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Asset Substitution and Debt Renegotiation
Author(s) -
Flor Christian Riis
Publication year - 2011
Publication title -
journal of business finance and accounting
Language(s) - English
Resource type - Journals
SCImago Journal Rank - 1.282
H-Index - 77
eISSN - 1468-5957
pISSN - 0306-686X
DOI - 10.1111/j.1468-5957.2011.02253.x
Subject(s) - economics , volatility (finance) , agency cost , monetary economics , debt , capital structure , ex ante , substitution (logic) , equity (law) , asset (computer security) , financial economics , finance , macroeconomics , corporate governance , computer security , computer science , political science , law , shareholder , programming language
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.