The Optimal Mix of Bank and Market Debt: An Asset Pricing Approach

54 Pages Posted: 23 Mar 2003

See all articles by Dirk Hackbarth

Dirk Hackbarth

Boston University - Department of Finance & Economics; Centre for Economic Policy Research (CEPR); European Corporate Governance Institute (ECGI)

Chris Hennessy

London Business School

Hayne E. Leland

University of California, Berkeley - Walter A. Haas School of Business

Date Written: March 21, 2003

Abstract

This paper examines the optimal mix and priority structure of bank and market debt using a tax shield-bankruptcy cost tradeoff model where the only unique feature of banks is their ability to renegotiate. Closed-form expressions are derived for the values of renegotiable bank debt, non-renegotiable market debt, equity, and levered firm values. Optimal debt structure hinges upon the division of ex post bargaining power between the firm and bank. Weak firms utilize bank debt exclusively. Strong firms use a mixture of bank and market debt, with bank debt senior. The model explains: (i) why small firms use bank debt exclusively; (ii) why large firms employ mixed debt financing; (iii) why bank debt is senior; and (iv) why firms shift from bank debt into a mixture of market and bank debt over their life-cycle. Optimal debt contracts entail Absolute Priority, and we provide estimates of the cost of ex post priority violations across creditor classes.

Keywords: Banking, Capital Structure, Priority, Contingent Claims Pricing

JEL Classification: G13, G32, G33

Suggested Citation

Hackbarth, Dirk and Hennessy, Christopher and Leland, Hayne E., The Optimal Mix of Bank and Market Debt: An Asset Pricing Approach (March 21, 2003). EFA 2003 Annual Conference Paper No. 485. Available at SSRN: https://ssrn.com/abstract=367820 or http://dx.doi.org/10.2139/ssrn.367820

Dirk Hackbarth

Boston University - Department of Finance & Economics ( email )

Department of Finance
595 Commonwealth Avenue
Boston, MA 02215
United States
(617) 358-4206 (Phone)
(617) 353-6667 (Fax)

HOME PAGE: http://people.bu.edu/dhackbar/

Centre for Economic Policy Research (CEPR) ( email )

London
United Kingdom

European Corporate Governance Institute (ECGI) ( email )

c/o ECARES ULB CP 114
B-1050 Brussels
Belgium

Christopher Hennessy (Contact Author)

London Business School ( email )

Sussex Place
Regent's Park
London, London NW1 4SA
United Kingdom

Hayne E. Leland

University of California, Berkeley - Walter A. Haas School of Business ( email )

Haas School of Business
545 Student Services Building
Berkeley, CA 94720
United States
(510) 642-8694 (Phone)
(510) 643-1420 (Fax)

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