Risk Moment RES

Credit Risk, Liquidity Risk, and Optimal Capital Structure under Incomplete Accounting Information

WOLFGANG BÜHLER
University of Mannheim - Department of Business Administration and Finance
TIM O.H. THABE
University of Mannheim October 2006EFA 2006 Zurich Meetings Paper
Mannheim Finance Working Paper No. 2006-13

Abstract:
In a structural model for credit risk we endogenize inability to pay as a second independent reason for default besides overindebtedness. Inability to pay is triggered by rational behavior of incompletely informed outsiders. The firm needs to raise additional cash via secondary equity offerings in order to service it’s coupon payments. Underpricing of secondary equity offerings is explained as necessary for these offerings to be successful. In addition to Duffie/Lando (2001) we find that the liquidity risk has a strong impact on the current firm value and the optimal leverage. Credit spreads of debt in the primary market depend on the degree of liquidity risk. They can be lower or higher than in case without liquidity risk.Our results have a number of additional, interesting consequences. Contrary to Duffie/Lando (2001) incomplete information of outside investors has an impact on the default probability of the firm and therefore on the optimal capital structure which is determined in the primary market. The debt-equity ratio is typically lower than in the Duffie/Lando (2001) model that operates under complete information in the primary market and can result in lower credit spreads.
Keywords: Bond Default, Credit Spread Modelling, Incomplete Accounting Information, Optimal Capital Structure, Seasoned Issue Underpricing

JEL Classifications: D82, D92, G12, G13

Working Paper Series

Bühler, Wolfgang and Thabe, Tim O.H., “Credit Risk, Liquidity Risk, and Optimal Capital Structure under Incomplete Accounting Information” (October 2006). EFA 2006 Zurich Meetings Paper Available at SSRN: http://ssrn.com/abstract=906988

http://papers.ssrn.com/sol3/papers.cfm?abstract_id=906988

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