Capital Structure, Business Risk, and Default Probability

Abstract

This paper addresses the theoretical foundations of default probability, using the neo-classical theory of capital structure as a starting point. A model of optimal capital structure is constructed and reworked into a model of default probability. The comparative static analyses show that both optimal capital structure and default probability are U-shaped functions of business risk, as measured by cash flow volatility. This finding is in contrast with many papers that assume a linear negative relationship between capital structure and business risk, and a linear positive relationship between default probability and business risk. The other comparative statics show straightforward results, either analytically (capital structure) or numerically (default probability). As such, the model may be a valuable contribution in comparison to the multitude of theory-less empirical studies and a useful alternative to the default theory based on option pricing.