Capital Structure, Debt Maturity, and Stochastic Interest Rates

Abstract

This paper develops a model in which an optimal capital structure and an optimal debt maturity are jointly determined in a stochastic interest rate environment. The model yields leverage ratios that are consistent in spirit with empirical observations. The maturity and the credit spread of an optimally issued debt are found to be smaller than the commonly observed values, indicating that factors not considered in a typical capital structure model play important roles in determining them. It is found that the long-run mean of the short-term interest rate process is a key variable in the determination of both the optimal capital structure and the optimal maturity structure. In addition, the volatility of the interest rate process and the correlation between the interest rate process and the firm's asset value process play important roles in the determination of the debt maturity structure. Our model suggests that the traditional capital structure models with constant interest rates cannot be calibrated directly to explain empirical observations.