Asset Substitution, Debt Pricing, Optimal Leverage and Maturity

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