Optimal Debt Dynamics, Issuance Costs, and Commitment

Abstract

We investigate optimal capital structure and debt maturity policies in the presence of fixed issuance costs. We identify the global-optimal policy that generates the highest values of equity across all states of nature consistent with limited liability. The optimal policy without commitment provides almost as much tax benefits to debt as does the global-optimal policy and, in the limit of vanishing issuance costs, allows firms to extract 100% of EBIT. This limiting case does not converge to the equilibrium of DeMarzo and He (2019), who report no tax benefits to debt when issuance costs are set to zero at the outset.

Debt Maturity and the Dynamics of Leverage

“…Such costs lead to a more conservative debt strategy, which in fact reestablishes a net benefit of debt, even without commitment. Benzoni, Garlappi, Goldstein, Hugonnier, and Ying (2020) conclude that this result holds even in the limit, as fixed issuance costs go to zero. Our model allows for debt covenants, proportional costs of debt rollover, and fixed costs of discrete debt restructurings.…”

“…6 The growing interest in the interaction between debt maturity and leverage dynamics by corporate theorists has recently inspired several papers related to our work. Benzoni, Garlappi, Goldstein, Hugonnier, and Ying (2020) focus on the main result of DeMarzo and He (2020), namely, that in the absence of any commitment or bond covenants, agency problems imply that the present value of future tax benefits of debt are perfectly offset by the present value of expected future bankruptcy costs. They show that this result may not be robust once one allows for fixed costs of debt issuance.…”

Leverage Dynamics without Commitment

“…Indeed, because our equilibrium produces the lowest possible equilibrium payoff for shareholders (Markov or not), all non-MPE equilibria can be supported by using our equilibrium off the equilibrium path. (See, for example, Benzoni et al (2020) and Malenko and Tsoy (2020), who use our results to support non-Markov strategies in which the firm is "punished" for exceeding a target leverage ratio by reverting to our MPE.) Naturally, we expect that firms will try to reduce the agency costs resulting from the leverage ratchet effect and capture some of the funding advantages of debt by using alternative commitment mechanisms such as collateral or covenants that restrict future debt issuance.…”

“…DeMarzo (2019) discusses alternatives and demonstrates that collateral allows the firm to capture the funding advantages of debt because it can be exclusively promised to a single creditor. Other important commitment mechanisms in practice include regulations, restrictions on the tax deductibility of leverage by corporations, and trading frictions (e.g., Benzoni et al (2020) argue that fixed costs of debt issuance can act as a commitment mechanism allowing the firm to capture tax benefits of debt). Finally, equity market imperfections may prompt the firm to actively manage its internal liquidity (cash) position (as in Hennessy and Whited (2005), Bolton, Chen, andWang (2011), andYang (2020)).…”

“…7 As in our model, the choice of debt maturity becomes an important commitment device that allows for future debt reductions in the face of negative shocks. Benzoni et al (2020) study the role of commitment when the firm faces a fixed transaction cost when issuing new debt. They consider the class of "s-S" capital restructuring policies as in Goldstein, Ju, and Leland (2001) and compare outcomes when the firm can commit to the restructuring boundary to those when it cannot.…”