Repurchasing Debt

Author(s): Lei Mao and Yuri Tserlukevich

Source: Management Science, Vol. 61, No. 7 (July 2015), pp. 1648-1662
Published by: INFORMS
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 MANAGEMENT SCIENCE wfflffi1
Vol. 61, No. 7, July 2015, pp. 1648-1662 ■■■■■.
ISSN 0025-1909 (print) | ISSN 1526-5501 (online) http://dx.doi.org/10.1287/mnsc.2014.1965
©2015 INFORMS

Repurchasing Debt
Lei Mao
Finance Group, Warwick Business School, University of Warwick, Coventry CV4 7AL, United Kingdom,
lei.mao@wbs.ac.uk

Yuri Tserlukevich
Department of Finance, Arizona State University, Tempe, Arizona 85287, yuri.tserlukevich@asu.edu

In athis
grouppaper we to
sell debt build a theoretical
the firm model
only at face value.of a firmbecause
However, repurchasing its corporate
of the cross-creditor debt. We buying
externalities, find that
back firm creditors as
debt is cheaper and easier when there are many creditors, e.g., when debt is traded on the open market. We further
show that repurchases contribute to flexibility in firms' capital structure and can increase ex ante firm value. The
value of repurchases to the shareholders increases with the firm's ability to save cash and delay the repurchase.
Data, as supplemental material, are available at http://dx.doi.org/10.1287/mnsc.2014.1965.
Keywords : savings; debt repurchase; debt overhang
History : Received October 17, 2012; accepted March 3, 2014, by Brad Barber, finance. Published online in Articles in
Advance August 13, 2014.

1. Introduction company at less than its face value, even if the mar
pricesecu
The low price of corporate debt in the secondary at which the creditors would be willing to tr
with
rities market and recent tax incentives arising fromeach other or with third parties is much low
To show this, we provide in the model an exam
the postcrisis American Recovery and Reinvestment
Act of 2009 presented an opportunity to many offirms
a firm with a sole lender or a group of coo
to restructure or reduce outstanding debt on more
nated lenders, under Modigliani-Miller conditi
favorable terms. By repurchasing their debt with cash
(Modigliani and Miller 1958). In this frictionless sett
or assets, companies were able to reduce their the
existing
minimum price at which the lender agrees to
indebtedness (which carries no tax advantage net
the of
marginal unit of risky debt back to the firm
cash) at less than the original face value, reduce their
equal to the face value of the debt, above the mar
interest costs, and remove restrictive covenants. In 2010,
value. All additional bonds are also repurchased at
for example, companies initiated 126 cash repurchases face value.2 The firm has to pay a premium becau
of publicly traded bonds, with an aggregate amount using cash or any safe asset for repurchase advers
of $26.3 billion, compared with just 49 transactions
affects the value of the remaining debt claims. Beca
during the period 1986-1996 (see Figure l).1 Despite the
the debt is secured by cash and assets inside the fir
increasing number of debt repurchases, the academic
repurchasing the debt essentially amounts to payi
literature on this topic is virtually nonexistent. In this
the lender with his own money.
paper, we provide a formal theoretical framework
However, debt that is held by many bondholders
for corporate debt buybacks, with the goal of under
be repurchased at a significantly lower price becau
standing when a repurchase is optimal and what the
of cross-creditor externalities. For example, a firm
implications are for shareholders and creditors. The
framework lends itself to a number of applications and its bonds on the open market as long as the
repurchase
empirical predictions. are small investors willing to sell their entire stake. Th
To set a benchmark, we build a simple one-period difference from the single-creditor case is that the sel
model of the corporate repurchase and show that do not internalize a decline in the value of the remaini
credi
tors as a group should not sell risky debt back to the debt because it is held by other investors. In fact,
tender offer repurchase may even be successful f
prices
1 These estimates are conservative because many repurchases slightly below the market price if investors
are not
recorded in the Fixed Income Securities Database (FISD).optimistic
They are about the repurchase completion. Th
omitted if they were negotiated privately or structured as exchanges
for cash, or if they were bundled with assets, common shares,
or senior debt. For example, the IMAX Corporation 2exchanged
Note, however, that it is impossible to buy back all debt at the
$90 million in notes at less than 24% of their face value;value,
however,since if there were enough cash to do this, the debt would
that transaction does not appear in our data. be risky.

1648

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Mao and Tserlukevich: Repurchasing Debt
Management Science 61(7), pp. 1648-1662, ©2015 INFORMS 1649

Figure 1 U.S. Debt Repurchases, 1986-2013

(A)

200
200 --

150
150 --

100
100

50
50 --

°4
°4 ' t *■
t » Tt« **
' I '1
I ' I«' I !
' I '«
I ' IΤ
' I 'II
1986 1988 1990 1992 1994 1996 1998 2000 2002 2004 2006 2008 2010 2012

Year

—I 1 1 1 1 1 1 1 H
1986 1988 1990 1992 1994 1996 1998 2000 2002 2004 2006 2008 2010 2012

Year

Notes. Panel (A) shows the annual number of repurchases π for the years 1986-2013. Panel (B) shows the annual volume of repurchases for 1986-2013. We
include only transactions coded in the database as "T" (tender offer) or "IRP" (issue repurchase) with corporate bonds. Repeated repurchases by the same
company are treated as separate. The total volume of repurchases is computed as the repurchase price, which is equal to the averaged-over-year "action price" i
FISD, multiplied by the number of shares repurchased in this transaction, and summed over all transactions for this year. We dropped three observations for which
the action price likely contains a recording error (e.g., equal to zero).

investors that do not tender or exchange their bondsMoore 1998, Mella-Barral and Perraudin 1997). As in
are exposed to greater risk and lower value.3 this literature, shareholders in our model are able
Our insight—that debt held by multiple bondholdersto force concessions from debtholders. However, the
can be repurchased at a lower cost—contrasts sharplystrategic debt service literature deals with bargaining
with the predictions of the literature on debt rene after default, when cash effectively already belongs
gotiation and strategic debt service (e.g., Hart andto creditors, and the goal of negotiations is only to
reduce bankruptcy costs. For this reason, small bond
3 There are legal restrictions applicable to the tender offer repurchases
holders in this literature, who can either abstain from
of publicly traded debt that prohibit changing the debt principal
without the debtholders' unanimous consent. We discuss this negotiations or demand a premium by free riding on
later on. large bondholders, make debt renegotiation impractical.

