Chapter 60
Alternative Methods to Determine Optimal Capital Structure: Theory
and Application
Sheng-Syan Chen, Cheng-Few Lee, and Han-Hsing Lee
Abstract In this paper, we review the most important and
representative capital structure models. The capital struc-
ture models incorporate contingent claim valuation theory
to quantitatively analyze prevailing determinants of capital
structure in corporate finance literature. In capital structure
models, the valuation of corporate securities and financial de-
cisions are jointly determined. Most of the capital structure
models provide closed-form expressions of corporate debt
as well as the endogenously determined bankruptcy level,
which are explicitly linked to taxes, firm risk, bankruptcy
costs, risk-free interest rate, payout rates, and other impor-
tant variables. The behavior of how debt values (and there-
fore yield spreads) and optimal leverage ratios change with
these variables can thus be investigated in detail.
Keywords Optimal capital structure r Structural model
Capital structure model r Credit risk
60.1 Introduction
The traditional capital structure theories investigate how the
capital structure of a firm can be affected by some crucial
determinants, such as the financial distress costs and agency
costs. However, it is a difficult task to measure their effects
on the capital structure decisions and security pricing. It is
of great interest for corporate managers and researchers to
quantitatively examine how these effects influence a com-
pany and its financial decisions under various conditions.
The capital structure models employ contingent claim valua-
S.-S. Chen
National Taiwan University, Taiwan
e-mail: fnschen@management.ntu.edu.tw
C.-F. Lee
Rutgers University, USA
e-mail: lee@business.rutgers.edu
H.-H. Lee ()
National Chiao Tung University, Taiwan
e-mail: lee@rbsmail.rutgers.edu
C.-F. Lee et al. (eds.), Handbook of Quantitative Finance and Risk Management,
DOI 10.1007/978-0-387-77117-5_60,  c Springer Science+Business Media, LLC 2010
tion (option pricing) theory for analyzing classical corporate
finance issues and can deepen the understanding of the firm’s
financial decisions. Furthermore, the contingent claim valua-
tion enables risky debt pricing using marketable securities of
the firm, such as common stock, bond or credit default swaps
(CDS) prices, to estimate the firm value parameters and in
turn the default risk. This approach avoids the use of bond
rating and risk premium (markup), which are difficult to pin
down and often are stale in contrast to the trading data of
marketable securities.1
The structural credit risk modeling or defaultable claim
modeling is pioneered by the seminal paper by Black and
Scholes (1973) in which corporate liabilities can be viewed
as a covered call – own the asset but short a call option. Black
and Scholes (1973) assume that a company issues only one
r zero-coupon bond and equity. At the maturity, debt holders
either receive the face value of debt if the company is sol-
vent, or take control of the company otherwise. This option
analogy allows the closed-form expression for the corporate
securities. Later on, Merton (1974) rigorously elaborates the
pricing of corporate debt. In addition, the valuation of any
corporate security can be modeled as a contingent claim on
the underlying value of firm. This Black-Scholes-Merton ap-
proach of modeling default claims is named structural ap-
proach since the model explicitly ties default risk to the firm
value process and its capital structure.
In modeling the cause of default-trigger mechanism, the
Black-Scholes-Merton approach implicitly assumes that a
company can only default at a certain time point when its
bond principal is due. While this default trigger mechanism
is apparently unrealistic, Black and Cox (1976) first propose
a model in that default can occur during the life of the bond –
a company defaults on its debt if the asset value of the com-
pany falls below a certain exogenous default boundary due
to bond covenant. In the same paper, Black and Cox (1976)
also point out that default decision can be endogenized by
1
Another advantage of the structural approach is that macro- and micro-
conditions have been implicitly incorporated into the evolution (change)
of firm values and, in turn, security prices, and need not be modeled
separately.
933
934
shareholders’ discretion to maximize equity value. These
two types of default mechanisms, exogenously specified by
bond covenant and endogenously determined by manage-
ment, have been widely adopted in most of the succeeding
structural models.2
Subsequent researchers extend the structural approach
further and incorporate more realistic assumptions. Based on
the key objectives of these models, one can classify them as
corporate bond pricing model and capital structure model.
Corporate bond pricing models, typically assuming stochas-
tic interest rate, are primarily developed to price defaultable
corporate debt. In order to accommodate a more realistic
and complex debt structure, these models typically assume
an exogenous default barrier and bondholders receive a re-
covery rate times the face value of debt at maturity if a firm
defaults.3 For example, the Longstaff and Schwartz model
(1995) is the most well-known corporate bond pricing model.
By contrast, the capital structure models incorporate corpo-
rate finance theory and put the emphasis on the default event
itself. The valuation of corporate securities and financial de-
cisions are jointly determined, and the analyses focus on the
complex relations between credit risk, risk premiums, and
the firm’s financing decisions rather than on the valuation
of complex credit securities. In contrast to corporate bond
pricing models, the simple stationary debt structure assump-
tion, debt structure with time-independent payouts, is widely
adopted in order to obtain closed-form expression of debt,
equity, and firm value. In this paper, we restrict ourselves to
capital structure models and exclude those models focusing
on risky debt pricing.4
In the capital structure models, the most notable devel-
opments are the works by Leland (1994) and Leland and
Toft (1996). They extend the endogenous default approach
by Black and Cox (1976) to include the tax shield of debt and
bankruptcy costs, and explicitly analyze the static tradeoff
theory of capital structure. Various important issues includ-
ing the endogenous default boundary, leverage ratio, debt
value, debt capacity, yield spread, and even potential agency
costs are discussed in detail. Note that apart from the early
structural models, Leland and Toft (1996) point out that
equity in a capital structure model is not precisely analo-
gous to an ordinary call option or vanilla barrier option. The
bankruptcy boundary varies with the risk of the firm’s activ-
ities. Furthermore, the tax benefits and the potential loss in
2
Geske (1977) proposes another way of modeling corporate debts as
compound options.
3
There are some exceptions. For example, Briys and de Varenne (1997)
assume recovery of firm value when a firm defaults. However, the trade-
off is its simpler debt structure, a zero-coupon bond.
4
Readers who are interested in other structural models can refer to the
survey paper by Elizalde (2005).
S.-S. Chen et al.
bankruptcy imply that debt and equity holders do not split a
claim depending only on the underlying asset value.
While the Leland (1994) and the Leland and Toft (1996)
models provide some insights of the capital structure issues,
their predicted optimal leverage and yield spreads seem not
to be consistent with historical average. Consequently, the
more recent studies introduce additional realistic features in
order to meliorate the model-predicted leverage and yield
spreads. We will also review the some of these extensions.
This paper is organized as follows: In Sect. 60.2, we
will briefly review traditional capital structure theory. In
Sect. 60.3, we will present in detail two most representative
capital structure models – Leland (1994), and Leland and
Toft (1996) models – and their implications. In Sect. 60.4,
more recent studies including debt renegotiation, dynamic
capital structure, as well as other developments are pre-
sented. In Sect. 60.5, the applications and empirical per-
formance of capital structure models are discussed. In
Sect. 60.6, conclusion is given.
60.2 The Traditional Theory of Optimal
Capital Structure5
Durand (1952) proposes an approach to explain why there
is an optimal capital structure for a firm. Called the tradi-
tional approach, it suggests that “moderate” amounts of debt
do not noticeably increase the risks to either the debtholders
or the equityholders. Hence, both cost of debt (i ) and cost
of equity (rE ) are relatively constant up to some point. How-
ever, beyond some critical amount of debt used, both i and
rE increase. These increases in both the cost of debt and eq-
uity begin to offset the decrease in the average cost of capital
because of cheaper debt. Therefore, the average cost of cap-
ital (rA ), initially falls and then increases. This allows for a
minimum value for the average cost of capital function. If
the average cost of capital is at the minimum, then the firm’s
value (V ) is maximized
.1  TC /EBIT
V D (60.1)
rA
where TC D corporate tax rate and EBIT D earnings before
interest and tax. This implies that there is an optimum capital
structure for the firm.
60.2.1 Bankruptcy Costs
The theoretical analysis of Modigliani and Miller (1958)
indicates that in the presence of corporate taxes (TC ), the
5
This chapter is an excerpt from the book by Lee et al. (2009).
60 Alternative Methods to Determine Optimal Capital Structure: Theory and Application 935

