The theory of debt maturity

Using the concept of options, Myers’ (1977) regards growth opportunity as a call

options of real assets whose exercise price is the capital of future investment, and the exercise value depends on the asset value in the future. As many studies argued, there are interest conflicts between stockholders and bondholders. While firms use risky debt to finance their investment project, the benefits of investment should be split into bondholders and stockholders. The profits of bondholders are fixed; however, the profits of stockholders are uncertain. For this reason, stockholders may choose second-best investment strategies, and firms may lose some investment opportunities with positive NPV or have to burden the costs of the strategies that avoid taking second-best investment projects. Myers’ presents that the problems of underinvestment could be abated by decreasing the maturity of debt. If firms use short-term debt to finance, the lenders and borrowers would recontract before growth options are exercised. Thus, firms with more growth opportunities in their investment projects will have more incentive to issue short-term debt.

According to agency cost hypothesis, Smith (1986) suggests that compare with managers of unregulated firms, managers of regulated firms have less discretion to future investment decisions. Thus, regulated firms would have more long-term debts.

Barclay and Smith (1995) also confirm the respects of Myers’ theory, their research finds that firms with less growth opportunities have more long-term debt in their capital structure.

Furthermore, Barclay and Smith argue that firm size is also relative to the maturity structure of debt. The costs of debt public issue have significant economic scale. However, small firms

would hardly take the advantage of economic scale, thus they prefer to choose private debt and more short-term debt which with lower cost of issue. On the other side, the multi-national corporations will choose more short-term debt. If large firms execute board operation, they would like to issue foreign debts. However, the foreign debts have less liquid than bond market in the United States, thus they would prefer to issue short-term debt. Therefore, the positive relationship between firm size and debt maturity of the large firms that execute board operations is decreasing. Smith and Warner (1979) also presents that small firms face more serious conflicts between stockholders and bondholders than large and well-developed firms.

Therefore, small firms would like to eliminate the conflicts by issuing short-term debt.

B. Term structure

Brick and Ravid (1985) use the model including tax to analyze the maturity structure of debt. Because of agency problem, there is optimal term to maturity of debt. However, in the situation of including tax, when the slope of yield curve is positive, (after the adjustment of default risk), it is the optimal decision to issue debt with longer maturity. When the slope of yield curve is negative, the optimal choice is choosing debt with shorter maturity.

Furthermore, if the yield curve is upward, according to expected hypothesis, the interest payment of long-term debt is higher than the expected interest payment of refinancing with short-term debt. However, the interest payment of long-term debt is less than short-term debt in later years. In this condition, issuing long-term debt could reduce the expected tax burden of firms, and increase the short-term value of firms. Therefore, if the term structure is upward, as tax rate increasing, firms would tend to choose more long-term debts.

C. Asymmetric information and liquidity risk

Flannery (1986) suggests that when the information possessed by outside investors is the same with insiders of firms, they would have the same evaluation of firms’ debt. If there are asymmetric information problems in the bond market, the insider would like to issue debt

with overestimated value, the outside investors will misunderstand the true value of firms, and firms whose true value are good will suffer loss. Firms can signal them by choosing the structure of debt maturity. If the transaction cost is low, there is only pooled equilibrium in the market, low-quality firms do not need to pay any cost to imitate high-quality firms, so all of the firms will choose to issue short-term debt. If the transaction cost is high, separated equilibrium might occur, high-quality firms could issue short-term debt to signal their true value to outsiders, and if the cost of imitation was too high, low-quality firms can only issue long-term debt.

Diamond (1991) analyzes the structure of debt maturity with the information of borrowers’ credit rating. The differences of credit rating will also affect the decision of the debt maturity structure. If the insiders have positive information for future development, firms would prefer to issue debt with shorter debt maturity. When debt matures, firms can still refinance by issuing debt successfully, and their problems of liquidity risk are less, and firms could also signal their positive foreground of future by issuing short-term debt. Therefore, Diamond argues that firms with higher credit rating prefer to issue short-term debt. Firms with lower credit rating have no choice but only to issue short-term debt because their profits could not afford for long-term debt. Firms with credit rating between the two extreme sides prefer long-term debt.

Guedes and Opler (1996) support the argument of Diamond. Because the problems of moral hazard exist, low quality firms could not enter into the bond market. Their research finds that firms with investment grade credit rating issue debt with longer maturity or shorter maturity. However, firms with speculative grade credit rating choose to issue debt with medium maturity. In order to avoid liquidity risk and the risk of inefficient payment, firms with higher risk (speculative grade) would not like to issue short-term debt and intend to issue debt with longest maturity that they could issue. However, firms with higher risk would be

obstructed in the long-term debt market because there will be moral hazard problems when requested return leads to risk transference.

Stohs and Mauer (1996) argue that firms with lower leverage would like to have less financial distress and have lower liquidity risk. Thus, those firms have less incentive to manipulate debt maturity. On the other hand, firms with higher leverage will prefer to issue long-term debt.

D. Matching hypothesis

Previous literatures argue that if debt has shorter maturity than assets, firms may be short of cash of repayment. Thus, debt maturity should match with assets maturity. Myers’ (1977) presents that firms will arrange the payment of debt match with the decreasing of assets value, and reduce the agency cost of debt by this way. Therefore, firms with more long-term assets could afford to more long-term debt. The matching of maturity will make firms could extend the maturity of long-term debt in the condition of non-significantly increasing of agency cost of debt.

E. Managerial stock ownership

Datta, Iskandar-Datta, and Raman (2005) suggest that managerial stockholders play an important role in the decision of the structure of debt maturity. Managers who own the stock of firms could align the interest between managers and stockholders and reduce the agency problem. If managers have higher shareholding, they would choose more debt with shorter maturity, and then take monitor more often. On the other hand, if managers have lower shareholding, they would choose to extend the maturity of debt. Thus, there is significantly negative relationship between the structure of debt maturity and the managerial stockholders.