The Risk and Return of Mezzanine Debt

摘要

Optimal capital structure derived solely from debt and equity financing surfaces controversial views in the mainstream finance literature. Mezzanine debt as a hybrid of debt and equity provides an alternative financing channel to enable firms to optimize the risk-return tradeoff in their capital structure. The insertion of this additional strip of financing complicates the risk-return between the secured lenders, mezzanine lenders and equity investors. Pricing of mezzanine risks is thus of interest to mezzanine investors. This paper introduces a theoretical framework of pricing the risk premium of mezzanine debt. The model takes into consideration the loan-to-value ratio, debt coverage ratio, default risk, holding period returns, cost of secured debt and the return on equity. The determination of the risk premium would throw more light on the implications for the successful creation of mezzanine debt as well as the risk-return tradeoff.