AGENCY COSTS, RISK MANAGEMENT, AND CAPITAL STRUCTURE

The joint determination of capital structure and investment risk is ex amined. Optimal capital structure reflects both the tax advantages of debt less default costs (Modigliani and Miller (1958, 1963)), and the agency costs resulting from asset substitution (Jensen and Meekling (1 976)). Agency costs restrict leverage and debt maturity and increase y ield spreads, but their importance is small for the range of environme nts considered. Risk management is also examined. Hedging permits grea ter leverage. Even when a firm cannot precommit to hedging, it will st ill do so. Surprisingly, hedging benefits often are greater when agenc y costs are low.