value of the levered firm (VL ) exceeds the value of the other-
wise comparable unlevered firm (VU ). The difference can be
viewed as an increment to present value derived from the tax
shelter (TC B). Therefore, we can write
VL D VU C T C B (60.2)
where B D total amount of debt.
One issue not considered in deriving this result is the pos-
sibility of corporate bankruptcy. Obligations to bondhold-
ers constitute a first claim on a company’s assets. However,
under US law, stockholders, who are the owners of public
companies, have only limited liability. Their personal assets,
other than holdings in the firm, are protected from the claims
of bondholders. If operating performance is sufficiently poor,
stockholders can avoid obligations to bondholders through
the firm’s declaring bankruptcy. Essentially, bankruptcy turns
over the firm to its debtholders. Bankruptcy proceedings can
be very costly. Heavy legal fees must be paid, and assets
must often be sold at “bargain basement” prices, frequently
following lengthy and expensive disputes among competing
claimants. Taken together, these bankruptcy costs may be far
from negligible, and the possibility of their being incurred
must be considered in assessing a firm’s market value.
After bankruptcy, the firm belongs to its creditors, who
must therefore bear these costs. However, purchasers of cor-
porate bonds will be aware of this and will charge a higher
price – that is, demand a higher interest rate – for debt. This,
in turn, reduces the amount of earnings available for distri-
bution to stockholders, reducing the value of shares. Hence,
before bankruptcy, costs are carried by stockholders as re-
ductions in the value of their equity holdings.
How much does the possibility of bankruptcy lower the
firm’s value? Two factors must be considered: (1) the costs
incurred in the event of bankruptcy and (2) the likelihood, or
probability, of bankruptcy occurring. The greater the amount
of debt a firm has, the more likely it will fail to meet its
obligations and be driven to bankruptcy. Therefore, seeing
this risk, bondholders will demand higher rates of interest
the larger the debt. Thus, expected bankruptcy cost is an in-
creasing function of the proportion of debt in a firm’s capital
structure. Taking into account the possibility of bankruptcy
and its effect on firm value, we can augment Equation (60.2)
as follows:
VL D VU C TC B  present value of bankruptcy costs
(60.3)
The higher the level of debt, the greater the present value of
the tax shield. As we saw in Equation (60.2), the effect is lin-
ear, in the sense that the value of the tax shield is a constant
multiple TC (the corporate tax rate) of the debt value. How-
ever, as Equation (60.3) indicates, one must now subtract the
present value of bankruptcy cost. This, too, is an increasing
function of the debt level, reflecting the increase in the prob-
ability of bankruptcy that attaches to increasing debt levels.
If these factors operate in conjunction, as illustrated in
Fig. 60.1, then an optimal capital structure results. One sees
for the unlevered firm, zero values for the tax shield and
bankruptcy costs. Each increases with the level of debt is-
sued, the net effect being a relationship between firm value
and debt level that shows a maximum value for a debt level
well below 100% of total value. Myers (1984) called the opti-
mal capital structure discussed in this section the static trade-
off theory.6
6
Myers (1984) also proposes a pecking-order theory to contrast to the
static trade-off theory.

