Debt Capacity
Ifthecashflowsoftheacquiringand targetfirms areless
thanperfectlycorrelated,thecashflowsofthecombinedfirm
willbe less variablethanthe cash flowsof theindividual
firms.Thisdecreaseinvariabilitycanresultinanincreasein
debtcapacityandin thevalueof thefirm.Theincreasein
value, however, has to be weighed against the immediate
transferofwealthtoexistingbondholdersinbothfirmsfrom
thestockholdersofboththeacquiringandtargetfirms.The
bondholdersinthepremergerfirmsfind themselveslending
toasaferfirmafterthetakeover.Thecouponratestheyare
receivingarebasedontheriskierpremergerfirms,however.
If the coupon rates are not renegotiated, the bonds will
increasein price,increasing thebondholders’ wealthatthe
expense of the stockholders.
Thereareseveralmodelsavailableforanalyzingthebenefits
ofhigherdebtratiosasaconsequenceoftakeovers.Lewellen
(1971)analyzesthebenefitsintermsofreduceddefaultrisk,
sincethecombinedfirmhaslessvariablecashflowsthando
the individual firms.
14 Heprovidesarationaleforanincreaseinthevalueofdebt
afterthemerger,butattheexpenseofequityinvestors.Itis
notclear,inhismodel,thatthevalueofthefirmwillincrease
after the merger. Leland and Skarabot (2003) argue that
mergers can increase debt capacity but at the expense of a loss
of theindividualfirms’ debtto equitychoices and limited
liabilities.
15 Stapleton (1985) evaluates the benefits of higher debt
capacity after mergers using option pricing.
16 Heshowsthattheeffectofamergerondebtcapacityis
alwayspositive,evenwhentheearningsofthetwofirmsare