Hi David

Am not clear intuitevely about how increase in leverage transfers wealth from nondholders to share holders?Please help me out ..

Anil

Hi Anil,

Can I assume this refers to Stulz Debt Overhang (3.6.1), if not please advise?
As a general (universal) statement, I think its imprecise as there are new/old shareholders and new/old bondholders.
Also, under the capital structure idea in Stulz 3.3, the notion is that increased leverage (only up to a point) is creating new shareholder value (not necessarily tranferring from bond holders) by lowering the WACC.

But if we refer to debt overhang: the notion here is sort of the converse/corrollary to Stulz example that i illustrated in the spreadsheet: http://www.bionicturtle.com/premium/editgrid/2008_oprisk_stulz_debt_overhang/
In the example, shareholders of the highly levered gold firm (perversely) do not want to invest in a value-adding project because they will be diluted.
Similarly, given enough debt overhang (high leverage) per Stulz p 70 illustrates the issue. It may be helpful to think of equity as a call option on firm assets, per merton model:

If the firm is highly leveraged, the shareholders are almost holding an underwater call option (the value of the firm may barely compensate bond holder but not much left over for shareholders). If so, shareholders might as well take on risk projects (in Merton terms, increase firm volatility) because their worst case scenario is zero. With risky projects, they at least have a chance of higher payoff (but no downside).

But bondholders do not necessarily approve: the risky projects may reduce firm value and eat into their principal.

It’s not unlike an argument against executive stock options that goes: the options, because they are asymmetrical payoffs with no downside, induce risky behavior; i.e., encourage execs to “buy lottery tickets.”

as i think about, the idea may be more simply illustrated in the Merton model with:

firm value = equity value [as call option on firm value] + debt value

given that, if leverage increases only the risk of the firm (i.e., at a certain cap structure, leverage increases the cost of financial distress) without increasing firm value, then you can see how:

more risk implies greater equity value [i.e., call option with higher volatility]
but if firm value is unchanged, then:

same firm value = higher equity value + [must be:] lower debt value
i.e., transfer of wealth

David

Hi David,

Thanks,That helps...anyways that was from impact of rating change on security prices---de servingy chapter 2.

Hi Anil,

Okay, understood.
I see that now in de Servigny; it’s pretty non-specific mention (i.e., no distinction between current/new shareholder and bondholders).

I’d say the above Stulz-based argument could be used here....

David