Payout, debt and takeovers in declining industries

We present a real-options model of takeovers and investment in declining industries. Managers are assumed to maximize the present value of the cash flows that they can capture from the firm. The managers must pay out a minimum amount of cash to prevent investors from exercising their property rights and taking over the firm. As product demand declines, a first-best abandonment level is reached, where overall value is maximized by shutting down the firm and releasing its capital to investors. Absent takeovers, managers of unlevered firms always wait too long to shut down; they abandon the firm’s business too late. We model the managers’ payout policy absent takeovers and derive an optimal debt ratio, which enforces first-best abandonment decisions under plausible restrictions on equity issues. We analyze the effects of takeovers of unleveraged or under-leveraged firms. Takeovers by raiders enforce first-best abandonment. Hostile takeovers by other firms occur either at the first-best abandonment point or too early. We also consider management buyouts and mergers of equals and show that in both cases closure happens inefficiently late. JEL Nos.: G34,C72,G13