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 Mao and Tserlukevich: Repurchasing Debt
1650 Management Science 61(7), pp. 1648-1662, ©2015 INFORMS

The distinction must be made, because the

decreasing the existing
asset risk, conflicts with the bondhold
ers' holdout problem
literature on the topic often draws conclusions in anticipation of a higher price
on the
following
basis of debt renegotiation theory. For the investment.
example, Mann
Fourth, our
and Powers (2007) argue that tender offers areframework
easier provides insights on debt
repurchase timing.debt
to complete in firms with more concentrated Because the expected gain from
ownership. a repurchase increases with the risk of default, and
Using the benchmark model, we the payout function
explore is convex in the repurchase price,
in detail
managers have
how debt repurchases work in different an incentive to postpone the repur
situations.
chase until
First, we discuss the cases that include a date closer to debt maturity. Therefore,
bankruptcy
costs, tax, and transaction costs, and thewe option
show to buy back debt must be kept "alive" by
that
(1) costly bankruptcy encourages repurchases, and increasing cash reserves instead of immediately reduc
(2) taxation and transaction costs discourage repuring debt. It is therefore important, going forward, to
recognize
chases. Intuitively, fixed and proportional bankruptcy that shareholders may intentionally engage
costs decrease the value a lender can recover after in simultaneous borrowing and saving to increase the
a firm defaults and therefore encourage bondhold value of the repurchase option.
ers to make concessions. The surplus from the lower This paper is related to the literature on debt restruc
bankruptcy costs is then split between shareholders turing and debt exchanges. Since the seminal con
and bondholders according to the relative bargaining tributions of Froot (1989), Bulow and Rogoff (1991),
Bulow et al. (1988), and Gertner and Scharfstein (1991),
power. Expected bankruptcy costs in repurchases are
who focused on the implications of the sovereign and
reduced in two distinct ways. Cash or assets transferred
corporate debt exchanges that were prevalent in the
to creditors before bankruptcy reduce the proportional
1980s, ours is the first formal study to address the
bankruptcy costs. In addition, a repurchase at a price
current phenomenon of corporate debt repurchases.
below face value reduces the probability of bankruptcy.
Gertner and Scharfstein (1991) show, in particular, that
Taxation is shown to affect the repurchase incentive
offering new senior securities (cash paid to debtholders
primarily through cancellation of indebtedness (COD)
is one example of such a security) in exchange for
tax, proportional to the repurchase discount.
distressed junior debt is beneficial to shareholders
Second, we argue that, from the ex ante perspective,
and that offering new junior securities, such as equity,
the ability to repurchase debt at a price belowcan face
reduce shareholder value. However, Gertner and
value is beneficial to the firm. The option to repurchase
Scharfstein do not discuss the price, timing, and other
increases the firm's ex ante value and the firm's initial
determinants of debt repurchases, which are the focus
debt capacity. Although bondholders may be exploited
of our investigation. Froot (1989), Bulow and Rogoff
ex post, the overall effect on firm value is positive
(1991), Bulow et al. (1988), and others study open
because the firm has greater financial flexibility. There market sovereign debt repurchases in the presence of the
fore, we conclude that publicly traded debt or multipledebt overhang problem. The major difference between
investor ownership that facilitates future repurchasescorporate and sovereign debt buybacks is that, in the
increases the ex ante firm value. In contrast, a conver
latter, cash and assets cannot be meaningfully pledged
sion option, which contains an equity component and(see Bulow 1992 for details).
makes it harder to repurchase debt because it requires Our hypothesis that the firm benefits from saving
additional U.S. Securities and Exchange Commissioncash for a future repurchase contributes to the literature
(SEC) approval, decreases firm value.4 on the determinants of cash holdings. Several recent
Third, although a repurchase reduces firm indebt studies examine the optimal cash holding policy. For
edness, it does not always reduce firm risk and theexample, Foley et al. (2007), Opler et al. (1999), and
probability of bankruptcy. For example, when theFaulkender and Wang (2006) point to a variety of
repurchase price is equal to face value, the firm's lia problems that originate from holding excessive cash.
bilities and assets are reduced by the same amount,From a theoretical standpoint, DeAngelo et al. (2011)
and therefore firm risk remains unchanged. Therefore, argue that carrying cash is costly, whereas Dasgupta
repurchases at a high price will have only limited et al. (2009) posit that cash holdings have a beneficial
success in mitigating agency conflicts that originate effect by relaxing intertemporal financing constraints.
from risky debt, such as the underinvestment problem. Our results have connections to the literature that
A low-price repurchase, which would be successful ininvestigates investment, debt, and the propensity
to save in financially constrained firms. In related
empirical studies that focus on debt exchanges and
4 Contrary to the intuition that a call option is similar to a repurchase
option, they are significantly different for the following reason. The
repurchases, the propensity for debt reduction has been
call option is in the money when the debt value is high, and thelinked to the proportion of public and bank debt, debt
repurchase option is in the money when the debt value is low. seniority, maturity, and the value of growth options.

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Mao and Tserlukevich: Repurchasing Debt
Management Science 61(7), pp. 1648-1662, ©2015 INFORMS 1651

James (1996) offers a comprehensivealso solicit "exitof

overview consents"
this with their offer, in which
case the holders
literature. Kruse et al. (2009) provide recent evidenceof the securities are asked to consent
that shareholders benefit when a firm repurchases
to amendments to the security as a condition of their
debt. We contribute to these results acceptance
by laying of the
outoffer
the (Kaplan and Truesdell 2008).
If the consent
conditions that determine the repurchase price. solicitation
Finally, is successful, any holders
our study is related to the growing wholiterature
refuse to acceptthat
the offer would continue to hold
examines the role of debt and savings their old securities,
using structuralwhich are stripped of protective
dynamic models.5 covenants and made effectively junior to the new
security.
An additional advantage of conducting a tender
2. Institutional Background
offer with exit consents is the ability to remove existing
There are three main mechanismscovenants
for buying back
that restrict the borrower's future actions
corporate debt: an open-market repurchase, a tender
(Mann and Powers 2007). Having removed these
offer, and a privately negotiated repurchase.6 An open
covenants, the company may gain more flexibility in
market repurchase, which includes repurchases in
making investment and financing decisions. For exam
private markets by institutional buyers, is executed over
ple, a firm may be able to increase capital expenditures,
a period of time and allows for potentially different
make an acquisition, increase dividends, liquidate
prices for each bond sold back to the firm. A tender
assets, transfer money to subsidiaries, change the finan
offer is typically conducted by offering a single price to
cial reporting procedure, alter collateral, consolidate
all bondholders. Repurchases are conducted using cash
assets, merge with another company, change lines of
savings, proceeds from the sale of assets, or proceeds
business, or modify its bylaws (King and Mauer 2000,
from senior security issuance collateralized by these
Roberts and Sufi 2009).
assets (Gertner and Scharfstein 1991). In this paper, we
However, there are two difficulties that companies
do not discuss debt-for-equity exchanges or debt-for
must overcome. First, tender offers for publicly traded
debt exchanges, which have different implications.
debt require compliance with the Trust Indenture Act
An open-market repurchase is an easy way for an
of 1939, §316(b), which prohibits debtholders from
issuer to buy back relatively small amounts of debt.
changing the principal of debt without the debtholders'
Other than complying with the antifraud provisions
unanimous consent. It is designed, in particular, to
of the federal security laws, these transactions are not
prevent the company from exploiting minority bond
normally subject to review by the SEC.7 However, it
holders. Managers can (and do) avoid this restriction
is difficult to repurchase large amounts in a limited
by buying back a portion of debt on the open market
time on the open market. Also, this mechanism does
or by combining cash repurchases with exchanges for
not permit the issuer to amend the covenants of the
bonds because the issuer or the affiliates are not entitled other securities (see, e.g., Brudney 1992, Gertner and
Scharfstein 1991, Shuster 2007).8 They can also avoid
to vote for the purpose of giving consents under the
indenture. having their repurchase classified as a tender offer by
soliciting a limited number of holders, repurchasing
Tender offers can include a fixed premium over
over a fairly long period of time, and/or purchasing
the current trading price and allow the repurchase of on different terms from each holder.
larger amounts. Importantly, tender offers may include
Second, whenever debt is repurchased below its
additional incentives for bond investors, which all but
face value, the firm is subject to a tax on the COD
guarantee a successful repurchase. To motivate the
income. Unless an exception applies, such as insol
holders of bonds to tender without offering a large
vency or bankruptcy at the time of the repurchase,
premium, and to avoid the need to comply with all
shareholders must recognize the COD income upon
of the existing contractual requirements, companies satisfaction of its indebtedness for less than the amount

