Counteracting Forces Against Expropriation

Self-commitment can lower interest rates.

How to align prospective bondholders with the firm.

Bond covenants reduce exploitational opportunities in the future—but at a cost in flexibility.

And, again, covenants reduce the flexibility of the firm to take advantage of other opportunities. Sometimes, reputation can substitute for covenants.

Bondholders demand a premium ex ante that they would not demand if the firm could commit not to expropriate them ex post. The premium may prevent the firm from raising debt at fair interest rates, and thus tilt the optimal capital structure more towards equity. Even managers with the best intentions not to act against bondholders may not be able to shield themselves from the pressures of expropriating creditors later. Who ultimately loses? To the extent that smart bond investors anticipate their fate, they will demand and receive fair compensation. Ultimately, it is the firm that suffers. Its inability to commit not to expropriate creditors may prevent from issuing debt at fair prices—which may mean it may have to forego debt's other advantages, such as tax savings.

In the real world, there are a number of mechanisms that can help to reduce the fears of bondholders, and thereby allow the firm to issue debt at acceptable interest rates—and thereby lower the firm's cost of capital.

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