Asset values and cost of capital: Implications for capital structure decisions

This thesis uses commercial aircraft transactions that occurred between 1978 and 1991 to examine relationships between "real" asset values, cost of capital, and capital structure decisions. The thesis consists of three primary sections. The first section examines effects of firms' financial conditions on proceeds generated from asset sales. Results presented in this chapter indicate that financially distressed airlines often sell aircraft at discounts to their fundamental values. Discounts are greatest during industry-wide recessions when competition among buyers for used aircraft is weak. Furthermore, a substantial increase in used aircraft buying activity by conservatively financed airlines is observed during depressed periods. These results suggest that the prospect of liquidating assets at fire-sale prices and the possibility of buying competitors' assets at discounted prices provide firms with incentives to maintain conservative capital structures. The second section of this thesis examines the effectiveness of bankruptcy court protection in reducing costs of financial distress associated with distressed asset sales. Evidence documented in this section indicates that while bankruptcy court protection may help distressed firms to avoid piecemeal liquidation, it does little to mitigate discounts associated with hurried asset sales. The third section examines the effectiveness of collateral in reducing the cost of capital. Theoretically, the value of secured debt should never fall below the market value of the underlying assets. Analyses presented in this section show that even when collateral values far exceed the debt's face value, risk premiums average more than 300 basis points. Furthermore, creditors expect the value of their claims to be "written-down" by 24% to 36% in bankruptcy. These results suggest that, by making secured debt more expensive than it would otherwise be, bankruptcy courts' propensities to violate absolute priority affects managers' capital structure decisions.