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Design and valuation of debt contracts

Hua Fan, 2000
Faculty Advisor: Suresh Sundaresan
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In this thesis, I develop a corporate debt valuation model that explicitly considers the strategic interactions between equity holders and debt holders upon debt renegotiation. Two formulations of reorganization are presented: debt-equity swaps and strategic debt service resulting from negotiated debt service reductions. The model is also general enough to include the valuation of various contractual features of corporate debt contracts: the cash flow based bond covenant, the subordinated debt with or without cross default provision, and the secured debt contract. I also study how a firm's operational policies vary with bond covenants in place. Certain bond covenants may lead to more conservative dividend policies and conservative choice of risk levels, which in turn benefit both the equity and debt holders via lowered expected cost of liquidation. In this study, the debt borrowing limit of the firm and the optimal capital structure are also discussed. Furthermore, I formulate a general setup of the security design problem: which type of security should a firm choose to finance a new investment? I show that the use of a secured debt contract offers a way to reach firm's optimal capital structure since it decreases the potential liquidation cost and therefore reduces the cost of borrowing. In addition, the issuance of secured debt contract also increases the debt borrowing limit and alleviates the conflicts between debt-equity holders on investment decision.

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