due under the obligation. The COD income is usually

5 For example, Morellec and Nikolov (2009) and Hugonnier et al.the difference between the amount due under contract
(2011) link cash holdings to investment, competition, and a desire
and the amount paid.9 Firms facing COD tax may find
for liquidity. In the model of Riddick and Whited (2009), a savings
policy presents a trade-off between tax penalties and the reduction that the additional tax partially offsets the benefits of
in expected future financing costs.
6 Debt repurchases may also be conducted as auctions. For example,8 Shuster (2007) gives examples of the provisions that were originally
Hovnanian Enterprises, Inc., used a modified Dutch auction withdesigned to remove small percentages of abstaining bondholders in
base bid prices ranging from $480 to $750 per $1,000 of the face value.otherwise fully consensual agreements but can be used to satisfy
The company eventually paid $223 million to buy back $578 million the requirements of §316(b) without agreement of the majority of
of debt in February and April of 2009. bondholders.

7 However, issuers may face greater regulation by the SEC if they9 This difference and the associated COD tax can be nontrivial. For
proceed with very large repurchases through these transactions. See,example, Harrah's Entertainment paid about 48 cents on the dollar
for example, Demont (2009). to repurchase $788 million of its debt in the second quarter of 2009.

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 Mao and Tserlukevich: Repurchasing Debt
1652 Management Science 61(7), pp. 1648-1662, ©2015 INFORMS

buying back debt at a low price. However, theis2009

Since the problem trivial in the case of riskless debt,
American Recovery and Reinvestment Act allows
we require defer
that the firm defaults in at least some states
of the world;
ring the COD tax costs for up to 11 years, i.e.,
effectively
making debt repurchases more attractive.10
C + X<D<C + X. (1)

3. Model of Debt Repurchase If the firm becomes bankrupt, th

In this section, we lay out the benchmark single-period
observed, and debtholders have first cl
model in the frictionless case with a assets.
single bondholder
In the frictionless model, we
and then with multiple bondholders. areWe no
are costs
interested
associated with bankrup
in the repurchase price, the creditors' incentives to ten
since our objective is to determin
der/sell debt, and the implications of the repurchases
firm's financial position on the incen
for the firm value. Later we relax some of theleverage,
decrease assump we assume that th
tions of this framework and analyze how
debt different
and postpone the discussion of
financing frictions affect debt repurchases.
until later. Lenders assume equal sen
future debt issues are restricted to subordinate claims
3.1. Model Setup
only and do not affect the recovered amount of the
Suppose that the firm has cash C, orlender
senior a liquid risk
in the event of default.
less asset of an equivalent value, or proceeds from a
We assume that the firm is restricted from paying
senior security collateralized by this asset. The existing
dividends or conducting share repurchases because
assets of the firm generate a cash flow x, distributed
such a distribution of cash would result in the value
continuously according to the cumulative
transfer from distribu
the lenders to the shareholders.12 Provi
tion function (CDF) F(x) on the nonnegative bounded
sions limiting distributions affecting debt repayments
support [Χ, X]. If cash flows can be negative, X < 0,
are commonly included in debt covenants (Smith and
we redefine C' = C + min(X); if the firm can spend
Warner 1979). Obviously, if unlimited dividends or
only part of available cash on debt repurchase, then C
share repurchases are allowed before the principle
contains only this part. Cash or safe asset C is given
amount of debt comes due, shareholders' first-best strat
and cannot be increased by, e.g., issuing new equity or
egy entails selling all assets to maximize the payout.
warrants.11 Therefore, the objective of the manager is
Shareholder-debtholder conflicts are trivially resolved
to maximize the value of equity with respect to two
in this case (see, e.g., Jensen and Meckling 1976). Finally,
alternative strategies: saving amount C are
there orother
using cash
uses for the firm's cash that we do not
to repurchase an amount of debt AD from the lenders.
allow in a simple model, such as investment considered
Note that the average repurchase price is PR = C/AD;
in the later sections of this paper, compensation to
for example, PR — 1 means that repurchase is made at
face value. employees, or perks to the management.

The firm's cash flows are independent of the repur

3.2. Single-Creditor Case
chase; that is, the repurchase does not generate any
We first consider debt held by a sole lender, such as a
synergies that can increase the value of the assets and
private investor or, alternatively, several large lenders,
therefore lead to the bondholder holdout problem
(similar to, e.g., Shleifer and Vishny 1986). We assume who collude when negotiating the sale price of debt.
that all of the firm's debt D (including accumulated The repurchase price restrictions can be derived from
interest at rate r) matures shortly after realization of x.the participation conditions for equity and debt holders.
Define the equity value, S0, as follows:

If not for the 2009 American Recovery and Reinvestment Act tax
deferral, Harrah's would face an immediate COD tax levied on the S0= [X (x + C-D)dF(x). (2)
JD-C
discount of about $400 million.
10 The act does not alter how COD income arises, but rather it affects
Define the equity value if the firm buys back AD of
when the debtor pays tax on the income. Usually, for repurchases
outstanding
after December 31, 2008 and before January 1, 2011, bondholders debt using all available cash C as SR; i.e.,
can elect to apply the COD over a five-year period beginning in
Λ
2014. Therefore, a firm that repurchased in 2008 will finish paying
the COD tax in 2019. The interested reader can find details in, for SR= / (x-D + AD)dF{x). (3)
J D—AD
example, Bortnick and Leska (2009).
11 If new equity is raised to repurchase or exchange risky debt, the
12 Clearly, the assumptions of "no dividends" and "no new equity"
shareholder value is almost always affected negatively. For example,
are closely related and make the study of repurchases (or any study
Gertner and Sharfstein (1991) show that raising new equity to finance
of risky debt) nontrivial.
debt repurchases (debt-for-equity swaps) decreases shareholder value.

