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Bond Prices, Yield Spreads, and Optimal Capital Structure with Default Risk

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  • Hayne Leland.

Abstract

This paper examines the value of debt subject to default risk in a continuous time framework. By considering debt with regular principal repayments (e.g. through a sinking fund), we are able to examine bonds with arbitrary maturity while retaining a time-homogeneous environment. This extends Leland's [1994] earlier closed-form results to a much richer class of possible debt structures. We examine the term structure of yield spreads and find that a rise in interest rates will reduce yield spreads of current debt issues. It may tilt the term structure as well. Duration is also affected by default risk. The traditional Macaulay duration measure overstates effective duration, which for junk bonds may even be negative. While short term debt does not exploit tax benefits as completely as does long term debt, it is more likely to provide incentive compatibility between debt holders and equity holders. The agency costs of asset substitution are minimized when firms use shorter term debt. Optimal capital structure depends upon debt maturity. Optimal leverage ratios are smaller, and maximal firm values are less, when short term debt is used. The yield spread at the optimal leverage ratio increases with debt maturity.

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Bibliographic Info

Paper provided by University of California at Berkeley in its series Research Program in Finance Working Papers with number RPF-240.

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Date of creation: 01 Nov 1994
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Handle: RePEc:ucb:calbrf:rpf-240

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Postal: University of California at Berkeley, Berkeley, CA USA
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Web page: http://haas.berkeley.edu/finance/WP/rpflist.html
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Cited by:
  1. TINA M. Mukta Kulkarni & Mark L. Lengnick-Hall, . "Obstacles To Success In The Workplace For People With Disabilities: A Review And Research Agenda," Working Papers 0031, College of Business, University of Texas at San Antonio.
  2. Marco Realdon, . "Valuation of Put Options on Leveraged Equity," Discussion Papers 03/19, Department of Economics, University of York.
  3. Alina Sima (Grigore) & Alin Sima, 2011. "Distance to Default Estimates for Romanian Listed Companies," The Review of Finance and Banking, Academia de Studii Economice din Bucuresti, Romania / Facultatea de Finante, Asigurari, Banci si Burse de Valori / Catedra de Finante, vol. 3(2), pages 091-106, December.
  4. N. Letifi & J.-L. Prigent, 2014. "On the debt capacity of growth and decay options," Working Papers 2014-391, Department of Research, Ipag Business School.
  5. Bhanot, Karan & Mello, Antonio S., 2006. "Should corporate debt include a rating trigger?," Journal of Financial Economics, Elsevier, vol. 79(1), pages 69-98, January.
  6. Marco Realdon, . "Convertible Subordinated Debt Valuation and "Conversion in Distress"," Discussion Papers 03/18, Department of Economics, University of York.
  7. Décamps, Jean-Paul & Villeneuve, Stéphane, 2009. "Rethinking Dynamic Capital Structure Models with Roll-Over Debt," IDEI Working Papers 528, Institut d'Économie Industrielle (IDEI), Toulouse, revised Nov 2011.

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