Bond Finance and the Leverage Ratio

Abstract

Unconstrained profit maximization permits a firm to make sizeable adjustments to the share of bond finance, investment, and the leverage ratio in response to changes in its economic environment. By contrast, a binding pledgeable income constraint limits movements in investment and the leverage ratio but permits some flexibility in the choice of bond versus loan finance. Due to the existence of distress costs of bond finance in the low payoff state, the share of bond finance remains low compared to more expensive loan finance under both constrained and unconstrained profit maximization.