OPTIMAL CAPITAL STRUCTURE, ENDOGENOUS BANKRUPTCY, AND THE TERM STRUCTURE OF CREDIT SPREADS

This article examines the optimal capital structure of a firm that can choose both the amount and maturity of its debt. Bankruptcy is determ ined endogenously rather than by the imposition of a positive net wort h condition or by a cash now constraint. The results extend Leland's ( 1994a) closed-form results to a much richer class of possible debt str uctures and permit study of the optimal maturity of debt as well as th e optimal amount of debt. The model predicts leverage, credit spreads, default rates, and writedowns, which accord quite closely with histor ical averages. While short term debt does not exploit tax benefits as completely as long term debt, it is more likely to provide incentive c ompatibility between debt holders and equity holders. Short term debt reduces or eliminates ''asset substitution'' agency costs. The tax adv antage of debt must be balanced against bankruptcy and agency costs in determining the optimal maturity of the capital structure. The model predicts differently shaped term structures of credit spreads for diff erent levels of risk. These term structures are similar to those found empirically by Sarig and Warga (1989). Our results have important imp lications for bond portfolio management. In general, Macaulay duration dramatically overstates true duration of risky debt, which may be neg ative for ''junk'' bonds. Furthermore, the ''convexity'' of bond price s can become ''concavity.