between investment and public (non-renegotiable) debt financing, but few investigate how ex ante private (renegotiable) debt financing affects both investment and financing decisions. The analysis in our paper complements and extends these studies by focusing on examining the relation among optimal capital structure, expansion investment and debt restructuring with a credible threat in a unified dynamic model.

The contributions most closely related to our paper are Nishihara and Shibata (2016), Silaghi (2018), Pawlina (2010), Morellec et al. (2015) and Tan et al. (2020). The former two papers consider strategic debt restructuring with a credible threat and financing policies for restructuring funds. Nishihara and Shibata (2016) examine the choice between debt restructuring and formal bankruptcy (direct liquidation) when the firm is in financial distress, and its means of financing for restructuring funds. Moreover, they examine the impact of the possibility of debt renegotiation in the future on the initial optimal capital structure. However, they do not investigate how the use of equity financing varies across firms. Silaghi (2018) focuses on the financing decisions for restructuring funds, including issuing equity, taking new debt and asset sales. He provides a thorough analytical study of the use of equity financing in renegotiation and highlights the important parameters influencing the use of equity financing. However, the first two papers consider this problem in a static model and do not investigate the interactive effect of growth option on strategic debt restructuring and financing policies. Furthermore, they do not explore how the possibility of debt renegotiation affects agency conflicts regarding underinvestment and asset substitution. To our knowledge, these topics have not yet been considered in the literature, and thus our paper focuses on these issues.

The latter three papers consider the interaction of debt renegotiation, investment and financing. The key difference between our paper and Pawlina (2010) is that we consider a new debt renegotiation pattern in which creditors only accept debt restructuring offers when a credible threat is posed by shareholders. In general, when firms are in distress, shareholders can threaten lenders and force concessions from them with the possible liquidation of the firm. With respect to Pawlina (2010), owing to debt restructuring occurring prior to default, the shareholders’ liquidation threat may become non-credible since it would be better for them to keep servicing the existing debt (see Christensen et al. (2014); Silaghi (2018)). In contrast to Pawlina (2010), our model ensures that the value received by creditors in renegotiation will be at least as large as that under formal bankruptcy. This design can make debt restructuring occur at the bankruptcy threshold such that the liquidation threat offered by shareholders is credible. Thus, renegotiation would benefit both the creditors and shareholders and thus reach a Pareto improvement for the two negotiating parties. In contrast to exacerbating the underinvestment problem, as in Pawlina (2010), the possibility of credible debt renegotiation in our paper mitigates underinvestment and risk-shifting incentives. Furthermore, our paper examines a partial permanent debt reduction, but Pawlina (2010) consider a full temporary debt reduction. Finally, our paper not only investigates the choice between public and private debt financing when firms are founded but also studies the choice of the means of financing used to obtain restructuring funds during renegotiation. By contrast, Pawlina (2010) does not consider this question.

Besides, the main difference between this paper and Morellec et al. (2015) is as follows. First, Morellec et al. (2015) consider a firm with assets in place financed by equity, but in our model, the firm is initially financed with a mixture of renegotiable debt and equity. Second, the exercise cost of the growth option in Morellec et al. (2015) is financed by renegotiable debt and equity rather than purely by internal equity as in our paper. Thus, Morellec et al. (2015) investigate overinvestment problem, while we instead address the underinvestment problem. Third, Morellec et al. (2015) focus on the choice between private and public debt at investment timing and its relation to corporate investment. By contrast, our paper investigates the effects of firms’ growth option and characteristics on the choice in strategic default between debt restructuring and formal liquidation, the inefficiencies arising from underinvestment and asset substitution, and the choice between private and public debt financing at the beginning of the firm.

Finally, Tan et al. (2020) develop a continuous-time model of credible debt restructuring by a Nash bargaining game, and examine its impact on investment and financing polices. The main difference between our paper and Tan et al. (2020) is as follows. First, Tan et al. (2020) examine debt renegotiation for full and temporary debt reduction, i.e., strategic debt service, without considering relevant renegotiation costs. While our paper investigates debt renegotiation for partial and permanent debt reduction with considering relevant renegotiation costs for buyback premium costs for initial debt, transaction costs and equity issuance costs. Therefore, Tan et al. (2020) can only apply to the anticipated debt restructuring with prior contracts, and the debt restructuring way in our paper is more flexible and more widespread application since it can not only handle ex ante debt restructuring with contract but also deal with ex post debt restructuring. Second, Tan et al. (2020) investigate the effect of debt restructuring on firm's investment and financing decisions for a startup firm. By contrast, our paper considers an established firm with assets in place and growth option in future, and highlights the effects of debt restructuring on underinvestment and asset substitution and of firms' characteristics (i,e., high-low renegotiation costs and operational risk) on the choice in strategic default between debt restructuring and formal liquidation. Third, our paper explores how to choose the way of financing for restructuring funds at renegotiation, which is not considered in Tan et al. (2020).

The remainder of the paper is organized as follows. Section 2 sets up the model. Section 3 presents the model solution, in which we first price corporate securities at various times and then derive the timing of default, investment, restructuring and capital structure. Section 4 provides numerical results and economic analysis. Section 5 concludes the paper.