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Mao and Tserlukevich: Repurchasing Debt
Management Science 61(7), pp. 1648-1662, ©2015 INFORMS 1653

Similarly, define the market values of debt as, respec- attempt to buy back their
tively, d0 and dR/ where the 2009 Royal Bank of Scotland tender debt repur
chase offer included subordinated notes. However,
J _ [D~C(r , rWFirï4-r> fX dF(r) 141 understanding repurchase offers for junior debt is
0 Jx Jd-c ' complicated because they lead to an additional conflict
D_AD x between the different classes of the bondholders. Addi
dR = j xdF(x) + (D- AD) J dF(x). (5) tionally, we assume in this section that
- D'AD facilities and other high-priority obligations are repaid
Note that, because of assumption (1), the initial price of before the price for senior debt can be negotiat
debt is below face value; P0 = d0/D < 1. The following debtholders are fully rational and attentive, and t
proposition links equity and debt values to the price of are no bankruptcy costs or other financing fric
the repurchase. Consider first a tender offer, when a fixed price
is offered to everyone who sells their bonds. If all
Proposition 1 (The Fair Repurchase Price Is the bondholders tender simultaneously, they are served
Face Value). Under the assumptions of the benchmark sequentially in random order until the full amoun
model, allocated for this purpose is spent. There is usually no
... ... _ , „ r r j j j <s\ minimum subscription requirement for the offer. It is
m R> 0 an R < °' ^ intuitive that the tender offer equilibrium is conting
(ϋ) if Pr> I, then SR < S0 and dR + C> d0; (7) on how Dffer priC6/ pr compares to the pre
. , . ,, , „ , , , . , chase and the expected postrepurchase prices. For
that is, regardless of the current market price, repurchases , .,„ . . ... ,ur, ,, , ,
, 6 , · , , r i i r. ι ι υ example, if the tender offer price is high, the bondhold
by the firm at the price below face value benefit sharehold- h. ... , , JT ,, ,
3 J, , r , . , r ι ι f ers will participate because the expected postrepurchase
ers, and repurchases at the price above face value benefit . nr . . , , , T/,u , , u
r r J J price, PR, is gomg to be lower. If the tender offer price
on 0 ers' is low, the bondholders will all abstain because the
Proof. All proofs can be found in the appendix. □ debt price without the repurchase, P0
It follows that the face value is the only price at £rst ?eP ^ formalizing this intu
which both sides agree to buy and sell debt. Note that ^d-pomt price PF at which t
the repurchase price is unique because in the frictionless Price remams exactly the same a
case debt repurchase does not change the total value Lemma 1. Suppose debt is repurchased
of the firm. However, we show in later sections that der offer from multiple bondholders:
there may be a range of acceptable prices in cases (i) There is a unique fixed-point ten
when the firm's assets increase after the repurchase such that post-tender price remains
due to, e.g., reduction in bankruptcy costs, smaller
tax, or more efficient investment. For example, we Pf = P = Pr·
show that the prospect of reducing bankruptcy costs
makes room for negotiations between shareholders and ^ ρ ^ p
bondholders and generally leads to a lower repurchase Pnce' r < o·
price. According to its definition, the fixed-point price is
the only tender offer repurchase price at wh
3.3. Multiple Creditors holders expect the same price after the repurchase is
In this section we argue that the firm can repurchase complete and are therefore indifferent between k
debt from multiple bondholders at the market price, or tendering their bonds. The significance of the l
or potentially at an even lower price. We show that is in showing that the fixed-point price is lowe
a firm can repurchase its bonds on the open mar- the market price. Therefore, repurchasing part o
ket or through the tender offer as long as there are debt at the market price will decrease the value of
small investors willing to sell their entire stake. The bonds for the remaining bondholders. We ne
important difference from the single-creditor case is this result to discuss the possible equilibria ba
that the sellers do not internalize a decline in the the tender offer price.
value of the remaining debt because it is held by other First, we consider the case when the tender offe
investors. is high, above the prerepurchase and the fixed-point
We model a single-date, same-seniority (pari passu) price, Ρ > P0 > PF. From Lemma 1
debt repurchase from a group of identical bondholders, do not tender receive a strict
each holding the same small share of debt. When the price, PR < P0. Therefore, there
firm has outstanding debt of different seniorities, the in this case: the firm offers a p
argument extends to the most senior debt. Sometimes, P0, all bondholders tender, and
in addition to the senior debt, the companies also them are served randomly unt

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 Mao and Tserlukevich: Repurchasing Debt
1654 Management Science 61(7), pp. 1648-1662, ©2015 INFORMS

Second, suppose that the tender offer price is between spent $223 millio
the prerepurchase price and the fixed-point price, equal to $578 milli
P0 > Ρ > PF. The equilibrium in this region depends on 39% of the face val
the beliefs about the number of bondholders participât- to buy back a $78
ing in the repurchase. on the market. Beazer Homes used $58 million to buy
Proposition 2. Suppose the tender offer price Ρ e million in debt (Ng 2009).
(PFl P0). If every bondholder has a uniform beliefj about v ™ereare two other important points th
the fraction of bondholders who will participate in the offer, llke; to1brlmSJtl° }fht conlu"ctlon Wlt
^en multiple bondholders. First, we have assumed through
1 'for j > j\ all bondholders tender, and the tender offer °^tbat each Îvestor h°lds a" iden
is successful' a s xt enhrely to the firm. Such contmuum
2. for j <>, all bondholders abstain from the tender offer, of homogeneous investors is a su
and the offer fails our results, but not a necessary one. For exa
The threshold belief j* e (0, C/(PD)) is given as a unique the credit°r composition involves
solution to the Equation (A8) in the mvestors.
appendix. mvestors'wlU ftrst be purchas
These mvestors can sell their entire debt
The proposition gives the threshold belief regarding holding in response to the offer and do not n
the fraction of tendering bondholders, which can trigger internalize the consequences of the repurch
a "bank run" (Diamond and Dybvig 1983). For example, outstanding debt.
if the belief about the success of the offer is highly Second, the news of the incoming tender offer
optimistic, i.e., j —>· 1, then it implies PR<P, and the ing information on the size of the offer and its
offer is successful as nontendering bondholders are may alter the market prices for both debt
expected to be worse off. In contrast, j -*■ 0 implies Specifically, anticipation of the repurchase at
that PR> P, and the offer fails. Following Diamond can result in the market value of debt lowe
and Dybvig, we treat belief j as exogenous. initial price. Recall that the price, P0, is defi
Third, an even lower tender offer price, which is expected payoff to bondholders if the repurcha
lower than the fixed-point price, trivially leads to the anticipated or if it is not expected to be succ
repurchase failure. By the definition of the fixed point, appendix provides the expression for the mar
for any Ρ <Pp and any belief the postrepurchase with the adjustment for the repurchase, w
price is expected to increase, PR>P, because, intuitively, he different from the initial price P0. It is
too little cash is spent compared to the debt reduced. however, that the equilibrium does not hi
Therefore, every bondholder will abstain from tendering. precise price, which incorporates anticipa
Intuition for the open-market debt repurchases is repurchase. Instead, it depends on the relation b
similar to that for the tender offer case. An important the (i) tender offer price (P), (ii) the price i
difference, however, is that bondholders may receive chase fails (P0), and (iii) the price if the repur
different prices for their holdings, depending on the successful (PR).
relative timing of the sale. As we have argued, the Our result that debt is more easily repurch
price for the remaining debt will decrease with each there are many bondholders seems to run
repurchase at the price above the fixed point, including conclusions of the strategic debt service litera
the market price. Therefore, bondholders have a strong and Moore 1998, Mella-Barral and Perra
incentive to participate, and those who sell first will in that literature, firms facing financial distr
receive the best deal. At first, this may appear coun- strategically and force concessions from d
terintuitive because a debt reduction would seem to However, whereas strategic debt service d
make the remaining debt safer. Instead, a repurchase bargaining after default, when cash effectivel
consumes cash inside the firm, making the remaining belongs to creditors, we discuss repurch
debt riskier. We do not formally define the equilibrium solvent firm. Because of this difference, w
for the case of open-market repurchases because it the dispersion of debtholders that is comm
requires modeling heterogeneity among bondholders as an impediment to renegotiations actuall
and building a sequential game for the stages of the reduce leverage and the probability of bank
repurchase. In sum, our model suggests that, given a debt repurchases,
continuum of dispersed creditors, the firm is always
able to repurchase a. the cu'rent marta price. 4 Model Extensions
Anecdotal evidence supports this conjecture. For
example, in the year 2009, Hexion Specialty Chemicals 4.1. Bankruptcy and Bankruptcy Costs
spent $63 million to buy back debt from the open In this section we assume that in the event
market with face value up to $288 million. The average lenders take, over the firm and implement f
price was 22% of the face value. Hovnanian Enterprises policies, subject to a fraction of the firm's a

