Collateral and Debt Capacity in The Optimal Capital Structure

This paper considers how collateral is used to finance a going concern. We focus on firms that offer collateral with significant debt capacity, and a setting where debt is unconditionally an optimal contract. A theory is developed in which firms with better quality collateral use that collateral to finance new investment opportunities with unsecured debt, while firms endowed with lower quality collateral use secured debt. Better quality firms must also issue equity to separate themselves from lesser quality firms, implying lower leverage and greater uncommitted cash flow from operations with which to meet debt service requirements. Empirical evidence from Real Estate Investment Trusts (REITs) support predictions of the theory, where we find that firms with less reliance on secured debt and lower total leverage invest more, are valued more highly and financially outperform firms with higher levels of secured debt and total leverage. Our findings provide alternative perspective on risk-shifting and the value of free cash flow, and demonstrate limits to the benefits of leverage as it depends on debt capacity.