Shareholders Valuation of Long-Term Debt and Decline in Firms’ Leverage Ratio

63 Pages Posted: 27 Nov 2017

See all articles by Ranjan D'Mello

Ranjan D'Mello

Wayne State University - Department of Finance

Mark Gruskin

Pennsylvania State University

Manoj Kulchania

Wayne State University - Finance Group

Date Written: November 6, 2017

Abstract

The median U.S. non-regulated firm reports a 47 percent decline in leverage ratio between 1980 and 2010. We investigate whether the cost-benefit tradeoff to shareholders, captured by the valuation impact of an additional dollar of debt on owners’ equity, is an explanation for the observed change in leverage. Using Faulkender and Wang (2006) methodology, we find that shareholders view increasing debt to have a negative impact on their wealth, that is, shareholders perceive firms to be over-levered. Further, the net cost of issuing additional debt has increased steadily for three decades beginning in 1980 before declining marginally after 2010. This trend holds for different groups of firms classified on factors known to affect capital structure decisions. Managers respond to the changing cost to shareholders by reducing (increasing) leverage when the cost of debt increases (decreases). The time-series pattern in the marginal cost of debt persists after controlling for firm-specific characteristics. We find that macroeconomic factors, such as federal debt, play a role in explaining the marginal value of debt.

Keywords: Capital Structure, Marginal Cost of Debt, Leverage

JEL Classification: G30, G32, G34

Suggested Citation

D'Mello, Ranjan and Gruskin, Mark and Kulchania, Manoj, Shareholders Valuation of Long-Term Debt and Decline in Firms’ Leverage Ratio (November 6, 2017). Journal of Corporate Finance, Forthcoming, Available at SSRN: https://ssrn.com/abstract=3074689

Ranjan D'Mello

Wayne State University - Department of Finance ( email )

328 Prentis Bldg.
5201 Cass Avenue
Detroit, MI 48202
United States
313-577-7828 (Phone)

Mark Gruskin

Pennsylvania State University

University Park
State College, PA 16802
United States

Manoj Kulchania (Contact Author)

Wayne State University - Finance Group ( email )

2771 Woodward Ave
Detroit, MI 48201
United States
313-577-7837 (Phone)

HOME PAGE: http://ilitchbusiness.wayne.edu/profile/fr3472

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