Date: 2001-2005

Economists Ram Tamara and Robert Damuth were asked to determine whether legislation to limit the amount of debt that a nonfinancial corporation can hold in its capital structure was feasible. Here, they explain how they conducted their analysis in the absence of a formula or an off-the-shelf approach.

“To determine the “feasibility of debt-limiting legislation,” we had to first define feasibility and the scope of our analysis. Feasibility can mean economic feasibility—cost versus benefit; or technical feasibility—determination of a debt limit, absolute number, or a formula; or political feasibility—balancing the interests or constituents; or the feasibility of enforcing and monitoring a debt limit.”

We decided to focus on economic feasibility, that is, whether imposing debt limits would produce measurable benefits that outweigh costs. Once we identified the costs and benefits of debt limiting legislation, however, we realized that measuring costs would not be straightforward, as it is with investment projects.

Measuring the economic feasibility of a typical investment project

Let’s say we want to measure the economic feasibility of an investment project like building a baseball stadium in the District of Columbia for the Washington Nationals. We would measure construction costs—land acquisition, wages, materials—and opportunity costs, the value of all the foregone opportunities as a result of the decision to build the stadium. The benefits would be the potential revenues earned from ticket sales and from sales by retail establishments in and around the stadium.

Measuring the economic feasibility of imposing debt limits

In the case of debt limiting legislation, the costs are the increased cost for firms of raising capital. Because of the preferential tax treatment accorded to interest payments on debt, a firm can decrease its cost of capital by increasing its debt financing. At some point, however, the “agency costs” and “bankruptcy costs” of debt outweigh the benefits of debt financing. Therefore the optimum amount of debt and equity in a firm’s capital structure is a notional concept with no clear indication of what such an optimum ratio would be. This makes it difficult to quantify the cost imposed by a restriction on debt financing.

Imposing limits on corporate debt to prevent bankruptcies

The purported benefit of a legislated debt limit is that it will prevent bankruptcies. First, given that we do not have an accepted optimal debt-equity ratio it is hard to identify the tipping point where an extra dollar of debt would cause a firm to go bankrupt. Second, several factors, other than high levels of debt, can lead to bankruptcy. So it is hard to identify the contribution of debt to bankruptcy. And it is hard to quantify the number of bankruptcies that can be prevented and the costs that can be avoided by imposing a debt limit.

Constructing and testing hypotheses

Rather than attempting to identify and quantify costs and benefits, we decided to evaluate the following hypotheses.

• On average, firms pick debt–equity levels that are consistent with the nature of their industry, the nature of the assets they hold, and their expected future profitability. If we find support for the hypothesis that industry- and firm-specific characteristics explain the average debt levels of firms then we can conclude that market forces determine a firm’s optimal debt-equity mix, and that legislating debt limits would be redundant and possibly harmful.

• Debt levels of firms that experience financial distress differ from those of firms that do not experience such distress. If debt levels of firms in distress are not statistically different from those that are healthy, then we can conclude that firms face financial distress for reasons other than high debt levels.

• If a debt limit is set based on the average debt levels of firms that experience financial distress, how many successful firms will be constrained by this limit, and how many bankruptcies can be avoided? With a hypothetical debt limit in hand we can evaluate the increase in the cost of capital for firms that are constrained by the limit and compare it with the bankruptcy cost estimates for the U.S. economy—costs that could be avoided by the debt-limiting legislation.

The results

Our econometric analysis showed that on average firms choose a debt–equity mix that is based on the characteristics of their industry- and on firm-specific characteristics such as size, profitability, and nature of assets.

After controlling for industry and size, we found that firms that experience financial distress do not have higher levels of debt than healthy firms. Using a hypothetical debt limit based on the average debt levels of firms facing financial distress, we calculated that the increase in cost of capital imposed by the proposed legislation would far outweigh the benefit of bankruptcy costs that might be avoided. In other words, the cost imposed by the legislation outweighs the benefit.

Our client, who himself is an economist, expected that debt-limiting legislation would have a positive impact in preventing bankruptcies. But the soundness of our approach persuaded him otherwise.