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The role of private and public debt in corporate capital structures.

* Over the last decade, a number of developments have drastically changed the market for corporate debt. Among those developments have been the evolution of the "high-yield" bond market, the adoption of shelf-registration procedures, and the evolution of the market for resale of bank loans. Recently, the Securities and Exchange Commission (SEC) approved Rule 144a, which considerably enhances the liquidity of privately placed securities and is expected to contribute to a growing private placement market.(1) In light of these changes, it is helpful to understand the relative importance of private and public debt markets and whether they play unique roles.

Several researchers (including Berlin and Loeys[3], Diamond[8], Fama[9], and Stiglitz[16]) have provided theoretical arguments on the motivations for the use of private debt in corporate capital structures. Despite the regulatory and theoretical interest in the distinction between public and private debt markets, empirical analysis of the choice between the two markets has traditionally received little attention in the literature. Recently, empirical researchers have begun to look at this decision at the firm level.(2) Studies by James[11] and Lummer and McConnell[13] address the issue by examining stock price reactions to announcements of private financing. Their evidence is consistent with a unique role for private debt in resolving informational asymmetries. Blackwell and Kidwell [4] analyze the private/public debt issue decision for public utilities. Their evidence indicates that flotation costs of debt and market volatility effect the choice. However, the evidence regarding the impact of agency costs of debt is mixed. While these costs appear to play a role for smaller firms, there is no such effect for larger firms. Given the profound differences in capital needs and financial policy between public utilities and other industrial firms, generalization of their results to industrial firms may not be straightforward.

This study seeks to examine some of the issues raised by Blackwell and Kidwell using data for a sample of commercial and industrial firms. For a subset of Fortune 500 firms, we document the extent of reliance on private markets in obtaining long-term debt financing. In addition, we employ cross-sectional analysis to examine the relationship between the potential for leverage-related costs and the choice between private and public markets. This evidence is helpful in understanding the functions of these markets.

I. Determinants of the Private/Public

Debt Choice

Firms can obtain long-term debt financing privately or through public offerings. Public offerings with maturities longer than nine months must be registered with the SEC. Private market issues (i.e., bank loans and private placements) are exempt from registration requirements.

The classification employed in the study (private versus public), in effect, distinguishes long-term debt issued widely from long-term debt issued to a select group of lenders. However, private debt includes several types of debt that are not identical. Private debt consists of direct loans from banks or institutions and brokered debt that an investment banker places with several institutional investors. Brokered debt may be closer to public debt in terms of the nature of the contracts and the relationship between the borrower and institutional lender. While more detailed partitioning may reflect some useful distinctions, such partitioning cannot be made with existing published data.(3)

Prior research has posited four considerations in the choice between private and public debt markets: (i) flotation costs, (ii) leverage-related costs, (iii) the value of liquidity, and (iv) the resolution of information problems.(4)

Public offerings are associated with significant issue costs such as fees for SEC registration, listing, trustees, investment bankers, and printing. Use of private markets avoids or reduces most of these flotation costs. Firms with large issues have more viable access to public markets because they can spread the fixed component of issue costs over the larger volume. Issue cost considerations encourage firms with small issue sizes to place their debt privately.

Leverage-related costs (i.e., bankruptcy costs and agency costs of debt) associated with formal default could also affect the choice between private and public markets. Berlin and Loeys[3] and Myers[14] argue that private debt, especially bank debt, is associated with better monitoring. In addition, if reorganization is costly, private debt may provide the flexibility to reschedule, thus avoiding formal default and the attendant costs. Therefore, firms that face high leverage-related costs may choose private debt to reduce these costs.(5)

Public offerings, generally, have greater liquidity than offerings in private markets because public issues can be resold in competitive secondary markets. Prior to the adoption of Rule 144a, SEC regulations restricted the resale of private debt. If, due to restricted liquidity in secondary markets, yields on private debt exceed yields on public debt, then firms would prefer to issue public debt. Zwick[18] provides evidence that yields on private debt exceed those on public debt by 50 basis points controlling for credit quality, duration and tax treatment.(6) Secondary market liquidity and the associated savings should be directly linked to issue size, thus making public issues more attractive for firms with larger amounts of outstanding debt. Secondary markets for small public issues could be quite thin and provide little reduction in yields.

