Project Characteristics, Insolvency Risk, and Optimal Debt Maturity

Abstract:     
This paper examines the corporate debt maturity decision when the debt is used to finance a project, interest payments are tax-deductible, and financial distress is costly. In contrast to previous work in this area, (i) financial distress is triggered by the firm's inability to meet coupon obligations, and (ii) the effect of the project characteristics (length, risk, growth rate, etc.) on optimal debt maturity is a major focus. We demonstrate the importance of project duration in determining bond maturity, particularly for high-grade bonds. Our model also explains why high-grade bond maturities show greater dispersion than lower-grade bond maturities. It predicts a negative relationship between optimal debt maturity and project risk, cost of financial distress, and degree of leverage (most of the time); and a positive relationship between optimal maturity and the corporate tax rate. However, the effect of project growth rate and interest rate depends on the quality of the particular bond.

JEL Classification: G32

working papers series