ahnnecabiles
New Member
Hi David,
According to the Stulz readings, in order to maximize value creation, we have to determine the optimal level of firm’s debt to equity ratio, so as to benefit optimally from leverage (through tax shields) at the “optimal” level of financial distress cost (such that the benefit of tax shields, etc. outweighs bankruptcy costs). However, in determining the optimum level of debt, we do not include the amount of the firm’s leveraging from off-balance sheet transactions (such as derivatives), which may likewise increases the firm’s probability of financial distress. In other words, leveraging from derivatives (e.i. being a protection seller in a cds – an off-balance sheet transaction – does not enter the firm’s “debt” account) actually increases the firm’s probability of financial distress, because at some point, taking so much cds as protection seller increases the firm’s probability of default. If my argument is correct, how then can we determine the optimal D/E of a firm reflecting its off-balance sheet leverages?
According to the Stulz readings, in order to maximize value creation, we have to determine the optimal level of firm’s debt to equity ratio, so as to benefit optimally from leverage (through tax shields) at the “optimal” level of financial distress cost (such that the benefit of tax shields, etc. outweighs bankruptcy costs). However, in determining the optimum level of debt, we do not include the amount of the firm’s leveraging from off-balance sheet transactions (such as derivatives), which may likewise increases the firm’s probability of financial distress. In other words, leveraging from derivatives (e.i. being a protection seller in a cds – an off-balance sheet transaction – does not enter the firm’s “debt” account) actually increases the firm’s probability of financial distress, because at some point, taking so much cds as protection seller increases the firm’s probability of default. If my argument is correct, how then can we determine the optimal D/E of a firm reflecting its off-balance sheet leverages?
