Optimal capital structure with earnings above a floor

This paper derives the optimal capital structure of a firm whose earnings follow a geometric Brownian motion with a lower reflecting barrier. The barrier can be interpreted as a market intervention threshold (e.g., a price floor) by the government or an exit threshold of weak competitors in the market. Unlike in the standard model with no barrier, the firm is able to issue riskless debt to a certain capacity determined by the barrier. The higher the barrier, the larger the riskless debt capacity, and the firm prefers riskless capital structure rather than risky capital structure. Notably, with intermediate barrier levels, the firm can choose riskless capital structure with lower leverage than the level with no barrier. This mechanism can help explain debt conservatism observed in practice. The paper also entails several implications of public intervention by examining the lowest barrier (i.e., the weakest intervention) to achieve riskless capital structure.