Optimal Capital Structure of the Firm in the Presence of Costs of Financial Distress

Abstract

In this paper we propose a model of optimal capital structure that incorporates costs of financial distress. The model is successful in explaining the observed leverage ratios in the US. First, we consider customer-driven financial distress where prices for the firm output decline whenever the firm has poor financial status. We find that costs of financial distress account for about 8-9% decrease in optimal leverage and cause higher yield spreads than predicted by traditional structural models. Second, we explore employee-driven financial distress originating from loss of intangible assets when firm revenues decline. We find that contracting problems within the firm lead to overpayment to firm employees and result in lower optimal debt in its capital structure. Finally, we examine the state tax effect on optimal leverage and yield spreads. A 5% increase in state tax reduces optimal leverage by approximately 10% and widens the yield spreads.