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A Theory of Cash Flow-Based Financing with Distress Resolution

Barney Hartman-Glaser¹; Simon Mayer²; Konstantin Milbradt³

¹ Anderson Graduate School of Managment, University of California at Los Angeles , · ² Tepper School of Business, Carnegie Mellon University , · ³ Kellogg School of Management, Northwestern & National Bereau of Economic Research

Abstract We develop a dynamic contracting theory of asset- and cash flow-based financing that demonstrates how firm, intermediary, and capital market characteristics jointly shape firms’ financing constraints. A firm with imperfect access to equity financing covers financing needs through costly sources: an intermediary and retained cash. The firm’s financing capacity is endogenously determined by either the liquidation value of assets (asset-based) or the intermediary’s going-concern valuation of the firm’s cash flows (cash flow-based). The optimal contract is implemented with defaultable debt—specifically unsecured credit lines and senior-secured debt—and features risk-sharing via bankruptcy. When the firm does well, it repays its debt in full. When it does poorly, distress resolution mirrors U.S. bankruptcy procedures (Chapters 7 and 11). Secured and unsecured debt are complements because risk-sharing via unsecured debt increases secured debt capacity. Debt and equity are dynamic complements because future access to equity financing increases current debt capacity.

DOI

10.1093/restud/rdaf009

Volume

92 (6)

Pages

3995-4025

Language

en

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