Fig. 60.1 Possibility of optimal

debt ratio when allowing for
present value of bankruptcy costs
936
Fig. 60.2 Possibility of optimal
debt ratio when allowing for
present value of bankruptcy and
agency costs
60.2.2 Agency Costs
Agency costs are legal and contract costs that protect the
rights of stockholders, bondholders, and management, and
arise when the interests of these parties come into conflict.
Such organizational conflict may lead to capital structure de-
cisions that affect the firm’s value. Asset substitution prob-
lem arises when a firm invests in assets that are riskier than
those that the debtholders expect. For example, having sold
debt, stockholders may gain if the corporation abandons
its low-risk projects in favor of more risky projects. If the
higher-risk projects are successful, the stockholders will ben-
efit from the high returns. On the other hand, this exposes
bondholders to a higher degree of risk than they anticipate
when the bonds were purchased, and thus they face a higher-
than-expected chance of corporate bankruptcy.
Bondholders anticipate such possibilities and require that
bonds be protected by restrictive covenants. Such covenants
involve two types of costs to the firm. First, there are costs
in monitoring the covenants, and second, these covenants re-
strict management flexibility, possibly precluding courses of
action that would raise the firm’s market value. These costs
are borne by stockholders, resulting in a lower market value
for equity. Jensen and Meckling (1976) use agency costs of
debt and equity to suggest that there is an optimum com-
bination of outside debt and equity that will be chosen to
minimize total agency costs. Therefore, it is possible for the
existence of an optimal capital structure even in the absence
of taxes and bankruptcy costs.
In general, one might expect that agency costs of this sort
will be greater the higher the debt. If there is little debt, bond-
holders will consider their investments relatively secure and
demand only modest, fairly inexpensive protection of their
interest. At higher debt levels, more stringent assurances will
S.-S. Chen et al.
be required. Thus, agency costs affect firm value in much
the same way as bankruptcy costs. The greater the debt, the
greater the agency cost against firm value. This is illustrated
in Fig. 60.2, which extends Fig. 60.1 by allowing for agency
cost. At any level of debt above zero, agency cost causes a de-
crease in market value; the greater the debt level, the larger
the agency cost factor. Hence, agency cost yields a lower op-
timal amount of debt in the capital structure than would oth-
erwise prevail. If there is agency cost, then Equation (60.3)
can be rewritten as
VL D VU C TC B  present value of bankruptcy costs
Agency cost (60.3a)
In a review paper, Harris and Raviv (1991) survey capi-
tal structure theories based on agency costs, asymmetric in-
formation, product/input market interactions, and corporate
control considerations (but excluding tax-based theories).
Therefore, this paper gives us further detailed information
about the result discussed in this section.
60.3 Optimal Capital Structure
in the Contingent Claims Framework
The traditional capital structure theory identifies some prime
determinants of optimal capital structure. Nevertheneses, the
theory is less useful in practice since it provides only qualita-
tive guidelines. The structural approach enables quantitative
analysis and thus has become very popular in the corporate
finance literature. We will review in detail how the determi-
nants mentioned in Sect. 60.2 affect capital structure deci-
sions under the contingent claim framework in this section.
60 Alternative Methods to Determine Optimal Capital Structure: Theory and Application
In the analysis of optimal capital structure, Brennan and
Schwartz (1978) are the first to provide the quantitative
examination of optimal leverage using contingent claims
approach. However, their analysis employs numerical tech-
niques and lacks a close-form solution. As a result, their
numerical-based study cannot provide general comparative
statics of financial variables and further discussion. In this
section, we review in detail two most representative capital
structure models – Leland (1994) and Leland and Toft (1996)
models – and the implication of these models. These two
studies provide closed-form expressions of corporate secu-
rities as well as comparative statics. Their methodology and
stationary debt structures are widely adopted in the litera-
ture. In addition, these two models have served as benchmark
models in the optimal capital structure literature.
60.3.1 The Leland (1994) Model
Leland (1994) extends the endogenous default approach by
Black and Cox (1976) to include the tax shield of debt and
bankruptcy costs, which is also termed the Static tradeoff
model in the corporate theory. In the Leland (1994) model, fi-
nancial distress is triggered when shareholders no longer find
that running a company is profitable, given the revenue pro-
duced by the assets to continue servicing debt. Bankruptcy
is determined endogenously rather than by the imposition of
a positive net worth condition or by a cash flow constraint.
In this model, two major assumptions are as follows: (1) The
activities of the firm are unchanged by financial structure,
and the capital structure decisions, once made, are not sub-
X
sequently changed; (2) The face value of debt, once issued,
remains static through time.
Consider a firm with asset value V , which follows a dif-
fusion process with constant volatility of rate of return:
dV
D .V; t/dt C dW (60.4)
V Next, Leland (1994) derives the total value of the firm,
where W is a standard Brownian motion. The stochastic pro-
cess of V is assumed to be unaffected by the financial struc-
ture of the firm. Therefore, any net cash outflows associated
with the choice of leverage such as coupons after tax bene-
fits must be financed by selling additional equity. In addition,
there exists a riskless asset that pays a constant rate of inter-
est r.
Denote any claim F .V; t/ on the firm that continuously
pays a nonnegative coupon, C , per instant of time when the
firm is solvent. When the firm finances the net cost of the
coupon by issuing additional equity, any such asset’s value
must satisfy the PDE:
1 2 2
 V FVV .V; t/CrVFV .V; t/rF.V; t/CFt .V; t/CC D 0
2
937
with boundary conditions determined by payments at matu-
rity, and by payments in bankruptcy happens prior to matu-
rity. When securities have no explicit time dependence as this
case, the term Ft .V; t/ D 0, and the above equation becomes
an ordinary differential equation with F .V / satisfying
1 2 2
 V FVV .V; t/ C rVFV .V; t/  rF.V; t/ C C D 0:
2
(60.5)
The equation has the general solution
F .V / D A0 C A1 V C A2 V X ; (60.6)
where X D 2r= 2 and the constants A0 , A1 , and A2 are
determined by boundary conditions. Any time-independent
claim with an equity-financed constant payout C 0 must
have this functional form.
First, Leland (1994) provides the solution of the perpetual
debt. Debt promises a perpetual coupon payment, C , whose
level remains constant unless the firm declares bankruptcy.
Let VB denote the constant level of asset value at which
bankruptcy is declared. If bankruptcy occurs, a fraction 0 
˛  1 of asset value will be lost to bankruptcy cost. Accord-
ingly, debtholders receive .1˛/VB and shareholders receive
nothing.7
Boundary conditions are:
At V D VB ; D.V / D .1  ˛/VB
As V ! 1, D.V / D C =r
 
