The Value of Financial Flexibility: Equilibrium Liquidation Values and Endogenous Capital Structure Heterogeneity

Firms with lower leverage are not only less likely to experience financial distress but are also better positioned to acquire assets from other distressed firms. With endogenous asset sales and values, each firm’s debt choice then depends on the choices of its industry peers. With indivisible assets, otherwise identical firms may adopt different debt policies—some choosing highly levered operations (e.g., to take advantage of tax benefits), others choosing more conservative policies to wait for acquisition opportunities. Moreover, the acquisition channel induces firms to reduce debt when assets become more redeployable. Finally, our paper highlights a simple pitfall: theoretical implications for debt do not always map into empirically measured implications for debt-to-value ratios, because value is also endogenous. Firms with more leverage are more likely to experience future financial distress. Importantly, their expected costs of bankruptcy are likely to be higher not only when they themselves, but also when their industry peers have taken on more debt. More firms will then want to sell the same types of assets at the same time, and their peer firms—who would otherwise have been the natural asset buyers—become themselves more limited in their capacity to absorb these assets (Shleifer and Vishny (1992)). As a result, the fire-sale discounts relative to fundamental asset values will become steeper. And, therefore, the debt choices of individual firms today, aggregated into industry debt, can themselves influence the asset liquidation values and have anticipative feedback into firms’ debt choices in the first place. Like most earlier literature, in our model, firms choose their capital structures before they learn their profitabilities. Leverage confers direct value benefits, such as tax benefits, signaling benefits, or incentive enhancements. However, leverage can also lead to tough choices for firms that later experience negative shocks. Once in default, the creditors must decide whether to liquidate on the one hand, or to reorganize and continue operations on the other. If they liquidate, firms receive the prevailing market price for their assets. The assets will then be in the hands of buyers who can presumably put them to better use. If they reorganize, firms keep the assets but may still suffer some impairments, such as direct costs and strained relationships with key stakeholders. A distressed firm is not worth as much as it would have been in the absence of default. Unlike most earlier literature, in our model, debt-laden capital-constrained firms are not only more likely to sell but also less likely to buy. We assume that all firms are competitive and can anticipate but not internalize the effects of their peers. The mechanism in our model that coordinates their debt choices is the endogenous asset price.1 For example, suppose that some firms adopt more aggressive debt policies. In the future, this will increase the supply and reduce the demand for liquidated assets, resulting in a lower equilibrium price. In turn, the anticipated lower price creates two counterbalancing motivations for the remaining firms today: (1) they will fear running into financial distress more; and (2), if they reduce their own debt, they will be more likely to enjoy future vulture buying opportunities. Thus, their best response to higher debt by their peers is lower debt for themselves. Interestingly, when assets are indivisible, a-priori homogeneous firms may even endogenously split into two coexisting types, with some types levering up and operating more aggressively—even anticipating distress and having to fire-sell—and other types maintaining conservative capital structures (“dry powder”) to take advantage of these anticipated future fire sales. The “opportunistic-acquisition” channel can reverse an important implication of models with only the “financial distress” channel. In Williamson (1988) and Harris and Raviv (1990), when assets are more redeployable, firms take on more debt because their distress costs will be lower (Benmelech, Garmaise, and Moskowitz (2005)). By contrast, in our model, firms may take on less debt to take advantage of more favorable future buying opportunities. Our model can also offer further insights. Depending on 1Earlier papers assume the liquidation price is exogenous. The exception is Gale and Gottardi (2015). We will discuss the differences in detail in Section III.A.