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

Hayne E. Leland and Klaus Bjerre Toft.
Authors registered in the RePEc Author Service: Hayne Ellis Leland

No RPF-259, Research Program in Finance Working Papers from University of California at Berkeley

Abstract: 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."

Date: 1995-12-01
References: Add references at CitEc
Citations: View citations in EconPapers (24)

There are no downloads for this item, see the EconPapers FAQ for hints about obtaining it.

Related works:
Journal Article: Optimal Capital Structure, Endogenous Bankruptcy, and the Term Structure of Credit Spreads (1996)
This item may be available elsewhere in EconPapers: Search for items with the same title.

Export reference: BibTeX RIS (EndNote, ProCite, RefMan) HTML/Text

Persistent link: https://EconPapers.repec.org/RePEc:ucb:calbrf:rpf-259

Ordering information: This working paper can be ordered from
IBER, F502 Haas Building, University of California at Berkeley, Berkeley CA 94720-1922

Access Statistics for this paper

More papers in Research Program in Finance Working Papers from University of California at Berkeley University of California at Berkeley, Berkeley, CA USA. Contact information at EDIRC.
Bibliographic data for series maintained by Christopher F. Baum ().