C C V
D.V / D C .1  ˛/VB  (60.7)
r r VB
The above equation can be rewritten as D.V / D Œ1  pB
.C =r/ C pB Œ.1  ˛/VB where pB  .V =VB /X has the
interpretation of the present value of $1 contingent on future
bankruptcy; that is, V falls to VB .
v.V /, which reflects three terms: the firm’s asset value,
plus the value of the tax deduction of coupon payments,
less the value of bankruptcy costs. Consider a security pays
no coupon, but has a value equal to the bankruptcy costs.
Because its returns are time independent, it must satisfy
Equation (60.6) with boundary conditions
At V D VB ; BC.V / D ˛VB
As V ! 1; BC.V / D 0:
7
Leland (1994) also has a discussion (in Sect. VI.C) under the condition
of deviation of absolute priority, in which bondholders do not receive all
of the remaining asset value and stockholders also receive a fraction of
the remaining asset value.
938
The solution in this case is
˛VB .V =VB /X ; (60.8)
and BC.V / is a decreasing convex function of V .
Next consider the value of tax benefits associated with
debt financing. Denote the corporate tax rate as TC . These
benefits resemble a security that pays a constant coupon
equal to the tax-sheltering value of interest payments, TC C ,
as long as the firm is solvent. In other words, TB.V / equals
the value of the tax benefit of debt. Since it is also time in-
dependent and must satisfy Equation (60.6) with boundary
conditions
At V D VB ; TB.V / D 0
As V ! 1; TB.V / D TC C =r:
The solution with these boundary conditions is
TC C =r  .TC C =r/.V =VB /X (60.9)
8
The TB.V / is an increasing, strictly concave function of V .
Note that the value of tax benefits above presumes that
the firm always benefits fully in amount TC C from the tax
deductibility of coupon payments when it is solvent. How-
ever, under U.S. tax codes, to benefit fully, the firm must have
earnings before interest and taxes (EBIT) that is at least large
as the coupon payments C . Leland (1994) also provides the
solution, in which EBIT is related to asset value,V , and tax
benefits may be partially lost when the firm is still solvent.
In sum, the total value of the firm, v.V /, consisting of the
above three terms, the firm’s asset value, the value of the tax
deduction of coupon payments, and the value of bankruptcy
costs, can be expressed as:
v.V / D V C TB.V /  BC.V /
D V C .TC C =r/Œ1  .V =VB /X  ˛VB .V =VB /X
(60.10)
v.V / is strictly concave in asset value, V , when C > 0 and
either ˛ > 0 or TC > 0. Note that if ˛ > 0 or TC > 0, then
v.V / < V as V ! VB , and v.V / > V as V ! 1. This
coupled with concavity implies that v.V / is proportionally
more volatile than V at low values of V , and is less volatile
at high value of V .
8
Note that this equation represents that the firm always benefitfully
from the tax deductibility of coupon payment when it is solvent. How-
ever, to benefit fully the firm must have EBIT over the coupon payment,
C . Leland (1994) provides an alternative approach in Appendix A in
which tax benefits may lost when the firm is still solvent.
S.-S. Chen et al.
Note that Equation (60.10) is similar to Equation (60.3).
If .V =VB /X approaches to zero, then Equation (60.10) re-
duces to original M&M proposition I as defined in Equation
(60.2). For this condition to hold, either (i) .V =VB / ! 1 or
(ii)  2 ! 0 and V > VB . In both cases, the firm is un-
likely to go bankrupt, and therefore tax saving per period
on the interest payments becomes a sure stream. As a re-
sult, the tax benefit claim in Equation (60.9) will be TC C =r,
and Equation (60.10) will coincide with the original M&M
proposition I in Equation (60.2), even with the existence of
bankruptcy cost. On the other hand, without the bankruptcy
cost (˛ D 0), the tax benefit claim under Leland’s specifi-
cation is still different from that by M&M. The difference, a
minus term (.TC C =r/.V =VB /X ), is coming from the pos-
sibility of future bankruptcy, and thus lowers the tax shield
of debt.
The value of equity is the total value of the firm less the
value of debt as follows:
E.V / D v.V /  D.V / D V  .1  TC /.C =r/
CŒ.1  TC /.C =r/  VB .V =VB /X:
(60.11)
Leland next provides the bankruptcy-triggering asset level
VB chosen by the firm. To maximize the value of equity at
any level of V , the equilibrium bankruptcy-triggering asset
value VB is determined ˇ endogenously by the smooth-pasting
@E.V IVB ;T / ˇ
condition @V ˇ D 0.
V DVB
VB D Œ.1  TC /C =r ŒX=.1 C X / D .1  TC /C =.r C 0:5 2 /
(60.12)
Since VB < .1 TC /C =r, equity is indeed convex in V . Sev-
eral observations of the asset value, VB , at which bankruptcy
occurs are:
(1) It is proportional to the coupon, C .
(2) It is independent of the current asset value, V .
(3) It decreases as the corporate tax rate, TC , increases.
(4) It decreases as the risk-free interest rate, r, rises.
(5) It decreases with increases in the riskiness of the
firm,  2 .
Finally, VB in Equation (60.12) is independent of time
and it confirms the assumption of the constant bankruptcy-
triggering asset level VB .
In addition to the determinants of bankruptcy level, with
the closed-form expressions, corporate debt values and op-
timal leverage are explicitly linked to taxes, firm risk,
bankruptcy costs, risk-free interest rate, and bond covenant.
The behavior of how debt values (and therefore yield
spreads) and optimal leverage ratios changes with these vari-
ables is discussed in detail. In addition, Leland shows that a
60 Alternative Methods to Determine Optimal Capital Structure: Theory and Application 939

positive net worth covenant9 can eliminate the firm’s incen-
tive to increase risk and lower the agency problem.
However, optimal capital structure refers not only to lever-
age ratio, but also to the maturity of debt. The consol bond
assumption of the Leland model confines the analysis in
this dimension. As a result, Leland and Toft (1996)10 pro-
pose a finite maturity debt structure for further discussion of
this issue.
of bankruptcy. Let f .sI V; VB / denote the density of the first
passage time s from V to VB , and F .sI V; VB / is the cu-
mulative distribution function of the first passage time to
bankruptcy; that is, the default probability at time s. Under
risk-neutral valuation with the drift rate .r  ı/, the bond
with maturity t has the value
Z t
d.V I VB ; t/ D e rs c.t/Œ1  F .sI V; VB / ds
0

