Optimal Capital Structure, Endogenous Bankruptcy, and the Term Structure of Credit Spreads

This paper examines the optimal capital structure of a firm which can choose both the amount and maturity of its debt. Bankruptcy is determined endogenously rather than by the imposition of a positive net worth condition or by a cash flow constraint. The results extend Leland's [1994] closed-form results to a much richer class of possible debt structures and permits study of the optimal maturity of debt as well as the optimal amount of debt. The model generates predictions of leverage, credit spreads, default rates, and writedowns which accord quite closely with historical averages. While short term debt does not exploit tax benefits as completely as long term debt, it is more likely to provide incentive compatibility between debtholders and equityholders. The agency costs of "asset substitution" are minimized when the firm uses shorter term debt. The tax advantage of debt must be balanced against bankruptcy and agency costs in determining the optimal maturity of the capital structure. The model predicts differently shaped term structures of credit spreads for different levels of risk. These term structures are similar to that found empirically by Sarig and Warga [1989]. The model has important implications for bond portfolio management. In general, Macaulay duration dramatically overstates true duration of risky debt, which may be negative for "junk" bonds. Furthermore, the "convexity" of bond prices can become "concavity."

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