Leland 1994
Leland 1994
Leland 1994
Overview
Develops a structural model for corporate debt,
yield spreads, optimal leverage.
Derives closed-form solutions for optimal leverage
under various cases.
Has some interesting predictions for junk vs.
investment grade bonds.
Though the base model doesnt explain empirical
findings well, some variations of it do come close.
Brief Background
Builds on earlier structural models of Merton (1974)
and Black and Cox (1976).
Incorporates effects of taxes, bankruptcy costs, and
protective covenants in their model.
Brennan and Schwartz (1978) have a similar idea,
but this paper develops an analytical model with
closed-form solutions.
Studies optimal leverage, debt pricing, yield
spreads, and credit risk issues.
Merton model:
Zero-coupon debt, face value F, maturity T
Default only at T, iff V(T) < F
If default, bond holders get random V(T), equity holders gets
zero
Model Assumptions
Security value depends on the underlying firm value
but time independent.
Face value of debt, once issued, remains static
through time.
Firm finances the net cost of the coupon by issuing
additional equity.
There exists an asset that pays constant rate of
interest r.
Model Parameters
C coupon
V current value of assets of the firm
corporate tax rate
bankruptcy costs
r risk free interest rate
2 volatility of asset value
D value of debt
E value of equity
v total value of the firm.
A Generic Model
The asset value V of the firm follows a diffusion
process with constant volatility of rate of return:
V is assumed to be unaffected by the financial
structure of the firm.
Let F(V,t) be the value of the claim on the firm that
pays C continuously when solvent.
The assets value must satisfy:
A Generic Model
No closed form solutions for above.
Brennan & Schwartz (1978) use numerical techniques.
A Generic Model
A0, A1, A2 determined by boundary conditions.
Let VB be asset value that triggers bankruptcy,
represent bankruptcy costs.
When bankrupt, VB is incurred, debtholders get (1)*VB and equity holders get nothing.
Apply (4) for value of debt D(V) with following
boundary conditions:
We get:
A Generic Model
Debt has two counteracting effects:
i. Decrease firm value due to bankruptcy costs BC(V)
ii. Increase firm value due to tax benefits TB(V).
Model Extensions
Some assumptions are relaxed and alternatively
modeled.
1. No tax shield when asset value falls beyond a point.
2. Firm has net cash outflows after equity financing (so
asset value is affected by extent of debt). [Imp]
3. Absolute priority of debtholders not respected.
Summary
Protected & unprotected investment grade bonds
behave as expected.
Unprotected junk bonds exhibit different behavior.
Higher risk free rates lead to greater optimal debt
level due to tax benefits.
Modified model predicts values close to observed.
Protected debt mitigates agency problems and hence
leads to higher firm values.
Equity return volatility changes with firm value.