Dynamic Capital Structure: Debt Rollover and Funding Liquidity

Abstract

This thesis examines capital structure implications of liquidity frictions in the rm's funding markets when debt is rolled over. The thesis revisits the classic rollover models by Leland (1994a) and Leland and Toft (1996) by virtue of the key conduit debt rollover provides in terms of enabling funding market liquidity to in uence shareholders' default decision after debt is in place. Debt is redeemed at par and replenished with new debt of identical terms issued at market value. Liquidity frictions are introduced in the static models by He and Xiong (2012) and Leland (2006) that are extensions of Leland and Toft (1996) and Leland (1994a) respectively. As liquidity deteriorates the market value of debt declines and makes debt rollover more expensive. In turn, shareholders become reluctant to raise the required capital to service debt payments and endogenously default earlier. This exacerbates the rm's default risk and elucidates an entwined relationship between liquidity and credit risk. To alleviate the impact of liquidity frictions through the rollover channel the rm moves to a lower leverage ratio at its optimal capital structure. While predicted credit spreads improve considerably with the introduction of liquidity frictions leverage ratios continue to dwarf those observed empirically for realistic parameter values. Backed by the empirically documented behavior of frequent capital structure adjustments the novelty of the thesis rests in developing a dynamic capital structure model with liquidity frictions in the rm's funding markets and debt rollover. The proposed model predicts optimal leverage ratios and credit spreads that accord quite closely with empirical estimates for realistic parameter values. Moreover, a novel channel is identi ed - the re nancing channel, through which the rm can compensate liquidity distressed bondholders by way of pursuing a more aggressive re nancing policy. As funding market liquidity deteriorates the rm optimally moves to a lower leverage ratio with a view to economize on the more expensive debt nancing and to alleviate the impact through the rollover channel. By re nancing more frequently following potential appreciation in asset value the rm improves the liquidity provision embedded in the call feature on debt. Liquidity frictions have a minor impact on the rm's optimal capital structure, when long term debt is issued, because debt rollover is limited and the rm already pursues an aggressive re nancing policy to exploit the tax bene ts of debt. For shorter maturities the e ect is more pronounced and highlights the role of short term debt in terms of amplifying the rm's rollover risk.