Ce rt p.t/Œ1  F .sI V; VB /

Z t
60.3.2 The Leland and Toft (1996) Model
C e rs .t/VB f .sI V; VB /ds
0
In the Leland and Toft (1996) model, financial distress is
The first term represents the discounted expected value of
triggered, as assumed in Leland (1994), when shareholders
the coupon flow; the second term represents the expected
no longer find that running a company is profitable. In this
discounted value of repayment of principal; and the third
model, they further examine the optimal capital structure of
term represents the expected discounted value of the frac-
a firm that can choose both the amount and maturity of its
tion of the assets, which will go to debt with maturity t, if
debt. They again setup a stationary debt structure by issu-
bankruptcy occurs. Integrating the first term by parts yields
ing finite maturity debt with continuous coupon and retiring
the same constant amount (principal) of debt issued in the  
c.t/ c.t/
past simultaneously. As a result, at any given time, the firm d.V I VB ; t/ D C e rt p.t/  Œ1  F .t/
r r
has many overlapping debt outstanding, while the total cash  
flow to debt holders is constant. The results extend Leland’s c.t/
C .t/VB  G.t/ (60.14)
(1994) closed-form results to a much richer class of possible r
debt structures and dividends payment and permit study of
the optimal maturity of debt as well as the optimal amount of where Z t
debt. G.t/ D e rs f .sI V; VB /ds
The firm has productive assets whose unleveraged value 0

V follows a continuous diffusion with constant proportional Using the result of F .t/ from Harrison (1985) and G.t/ from
volatility  Rubinstein and Reiner (1991):

2a
dV V
D Œ.V; t/  ı dt C dZ (60.13) F .t/ D N Œh1 .t/ C N Œh2 .t/ (60.15)
V VB

aCz
az
where .V; t/ is the total expected rate of return on asset V V
value V ; ı is the constant fraction of value paid out to secu- G.t/ D N Œq1 .t/ C N Œq2 .t/
VB VB
rity holders; and dZ is the increment of a standard Brownian
(60.16)
motion. The process continues without time limit unless V
falls to a default-triggering valueVB . VB will be determined
where
endogenously and shown to be constant in a rational expecta-
tions equilibrium. Finally, a default-free asset exists and pays .b  z 2 t/ .b C z 2 t/
a continuous constant interest rate r. q1 .t/ D p I q2 .t/ D p
 t  t
Consider a bond issue with maturity t periods from the
present, which continuously pays a constant coupon flow .b  a 2 t/ .b C a 2 t/
c.t/ and has principal p.t/. Let .t/ be the fraction of as- h1 .t/ D p I h2 .t/ D p
 t  t
set value VB , which debt of maturity t receives in the event

.r  ı  . 2 =2// V
aD I b D ln I
9
The positive net-worth covenant is modeled by setting default bound-
2 VB
ary equal to the principal value of debt.
Œ.a 2 /2 C 2r 2 1=2
10
Leland (1994b) proposes an exponential model similar to sinking zD
fund that firms retire debt at a proportional rate m through time. In the 2
absence of default, the average
R1 maturity of debt is finite as the time-
weighted average: T D 0 t .memt /dt D 1=m. and N./ is the cumulative standard normal distribution.
940 S.-S. Chen et al.

A stationary debt structure with time-independent debt The equilibrium bankruptcy-triggering asset value VB is
service payments is assumed by Leland and Toft (1996) as determinedˇ endogenously by the smooth-pasting condition
@E.V IVB ;T / ˇ
the following. Consider an environment where the firm con-
@V ˇ D 0.
tinuously sells a constant (principal) amount of new debt with V DVB

maturity of T years from issuance, which (if solvent) it will

.C =r/ .A=.rT/  B/  AP=.rT/  TC Cx=r
redeem at par upon maturity. New bond principal is issued at VB D
a rate p D .P =T / per year, where P is the total principal 1 C ˛x  .1  ˛/B
(60.19)
value of all outstanding bonds. The same amount of princi-
pal will be retired when the previously issued bonds mature. p p
Therefore, as long as the firm remains solvent, at any time s where A D 2aerT N.a T /  2zN.z T /  2
p n
p rT p  T
the total outstanding debt principal will be P , and have a uni- .z T / C 2ep n.z T / C .z  a/
 T
form distribution of principal over maturities in the interval

p p
.s; s C t/. 2 2
Bonds with principal p pay a constant coupon rate c D B D  2z C N.a T /  p n.z T /
z 2 T  T
.C =T / per year, implying the total coupon paid by all out-
1
standing bonds is C per year. Total debt service payments C.z  a/ C
are therefore time-independent and equal to .C C P =T / per z 2 T
year. Accordingly, this environment assumed by Leland and
x D a C z11 and n./ denotes the standard normal density
Toft (1996) avoids the time-dependent debt service require-
function.
ments such as the single issue of debt outstanding assumed
The solution is independent of time, indicating that the
by Merton (1974).
earlier assumption of a constant VB is warranted: it repre-
Assuming the fraction of firm asset value lost in
sents a rational expectations equilibrium. As T ! 1, it can
bankruptcy is ˛ and .t/ D =T per year for all t, this im-
be shown that VB ! .1  TC /.Cx=r/=.1 C x/ as in Equation
plies  D .1  ˛/. Therefore, writedown for debt is the fixed
(60.12). Note that VB will depend on the maturity T of debt
fraction of the principal value of debt lost in bankruptcy,
chosen, for any given values of total bond principal P and
which is .1  .1  ˛/VB =P /. Leland and Toft derive the
coupon rate C . This is an important difference between Le-
closed-form solution of the value of all outstanding bonds,
land and Toft model and the flow-based bankruptcy model
with debt of maturity T years, by integrating all the outstand-
(e.g., Kim et al. (1993) or with a positive net worth covenant
ing debt during this period:
model (e.g., Longstaff and Schwartz (1995), in which they
Z T imply that VB is independent of debt maturity.
D.V I VB ; T / D d.V I VB ; t/dt And finally, the value of equity is given by
0

