Dynamic Capital Structure with Debt Renegotiation and Mean-reverting Earnings

Abstract

We develop a model of optimal capital structure with debt renegotiation and mean- reversion in earnings. Comparative statics are presented for optimal leverage, coupon choice and the renegotiation threshold, as well as related capital structure metrics. We also conduct a cross-model comparison with a framework featuring a conventional geometric Brownian motion-based state variable to examine implica- tions of varying assumptions about the evolution of earnings.
We show that a manager who maximises firm value selects a higher initial lever- age and that the leverage choice correlates negatively with earnings. This contrasts with predictions by earlier models of capital structure. In addition, we predict lower bond yields and higher recovery rates of debt compared to the benchmark case. The size of deviations from the absolute priority rule is equivalent across the models, given proportional bankruptcy costs and distribution of bargaining power between agents.
Our analysis brings capital structure research closer to the practical discussion by coupling two realistic elements. We let the diffusion of earnings align better with how they observably evolve and allow for restructuring of the firm at a sufficiently low earnings level.