Optimal Capital Structure
Why do companies take on debt (Credit Risk) at all? Why not just use Equity? Credit Risk models are linked to Capital Structure theory (Modigliani-Miller and Trade-Off Theory).
The Trade-Off
Companies balance two opposing forces:
1. The Benefit: Tax Shield
- Interest payments are tax-deductible.
- More Debt = Less Tax = Higher Firm Value.
- This encourages borrowing.
2. The Cost: Bankruptcy Costs (Financial Distress)
- As Debt increases, the Probability of Default (PD) rises.
- Direct Costs: Lawyers, court fees.
- Indirect Costs: Customers leave, suppliers demand cash, employees quit.
- This discourages borrowing.
The Optimal Point
The firm maximizes value where Marginal Benefit of Debt (Tax) = Marginal Cost of Debt (Bankruptcy Risk).
- This optimal point determines the firm's "Target Leverage".
Leland-Toft Model
A famous model that combines Structural Credit Risk with Capital Structure. It calculates:
- The optimal amount of debt to issue.
- The optimal maturity of the debt.
- The yield spread the firm should pay.
Note
Dynamic: As asset volatility rises, the "Bankruptcy Cost" curve shifts up. Therefore, risky tech startups should have LOW debt (Optimal). Stable utility companies should have HIGH debt.
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