Finally, the private issue market provides two opportunities to avoid problems associated with informational asymmetry between the public market and management. Campbell[6] has suggested that firms possessing proprietary information will seek financing in the private market rather than make the disclosure required for public offering. Further, James[11] hypothesizes that firms arrange for private issue of a portion of the firm's debt and disclose the terms of financing to signal the firm's true value to the market. Thus, private lenders certify the firm's value. Lummer and McConnell [13] provide supporting evidence.

The arguments regarding the role of secondary market liquidity, flotation costs, and leverage-related costs in the public/private placement decision can be integrated into a single analysis.(7) Issuance of debt in private markets reduces the costs of flotation and financial distress. However, the yield on private debt includes compensation for illiquidity. Firms with small issues should choose private markets due to the large flotation costs relative to issue size and small reductions in yield that accompany public offerings. Firms with larger issues can more actively switch between private and public debt based on the severity of the potential for financial distress, the ability to spread fixed issue costs over a larger volume, and the value of the additional liquidity obtained by public offering.

II. Data and Descriptive Statistics

In this section, we provide evidence on the extent of reliance on private/public long-term debt markets by commercial and industrial firms. In order to detect trends in recent years, we analyze data for even-numbered years from 1980 through 1988.

A. Sample Description

Firms in the Fortune 500 as of 1980 constitute our initial set of firms. The Fortune list consists of the 500 largest firms in terms of annual sales. This group was selected to ensure that firms with access to public debt markets are well represented. The following criteria were used to select firms the 1980 Fortune 500: (i) Data on public debt issues are available in Moody's

Industrial Manual for the fiscal years ending in

1980, 1982, 1984, 1986, and 1988. (ii) Information on firm-specific asset characteristics

is available on the 1989 COMPUSTAT tape. This

requirement allows for the analysis of how private

debt usage may be related to such characteristics.(8)

(iii) Stock returns are available in the CRSP Daily

Returns File. This allows for a market-based assessment

of the firm's risk.

We imposed the first constraint in order to provide comparability in the sample over time. The above criteria resulted in a final set of 156 firms.

Exhibit 1 reports statistics regarding firm size, the magnitude of long-term debt and leverage for the sample in each of the years 1980 and 1988. Firms size is computed as the sum of the book value of long-term debt,(9) capitalized leases, and the market value of preferred and common stock. The sample exhibits considerable variation in firm size with a minimum of roughly $100 million in each year. The median firm size is $1.3 and $2.6 billion in 1980 and 1988, respectively. These figures indicate that the sample consists of medium- to large-sized firms and does not contain any small firms. However, in terms of the dollar magnitude of long-term debt (including the current portion), the sample includes firms with less than $10 million of debt as well as firms with more than $1 billion in debt. Thus, the sample contains firms with sufficient variation in the amount of long-term debt in order to shed light on the importance of liquidity and issue cost considerations on the choice between private and public markets. The variation in debt usage is also confirmed by data on leverage ratios (long-term debt/firm size) that range from less than 1% to over 75%.


B. Extent of Reliance on Private Long-Term Debt

Data on the amount of outstanding public long-term debt issued by firms in the sample were collected from Moody's Industrial Manual. Public long-term debt is defined as any publicly traded debt with maturity greater than one year at the time of issuance. This debt includes convertible debt as well as nonrated debt. Also included were Eurobonds, floating rate notes. and the debt of subsidiaries for firms that file consolidated financial statements.(10) Based on the total long-term debt issued by each firm, the proportion of debt that is public is calculated and the proportion of debt that is private is inferred. Specifically, the proportion of long-term debt that is private equals one minus the ratio of all long-term public debt to total long-term debt (including the current portions and excluding leases). This measure of private debt includes both long-term bank debt and privately placed debt with institutional investors.

Exhibit 2, Panel A presents distributional statistics on the use of long-term private debt for the sample of 156 firms for even-numbered years from 1980 through 1988. Throughout this period, more than half of outstanding long-term debt is private. The extent of reliance on private debt attests to an important role for private debt markets in relation to public debt markets.

The data also reveal that the reliance on private debt has decreased from 1980 to 1988. The cross-sectional means of the proportion of private debt in 1980, 1982 and 1984 are all about 60%. This figure drops to 55% in 1986 and 53% in 1988. While 18.4% of the firms had no public debt in 1980, this proportion declined to 12.3% in 1988. The drop in private debt in the mid-1980's can also be detected by comparing the medians and quartile cut-offs.

