Capital Structure and Contract Enforcement ;.uYWP|9
This paper studies how the degree of contract enforcement in a country influences firms' capital structures. We first document the capital structure for a new dataset of firms in two countries, Ecuador and the UK, that feature different degree of contract enforcement. We find that capital structure is different in these two countries in terms of mean leverage and the leverage size relation. In Ecuador leverage ratios are lower and smaller firms have smaller leverage ratios than large firms. In the UK leverage ratios are higher and bigger firms have smaller leverage ratios. We build a model of heterogeneous firms in an environment with lack of enforcement in debt contracts that delivers the observed capital structure in the data. In the model, the degree of contract enforcement acts like a tax or subsidy on the amount of borrowing for all firms. Weak contract enforcement corresponds to a tax that limits loans for all firms but hurts small firms more because their firm value relative to the tax is smaller and thus debt financing is more constrained. Strong contract enforcement corresponds to a subsidy on all firms that enables them to issue more debt but also helps disproportionately small firms given that the subsidy relative to their value is large. We quantify our mechanisms by calibrating our model to the firm datasets in the two countries and find that different degrees of enforcement can provide a unified rational for the differential capital structure observed in the data. VKl,m ;& N
How does the capital structure of firms differ across countries? We document the relation between firm size and leverage for two new comprehensive datasets of firms in two countries: Ecuador and the UK. We find that leverage, defined as the ratio of liabilities relative to as-sets, is on average higher in firms in the UK relative to firms in Ecuador. We also find that the relation between firm size and leverage ratios differ across the two countries. In the UK small firms tend to have larger leverage ratios than large firms. In contrast, small firms in Ecuador have smaller leverage ratios relative to larger firms inside the country. We also document the relation between growth and size. We find that on average firms’ sales in Ecuador grow faster than sales from firms in the UK. However both countries feature the common size-growth relation: small firms grow faster than large firms conditional on survival.1 We choose these countries due to availability of data and because we want to contrast the firms’ capital structure and dynamics in economies with different degree of contract enforcement. (p{%]M
This paper builds a model of heterogeneous firms to study the link between enforcement in financial contracts and firms’ capital structure. In particular we study how lack of enforcement in debt contracts and incomplete markets can provide a rational for the facts regarding leverage, growth and size across countries. In the model, the degree of contract enforcement acts like a tax or subsidy on the amount of borrowing for all firms. Weak contract enforcement corresponds to a tax that limits loans for all firms but hurts small firms more because their firm value relative to the tax is smaller and thus debt financing is more constrained. Strong contract enforcement corresponds to a subsidy on all firms that enables them to issue more debt but also helps disproportionately small firms given that the subsidy relative to their value is large. We quantify both mechanisms by calibrating our model to Ecuador and the UK and find that our model provides a unified rational for the relation between leverage, growth and size that is dependent on the degree of contract enforcement. u -t= M]
The framework is a dynamic model of heterogeneous firms similar to Albuquerque and Hopenhayn (2004) but with incomplete markets. Firms in the model borrow from foreign investors to finance the working capital and set up costs needed for production. Firms’ productivity consists of two components: a permanent component and an i.i.d. component. We assume that firms sign contracts with investors to finance working capital before their i.i.d. shock is known and that these contracts cannot be contingent on the shock realization. After observing their shock firms can choose to repay the capital borrowed and the debt due and remain in operation for the next period, or default and get a default value. Incentives to repay debt depend crucially on the value of keeping the firm in operation at every period relative to the value of default. <4;
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Firms with permanent productivity differences have a distinct degree of enforcement because of the larger value of more productive projects relative to a constant default value. The key insight from our model is that when enforcement is very weak this constant default value acts like a tax on firms borrowing. The tax is disproportionately more expensive for small firms and thus borrowing is limited mostly for these firms. Large firms have essentially a larger endogenous degree of enforcement in these economies because the surplus from the relation with lenders is larger for firms with high productivity, allowing greater borrowing. However very strong enforcement acts like a subsidy on firms that is disproportionately more beneficial for small firms that have a low value. Thus the borrowing capacity is relatively larger for small firms as they are the ones that benefit the most from the additional available loans. We show that without uncertainty and permanent productivity differences, our model delivers a monotonic relation between size and leverage that is increasing when enforcement is weak, and is decreasing when enforcement is strong. 04-_ K
In our model with uncertainty we find that the firm’s value depends inversely on the amount of debt that it owes to creditors. We show that firms with low values and high debt are inefficiently small because they under-invest relative to an unconstrained first best level. Enforcement problems are severe for low value firms, limiting the amount of risk-free funds. If firms instead borrow risky and default in some states, the high interest rates charged on loans also distort downward the optimal investment and the size of firms. Thus low value firms uniformly under invest and produce at inefficient scales. Incomplete contracts introduce rich dynamics in the debt firms owe and the value of firms. In our model firms with a history of bad shocks accumulate debt, while reducing its value because their low output is not enough to cover interest payments on outstanding debt. Incompleteness of contracts and enforcement problems are key for generating the result that firms decrease their value and are likely to exit after a sequence of bad shocks. The relation between debt and investment in our model also rationalized the fact that small firms on average grow faster than large firms. If an inefficiently small firm receives a sequence of good shocks, it can reduce debt and increase investment further, which translates into higher growth and a better scale. Thus our model generates ‘positive persistence’ for low and high productivity realizations in firms’ output because debt can adjust inducing a less or more efficient scale in firms which is magnified over time. IqYJ
We calibrate the full model to match certain features of the firm size distribution in Ecuador. We then increase the parameter controlling the degree of contract enforcement and compare the results to the UK statistics. We find that the enforcement friction and incomplete markets can deliver the features of the data in terms of mean leverage and the capital structure observed in both countries. The model can quantitatively account for the mean leverage ratios in Ecuador and for the size-leverage relation ranging from about 0.5 for small firms to 0.7 for large firms. The model with stronger degree of enforcement can also account for a larger mean leverage and the decreasing relation between leverage and size in the UK with ratios ranging from 0.9 for small firms to 0.7 for large firms. Both mechanisms, precautionary savings and differential endogenous degree of enforcement for firms with different sizes that varies with the country wise degree enforcement level, allow the model to deliver these results. The model also qualitatively matches the data in terms of the growth-size relation: small firms grow faster than large firms. However the growth statistics the model generates are smaller than in the data. The reason why grow is not high enough is because firms precisely engage in precautionary savings exactly to avoid the costs of underinvestment and volatile growth. ot<d
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The paper is related to the literature that studies the implications of financial frictions for the dynamics of firms and firm size. Cooley and Quadrini (2001) study how financial frictions can rationalize the relation of exit and growth with size. Our model shares many of the features of their paper, however we are concentrating on how enforcement frictions can help explain the relation between leverage and size. Moreover we focus on the distinct implications for debt financing in the presence of permanent and temporary productivity differences across firms. Albuqerque and Hopenhayn (2004) focus on the effects of enforcement problems and solve for the optimal state contingent contract. Our environment is different from them in that we consider an incomplete set of assets. Incomplete markets allows for firms in the model with a history of bad shock to decrease the effective degree of enforcement through time by increasing their debt holdings and for precautionary savings play a role. Clementi and Hopenhayn (2005) and Quadrini (2004) also study financial imperfections and firm dynamics. These papers study financial constraints that arise due to informational asymmetries between the lender and the entrepreneur and show that moral hazard considerations can also rationalize borrowing constraints which make investment sensitive to cash flows. They show that information asymmetries can also provide a rational for the relation between growth and size. [*^.$s(