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Mao and Tserlukevich: Repurchasing Debt
Management Science 61(7), pp. 1648-1662, ©2015 INFORMS 1655

lost during the transfer. It is clear from our discussion is inside the firm, would be
that the probability of bankruptcy is not affected when cost /3j.13 Therefore, expec
the repurchase is conducted at the face value. However, reduced in debt repurchases
the prospect of having lower bankruptcy costs and a bankruptcy is fixed, as captur
lower probability of bankruptcy after the repurchase is The second effect arises be
complete allows for a lower price even in the single ally lead to a lower probabili
creditor case. of the expected reduction in
To show this, we assume that a firm entering costs, debtholders agree to t
bankruptcy results in a fixed cost Β and proportional a result, there is an addition
cost β, which are known both to shareholders and to lower bankruptcy risk (the
creditors. Unlike in, e.g., Leland (1994), we recognize Overall, we predict that the
that safe assets may be different from risky assets price is lower when expect
and assume that cash or liquid assets are subject to higher. Additionally, keepin
cost β] e (0,1), and other assets are subject to cost eters fixed, the repurchase
β2 € (0,1). Although not crucial for our argument, it relative bargaining power of
may be reasonable to conjecture β1 < β2, meaning that
4.2. Optimal Leverage and
safe/liquid assets are easier to transfer to new owners.
Parameter βλ can also be interpreted as the agency As discussed earlier, disco
cost, such as the manager's ability to "burn" cash at a price below the face
before bankruptcy. For simplicity, we only consider a (relative to the debt issuan
single-creditor case. from bondholders to shareh
The expected bankruptcy costs are given by argue that repurchases posit
total firm value—the sum o
BC0= ί°~€ (β2χ + β10 + B) dF(x). (8) values. We are concerned wit
Jx
repurchases on optimal lev
The following proposition shows that the repurchase optimal debt structure.
We cast the classical trade-off intuition in our model.
price is generally lower when there are fixed and
proportional bankruptcy costs and gives the range of Following previous work on capital structure (e.g.,
possible prices. Leland 1994), we assume that the firm trades tax
benefits of debt with bankruptcy costs. Since we know
Proposition 3. Assume Β > 0, β1 > 0, β2 > 0, and that
from the previous sections that buying back debt at face
otherwise the assumptions from the frictionless case hold.
value leaves the total firm value unchanged, we focus
Then the repurchase price is
only on the market-price repurchases. The following
PRe[PrM proposition demonstrates, using for simplicity the
uniform distribution for the profit x, that both optimal
where the lower bound on the repurchase price, Pf11"leverage
< 1, is and firm value increase with repurchases.
the solution to Equation (A12) in the appendix.
Proposition 4. Suppose χ is distributed uniformly on
The proposition gives the upper and lower bounds
[Χ, X], the corporate income tax is Tc, and shareholders
for the repurchase price according to how the
havesur
an option to repurchase debt with cash C at the market
plus from lower bankruptcy costs is split between
price. Then the optimal amount of debt issued at t = 0 is
shareholders and bondholders. If shareholders have all
bargaining power, the lowest price, P™m, is obtained.
If, instead, bondholders have all bargaining power,
then debt is repurchased at the face value, as in theThe ex ante firm value is given by
frictionless case.
Because the bankruptcy costs are lower in the expec
V* = f*x(l-Tc)dF{x) + D*r(l-j)Tc
tation, firm value increases after the repurchase. Using ^ v ' ν v—£—,
expression (8), we find that firm value increases by after-tax asset value tax shield
rD*-CD*/d0
r ^ /"o

+ C-/3J xdF(x)
A(BC) = C^ Jx
[D C dF(x)+
Jd-xd
[° €(Β + β2χ)άΡ(χ). (9) Jx

bankruptcy cost on assets

Bankruptcy costs decrease, intuitively, for two reasons
First, during the repurchase, cash or safe asset C is
13 Cash is subject to bankruptcy costs, even if the firm can eventually
transferred directly to bondholders
restructure and exit the bankruptcy. For example,in LoPucki exchangeand for
lower debt. It matters because ifthatthe
Doherty (2011) estimate only direct firm subsequently
legal fees on all assets
defaults or becomes bankrupt,
including cash can be this
as high as 2%.cash or asset, which

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 Mao and Tserlukevich: Repurchasing Debt
1656 Management Science 61(7), pp. 1648-1662, ©2015 INFORMS