Panel B of Exhibit 2 presents a correlation matrix for the five years of private debt data. Correlation coefficients between the private debt proportions describe the stability of firm's choices between private and public markets over time. Private debt proportions from adjacent years have high positive correlations. For example, the correlation between private debt usage for 1980 and 1982 is 0.737. The high correlations indicate consistency in the use of private or public debt over two-year periods. Over longer intervals, the correlation falls. For instance, the correlation between the 1980 and 1988 private debt figures is 0.216. The low correlation indicates that there is less stability when market conditions and firm characteristics change considerably. The lowest correlation between adjacent years is between 1984 and 1986 (0.58) indicating that the timing of the biggest changes was the mid-1980's.

III. Evidence on Cross-Sectional

Regularities in the Use of Private Debt

This section examines whether there are discernible cross-sectional patterns in the use of private debt. Fixed costs in the issue of public debt and liquidity differences between private and public market issues imply that firms with smaller issue sizes prefer to issue private debt. If private debt is used because it is a superior mechanism for controlling agency conflicts, then the use of private debt should be higher for firms that have a greater potential for costs of financial distress. The cross-sectional implications of other motivations for the use of the private debt are unclear. For instance, the rationale that private debt is used to certify firm value argues for the existence of some private debt but does not suggest that the proportion of debt that is private will increase with the need for such certification.(11)

A. Description of the Cross-Sectional Model

To examine factors that could influence cross-sectional variation in use of private debt, we estimate the following regression:

[Mathematical Expression Omitted]

where PVD is the proportion of long-term debt from private sources and LLTD is the log of the book value of long-term debt. The other variables included are the ratio of fixed assets to total assets (FA), expenditure on advertising (AD) and research and development (RD) as percentages of sales, capital expenditures as a percentage of total assets (CEX), the ratio of earnings before depreciation, interest and taxes to total assets (EBDIT), and the volatility of stock returns adjusted for leverage (RISK). Variables other than RISK are measured as averages of available fiscal-year-end data over the nine-year period 1980 through 1988. The RISK measure is calculated as the proportion of market value of equity to firm value times the standard deviation of daily stock returns for each year averaged over the nine-year period.(12)

The magnitude of existing long-term debt (LLTD) is a proxy for the size of debt issues and captures the impact of issue costs and the value of secondary market liquidity. A firm with a large amount of outstanding debt would typically have larger issue sizes. The public issue process is relatively less costly for larger issues due to the ability to spread fixed costs. Therefore, firms with larger issues should use less private and more public debt. Furthermore, the value of secondary market liquidity for public issues increases with issue size. Both issue cost and liquidity arguments imply a negative relationship between private debt and the magnitude of existing long-term debt.

Variables measuring the potential for leverage related costs are drawn from previous studies of corporate leverage (for instance, Bradley, Jarrell and Kim [5]; Chaplinsky and Niehaus [7]; and Friend and Lang [10]). Fixed assets, advertising, and research and development expenses measure the division of assets between tangible and intangible assets and the potential for future discretionary investment decisions. Intangible assets are highly vulnerable to value losses in the event of financial distress. Capital expenditure is also a measure of the firm's growth opportunities. Theory predicts the private debt should increase as intangible assets and growth opportunities increase. Volatility of asset values is a proxy for the potential for financial distress. If private debt plays a role in reducing leverage-related costs, then private debt should increase as volatility and the risk of bankruptcy increase.

A profitability measure (EBDIT, the ratio of earnings before depreciation, interest and taxes to total assets) has been shown by Chaplinsky and Niehaus [7] and Friend and Lang [10] to be a critical determinant of leverage. Given the considerable influence of this variable on leverage, it is included as a control variable.(13) The above arguments imply the following null and alternate hypotheses for the coefficients in the private debt regression:

[Mathematical Expression Omitted]

For comparative purposes, a regression using leverage as the dependent variable is also reported. Leverage is measured as the ratio of long-term debt to firm size. Note that the signs would be reversed in the leverage regression for all variables other than the magnitude of long-term debt. Since long-term debt is included only to measure the impact of issue costs and secondary market liquidity, there is no hypothesized relationship between leverage and the amount of long-term debt. Long-term debt is included in the leverage regression for uniformity with the private debt regression.

