We create a dynamic model in which a self-interested, risk-averse manager makes corporate investment decisions at a levered firm with characteristics typical of public US firms. We examine the magnitude of distortions in those decisions when a new project changes firm risk and find expected changes in the values of future tax shields and bankruptcy costs to be important factors. We evaluate the extent to which these distortions vary with firm leverage, debt duration, project size, managerial risk aversion, managerial non-firm wealth, and the structure of management compensation packages. The corporate finance literature has extensively modeled the distortions in investment decisions that result from conflicts of interest between claimholders. These models generally imply that firms make suboptimal project choices, either in terms of good projects that are rejected, or bad projects that are accepted. Since it is difficult to observe management forecasts of project net present values, especially for projects that are not ultimately undertaken, it is difficult to assess the importance of these models quantitatively. One approach to evaluating the importance of investment distortions is to first calibrate a model that uses data from public firms, and then estimate the magnitude of the distortion in investment decisions by examining the characteristics of the projects that the model predicts would be accepted or rejected. Studies such as those by Mello and Parsons (1992), Leland

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Our model shows that deterioration in debt market liquidity leads to an increase in not only the liquidity premium of corporate bonds but also credit risk. The latter effect originates from firms ’ debt rollover. When liquidity deterioration causes a firm to suffer losses in rolling over its maturing debt, equity holders bear the losses while maturing debt holders are paid in full. This conflict leads the firm to default at a higher fundamental threshold. Our model demonstrates an intricate interaction between the liquidity premium and default premium and highlights the role of short-term debt in exacerbating rollover risk. THE YIELD SPREAD OF a firm’s bond relative to the risk-free interest rate directly determines the firm’s debt financing cost, and is often referred to as its credit spread. It is widely recognized that the credit spread reflects not only a default premium determined by the firm’s credit risk but also a liquidity premium due to illiquidity of the secondary debt market (e.g., Longstaff, Mithal, and Neis (2005) and Chen, Lesmond, and Wei (2007)). However, academics and policy makers tend to treat both the default premium and the liquidity premium as independent, and thus ignore interactions between them. The financial crisis of 2007 to 2008 demonstrates the importance of such an interaction— deterioration in debt market liquidity caused severe financing difficulties for many financial firms, which in turn exacerbated their credit risk. In this paper, we develop a theoretical model to analyze the interaction between debt market liquidity and credit risk through so-called rollover risk: when debt market liquidity deteriorates, firms face rollover losses from issuing new bonds to replace maturing bonds. To avoid default, equity holders need to bear the rollover losses, while maturing debt holders are paid in full. This

We examine the optimal mixture and priority structure of bank and market debt using a trade-off model in which banks have the unique ability to renegotiate outside formal bankruptcy. Flexible bank debt offers a superior trade-off between tax shields and bankruptcy costs. Ease of renegotiation limits bank debt capacity, however. Optimal debt structure hinges upon which party has bargaining power in private workouts. Weak firms have high bank debt capacity and utilize bank debt exclusively. Strong firms lever up to their (lower) bank debt capacity, augment with market debt, and place the bank senior. Therefore, the trade-off theory offers an explanation for: (i) why young/small firms use bank debt exclusively; (ii) why large/mature firms employ mixed debt financing; and (iii) why bank debt is senior. The trade-off theory also generates predictions consistent with international evidence. In countries in which the bankruptcy regime entails soft (tough) enforcement of contractual priority, bank debt capacity is low (high), implying greater (less) reliance on market debt. (JELG13, G32, G33) Existing trade-off models analyze the optimal amount of debt, but provide

We propose a two-sided jump model for credit risk by extending the Leland-Toft endogenous default model based on the geometric Brownian motion. The model shows that jump risk and endogenous default can have significant impacts on credit spreads, optimal capital structure, and implied volatility of equity options: (1) The jump and endogenous default can produce a variety of non-zero credit spreads, including upward, humped, and downward shapes; interesting enough, the model can even produce, consistent with empirical findings, upward credit spreads for speculative grade bonds. (2) The jump risk leads to much lower optimal debt/equity ratio; in fact, with jump risk, highly risky firms tend to have very little debt. (3) The two-sided jumps lead to a variety of shapes for the implied volatility of equity options, even for long maturity options; and although in generel credit spreads and implied volatility tend to move in the same direction under exogenous default models, but this may not be true in presence of endogenous default and jumps. In terms of mathematical contribution, we give a proof of a version of the “smooth fitting ” principle for the jump model, justifying a conjecture first suggested by Leland and Toft under the Brownian model. 1

This paper develops a model in the spirit of Hennessy and Whited (2005) in which the capital structure dynamics associated with transitory debt fully explain the long-horizon leverage paths documented by Lemmon, Roberts, and Zender (2008). The model shows how and why debt serves as a transitory financing vehicle to meet the funding needs associated with random shocks to investment opportunities. It yields a variety of new testable predictions about the time paths of leverage and the link between investment and capital structure dynamics. Although these dynamics also reflect financing frictions, predictable variation in capital structure primarily reflects the attributes of firms ’ investment opportunities–e.g., the volatility and serial correlation of investment shocks, the marginal profitability of investment, and the nature of capital stock adjustment costs–with the linkage between investment attributes and leverage dynamics reflecting firms ’ usage of transitory debt.

This paper studies a continuous-time agency model in which the agent controls the drift of the geometric Brownian motion firm size. The changing firm size generates partial incentives, analogous to awarding the agent equity shares according to her continuation payoff. When the agent is as patient as investors, performance-based stock grants implement the optimal contract. Our model generates a leverage effect on the equity returns, and implies that the agency problem is more severe for smaller firms. That the empirical evidence shows that grants compensation are largely based on the CEO’s historical performance—rather than current performance—lends support to our model. (JEL G32, D82, E2) This paper analyzes optimal executive compensation by studying a continuous-time moral hazard problem. The existing continuous-time agency models typi-cally employ the less-appealing arithmetic Brownian motion (ABM) framework that essentially entails a constant firm size. However, the relevance of firm size in the context of agency problems is widely documented.1 Our model repre-sents a significant departure from the previous literature in that we allow firm size to be time-varying and follow a geometric Brownian motion (GBM). We

Explicit presence of a reorganization process in addition to liquidation can lead to conflicts of interest between borrowers and lenders. In the first-best outcome, the reorganization adds value to both parties via higher debt capacity, lower credit spreads, and improvement in the overall firm value. If control of the ex-ante timing of reorganization and the ex-post decision to liquidate is given to borrowers, most of the benefits of the code are appropriated by borrowers ex-post. Lenders can restore the first-best outcome by seizing this control or by the ex-post transfer of control rights. On average, firms are more likely to default and are less likely to liquidate relative to the benchmark case with liquidation only. ∗ All authors are from Columbia Business School. We would like to thank seminar participants at Columbia,

This paper provides a formal model of contingent convertible bonds (CCBs), a new instrument offering potential value as a component of corporate capital structures for all types of firms, as well as being considered for the reform of prudential bank regulation following the recent financial crisis. CCBs are debt instruments that automatically convert to equity if and when the issuing firm or bank reaches a specified level of financial distress. CCBs have the potential to avoid bank bailouts of the type that occurred during the subprime mortgage crisis when banks could not raise sufficient new capital and bank regulators feared the consequences if systemically important banks failed. While qualitative discussions of CCBs are available in the literature, this is the first paper to develop a formal model of their properties. The paper provides analytic propositions concerning CCB attributes and develops implications for structuring CCBs to maximize their general benefits for corporations and their specific benefits for prudential bank regulation.