C C 1  e rT
D C P  I.T / E.V I VB ; T / D v.V I VB /  D.V I VB ; T / (60.20)
r r rT

C
C .1  ˛/VB  J.T /; (60.17) In contrast to the Leland (1994) model, the Leland and
r
Toft (1996) model has some different implications. First, by
where permitting a firm to choose its debt maturity, optimal lever-
Z T
age is lower when the firm is financed by shorter-term debt.
1 1 They also provide explanation of why a firm issues short-
I.T / D .G.T /  e rT F .T //;
e rt F .t/dt D
T0 rT term debt given that the longer-term debt generates higher
Z
aCz firm value. They find that short-term debt reduces the asset
1 T rt 1 V
J.T / D e G.t/dt D p  substitution agency problem. While short-term debt does not
T 0 z T V B
exploit tax benefit of debt, it can balance against bankruptcy

az !
V and agency costs in determining the optimal maturity of the

N Œq1 .T / q1 .T / C N Œq2 .T / q2 .T / : capital structure. This is a consequence that short-term debt
VB

Following Equation (60.10) by Leland (1994), total firm 11

If the payout rate (ı) is equal to 0, then it can be shown that
2 =2// 2 2 2 1=2
value is a C z D .rı. 2
C Œ.a / C2r
2
D 2r2 . This is exactly the

az 
az x defined in Equation (60.6) by Leland (1994). However, we should
TC C V V
v.V I VB / D V C 1  ˛VB note that the introduction of the payout rate relaxes the unreasonable
r VB VB assumption assumed by Leland (1994) that net cash outflows associated
(60.18) with the choice of leverage such as coupons after-tax benefits must be
where a and z have been defined in Equation (60.16). financed by selling additional equity.
60 Alternative Methods to Determine Optimal Capital Structure: Theory and Application
holders need not protect themselves by demanding higher
coupon rates and thus equity holders will also benefit. Sec-
ond, for bond portfolio management, they find that Macaulay
duration overstates true duration of risky debt, especially for
junk bonds that may have negative duration. Furthermore,
convexity can become concavity.
60.4 Recent Development of Capital
Structure Models
In Sect. 60.3, we have reviewed in detail two of the most
well-known capital structure models – Leland (1994), and
Leland and Toft (1996) models. These two models have
been served as benchmark models in the optimal capi-
tal structure literature. Their stationary debt structures and
time-independent setting have been widely adopted in the lit-
erature. However, compared with historical average, the op-
timal leverage implied in the Leland (1994) model is unrea-
sonably high, while the model’s predicted yield spread is too
low given the suggested high leverage, especially for the un-
protected debt. Furthermore, unreasonably large bankruptcy
costs as high as 50% is required to lower the optimal leverage
to this level.
In addition to the issues above, several implications by
the Leland (1994) model are also not in accordance with the
empirical observations. In the Leland (1994) model, the firm
will issue equity to finance contractual debt obligation until
equity value is driven to zero in the absence of reorganization
option. Hence, bankruptcy boundary coincides with the liqui-
dation barrier. However, in practice, it is normal for manage-
ment to file for bankruptcy when equity value is still positive.
Some researchers argue that a more realistic bankruptcy pro-
cedure may affect the valuation of corporate securities and
capital structure decisions. Therefore, subsequent studies at-
tempt to extend Leland’s (1994) model to a more realistic
setting and hope to make the model-implied yield spread and
leverage ratio to be more consistent with the observed aver-
age in practice.
The first branch of these extensions is to permit devia-
tions of absolute priority rule (APR) in Chap. 14 bankruptcy
proceedings. The importance of violations from APR has
been addressed in the literature. Eberhart and Weiss (1998)
clearly point out that APR is explicitly or implicitly assumed
in many seminal finance models, such as Merton (1974) and
Myers (1977). The APR is adhered since shareholders re-
ceive nothing until debt holders have been fully paid. The
APR is also assumed in most of the early structural mod-
els. However, empirical studies indicate that the APR viola-
tion is a common phenomenon (see Franks and Torous1989;
Eberhart et al. 1990; Weiss 1990). Therefore, it has of great
interest to researchers to analyze the cause of APR deviation
941
and its impact on capital structural decision under rational
expectation framework.
Structural models can demonstrate the violation of APR
by incorporating different default boundaries. Leland (1994)
has a discussion (in Sect. VI.C) regarding deviation of ab-
solute priority, in which bondholders do not receive all of
the remaining asset value and stockholders also receive a
fraction of the remaining asset value. Nevertheless, it can-
not explain the behavior of debt holders’ concession by
simply changing the boundary condition since their claims
will be reduced. Therefore, several recent models permit
the debt renegotiation by private workouts or by court-
supervised debt renegotiation under Chap. 14 bankruptcy
proceedings. For example, Fan and Sundaresan (2000) pro-
pose a game-theoretic setting that incorporates equity’s abil-
ity to force concessions and varying bargaining powers to
the debt holders and equity holders. Later on, Francois and
Morellec (2004) extend this bargaining game to explicitly
model Chap. 14 protection and court-supervised renegotia-
tion. By introducing the possibility of renegotiating the debt
contract, the default can occur at positive equity value. This
is in contrast to the Leland’s (1994) model that the default
occurs as the equity value reaches zero. As a consequence of
that, issuing new equity is costless, and the APR is respected.
Another branch of the extension is the dynamic capital
structure. Early capital structure models assume that the debt
issuance is a static decision. However, in practice, firms ad-
just outstanding debt levels in response to changes in firm
value. Early studies of dynamic capital structure include
works by Kane et al. (1984, 1985) and Fischer et al. (1989).
Recent works consist of the Goldstein et al. (2001) and Ju and
Ou-Yang models (2006), and many others. In general, the dy-
namic feature of these models predicts a lower leverage ratio
than those static capital structure models and is more in line
with the observed leverage in practice.
There are still other researchers who seek to explore the
capital structure problem of investment risks and agency
costs, the timing of default under more realistic bankruptcy
proceedings, alternative process, and other issues. We briefly
categorize these studies as follows (the list below is by no
means exclusive):
Dynamic Capital Structure:12 Fischer et al. (1989);
Goldstein et al. (2001); Ju et al. (2004); Ju and
Ou-Yang (2006). Strategic Default and Renegotia-
tion: Anderson and Sundaresan (1996); Mella-Barral
and Perraudin (1997); Mella-Barral (1999); Fan and
Sundaresan (2000); Francois and Morellec (2004). Risk
Management for Firms: Ross (1996); Leland (1998).
12
Taurén (1999) and Collin-Dufresne and Goldstein (2001) approach
this issue by proposing alternative models to reflect the firms’ tendency
to maintain a stationary leverage ratio. However, their studies focus on
the risky corporate debt pricing and the implications of credit spreads.
942 S.-S. Chen et al.