B. Estimates of the Cross-Sectional Model

Exhibit 3 presents the results of the regression analysis measuring each variable as a time-series average of the available data from 1980 through 1988. The first row presents the results for leverage. Similar to prior studies, the regression explains about 60% of the variation in leverage. Though the profitability measure (EBDIT) makes the greatest contribution to explanatory power, the evidence is consistent with the proposition that leverage-related costs play an important role in the debt-equity decision.

The second row of Exhibit 3 presents the results for private debt. Overall, the distinguishing characteristic of firms issuing debt privately rather than publicly is their smaller levels of long-term debt, as indicated by the significant, negative coefficient of the magnitude of long-term debt. This result indicates that issue costs and secondary market liquidity are important determinants of the public-private decision. The high fixed costs associated with the public issuance and the small gains from the liquidity of public markets cause firms with relatively low amounts of debt to choose private rather than public debt markets.

In contrast to leverage, there is no relationship between the proportion of private debt and the variables chosen as a proxy for leverage-related costs. A comparison of rows two and three of Exhibit 3 confirms that inclusion of the proxies for leverage-related costs adds little to our ability to explain the use of private debt.(14) As discussed in Section I, private debt is expected to allow for better monitoring and easier renegotiation of contracts compared to public debt contracts. This argument suggests that firms will rely more on private debt if they have a greater potential for financial distress. The lack of a link between the use of private debt and proxies for costs of financial distress fails to provide evidence consistent with this proposition.

C. Additional Tests of Cross-Sectional Variation

The lack of positive results for the variables that are a proxy for leverage-related costs could potentially be attributed to three problems with the regression model described above.(15) First, nonlinearities might cause insignificance of the regression coefficients when relationships do exist. Second, averaging of the dependent and independent variables over a long time period might eliminate important changes in the variables across time. Third, inclusion of firms that vary so widely in size and amount of long-term debt outstanding might bias regression results if firms with very large issue sizes confront substantially different trade-offs in the private/public debt decision than firms with medium size issues. These possible explanations of the results are examined below.

Nonlinearities in the relationship between the proportion of private debt and the independent variables could potentially cause the lack of significance in the regression, which assumes a linear relationship. This is examined by grouping firms in the upper and lower quartiles of the values of each explanatory variable and examining the difference in the proportion of private debt between the two groups. Results, not reported for brevity, confirm that the use of private debt is significantly related only to the magnitude of long-term debt.

The use of time-series averages for the explanatory variables is appropriate if the basic firm characteristics are stable across time but are measured with error. Similarly, a time-series average for the private debt figure is appropriate if firms have constant target levels of private debt but temporarily depart from these targets as new issues are made or old issues retired. However, if firm characteristics and target private debt ratios are not constant through time, then averaging may obscure important information. This possibility is investigated by using a pooled data set. This set consists of data across 139 firms for each of five years (1980, 1982, 1984, 1986, and 1988).(16) The estimation procedure employed corrects for heteroscedastic and autoregressive components in the errors.(17)

Exhibit 4 presents the regression results using the pooled data set. The explanatory power of the model using the pooled data set is modestly higher than the explanatory power using time-series averages. The relationship between long-term debt and private debt remains negative and significant as hypothesized by the issue cost and liquidity arguments. Of the proxies for leverage-related costs, only capital expenditures is significant. However, its sign is inconsistent with the hypothesis that private debt reduces leverage-related costs. The results in Exhibit 4 demonstrate that the lack of results in Exhibit 3 cannot be attributed to averaging a nonstationary time-series.

Blackwell and Kidwell [4] hypothesize that issue costs prevent firms with small issue sizes from using public markets while large firms will use the public markets almost entirely due to liquidity related savings. They also hypothesize that medium size firms are the most likely firms to choose actively between private and public offerings based on issue costs, leverage-related cost, and the value of liquidity. If their contention is correct, the full sample regressions may mask relationships because large firms that only occasionally acquire small blocks of funds in private markets are included along with medium size firms.(18) To examine this possibility, the data set was split into halves based on the dollar magnitude of long-term debt and the regressions were repeated. The magnitude of outstanding debt rather than firm size is used to segment the sample since Blackwell and Kidwell's arguments rely on economies of scale in issue costs and secondary market liquidity.

