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

Hayne E. Leland and Klaus Bjerre Toft
The Journal of Finance
Vol. 51, No. 3, Papers and Proceedings of the Fifty-Sixth Annual Meeting of the American Finance Association, San Francisco, California, January 5-7, 1996 (Jul., 1996), pp. 987-1019
Published by: Wiley for the American Finance Association
DOI: 10.2307/2329229
Stable URL: http://www.jstor.org/stable/2329229
Page Count: 33
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Optimal Capital Structure, Endogenous Bankruptcy, and the Term Structure of Credit Spreads
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Abstract

This article examines the optimal capital structure of a firm that 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 (1994a) closed-form results to a much richer class of possible debt structures and permit study of the optimal maturity of debt as well as the optimal amount of debt. The model predicts 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 debt holders and equity holders. Short term debt reduces or eliminates "asset substitution" agency costs. 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 level of risk. These term structures are similar to those found empirically by Sarig and Warga (1989). Our results have 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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