Norges Handelshøyskole (NHH) Department of Finance and MS Kristian R. Miltersen Copenhagen, May 26, 2011 FIN509: Capital Structure and Credit Risk August 2011 Short Description The course gives a thorough overview of the academic literature in dynamic capital structure and its applications to credit risk. The main focus is on the theoretical models and the so-called structural models, in particular, but the course also reviews the reduced form models used to price credit risky bonds and derivatives and relate them to the structural models. The curriculum and the themes will be coordinated with FIN514 Corporate Finance Theory. The two courses can be taken separately or together. There will be virtually no overlap in curriculum. Format The course runs intensively over two weeks in beginning of August 2011. There will be sessions each day (Monday to Friday), mainly in the mornings. Each session numbered 1 to 10 is outlined below in the Course Overview section. The instructor of the course will be Prof. Kristian R. Miltersen from Copenhagen Business School. The course will run in parallel with and will be coordinated with FIN514 Corporate Finance Theory taught by Prof. Dirk Hackbarth. Course Overview Session 1: Introduction to Capital Structure Models in Continuous Time and the Trade-Off between Tax Advantages and Bankruptcy Costs 1. General introduction 2. Black and Cox (1976) 3. Leland (1994) 4. Leland (1998) 5. Introduction to Mathematica (and MatLab) Session 2: What is Firm Value and its use as State Variable in the Models? 1. Kane, Marcus, and McDonald (1984) 2. Kane, Marcus, and McDonald (1985) 3. Introduction to student projects Session 3: Dynamic Models of Capital Structure 1. Fischer, Heinkel, and Zechner (1989b) (Fischer, Heinkel, and Zechner (1989a) will be covered in FIN514) 2. Goldstein, Ju, and Leland (2001) Session 4: More Classes of Debt and Covenants of Debt 1. Hackbarth, Hennessy, and Leland (2003) 2. Bienz and Miltersen work in progress Slide presentation.
Session 5: The Maturity Structure of Debt 1. Leland and Toft (1996) 2. Leland (1998) and Ericsson (2000) 3. Flor and Lester (2002) 4. Miltersen and Torous work in progress Slide presentation. Session 6: Strategic Debt Service and Renegotiation of Debt Terms 1. Anderson and Sundaresan (1996) 2. Mella-Barral and Perraudin (1997) 3. Mella-Barral (1999) 4. Hege and Mella-Barral (2005) 5. Christensen, Flor, Lando, and Miltersen (2002) 6. Gibson and Sundaresan (2001) 7. Chen (2003) 8. Pawlina (2007) 9. Flor (2002) 10. Fan and Sundaresan (2000) Session 7: Investments and The Optimal Capital Structure 1. Myers (1977) 2. Miao (2005) 3. Hackbarth and Mauer (2009) 4. Dockner, Mæland, and Miltersen work in progress Slide presentation. Session 8: Reduced Form Models, (Lando, 2004, Chapter 5 and 6) Motivation for studying intensity models From Poisson to Cox processes The fundamental example of zero-coupon pricing Generalizing the example Fractional Recovery An example where the fundamental identity does not work Correlating intensities and interest rates: two approaches The structure of risk premia Conditionally diversifiable default risk Incomplete information and intensity models Pros and cons, estimation issues Rating-based models as intensity models A calibrated method Incorporating stochastic spreads Fractional recovery in rating based models Class dependent recovery The connection with affine models Discussion of empirical issues related to ratings Session 9: Ratings and Structured Capital Structure Models 2
1. Papers by Manso and co-authors Session 10: Asymmetric Information 1. Duffie and Lando (2001) 2. Kraft and Miltersen work in progress Slide presentation. Empirical papers not covered in the course: Strebulaev (2007), Lemmon, Roberts, and Zender (2007), Leary and Roberts (2005), Hennessy and Whited (2007) Syllabus Lando book Lando (2004) Journal and working papers referenced above Class notes to be distributed Course Approval Satisfactory participation in the course and satisfactory outcome of the student projects. Potential subjects for student projects 1. Different debt classes 2. Callability in Leland (1994) 3. Going concern value at the lower boundary in Leland (1994) 4. Different drifts in Leland (1994) 5. No Arbitrage in Leland (1994) (as in Kane et al. (1984), Kane et al. (1985), and Fischer et al. (1989a)) 6. Asset substitution model with two drifts and two volatilities 7. An EBIT based Leland-94-model 8. Leland (1994) with taxes as in Goldstein et al. (2001) (I.e., a Goldstein-Ju-Leland-model with no restructuring boundary) 9. Investments in Leland (1994) 10. Asymmetric information Exam Take home exam. 3
