Growth Options, Macroeconomic Conditions and the Cross-Section of Credit Risk

Abstract

This paper develops a structural equilibrium model with intertemporal macroeconomic risk, incorporating the fact that firms are heterogeneous in their asset composition. Compared to firms that are mainly composed of invested assets, firms with growth options have higher costs of debt because they are more volatile and have a greater tendency to default during recession when marginal utility is high and recovery rates are low. Our model matches empirical facts regarding credit spreads, default probabilities, leverage ratios, equity premiums, and investment clustering. Importantly, it also makes predictions about the cross-section of all these features.Keywords: Asset composition, capital structure, credit spread puzzle, equity premium, growth options, macroeconomic risk, value premium $ We thank an anonymous referee whose suggestions have greatly improved the paper.

Financing Asset Sales and Business Cycles*

“…Following Arnold, Wagner, and Westermann (2013), each firm has one growth option that is costly to exercise. The key innovation in our paper is that we allow firms to endogenously choose between financing the investment cost with the proceeds from the asset sales or the issuance of new equity.…”

“…In particular, a firm (i) can irreversibly exercise this option at any timet, (ii) needs to pay the exercise cost K¯i, and (iii) achieves additional future earnings of s¯iX t for all t ≥t for some factor s¯i > 0, in whichī is the realized state of the economy at the time of exercise. In contrast to Arnold, Wagner, and Westermann (2013), both the exercise cost K¯i and the factor s¯i are regime-dependent to model firms with varying degrees of the cyclicality of their growth option. If an expansion option is exercised, it is once and for all converted into assets in place, so the firm consists of only invested assets.…”

“…To study cyclicality of expansion options, we extend the model of Arnold, Wagner, and Westermann (2013) by allowing regime-dependency of the additional earnings factor s i , and the exercise cost K i of the option.…”

“…This model environment allows us to derive endogenous investment, equity financing, and financing asset sale decisions over the business cycles by linking these decisions to asset prices and economic fundamentals. To generate financing needs, model firms do not only consist of invested assets but, following Arnold, Wagner, and Westermann (2013), also have a growth option that is costly to exercise. We augment this model environment by incorporating business cycle dependency of the equity issuance cost, the asset liquidity, and the growth option.…”

Investment-Based Corporate Bond Pricing

“…Contrary to our work, these papers do not focus on the pricing of corporate bonds and do not consider the importance of macroeconomic conditions. More recently, Barclay, Morellec, and Smith (2006), Chen and Manso (2010) and Arnold, Wagner, and Westermann (2011) also explore the effects of growth options on credit risk. These papers consider a levered firm which finances a single growth option with an infinite amount of cash on hand.…”