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The Debt Trap: Wealth Transfers and Debt‐Equity Choices of Junk‐Grade Firms
Author(s) -
Kadapakkam PalaniRajan,
Meisami Alex,
Wald John K.
Publication year - 2016
Publication title -
financial review
Language(s) - English
Resource type - Journals
SCImago Journal Rank - 0.621
H-Index - 47
eISSN - 1540-6288
pISSN - 0732-8516
DOI - 10.1111/fire.12096
Subject(s) - leverage (statistics) , debt , equity value , monetary economics , equity (law) , economics , bankruptcy , gearing ratio , debt to equity ratio , debt financing , business , internal debt , financial economics , finance , debt levels and flows , population , demography , machine learning , sociology , computer science , political science , law , nonprobability sampling
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.