The results of the regression analysis for the sub-samples are reported in Exhibit 5 using the time-series averages from 1980 through 1988. The regression performance as judged by the F-statistic is much stronger for firms in the lower half of outstanding debt than for the larger firms. The improved explanatory power for the lower half is largely due to the significant negative effect of the magnitude of long-term debt (LLTD). Since this variable captures the ability to spread fixed issue cost and the value of liquidity, it is expected to be more relevant for firms with moderate amounts of long-term debt. Among firms with large amounts of debt, the gains from larger issue sizes could be minimal because they have reached the threshold level at which increasing issue size has little impact on percentage issue costs or liquidity. Consistent with this view, the magnitude of long-term debt is unrelated to the proportion of private debt for the larger firms.

Exhibit 5 also reveals that the null hypothesis is not rejected in either subsample for the variables that are proxies for leverage-related costs. This evidence suggests that the lack of significance of these variables in the overall sample is not due to a masking of significant relationships for firms in a particular size group by the inclusion of other size groups.(19) A possible explanation for the absence of a relationship between private debt and leverage-related costs is that firms facing low leverage-related costs may use private markets as long as lower issue costs offset inferior liquidity. Conversely, many firms that face high leverage-related costs may use an array of provisions in public debt contracts to mitigate these costs.(20)

IV. Conclusions

In this study, we examine the extent of reliance on private/public debt during the 1980's for a subset of Fortune 500 firms. Private debt accounts for almost 60% of all long-term debt. The corresponding proportion should be even higher for smaller firms which are excluded from our sample. Note that high proportion of private debt occurs despite its inferior liquidity and points to a vital role for private security markets.

The data reveals a decline in the use of private debt during the latter half of the 1980's. This trend may be potentially attributable to the lower costs of public issues due to recent developments such as shelf-registration and the evolution of high-yield bond markets. However, use of private placements is expected to increase due to the adoption of Rule 144a in 1990 which permits the resale of private issues among large institutional investors.

The cross-sectional variation in private debt usage is studied using time-series averages as well as pooled cross-section, time-series data. Our analysis does not reveal a relationship between the proportion of private debt and variables measuring costs of financing distress. Rather, the amount of long-term debt seems to be the only variable that explains the cross-sectional variation in the use of private debt. Not surprisingly, medium size firms rely more on private debt markets than larger firms. These findings indicate that informational asymmetries are perhaps a more critical determinant of the choice between private and public debt markets. Alternatively, the results for the costs of financial distress could be the consequence of lumping different types of private debt together.

( 1) Rule 144a, adopted in April 1990, allows large institutional investors with security holdings of at least $100 million to freely resell privately placed securities among themselves. ( 2) Shapiro and Wolf [15] and Wolf [17] provide the first analysis of the choice between public and private markets. They, however, focus on aggregated data, which shed no light decisions at the individual firm level. ( 3) Moody's Industrial Manual occasionally identifies the type of private debt. However, such coverage is not systematic across firms or even across debt issues for a given firm. A reasonable classification between bank and non-bank debt may perhaps be obtained for a sample of about 20 firms. Such as sample size would preclude meaningful inferences. No classification of private placements into negotiated and brokered categories is possible using public data sources. ( 4) Jarrell [12] has also suggested and provided evidence that access to public debt markets has been deliberately restricted for high risk firms by the SEC during most of its regulatory life. The recent surge in public, low-grade bond issues, documented in Altman [1], suggests that the relevance of this argument has diminished. ( 5) Alternatively, firms might seek to mitigate these costs by issuing public debt that contains provisions like convertibility, sinking funds, and short maturities. The observed relationship between the use of private debt and leverage-related costs depends on the relative costs of these two alternatives. ( 6) See Amihud and Mendelson [2] for additional discussion of the impact of liquidity on security prices. ( 7) This discussion parallels Blackwell and Kidwell's analysis. ( 8) Five firms with large credit subsidiaries and three firms that filed for bankruptcy were eliminated since their inclusion would distort the relationship between private debt usage and asset characteristics. ( 9) The current portion of long-term debt is included along with the noncurrent portion throughout the paper. (10) Zero-coupon debt was included at its market value. The current portion of long-term debt was also included. Debt of subsidiaries that was not listed as guaranteed by the parent and not included in consolidated financial statements was excluded. (11) The credibility of the certification should depend upon the seniority and the dollar magnitude of private debt rather than the proportion of debt that is private. (12) Firm size is computed as described in the footnote to Exhibit 1. The RISK variable captures the volatility of the underlying assets. A measure based on the volatility of operating cash flows during the period of study also yielded similar results. (13) Omission of this variable does not affect the results of the private debt regression. (14) Similarly, inclusion of industry dummy variables based on two-digit SIC codes did not improve the explanatory power or alter the significance of the coefficients. (15) Collinearity diagnostics, like variance inflation factors, suggests that the lack of significance of proxies for leverage-related costs is not induced by milticollinearity. The significance of these variables in the average regression is also consistent with such an inference. (16) Seventeen firms are lost in this analysis because they failed to report information for one or more of the financial characteristics in each year. (17) Due to the short time-series, five years, the estimation technique employed assumes that all firms have the same autocorrelation structure for their error terms and that errors are contemporaneously uncorrelated across firms. (18) The sample selection criteria result in the exclusion of small firms. (19) Segmentation of the sample into thirds rather than halves yielded similar results. (20) Note that while the overall sample reveals no relationship between private debt and potential for agency conflicts, private debt may still be the dominant alternative for selected individual firms.


