Dynamic Capital Structure With Callable Debt And Debt

Abstract

We consider a dynamic model of the capital structure of a firm with callable debt that takes into account that equity holders and debt holders have a common interest in restructuring the firm's capital structure in order to avoid bankruptcy costs. Far away from the bankruptcy threat the equity holders use the call feature of the debt to replace the existing debt in order to increase the tax advantage to debt. When the bankruptcy threat is imminent, the equity holders propose a restructuring of the existing debt in order to avoid bankruptcy. This proposal makes both debt holders and equity holders better o# and re-optimize the firm's capital structure. Both the lower and upper restructuring boundaries are derived endogenously by the equity holders' incentive compatibility constraints. Our way of renegotiating the debt when the bankruptcy treat is imminent is di#erent from the way the coupons of the debt is renegotiated in the the strategic debt service models of, e.g., Anderson and Sundaresan (1996) and Mella-Barral and Perraudin (1997). In our model the entire debt (principal as well as all future coupon rates) is restructured. It is not just the current coupon payment which is fine tuned