Corporate Finance, Asset Returns, and Credit Risk

This dissertation consists of three chapters. The first chapter empirically investigates how the intensity of product market competition affects the cost of debt. Using a large sample of loans to publicly traded US manufacturing firms, the chapter provides evidence that an intensification of product market competition among firms significantly increases the cost of bank loans. The analysis reveals that the effect is strongest in industries with high illiquidity and specificity of assets. This finding indicates that the liquidation value of assets is an important channel through which competition affects the cost of debt. Moreover, loans to firms that operate in more competitive industries contain more covenants restricting the firms' financing and dividend policies. Overall, the results suggest that banks explicitly take into account the risk arising from product market competition when pricing and designing debt contracts. The second chapter tests whether equity risk reflects the shareholders' incentives to default strategically on the firm's debt obligations. The chapter develops a model that relates shareholders' incentives to default strategically with the likelihood that debt renegotiations fail. Using an international cross-section of stocks to exploit the exogenous variation of insolvency procedures across countries and to test the model's predictions, the analysis reveals that the equity beta increases with the degree of creditor protection. Moreover, the equity beta decreases with the costs of liquidation and shareholders' bargaining power, and the sensitivity of this relationship weakens as country's creditor protection toughens. The results are economically important, and robust to various specifications and estimation techniques. The third chapter investigates how the debt structure and the strategic interaction between shareholders and creditors in the event of default affect expected stock returns. By endogenizing shareholders' decision to default, the model generates new predictions linking firm characteristics to expected stock returns through an intuitive economic mechanism. In particular, the model predicts that expected stock returns are higher for firms that face high debt renegotiation difficulties, and that have a large fraction of secured or convertible debt. Expected stock returns are lower for firms whose shareholders maintain strong bargaining power, and for firms subject to high liquidation costs. Using a large sample of publicly traded US firms between 1985 and 2005, the third chapter presents new evidence on the link between debt structure, renegotiation frictions, and stock returns, which is supportive of the model's predictions.


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