The Commitment Role of Equity Financing

Abstract

Existing theories of a firm’s optimal capital structure seem to fail in explaining why many healthy and profitable firms rely heavily on equity financing, even though benefits associated with debt (like tax shields) appear to be high and the bankruptcy risk low. This holds in particular for firms that show a strong commitment toward their workforce and are popular among employees. We demonstrate that such financing behavior may be driven by implicit arrangements made between a firm and its managers/employees. Equity financing generally strengthens a firm’s credibility to honor implicit promises. Debt, however, has an adverse effect on the enforceability of these arrangements because too much debt increases the firm’s reneging temptation, as some of the negative consequences of breaking implicit promises can be shifted to creditors. Our analysis provides an explanation for why some firms only use little debt financing. Predictions made by our theory are in line with a number of empirical results, which seem to stay in contrast to existing theories on capital structure.

International Debt Shifting: The Value-Maximizing Mix of Internal and External Debt

“…Second, the use of internal debt might weaken the commitment of the MNC (as principal) to incentive agreements with the managers (as agents) in the local subsidiaries. In such cases, increasing the level of internal debt would cause additional moral hazard costs because local managers lose trust in the implicit agreements with the MNCs on remuneration of managerial effort (Fahn et al, 2018). Both of these cost interactions should matter mostly for (very) high levels of total debt-to-asset ratios.…”

Relational Contracts, the Cost of Enforcing Formal Contracts, and Capital Structure Choice - Theory and Evidence

“…Within our model setup, it will turn out to be weakly optimal for the downstream rm to only use (internal) equity nancing (on which we impose no restrictions). But there are many reasons outside our model for why rms might use debt, for example because of associated tax benets (which we analyze in Appendix II, in Section 6), or because they do not have sucient internal funds and using external equity triggers agency costs (see Fahn et al, 2017). In these cases, the maximum debt level that we derive below is equivalent to the uniquely optimal debt level.…”

“…For example, prots might be taxed and interest payments are usually tax-deductible, which would reduce the eective cost associated with debt nancing (see Appendix II, Section 6). Furthermore, internal funds might not be sucient to nance I, and external equity associated with agency costs (see Fahn et al, 2017).…”

“…In Appendix II, in Section 6, we also let the upstream party make an up-front investment 5. InFahn et al (2017), we analyze a setting where internal funds are not sucient to nance I, and debt as well as external equity is available. Here, we aim at deriving (indirect) costs of debt nancing in a setup that is as simple as possible.…”

Size Matters - 'Over'investments in a Relational Contracting Setting

“…Contreras (2013) analyzes how relational contracts formed between a firm and its supplier interact with the quality of financial markets. Fahn, Merlo, and Wamser (2014) show how equity financing helps to enforce relational contracts. If debt is too high, a firm is able to share some of the costs of reneging on relational contracts with its creditors.…”