EFFECTS OF MEZZANINE DEBT ON OPTIMAL CAPITAL STRUCTURE: RISK AND RETURN

Abstract

Optimal capital structure derived solely from debt and equity financing has brought forward controversial propositions in mainstream finance literature. Mezzanine debt, a hybrid debt and equity, provides an alternative channel to financing for firms to seek optimization of the risk-return tradeoff in their capital structure. The insertion of the additional strip of financing has complicated the risk-return between the secured lenders, mezzanine lenders and equity investors. The evaluation of financing and credit risk factors of mezzanine debt posits a high dependence on secured debts, which are in turn influenced by interest rate risk, cash flow risk, market risk and default risk. Pricing of mezzanine risks is therefore of interest to the mezzanine investors (lenders), who may require a premium. The study in this dissertation attempts to construct a theoretical discounted cash flow model for evaluating the risk premium of mezzanine debt. This model will take into consideration the loan to value ratio, debt coverage ratio, default risks, loss recovery rate of the debt, the holding period returns and the cost of secured debt and the return on equity. It will also establish the relationship of priority claim or the subordinated structure of cash flows between the secured lender, the equity investor and the mezzanine lender within the context of a discounted cash flow framework. The determination of the risk premium will throw more light on the implications for the successful creation of mezzanine debt as well as the risk-return tradeoff.