Asset Substitution, Debt Pricing, Optimal Leverage and Maturity

57 Pages Posted: 27 Sep 2000

See all articles by Jan Ericsson

Jan Ericsson

McGill University; Swedish Institute for Financial Research (SIFR)

Abstract

I suggest a continuous time model for debt and equity valuation where leverage and maturity structure are chosen optimally by the firm's management. The capital structure decision involves trading off the tax benefits of leverage, financial distress costs and the agency costs associated with risk shifting incentives. Closed form solutions for the values of corporate securities, the levered firm and agency costs are obtained. I provide quantitative illustrations of how the capital structure decision is influenced by the potential for asset substitution. I show that in a typical scenario, a firm could afford to take on an additional 20% of leverage and use distinctly longer term debt maturity if asset substitution were ruled out. Furthermore I show that when deviations from the Absolute Priority Rule in bankruptcy are present, management is encouraged to increase risk ex post but will compensate ex ante by reducing leverage and using shorter maturity debt.

Keywords: Capital Structure, Corporate Bond Pricing, Agency Problems

JEL Classification: G13, G32, G33

Suggested Citation

Ericsson, Jan, Asset Substitution, Debt Pricing, Optimal Leverage and Maturity. Available at SSRN: https://ssrn.com/abstract=237529 or http://dx.doi.org/10.2139/ssrn.237529

Jan Ericsson (Contact Author)

McGill University ( email )

1001 Sherbrooke St. West
Montreal, Quebec H3A1G5 H3A 2M1
Canada
(514) 398-3186 (Phone)
(514) 398-3876 (Fax)

HOME PAGE: http://people.mcgill.ca/jan.ericsson/

Swedish Institute for Financial Research (SIFR)

Drottninggatan 89
SE-113 59 Stockholm, SE-113 60
Sweden

Do you have a job opening that you would like to promote on SSRN?

Paper statistics

Downloads
2,080
Abstract Views
6,437
rank
10,599
PlumX Metrics