Bankruptcy Procedures (Chapter 7 versus Chapter 11): The total value of the firm is
Broadie et al. (2007). Optimal Investment: Mauer and 8

Triantis (1994), Childs et al. (2005); Hackbarth (2006). ˆ T C
<V C C 
C TC C V
; when V > VQS
r C   r Q
Stochastic Interest Rate: Kim et al. (1993); Acharya and v.V / D
C VS
Carpenter (2002); Huang, Ju and Ou-Yang (2003); Ju and :̂V C  TC C V ; when V  VQS
Ou-Yang (2006). Jump: Dao and Jeanblanc (2006). C   r VQS
(60.22)
The Fan and Sundaresan (2000) model as well as the
rh i2
Goldstein et al. (2001) model are presented in detail in
rˇ rˇ
Sects. 60.4.1 and 60.4.2, respectively. We choose these two where  D 0:5  2
˙ 0:5  2
C 2r
2
.
papers that, in our opinion, are the most important or repre- For any V  VQS , Fan and Sundaresan set the optimal
sentative of that stream of research. The remaining research sharing rule between shareholders and debtholders as
will be presented in less detail and we will briefly outline
their key assumptions and results. Readers may refer to the E.V Q
Q / D v.V / and D.V Q
Q / D .1  /v.V /: (60.23)
original papers for details.
The Nash solution to the bargaining game can be character-
ized as
60.4.1 The Fan and Sundaresan (2000) Model
n o
Q
Q  D arg max v.V /0
Fan and Sundaresan (2000) propose a game-theoretic set- n o1
ting that incorporates equity’s ability to force concessions Q

.1  /v.V /  max Œ.1  ˛/V  K; 0
and various bargaining powers to the debt and equity hold-  
.1  ˛/V  K
ers. Two cases are discussed in their study where the firm’s D min    ; (60.24)
asset value falls below a certain boundary: Debt-equity swap v.V /
and strategic debt service. In the case of debt-equity swap,
where  denotes bargaining power of shareholders.
the debtholders exchange their claims for equity. In strategic
At equilibrium, Fan and Sundaresan (2000) show that debt
debt service, borrowers stop making the contractual coupon
holders accept less than the contractual coupon and still per-
and start servicing debt strategically until the firm’s assets
mit shareholders to run the company. This results in devia-
returns to its original level.
tions from APR, in which the shareholders will get a bigger
Some key assumptions under their framework include the
share and the debtholders will get a less proportion of the
following: (1) During the default period, the tax benefits are
firm. But both parties will be better off. Therefore, the con-
lost. (2) Asset sales for dividend payments are prohibited.
cession of debtholders is well explained under the Fan and
(3) The firm can be liquidated only at a cost. The propor-
Sundaresan’s framework.
tional cost is ˛.0  ˛  1/ and the fixed cost is K.K 0/.
They then solve the trigger point for strategic debt service
Note that debt holders have strict absolute priority upon
(K D 0 case) as
liquidation.
(4) The asset value of the firm follows the lognormal c.1  TC C TC /  1
diffusion process VQ D (60.25)
r 1   1  ˛
dV D .  ˇ/V dt C VdBt (60.21)
and the strategic service amount paid to debt holders S.V / D
where  is the instantaneous expected rate of return on the .1  ˛/ˇV .
firm gross of all payout, and ˇ is the firm’s cash payout ratio. It can be shown that the equity value satisfies the follow-
Here we present only the results of strategic debt service. ing differential equations:13
If the equity and debt holders can reach an agreement of tem-
porary coupon reduction when the firm is under financial dis- 1 2 2Q
 V EVV .V; t/ C .r  ˇ/V EQ V .V; t/  r E.V;
Q t/
tress, the firm will not lose its potential future tax benefits. At 2
the trigger point for the strategic service VQS , both parties will CˇV  c.1  TC / D 0; when V > VQS I
bargain the total value of the firm v.V /. 1 2 2Q
The driving force behind strategic behavior is the presence  V EVV .V; t/ C .r  ˇ/V EQ V .V; t/  r E.V;
Q t/
2
of proportional and fixed costs of liquidation. The bargain- CˇV  S.V / D 0; when V > VQS I (60.26)
ing power of equity holder clearly depends on the liquidation
cost ˛VS C K. Fan and Sundaresan (2000) endogenize both
the reorganization boundary and the optimal sharing rule be-
tween equity and debt holders upon default. 13
See Dixit and Pindyck (1994).
60 Alternative Methods to Determine Optimal Capital Structure: Theory and Application 943

with the boundary conditions: Note that when V > VQS , the contractual coupon is paid and
the tax shield is in effect. By contrast, when V  VQS , the
c.1  TC / tax shield is lost because the equity holders are strategically
lim E.V / D V 
V "1 r servicing the debt according to the cash flow generated by

the firm. Both the strategic debt service amount S.V / and
 cT C
lim E.V / D  ˛ VQS  the trigger level VQS are determined endogenously.
V #VQS C   r

