Debt, Default, and Risk Management: Corporate Policies Under Incomplete Markets

Abstract

We develop a dynamic theory of capital structure, liquidity and risk management, and payout policies for a financially constrained firm under incomplete markets. In addition to costly external equity financing, the key friction we emphasize is limited financial spanning. We show that the marginal source of external financing on a on-going basis is debt. The firm only relies on costly external equity financing or costly default, when it is near or exceeds its endogenous debt capacity. The firm may be either endogenously risk-averse or risk-loving depending on the degree of market incompleteness and its current leverage. When it is risk-averse, the firm optimally manages its risk by fully hedges its hedgeable risk so as to minimize the volatility of its leverage. When it is risk-loving, the firm gambles for resurrection by selling insurance or excessively loading up on insurance. A key prediction of our theory is that the most important determinant of future leverage is current leverage, in line with existing empirical evidence.