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Financial Analysts Journal (July-August 1987), pp. 12-25. [ 2.] Y. Amihud, and H. Mendelson, "Liquidity and Asset Prices:

Financial Management Implications," Financial Management

(Spring 1988), pp. 5-15. [ 3.] M. Berlin and J. Loeys, "Bond Covenants and Delegated

Monitoring," Journal of Finance (June 1988), pp. 397-412. [ 4.] D. Blackwell and D. Kidwell, "An Investigation of Cost Differences

between Public Sales and Private Placements of Debt,"

Journal of Financial Economics (December 1988), pp. 253-278. [ 5.] M. Bradley, G. Jarrell and E. Kim, "On the Existence of an

Optimal Capital Structure: Theory and Evidence," Journal of

Finance (July 1984), pp. 857-878. [ 6.] T. Campbell, "Optimal Investment Financing Decisions and the

Value of Confidentiality," Journal of Financial and Quantitative

Analysis (November 1979), pp. 913-925. [ 7.] S. Chaplinsky and G. Niehaus, "Ownership Structure and Capital

Structure," presented at the Western Finance Association

Meeting, 1988. [ 8.] D. Diamond, "Financial Intermediation and Delegated

Monitoring," Review of Economic Studies (July 1984), pp. 393-414. [ 9.] E. Fama, "What's Different about Banks?" Journal of Monetary

Economics (January 1985), pp. 29-39. [10.] I. Friend and L. Lang, "An Empirical Test of the Impact of

Managerial Self-Interest on Corporate Capital Structure," Journal

of Finance (June 1988), pp. 271-281. [11.] C. James, "Some Evidence on the Uniqueness of Bank Loans,"

Journal of Financial Economics (December 1987), pp. 217-235. [12.] G. Jarrell, "The Economic Effects of Federal Regulation of the

Market for New Security Issues," Journal of Law and Economics

(December 1981), pp. 613-686. [13.] S. Lummer and J. McConnell, "Further Evidence on the Bank

Lending Process and the Uniqueness of Bank Loans," Journal of

Financial Economics (November 1989), pp. 989-122. [14.] S. Myers, "Determinants of Corporate Debt Policies," Journal

of Financial Economics (November 1977), pp. 147-176. [15.] E. Shapiro and C. Wolf, The Role of Private Placements in Corporate

Finance, Division of Research, Graduate School of Business

Administration, Harvard University, 1972. [16.] J. Stiglitz "Credit Markets and the Control of Capital," Journal

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Corporate Bond Market," Review of Economics and Statistics

(February 1974), pp. 23-29. [18.] B. Zwick, "Yields on Privately Placed Corporate Bonds," Journal

of Finance (March 1980), pp. 23-29.
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Title Annotation:Topics in Capital Restructuring
Author:Easterwood, John C.; Kadapakkam, Palani-Rajan
Publication:Financial Management
Date:Sep 22, 1991
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