Abstract
This study examines the corporate credit spread of a firm that is constrained by an upper limit of debt issuance depending on the liquidation (collateral) value. We provide four important results. First, the upper limit of debt issuance may induce the firm to issue riskless (risk-free) debt. Second, the upper limit decreases the credit spread. Third, the credit spread increases with the liquidation value when the firm is financially constrained, while the credit spread decreases with the liquidation value when it is not. Fourth, the firm is likely to be financially constrained when cash flow volatility is high, the risk-free interest rate is low, corporate tax is high, and bankruptcy cost is high. Our results fit well with empirical studies.
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