Endogenous Debt Maturity: Liquidity Risk vs. Default Risk

We study the joint determination of a technology ---the degree of illiquidity of a project, its mean growth rate and the variability of the growth rate--- — and the optimal debt financing ---the face value of the debt, its coupon rate, and expected maturity—--- in an economy in which credit markets and decision makers are risk neutral and have the same discount rate. Our results show that the optimal maturity of the debt balances the risk of default due to illiquidity with the risk of strategic default. In a quantitative exercise we show how the optimal structure of debt varies with technological and environmental parameters. We find that when output is low (and, hence, the probability of default is high) firms choose to issue short term debt. In general, there is a positive relationship between output and maturity. We also fi nd that firms operating in more uncertain environments choose to issue shorter debt, while fi rms whose assets have higher resale value (e.g. face lower costs of re sales) issue longer maturity debt.