References Anderson, R. W. and S. M. Sundaresan (1996): Design and Valuation of Debt Contracts, The Review of Financial Studies, 9,37 68. Black, F. and J. C. Cox (1976): Valuing Corporate Securities: Some effects of Bond Indenture Provisions, The Journal of Finance, XXXI, 351 367. Chen, N. (2003): Chapter 11, Private Workouts, and Corporate Debt Pricing under Asymmetric Information, Working paper, Graduate School of Business, Columbia University, New York, NY 10027, USA. Christensen, P. O., C. R. Flor, D. Lando, and K. R. Miltersen (2002): Dynamic Capital Structure with Callable Debt and Debt Renegotiations, Working paper, University of Southern Denmark, Department of Accounting and Finance, Campusvej 55, DK 5230 Odense M, Denmark. Duffie, J. D. and D. Lando (2001): Term Structures of Credit Spreads with Incomplete Accounting Information, Econometrica, 69, 633 664. Ericsson, J. (2000): Asset Substitution, Debt Pricing, Optimal Leverage, and Maturity, Working paper, McGill University, Faculty of Management, 1001 Sherbrooke Street West, Montreal QC, H3A 1G5 Canada. Fan, H. and S. M. Sundaresan (2000): Debt Valuation, Renegotiation, and Optimal Dividend Policy, The Review of Financial Studies, 13, 1057 1099. Fischer, E. O., R. Heinkel, and J. Zechner (1989a): Dynamic Capital Structure Choice: Theory and Tests, The Journal of Finance, XLIV, 19 40. (1989b): Dynamic Recapitalization Policies and the Role of Call Premia and Issue Discounts, Journal of Financial and Quantitative Analysis, 24,427 446. Flor, C. R. (2002): Capital Structure and Real Assets: Effects of an Implicit Collateral to Debt Holders, Working paper, University of Southern Denmark, Department of Accounting, Finance, and Law, Campusvej 55, DK 5230 Odense M, Denmark. Flor, C. R. and J. Lester (2002): Debt Maturity, Callability, and Dynamic Capital Structure, Working paper, University of Southern Denmark, Department of Accounting, Finance, and Law, Campusvej 55, DK 5230 Odense M, Denmark. Gibson, R. and S. M. Sundaresan (2001): A Model of Sovereign Borrowing and Sovereign Yield Spreads, Working paper, Graduate School of Business, Columbia University, New York, NY 10027, USA. Goldstein, R. S., N. Ju, and H. E. Leland (2001): An EBIT-Based Model of Dynamic Capital Structure, Journal of Business, 74, 483 512. Hackbarth, D., C. A. Hennessy, and H. E. Leland (2003): The Optimal Mix of Bank and Market Debt: An Asset Pricing Approach, Working paper, Walter A. Haas School of Business, University of California at Berkeley, 545 Student Services Bldg. number 1900, Berkeley, California 94720, USA. Hackbarth, D. and D. C. Mauer (2009): Optimal Priority Structure, Capital Structure, and Investment, Working paper, University of Illinois at Urbana-Champaign, College of Business, 515 East Gregory Dr., MC-520, Champaign, IL 61820, USA. Hege, U. and P. Mella-Barral (2005): Repeated Dilution of Diffusely Held Debt, Journal of Business, 78,737 786. Hennessy, C. A. and T. M. Whited (2007): How Costly is External Financing? Evidence from a Structural Estimation, The Journal of Finance, LXII, 1705 1745. 4
Kane, A., A. J. Marcus, and R. L. McDonald (1984): How Big is the Tax Advantage to Debt? The Journal of Finance, XXXIX,841 853. (1985): Debt Policy and the Rate of Return Premium to Leverage, Journal of Financial and Quantitative Analysis, 20,479 499. Lando, D. (2004): Credit Risk Modeling: Theory and Applications, Princeton, New Jersey, USA: Princeton University Press. Leary, M. T. and M. R. Roberts (2005): Do Firms Rebalance Their Capital Structures? The Journal of Finance, LX,2575 2619. Leland, H. E. (1994): Corporate Debt Value, Bond Covenants, and Optimal Capital Structure, The Journal of Finance, XLIX,1213 1252. (1998): Agency Costs, Risk Management, and Capital Structure, The Journal of Finance, LIII, 1213 1243. Leland, H. E. and K. B. Toft (1996): Optimal Capital Structure, Endogenous Bankruptcy, and the Term Structure of Credit Spreads, The Journal of Finance, LI, 987 1019. Lemmon, M. L., M. R. Roberts, and J. F. Zender (2007): Back to the Beginning: Persistence and the Cross-Section of Corporate Capital Structure, Working paper, Eccles School of Business, University of Utah. Mella-Barral, P. (1999): The Dynamics of Default and Debt Reorganization, The Review of Financial Studies, 12,535 578. Mella-Barral, P. and W. R. N. Perraudin (1997): Strategic Debt Service, The Journal of Finance, LII,531 556. Miao, J. (2005): Optimal Capital Structure and Industry Dynamics, The Journal of Finance, LX, 2621 2659. Myers, S. C. (1977): Determinants of Corporate Borrowing, Journal of Financial Economics, 5, 147 175. Pawlina, G. (2007): Underinvestment, Capital Structure, and Strategic Debt Restructuring, Working paper, Dept. of Accounting and Finance, The Management School, Lancaster University, Lancaster LA1 4YX, UK. Strebulaev, I. A. (2007): Do Tests of Capital Structure Theory Mean What They Say? The Journal of Finance, LXII,1747 1787. 5