_Bf°' CD*M) dF(, m) 4.3. Repurchase Timi

Jx ' We previously adopted the assumption that debt must
' v ' be repurchased on a single date. This section extends
fixed costs of bankruptcy t , u .
the previous analysis by
Both D and V increase with the amount of r
Proof. See the appendix. □ allows us to understand what determines the opti
,. . , , ... . mal timing of debt repurchase and, in particular, the
The firm value and leverage are higher when repur- , , ,, , . ,. Γ , , , r ,
. ,, , , , , , , shareholder s mcentives to delay the repurchase,
chases are allowed because the bankruptcy cost and . ,, ,, , , , ,, , .
,, , . Τ, . Assume there are three dates, t = U, 1, 2, and values
the probability of bankruptcy are lower. Note that (10) , . . , . , , , _ , „ τι. a , L L ,
, , , , , r,. r, , , are denommated in date t = 0 dollars. The hrm s total
must be treated as an implicit equation, because dn can ,, , , , , „ . ,
, , j ,, ' ... , profit at the end date t = 2 is equal to the sum ot the
also depend on the optimal debt. The proposition only Τ , . , , T., , r. , ,
j . .-il · ι. Ρ ι j- . independently distributed profits from the hrst and
determmes optimal leverage given cash holdings; that r , . J. . r Οι λ . ,
, r . . . . ,, ... , -.i.i , · τ second periods, χ,+x2, where χ, 2 e IX, λ I. At f = 1,
is, cash C is not ointly determined with the optimal , . , . , , ' ., , , ,
debt D* information about χλ becomes available, and at
fj u · j- .ι ι ι , .ι ι . date t = 2, the information about x7 becomes available.
Our result is directly comparable to the classic / , , , , , . ,
dynamic capital structure literature (Goldstein et al. Smce^ m°del n
2001). In our model, the firm has an option to lower need ad]ust t
the leverage ratio in the future and is more aggressive Assume thaj thej
initially in order to increase current debt benefits. We xt 'can be rfduce
conclude that discounted debt repurchases are benefi- the next date'
cial to shareholders. Contrary to the initial intuition is revealed)· Si
that exploiting bondholders during the process leads due to the first
to an agency problem, allowing debt repurchases can Ci ~ C2" We alr
actually increase the ex ante firm value. This is because benefit from bu
the shareholders gain more than bondholders lose. The usinS a11 remaini
option to repurchase reduces the instances of defaults at'sence o
and increases debt capacity. tive function of the sh
The result that the option to repurchase debt is expected value of t
valuable to the firm has implications on debt design max yo
and the optimal creditor structure. In particular, some (cd
features of debt can interfere with the firm's ability to , χ r , χ
repurchase. For example, consider conversion options. dF(xχ), (12)
=/ /
They contain an equity part and therefore necessit
an additional SEC approval prior to the repurchase. where F(v,) and
Furthermore, the option to repurchase debt is directly functions for x1 an
affected by seniority structure. Our base model gives derivative of this
results for same seniority for all bondholders, based on as the "propensity
the observation that the repurchase offer is typically debt." Using th
made for a single class of senior debt. However, firms equity value, equi
commonly carry several tranches of debt with a slightly debt value, we
different seniority for each separately sold debt fraction, repurchase tim
making repurchases more difficult and reducing share- Lemma 2 In the f
holder value. Finally, the optimal creditor structure—in cPase -s irreievan
particular, distribution of debt among creditors—can
also affect repurchases. The more dispersed debt own- It is straight
ership is, the easier it is to restructure through a tender absence of fric
offer or an open-market debt repurchase. repurchase timing.
Overall, we find that bankruptcy costs and dispersed face value, regard
debt ownership, two assumptions that are common and cash simply
to U.S. firms, result in a lower repurchase price. With D0 - C0. The irre
moderate transaction costs, debt repurchases are there- case because t
fore beneficial to equity. However, despite the potential repurchases ear
advantage of immediate repurchase, we show in the matters outside
next section that treating the repurchase as an option Suppose the firm
and delaying its exercise results in even higher expected at the current
profits. holders are better off repurchasing later. This is because

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Mao and Tserlukevich: Repurchasing Debt
Management Science 61(7), pp. 1648-1662, ©2015 INFORMS 1657

the future price is uncertain, and the value function is rate Td. Alternatively, if the firm repurchases a portion
convex in the repurchase price. Therefore, by invoking of its debt, AD, the after-tax dividend is
Jensen's inequality and using the fact that the price at
PayoffRep = AD(1 + r(l — Tc))(l — Td)
the first date is equal to the expectation of the price at
the second date, we immediately obtain the following ~ TCODmax(AD — C, 0)(1 — Td), (15)
result.
where the second term is an additional tax on the

Proposition 5. Suppose debt is repurchased at price Pjh COD income if debt is repurchased at a discount. From
at date t = 1 or/and at price (x1 ) at date t — 2 such that (14) and (15), we compute the debt repurchase tax
advantage over saving as
Ρ1Μ=[ P^xJdFixJ. (13)
Jx\ AdvRep = (AD - C)(l + r) - (AD - C)rTc
Then it is optimal to delay repurchase. - TCODmax(AD-C, 0). (16)
If debt repurchase is associated with additional trans The direct benefit of repurchasing debt at a disc
action costs, it may become optimal to abandon the (first term) is reduced by a higher corporate tax beca
repurchase when the debt price becomes too high. of the lower debt net of cash (second term) and al
Transaction costs effectively increase the cost of the higher COD tax (third term). We compare this ex
repurchase, and therefore the firm repurchases selec sion to our base model and conclude that corpo
tively. We delegate details for this case to the appendix. and COD tax reduce the ex post benefits from
We show, in particular, that a proportional linear fee repurchase.
levied on the total transaction amount forces the firm
to repurchase only if the first-date profit does not 4.5. Debt Repurchase and Investment
exceed a particular trigger value, xj. Otherwise, the It is well known that excessive and risky debt sup
firm will optimally abandon the repurchase and avoidpresses new investment.14 Therefore, it seems natural
paying the transaction fee. Therefore, waiting until that restructuring through a debt repurchase would
f = 2 to learn about the realization of the first-periodincrease investment efficiency. However, our previous
analysis demonstrates that debt repurchases reduce firm
profitability leads to a higher firm value. A similar
risk only to the extent that the repurchase price is lower
intuition applies to the fixed costs, with the exception
than face value. We therefore anticipate that the ability
that the optimal strategy depends on the volume of
to mitigate the debt overhang problem also hinges on
the repurchase.
Based on the two-date model in this section, we negotiating a repurchase discount. To formalize and
extend this idea, we introduce capital investment into
conclude that companies, including those that would
the existing model of risky debt and study how buying
benefit from buying back debt using the first opportu
back debt affects investment incentives.
nity, are better off delaying the repurchase. At the end,
To model investment in a simple form, we assume
we may not observe as many repurchases in the data
that shareholders can invest amount I, expecting the
as predicted by the simple one-period model because
payoff x(I). The effect of investment on the cash flows
the option to buy back debt may expire unexercised.
is modeled through the cumulative distribution func
4.4. Net Tax Benefit tion G(x 11) on the domain [Χ, X]. Specifically, since
investment must positively affect future profits, we
Here, we discuss the tax implications of repurchasing
assume G, (χ | /) < 0, that is, the payoff from larger
debt versus saving cash. The purpose of this exercise is
investment first-order stochastically dominates the
twofold. First, it clarifies the tax implications for the
payoff from the smaller investment. A simple example
debt net of cash or negative debt, extensively discussed
for this investment is the linear shift in the probability
in the literature, but allows for a general price of
distribution of the payoff, corresponding to a constant
debt instead of the dollar-for-dollar price. Second, it
shows the trade-off between the value of a discounted positive return R > 1,

repurchase and the cost of a lower tax shield and the G(x 11) =F(x-RI), (17)
COD tax.
where F(x) is the CDF of the payoff distributio
As is standard in the literature (see, e.g., Auerbach
investment. Finally, we assume that investm
2001), we track the after-tax payoff to shareholders
under the two alternatives. If the firm saves C for one
be financed externally, and the financing is
cost φ( ■ ).
period, the after-tax dividend to shareholders is

