A Model of Debt Structure< /p>
Abstract:
We provide a model of th
e term structure of corporate debt. The optimal debt contract balances the
need to provide sufficient termination threat to make repayments incentive
compatible (favoring early repayments) with the desire to avoid costly earl
y liquidation (favoring late repayments). This simple trade-off endogenousl
y determines (i) the number of repayment dates, (ii) their timing, and (iii
) promised repayment amounts. Firms with stable risky cash flows and large
outside financing needs make debt payments earlier and more often, effectiv
ely a sequence of short-term debt contracts. For firms with cash-flow growt
h or significant risk-free cash-flow component, on the other hand, adding r
isky repayment dates can decrease pledgeable income. In some cases, pledgea
bility is maximized with one risky bullet repayment far in the future, effe
ctively a long-term debt contract.