Dynamic Recapitalization Policies and the Role of Call Premia and Issue Discounts

Fischer, Edwin O.; Heinkel, Robert; Zechner, Josef

doi:10.2307/2330977

Cited by 50 publications

(14 citation statements)

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“…Our results are therefore driven by both mean reversion and the long‐term nature of debt. Of course, a comprehensive model would permit periodic recapitalisation, perhaps similar to that in Fischer et al . (1989), but that is beyond the scope (and could be a possible extension) of this paper.…”

Section: The Recent Literaturementioning

confidence: 99%

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The Trade‐off Model with Mean Reverting Earnings: Theory and Empirical Tests

Sarkar

Zapatero

2003

The Economic Journal

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The 'trade-off theory' of capital structure predicts a positive relationship between earnings and leverage, contradictory to well established empirical evidence. Since corporate earnings are known to be mean reverting, we reformulate the trade-off model with mean reverting earnings. We show that, with mean reverting earnings, there should be a negative relationship between optimal leverage and the current earnings level. The model also illustrates the importance of the earnings reversion parameter in the determination of capital structure. The major implications of the model are supported by empirical tests carried out with a sample of firms in the S&P 500 Index.The capital structure decision is arguably one of the most important issues in corporate finance. Beginning with the irrelevance propositions of Miller and Modigliani (1958), there is a substantial literature on what Myers (1989, p. 80) calls 'the search for optimal capital structure'. In the theoretical literature, there are two major competing models, the traditional 'trade-off theory' and the more recent 'pecking order hypothesis'. According to the former, firms choose an optimal leverage ratio by balancing the tax benefits of debt against the costs associated with debt, e.g., bankruptcy costs or financial distress costs. The pecking order hypothesis is based on informational asymmetry between insiders (managers or shareholders) and outsiders. According to this theory, firms tend to raise funds in the following order of preference: internal finance (retained earnings), safe debt, risky debt, and finally equity.Certain implications of the trade-off theory have received empirical support; see, for example, Long and Malitz (1985), Mackie-Mason (1990) and Graham (1996). However, in a head-to-head comparison between the two theories, the pecking order model seems to be more favourably viewed than the trade-off theory (Baskin, 1989;Shyam-Sunder and Myers, 1999;Fama and French, 1999). To quote Fama and French (1999, p. 3) '… we identify one big contradiction of the trade-off model and one less serious contradiction of the pecking order model.' The 'big contradiction' is the earnings-leverage relationship. The actual relationship between leverage and earnings (or profitability) has been found to be negative (Titman and Wessels, 1988;Baskin, 1989;Rajan and Zingales, 1995;Fama and French, 1999). But according to the received wisdom, the trade-off theory predicts a positive relationship between leverage and earnings; see Brealey and Myers (1996), Shyam-Sunder and Myers (1999) etc. To quote Myers (1989, 'the * This paper was presented at the 2001 Rutgers Conference on Capital Structure, Lancaster University, McMaster University, and University of Southern California. We appreciate comments received from participants at these seminars, as well as Peter McKay, Mark Weinstein and especially David Mauer. We also thank two anonymous referees for their feedback and for many useful suggestions, and the editor Mike Wickens for his guidance. Finally, we thank John Graham...

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Section: The Recent Literaturementioning

confidence: 99%

“…This is a common assumption in the corporate debt/capital structure literature, e.g.,Leland (1994),Fischer et al (1989) etc. With long maturities, the return of principle has negligible value and can be ignored; seeLeland (1994).…”

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confidence: 99%

The Trade‐off Model with Mean Reverting Earnings: Theory and Empirical Tests

Sarkar

Zapatero

2003

The Economic Journal

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“…Depending upon the tax treatment of call premia, this is not necessarily optimal. The effects of call premia when the firm cannot precommit to a recapitalization policy are examined in Fischer, Heinkel, and Zechner[14]. g)' = maxl(yg), }.…”

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confidence: 99%

Dynamic Capital Structure Choice: Theory and Tests

Fischer¹,

Heinkel²,

Zechner³

1989

The Journal of Finance

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1,094

283

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This paper develops a model of dynamic capital structure choice in the presence of recapitalization costs. The theory provides the optimal dynamic recapitalization policy as a function of firm‐specific characteristics. We find that even small recapitalization costs lead to wide swings in a firm's debt ratio over time. Rather than static leverage measures, we use the observed debt ratio range of a firm as an empirical measure of capital structure relevance. The results of empirical tests relating firms' debt ratio ranges to firm‐specific features strongly support the theoretical model of relevant capital structure choice in a dynamic setting.

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“…Smith and Warner (1979) argue that debt may be called early to get rid of restrictive covenants on the firm's investment policy. Kraus (1983), Fisher et al (1989, and Mauer (1993) argue that calls are delayed because of transaction costs. Longstaff and Tuckman (1994) suggest that the bond call is delayed in the presence of multiple lenders.…”

Section: Fundamental Views On the Call Policymentioning

confidence: 99%

Prepayment risk on callable bonds: theory and test

François

Pardo

2015

Decisions Econ Finan

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We develop a framework for analyzing prepayment risk on defaultable callable bonds. We argue that prepayment risk emanates from the following informational asymmetry: Callable bond traders cannot determine the issuer's firm valuemaximizing call policy, and their best anticipation is the optimal refinancing policy given by a term structure model. We show that, from the callable bond holder perspective, the issuer's departure from the optimal refinancing policy translates into an accrued exposure to market risk. The prepayment risk magnitude represents this risk transfer, and we show that callable bond traders can infer it from observable bond characteristics. Tests on callable bond transaction data provide strong evidence for prepayment risk and validate our conjecture that insurance companies trade callable bonds to reduce their exposure to prepayment risk magnitude.

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Dynamic Recapitalization Policies and the Role of Call Premia and Issue Discounts

Cited by 50 publications

References 12 publications

The Trade‐off Model with Mean Reverting Earnings: Theory and Empirical Tests

The Trade‐off Model with Mean Reverting Earnings: Theory and Empirical Tests

Dynamic Capital Structure Choice: Theory and Tests

Prepayment risk on callable bonds: theory and test

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