PayoffSave = C( 1 + r( 1 - Tc))(l - Td), (14) 14 The debt overhang problem manifests itself in the prohibitively
high cost of external equity for firms with risky debt, leading to
assuming that tax Tc is levied on corporate income insufficient capital expenditures and high postinvestment "marginal ιj"
and cash distributions are subject to further tax at the (Hennessy 2004, Myers 1977, and others).

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 Mao and Tserlukevich: Repurchasing Debt
1658 Management Science 61(7), pp. 1648-1662, ©2015 INFORMS

Proposition 6. The optimal investment 1* is monotoni- Our theory pr

cally decreasing with the repurchase price and is given by First, discounte
- transfer from bondholders to shareholders and therefore
ΛX

/ -G,(r I Γ) dx = Φι(Γ). (18) should increase the value of equity and decrease the
D-c/p value of debt. The size of the value transfer, and there
Expression (18) can be interpreted as the marginal f°re the magnitude o
value of investment equal to the marginal cost of to be larger with the
external financing. The proposition shows that optimal contrasting prediction
investment is a decreasing function of debt net of cash. was developed and ve
Therefore, as we conjectured, investment incentives are chase literature; see,
unchanged with the dollar-for-dollar repurchases. Second, the repurchas
Repurchases at the price below the face value would expected bankruptcy
positively affect the optimal investment, but because 's dispersedly held
the anticipation of investment raises debt price, negoti- open market. Third, w
ating such a low price may be difficult. Intuitively, the carry cash and risky
prospect of valuable investment increases the repur- support in the existing
chase price. This is because the market will internal- (2009, p. 1985) state
ize the benefits of the investment, and bondholders debt obligations w
demand the premium. Overall, our results in this sec- we predict lower mark
tion extend and complement the analysis in Bulow unable to utilize debt b
and Rogoff (1991). They show that the buyback of example, if debt agre
sovereign debt is a giveaway to creditors because the
relief from debt overhang is expected to increase the Supplemental Mate
market value of debt. We discuss corporate debt and Supplemental material to t
link the effect on debt overhang to the repurchase .doi.org/10.1287/mnsc.201
price. Our contribution is to show that the ability of
the corporate debt buyback to mitigate the agency Acknowledgments
problems such as debt overhang crucially relies on The authors are grateful for
the low repurchase price. Finally, it follows from the referees, and Ilona Baben
analyses both in our paper and in Bulow and Rogoff Bernard Dumas, Way
(1991) that debt overhang can be mitigated if cash is Fulghieri, Andrea Gamb
alternatively used to cover a part of investment cost Miles Livingston, Robert
directly, instead of repurchasing debt first. Permacchi Eric Powers, Jay
Stulz, Josef Zechner, Jaime Zender, and Ale
(American Finance Associa ton (AFA) discussan
r frmrliieinn thank the participants in seminars at the Hong Kong Univer
sity of Science and Technology, AFA, Arizona State University,
When managers are confronted with a choice between the University of Colorado, the University of
saving cash and repurchasing debt, they face a trade- Nanyang Technological University Singapore, th
off between the costs and benefits of the repurchase. sity of Toronto, Singapore Management University
This paper provides a theoretical guidance for these University of Florida. The authors acknowledge f
decisions. We find that firms that can buy back debt at support from the Research Grants Council in H
a discounted price benefit from the repurchase and also and the research assistance of Daniel Deng,
benefit more if they delay the repurchase. Simultaneous
saving and borrowing creates an opportunity to buy Appendix A. Repurchase Price Derivation
back debt conditional on a lower price in the future, or Proof of Proposition 1. To show that SR>
scrap the repurchase plan otherwise. we define the function of G(y) as
Importantly, we show that the dispersion of debthold ■x

ers!_·
that is commonly seen as an impediment to rene- G(y)=i [x + y-D]dF(x), ye[0,D], (Al)
.2 11__ 1. J l 1 1 J Jd-U
gotiations actually helps to reduce leverage and the D_y
probability of bankruptcy in debt repurchases. Our Function G(y) increases in the argument
findings have implications for security desig
pricing of debt contracts. In particular
dominates private debt held
because the former is easier to repur
profitability decreases. = JD dF(x) > 0, (A2)

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Mao and Tserlukevich: Repurchasing Debt
Management Science 61(7), pp. 1648-1662, ©2015 INFORMS 1659

and therefore PR < 1, or alternatively C < AD, implies repurchase. Since (C/D
G(C) < G(AD), (1 — C/DP) remain outstanding, we have

fJd-c
(x + C-D)dF(x)<
Jo-ad
Γ [x + AD-D]dF(x),
DP
_C_
DP
(A3)(A9)
PAP)· p(P) =
which is the same
in the main text. T
value can be easily
main text. PEX(1) = P„. (A10)

Proof of Lemma 1 (Fixed-Point Pr

tender offer repurchase price is equal
price, PF = Ρ = PR. Note that,
the debt after repurchase is
using (5), Pr can be solved from the following equation: . ,, , ,. , , . . .,,, ,,
° σ and therefore the market price decreases more if the offer
dR r D"c/pf χ price is lower.
D - C/Pp " fx D-C/PF dF{X^
Proof of Proposition 3 (Bankruptcy Costs). The lower
+ dF(x) — PF (A4) bound on the repurchase price obtains when the bondholders'
c/Pf participation condition binds:

