The Optimal Capital Structure under Risks of Illiquidity and Over-indebtedness in a Double Barrier Option Framework

Abstract

Existing dynamic capital structure models are based on single triggers determining bankruptcy, mainly over-indebtedness or illiquidity. The latter one tends to underestimate optimal capital structures by ignoring capital providers' flexibility to inject fresh money. The former one leans towards overestimation as it neglects agency conflicts between equity investors and debt holders while implying infinitely "deep pockets" of equity investors. This article incorporates both constraints, over-indebtedness and illiquidity, examining corporate debt value and optimal capital structure in a double barrier world with knock-in and knock-out options. We are first to derive closed-form solutions for all value components of a levered firm and for the optimal capital structure in such a setting. By testing our model for firms publicly listed in the US, we gain evidence that incorporating both triggers allows for capital structure estimations that are in accordance with empirical findings.

Keywords: Dynamic models, Structural estimation, First hitting time, Second hitting time, Default Risk, Optimal Leverage

JEL Classification: G12, G31, G32, G33