A Model of Debt Structure

Abstract:
We provide a model of the 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 early liquidation (favoring late repayments). This simple trade-off endogenously 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, effectively a sequence of short-term debt contracts. For firms with cash-flow growth or significant risk-free cash-flow component, on the other hand, adding risky repayment dates can decrease pledgeable income. In some cases, pledgeability is maximized with one risky bullet repayment far in the future, effectively a long-term debt contract.