Can the Tradeoff Theory Explain Debt Structure?
Everett W. Lord Distinguished Faculty Scholar
London Business School
Hayne E. Leland
University of California, Berkeley - Walter A. Haas School of Business
AFA 2005 Philadelphia Meetings Paper
We examine the optimal mixture and priority structure of bank and market debt using a tradeoff model where banks have the unique ability to renegotiate outside formal bankruptcy. Flexible bank debt offers a superior tradeoff 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 tradeoff 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 tradeoff theory also generates predictions consistent with international evidence. In countries where the bankruptcy regime entails soft (tough) enforcement of contractual priority, bank debt capacity is low (high), implying greater (less) reliance on market debt.
Number of Pages in PDF File: 52
Keywords: Banking, Capital Structure, Priority Structure, and Contingent Claims Pricing
JEL Classification: G13, G32, G33
Date posted: January 5, 2005
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