Leverage Dynamics with Credit Supply Uncertainty

Abstract

This paper investigates how credit supply uncertainty influences corporate leverage dynamics. We develop a continuous-time model where firms encounter call premiums for retiring existing debt and proportional issuance costs. Additionally, firms must strategically time their debt adjustments while facing search costs and risks from stochastic investor participation. Our findings indicate that reducing credit supply uncertainty lowers refinancing uncertainty. This encourages shareholders to actively seek new investors and leads to a smaller optimal target leverage level. Furthermore, we demonstrate that stronger creditor bargaining power and higher call premiums increase debt restructuring costs, thus mitigating shareholders’ incentives to find new creditors.

Keywords: Leverage dynamics, Credit supply uncertainty, Debt adjustment costs.