Can the Tradeoff Theory Explain Debt Structure?

52 Pages Posted: 5 Jan 2005  

Dirk Hackbarth

Boston University Questrom School of Business

Chris Hennessy

London Business School

Hayne E. Leland

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

Date Written: August 2006

Abstract

We examine the optimal mixture and priority structure of bank and market debt using a tradeoff model where banks have the unique ability to renegotiate outside formal bankruptcy. Flexible bank debt offers a superior tradeoff between tax shields and bankruptcy costs. Ease of renegotiation limits bank debt capacity, however. Optimal debt structure hinges upon which party has bargaining power in private workouts. Weak firms have high bank debt capacity and utilize bank debt exclusively. Strong firms lever up to their (lower) bank debt capacity, augment with market debt, and place the bank senior. Therefore, the tradeoff theory offers an explanation for: (i) why young/small firms use bank debt exclusively; (ii) why large/mature firms employ mixed debt financing; and (iii) why bank debt is senior. The tradeoff theory also generates predictions consistent with international evidence. In countries where the bankruptcy regime entails soft (tough) enforcement of contractual priority, bank debt capacity is low (high), implying greater (less) reliance on market debt.

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

JEL Classification: G13, G32, G33

Suggested Citation

Hackbarth, Dirk and Hennessy, Chris and Leland, Hayne E., Can the Tradeoff Theory Explain Debt Structure? (August 2006). AFA 2005 Philadelphia Meetings Paper. Available at SSRN: https://ssrn.com/abstract=644011 or http://dx.doi.org/10.2139/ssrn.644011

Dirk Hackbarth (Contact Author)

Boston University Questrom School of Business ( 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/

Christopher Hennessy

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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