Dynamic Capacity Choice, Dynamic Capital Structure, and Credit Risk

Abstract

We investigate the joint effect of production capacity choices and capital structure decisions on corporate debt default - related yield spreads. We find that the main driver of credit spreads is the incentive of self-interested shareholders to cash out assets in an economic decline and to under-invest in an upturn. While the importance of these agency issues increases with the ease with which assets can be sold, credit risk shows a non-monotonic relationship with respect to asset liquidity. We also find that changes in corporate tax rates have larger effect on yield spreads than changes in personal tax-rates, even if the net tax shield after both of the changes is the same. The ability to adjust the capital structure considerably reduces credit risk. Finally, bankruptcy costs and debt/equity floatation costs have a relatively insignificant impact on yield spreads.

Keywords: dynamic capital structure, investment, credit risk, agency costs

JEL Classification: G12, G31, G32, E22