Abstract
Abstract This paper shows that short debt maturities commit equityholders to leverage reductions when refinancing expiring debt in low-profitability states. However, shorter maturities lead to higher transaction costs since larger amounts of expiring debt need to be refinanced. We show that this trade-off between higher expected transaction costs against the commitment to reduce leverage in low-profitability states motivates an optimal maturity structure of corporate debt. Since firms with high costs of financial distress and risky cash flows benefit most from committing to leverage reductions, they have a stronger motive to issue short-term debt. Evidence supports the model’s predictions.
Highlights
Significant progress has been made towards understanding firms’ dynamic financing decisions
Dynamic leverage adjustments? How do firms optimally refinance expiring debt? What is the optimal debt maturity structure given its implications for dynamic capital structure adjustments and which firms are most likely to issue short-term debt? We address these questions in a framework that does not rely on information asymmetries or agency conflicts
(See Appendix A.6 for the proof of Proposition 6.) Bankruptcy costs, corporate taxes and critical debt maturity: We find that bankruptcy costs as well as the magnitude of the tax shield of debt financing represent the main determinants for the critical average maturity that triggers voluntary debt reductions
Summary
Significant progress has been made towards understanding firms’ dynamic financing decisions. We allow firms to choose the mix of debt and equity to repay maturing debt, whereas firms in the above models must roll over maturing debt with new debt issues, keeping the face value of total debt constant In contrast to these papers, we concentrate on debt maturity and its role in mitigating conflicts of interest between debtholders and equityholders on capital structure dynamics. While the existing literature assumes that the face value of debt is kept konstant at rollover dates, we allow firms to optimally choose the refinancing mix This implies that a firm’s leverage capacity increases if it chooses a capital structure which forces it to regularly roll over a non-trivial portion of its debt.
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