Investors demand high risk premia for defaultable claims, because (i) defaults tend to con-centrate in bad times when marginal utility is high; (ii) default losses are high during such times. I build a structural model of financing and default decisions in an economy with business-cycle variations in expected growth rates and volatility, which endogenously generate countercyclical comovements in risk prices, default probabilities, and default losses. Credit risk premia in the calibrated model not only can quantitatively account for the high corporate bond yield spreads and low leverage ratios in the data, but have rich implications for firms ’ financing decisions. Risks associated with macroeconomic conditions are crucial for understanding asset prices. Naturally, they should also have important implications for corporate decisions. By introducing macroeconomic conditions into firms ’ financing decisions, this paper provides a risk-based expla-

In a setting where firms can choose their capital structures, we derive the optimal compensation contract for employees who are averse to bearing their own human capital risk, while equity holders can diversify this risk away. In the absence of other frictions, the optimal contract implies that all firms will be unlevered, and instead will hold cash. In the presence of corporate taxes, the optimal contract implies optimal debt levels consistent with those observed, implying that the importance of human capital risk is comparable to that of taxes in the capital structure decision. Our model makes a number of predictions for the cross-sectional distribution of firm leverage. Consistent with existing empirical evidence, it implies the existence of persistent unexplained idiosyncratic differences in leverage across firms. It also predicts that, ceteris paribus, firms with more leverage should pay higher wages, an as yet unexplored empirical implication of the model. JEL classification: G14.

We estimate firm-specific marginal cost of debt functions for a large panel of companies between 1980 and 2007. The marginal cost curves are identified by exogenous variation in the marginal tax benefits of debt. The location of a given company’s cost of debt function varies with characteristics such as asset collateral, size, book-to-market, asset tangibility, cash flows, and whether the firm pays dividends. By integrating the area between benefit and cost functions we estimate that the equilibrium net benefit of debt is 3.5 % of asset value, resulting from an estimated gross benefit of debt of 10.4 % of asset value and an estimated cost of debt of 6.9%. We find that the cost of being overlevered is asymmetrically higher than the cost of being underlevered and that expected default costs constitute approximately half of the total ex ante cost of debt. We thank Rick Green (the Acting Editor), and an anonymous referee, Heitor Almeida, Ravi Bansal,

We argue that a firm’s aggregate risk is a key determinant of whether it manages its future liquidity needs through cash reserves or bank lines of credit. Banks create liquidity for firms by pooling their idiosyncratic risks. As a result, firms with high aggregate risk find it costly to get credit lines from banks, and opt for cash reserves in spite of higher opportunity costs and liquidity premium. We verify this hypothesis empirically by showing that firms with high asset beta have a higher ratio of cash reserves to lines of credit, controlling for other determinants of liquidity policy. The effect of aggregate risk on liquidity management is economically significant, and is robust to variation in the proxies for firms ’ exposure to aggregate risk, and availability of credit lines. This effectistrueatthe firm level as well as the industry level, and it is significantly stronger in times when aggregate risk is higher. The positive relation between a preference for cash and asset risk is particularly strong for firms that are more likely to be financially constrained (small, non-rated, low payout firms).

We thank John Graham for making his data available. We also thank David Aboody and Ruihao Ke for helpful comments. 1 Electronic copy available at:

I propose an implementation of the q-theory of investment using bond prices instead of equity prices. Credit risk makes corporate bond prices sensitive to future asset values, and q can be inferred from bond prices. The bond market’s q performs much better than the usual measure in standard investment equations. With aggregate data, the fit is three times better, cash flows are driven out and the implied adjustment costs are reduced by more than an order of magnitude. The new measure also improves firm level investment equations. This paper was first circulated under the title "The y-theory of investment". I thank Daron Acemoglu,

We use the 2007 credit crisis to gauge the e¤ect of …nancial contracting on real corporate behavior. We identify heterogeneity in …nancial contracting at the onset of the crisis by exploiting ex-ante variation in long-term debt maturity. Our empirical methodology accounts for observed and unobserved time-invariant …rm characteristics by employing a di¤erence-in-di¤erences matching estimator. We …nd that …rms whose long-term debt was largely maturing right after the third quarter of 2007 reduced investment by 2.5 % more (on a quarterly basis) than otherwise similar …rms whose debt was scheduled to mature well after 2008. This relative decline in investment is statistically and economically signi…cant, representing one-third of pre-crisis investment levels. A number of falsi…cation and placebo tests con…rm our inferences about the e¤ect of credit supply shocks on corporate policies. For example, in the absence of a credit shock (“normal times”), the maturity composition of long-term debt has no e¤ect on investment. Likewise, maturity composition has no impact on investment in the crisis for …rms for which long-term debt is not a major source of funding. Our study highlights the importance of debt maturity for corporate …nancial policy. It shows how …nancial contracting ties credit supply shocks and …rm real decisions.

Abstract. We use an important legal event as a natural experiment to examine equity‐debt conflicts in the vicinity of financial distress. A 1991 Delaware bankruptcy ruling changed the nature of corporate directors ’ fiduciary duties in that state. This change limited incentives to take actions favoring equity over debt. We show that, as predicted, this increased the likelihood of equity issues, increased investment, and reduced risk taking. The changes are isolated to indebted firms (where the legal change applied). These reductions in agency costs were followed by an increase in average leverage and a reduction in interest costs. Finally, we can estimate the welfare implications of agency costs, because firm values increased when the rules were introduced. We conclude that equity‐bond holder conflicts are economically important, determine capital structure choices, and affect welfare.

Time to buy or just buying time? The market reaction to bank rescue packages

A common method of valuing the equity in leveraged transactions is the flows-toequity method whereby the free cash flow available to equity holders is discounted at the cost of equity. This method uses a standard definition of equity free cash flow, but the cost of equity varies over time as leverage varies. Various formulas can be used to calculate the time-varying cost of equity, most of which are inconsistent with the assumptions underlying the free cash flow calculation. In this paper we show how to include correctly the following in the flows-to-equity method: • A releveraging formula consistent with a fixed debt plan; • A yield spread on debt which is fair compensation for default risk; • The part of the yield spread which is "excessive"; • The expected cost of financial distress. We show that each of these can have a significant effect on valuation and the value derived in a consistent way can differ substantially from that derived by more conventional procedures.