This equation has a unique solution for Pf, which is betw

C/D and the prerepurchase price, P0 > C/D. It follows from ο -
considering PF = P0 and PF -*· (C/D)+ and using the fact that Setting it to equality and
function (A4) is continuous in between. obtain the implicit expression for
Specifically, suppose Pp — Po'' we show that the left-hand
price pmin·
side of (A4) is smaller than the right-hand side. This is
because, from Proposition 1, we have rD~c
f (x-D + C/ΡΓ)dF(x) + ί (C/ΡΓ -
Jd-c/pJd-c
C/pmin
dR<d0- C, (A5)
[°~C AB + p2x)dF(x) + pJD~CCdF(x) (A12)
dv dn — C /D-C/PJ™ Jx
D^CjP <D^CjP=P°' (A6)
' 0 ' 0 Since F(x) is continuous on [Χ, X], the left-hand side of this
Now suppose PF -» (C/D)+; then the left-hand side of (A4) equation is a continuously decreasing function for PRm
approaches 1, which is higher than PF. [C/D, 1] and has a minimum of zero at P™ = 1· Additionally,
since the right-hand side of the equation is strictly positive,
Proof of Proposition 2 (Tender Offer Equilibria). The there is a umque pmin < 1; that iS/ the lower bound on th
threshold belief j is defined as the fraction of participating repurchase price is below face value. The upper bound to th
bondholders, at which the postrepurchase price is exactly repurchase price obtains when the shareholders' participation
equal to the tender offer price: constraint binds. From Proposition 1, P^ax = 1. Finally, note
pR(j*) = ρ (A7) thât a^er the repurchase, the bankruptcy costs decrease to
fD-AD
which is BCr= (Β + β2χ)άΡ(χ),
Jx
(A13)
l λ D-j*D aX

D _ j*D Jx X }D_j,D = P- (AS) which is used

The left-hand side is monotonically decreasing in j*; therefo
the solution for j* is unique for all Ρ e (PF, Pn). In particular, „ τ v Λ
j* = 0 for Ρ = Po, and } = C/(PD) for Ρ = PF. Therefore, u PfOF°F Proposition 4 (
for / > j\ PR(j) < P, and the offer is successful. For j < f, the distribuhon tax, we can w
ΡAÎ) > Ρ' f^e bondholders will abstain.
S0=( (x+C — D)dF(x)~ [ (x+r(C-D))Tc
Jd-c Jx
Derivation of the Market Price After the

Repurchase Announcement where the second term is the expected value of tax payments.
To support the discussion of the multicreditor case, we prove The market value of debt is
the following: (i) the market price of debt reacts negatively -
to the news of the discounted repurchase, and (ii) the market d0 = f (x + C) dF(x
price is lower when the tender offer price is lower. U ^D~c
The market price is the weighted average of the price r d-c
paid in the tender offer and the price of the bonds after the - j (&* + ftC — B) dF

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 Mao and Tserlukevich: Repurchasing Debt
1660 Management Science 61(7), pp. 1648-1662, ©2015 INFORMS

where the last term is the expected value of bankruptcy To show that it is optimal to repurchase at t = 2, we compare
costs. Summing (Bl) and (B2) produces firm value without shareholders' value at date t = 0, S(Q = 0) and S(CX = C0),
repurchases: under two cases: Q = 0 (use all cash to repurchase at t = 0)
and Q = C0 (use all cash to repurchase at t = 1). We show
y that S(Q = 0) < S(C| = C0) by applying Jensen's inequality
= fX(x + C){l- Tc)dF(x) + r(D-C)Tc
tax shield
twice to get
after-tax asset value

S(C,=0)
- ftC f° C dF(x) -β2 [° C(x + B)dF(x). (B3)
Jx Jx
X X

" ν ' V V '

= f , (*i +x2- (D0 - CJPlM - x,
Jx Jd0-Co/P1m-xi
bankruptcy costs (on ca

The optimal
< ί Γ ί debt D*
, (xi+x2-£,, [Do - C0/
condition.h V^Do-Co/Pld-xi
For exam
[Χ, X], thendF(x i)
we hav
r - β, — β, Β X
D* = -Tc(X-X) + ^-^C--. (B4) ( „ ι ~ T~\ Γ IT.

ρ 2 P2 P2 *i*\i
Jx LJl
•'Do-Co/P^-xi
(Xj +x2 - D0 - Co/Ph)M dF(x2) dF{x j)

Now consider the = caseS(C1 with = Q), (B10) discoun

Suppose that debt is repurchased at t
holders compute the
and the expected value
result follows.
account the anticipated repurchase,
Optimal Timing with Transaction Costs. The model introduces
r Dr ρ Dr pX transaction costs as a proportional fee y, levied on the
dR = C + ( 1-β2) xdF(x) — amount.
total transaction B /We dF(x) + DR
consider only open-market d
Jx Jx Jdr
repurchases and prove the following claims: (i) the firm
repurchases
where, from the budget at f = 2 only if x, < x* the
condition, for some threshold
remain
the repurchase is xj € [Χ, X], and (ii) the propensity to delay the repurchase
CD
increases in y.
Dr=D- —, (B5)
do Note that, from Proposition 1, shareholders benefit from a
and d0 is given by (B2). repurchase when D1 — D2 < Q — C2. Therefore, from (B14),
The value of equity is
(1 -y)D1=d1(xl), (Bll)
SR = [X(x-DR)dF(x)~
J Dr [X(x-rDR)TcdF(x).
Jx (B6)
which proves our first claim.15
Second, for an interior x\, we can rewrite (
The sum of the value of debt and equity values produces
two separate terms reflecting value when th
in the main text. The first-order condition of (11) with res
optimal (the first term) and when it is not (t
to D* yields the optimal level of debt in (10). It then foll
directly that D* and the firmmax S
value increase with the am
of the repurchase. (Ci, Ci)

χ* %
Proof of Lemma 2 (Multiperiod
= ί 1 ί (XjExtension).
+ χ2 - D2) dF (χ2)This
dF (xj )lemm
j Χ JT>2~X\
JDi-χλ
concerns repurchase timing in the frictionless case. Us
P™ax = 1 from Proposition 1, and
Χ χ
therefore letting
+ [ ί (x1+x2 + Cl-D1)dF(x
Q = C0 + Dj - D0 and D2 = Dj - Q (B7) Jx'i •'Di-C1-Xi

Equity maximization is subject to the

in (12), we find that (12) is independent of Q, and therefore
the repurchase at t = 1,
the timing of the repurchase is irrelevant in the frictionless
case.

(l-y)(Q-C1) = P11(D0-D1), (B13)

Proof of Proposition 5 (Repurchase Timing). The propo
sition assumes that bonds are sold at theand at t = 2,
market price =
d0/D0 at ί = 1 and P^{xi) = d1(x1)/D1 at t = 2, where
(l-y)(C1) = Pi1(x1)(D1-D2), (B14)
(*i) = ( Dl dF(x2)
"J X\

15 Note that benefits per dollar used in the repurchase are measured
~l·j Τι f4-ίι4-Γι
+ x2 <Di
~l· Cf) dF(x2)' by the difference between the face value and the market value,
Jxi+X2+Cj<Di
1 - dx(x\)/Dv and that the cost of the repurchase per dollar is given
Then the budget conditions are by γ; therefore the threshold x' defines the point at which the benefit
exactly offsets the cost. Similar intuition applies to the case with
Q = Q + Pm(D0 - Dj), D2 = D1-C1/P2M(x1). (B9) nonlinear transaction costs.

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Mao and Tserlukevich: Repurchasing Debt
Management Science 61(7), pp. 1648-1662, ©2015 INFORMS 1661

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