The Effect of Debt Mix on the Value and Riskiness of the Recapitalization Firm

Abstract

The purpose of this paper is to explain the small increase in equity risk of Kaplan and Stein(1990) after the recapitalization by the effective mix of short to medium term bank debt and long term unprotected debt. When the tax savings on interest payments are not certain and contingent upon the survival of the firm, the Modiligani-Miller proposition no longer holds and the structure of debt matters in the valuation of the firm's securities. This paper shows that the stable cash flows of the recapitalization companies enable the firms to issue a larger fraction of new debt as a form of short to medium term bank debt at relatively low interest rates, but use it effectively like long term unprotected debt by rolling it over. The advantage in debt financing allows the firms to enjoy tax savings over the long period of time without making the face value of debt too big. The small increase in the face value of debt and big increase in the firm value resulting from low financing cost and low bankruptcy probability yield the small change in equity risk with a moderate increase in the riskiness of debt.