The equity value is
C  cT C
lim EV .V / D  ˛ 
V #VQS C   r VQS

8  

< .1  TC /C .1  TC /C  .1  C / TC C V
Q V  C  ; when V > VQS
E.V / D r .1   /r .C   /.1   / r VS (60.27)
:
v.V /  .1  ˛/V; when V  VQS

The Fan and Sundaresan model shows that debt renegotiation

encourages early default and increases credit spreads on cor-
porate debt, given that shareholders can renegotiate in dis-
tress to avoid inefficient and costly liquidation. It might be
the interest of debt holders to forgive part of the debt service
payments if they can avoid the wasteful liquidations, which
can be shared by the two claimants. If shareholders have no
bargaining power, no strategic debt service takes place and
the model converges to the Leland model. Furthermore, by
introducing the possibility of renegotiating the debt contract,
the default can occur at positive equity value. This is in con-
trast to the Leland’s (1994) model in that the default occurs
when the equity value reaches zero as a consequence of that
issuing new equity is costless and the APR is respected.
ously. In contrast to the unlevered firm value, the claim to
future EBIT flow should be more reasonable to changes in
capital structure. Furthermore, compared with previous mod-
els, this characterization also has assumptions that are more
in accordance with empirical findings.15
The single technology of a pure exchange economy pro-
duces a payout flow that is specified by the (EBIT) process
dı
D P dt C dz (60.28)
ı
The value to the claim of entire period is the discounting ex-
pected cash flows (unlevered firm)
Z

1
Q ıt
V .t/ D Et dsıs e rs D (60.29)
t r 

60.4.2 The Goldstein et al. (2001) Model
Goldstein, Ju, and Leland propose an EBIT-based model in
that the state variable is earnings before interests and taxes
(EBIT) instead of commonly used unlevered firm value.14
This approach is intuitively appealing: the EBIT-generating
machine runs independently of how the EBIT flow is dis-
tributed among its claimants. The advantage of taking the
claim on future EBIT is that all contingent claimants, includ-
ing the government claim, to future EBIT flows are treated in
a consistent fashion. More precisely, the government claim is
no longer treated as a cash inflow in a form of tax benefit, but
as a cash outflow on EBIT in a form of tax. In other words,
each dollar paid out, whether to interest payments, dividends,
or taxes, affects the firm in the same way. Another advantage
is that unlevered and levered equity never exist simultane-
14
Although unlevered firm value may not be traded, trading of equity
or other contingent claims allows the use of unlevered firm value as the
state variable (Ericsson and Reneby 2004a).
where  D .P  / is the risk-neutral drift of the payout
flow rate:
dı
D dt C dzQ (60.30)
ı
Since r and  are constants, V and ı share the same
dynamics:
dV
D dt C dzQ (60.31)
V
15
Fischer et al. (1989) assume that the following: (i) The value of an op-
timally levered firm can only exceed its unlevered value by the amount
of transaction costs incurred. It eliminates the arbitrage opportunity.
(ii) A firm that follows an optimal financing policy offers a fare risk-
adjusted return. Thus, unlevered firms offer a below-fair expected rate
of return. Goldstein et al. (2001) argue that these key assumptions by
Fischer et al. (1989) are not realistic. First, the arbitrage strategy is not
feasible because a bidder must pay a large premium in order to gain
control of management. They also argue that for publicly traded assets,
rational investors will push down security prices so that fair expected re-
turn is obtained on any traded assets regardless of the policies employed
by the management.
944 S.-S. Chen et al.

Accordingly, with boundary conditions

dV C dı lim Vsolv D V and Vsolv D 0 as V D VB

D rdt C dzQ : (60.32) V !1
V
Thus,
60.4.2.1 Optimal Static Capital Structure Vsolv D V  VB pB .V / (60.36)
(1.3) Define Vint as the value of the claim to interest pay-
Assume that a firm issues a consol bond with a constant ments.
coupon payment C as long as the firm remains solvent. As in
Leland (1994), any claim must satisfy the ordinary differen- C
Vint D C A1 V y C A2 V x
tial equation r

2 2 Since lim Dc D C
r , A1 D 0. This claim vanishes at V D
VF V C V FVV C P  rF D 0 (60.33) V !1
VB , one can obtain
2

where P is the payout flow. C

Vint D Œ1  pB .V / (60.37)
The solution to the above equation can be written as r
the sum of a particular solution to the full inhomoge-
neous equation and the general solution to the correspond- (1.4) Finally, separating the value of continuing operations
ing homogeneous equation. The general solution of VFV C among equity, debt, and government, we have
2 2
2
V FVV  rF D 0 (no intertemporal cash flows):
Esolv .V / D .1  Teff /.Vsolv  Vint / (60.38)
F D A1 V y
C A2 V x
(60.34)
Dsolv .V / D .1  Ti /Vint (60.39)
" r #,
 2
where x D  2
C  2
C 2r 2 2 Gsolv .V / D Teff .Vsolv  Vint / C Ti Vint (60.40)
2 2

2 s 3,


where Ti is the personal tax rate of interest payments, Td is
4 2 2 2
yD    C 2r 2 5  2 the effective rate for dividends, TC is the tax rate for corpo-
2 2 rate profits, and the effective rate Teff is

Note that x is positive and y is negative. Since A1 V y goes .1  Teff / D .1  Tc /.1  Td /

to infinity while V becomes large, A1 equals zero for all
claims of interest. (1.5) Define Vdef .V / as the present value of the default
claim.
(1.1) Define pB .V / as the present value of a claim that pays
$1 contingent on firm value reaching VB . Vdef .V / D A1 V y C A2 V x

pB .V / D A1 V y C A2 V x with boundary conditions

with boundary conditions lim Vdef .V / D 0 and Vdef .V D VB / D VB

V !1

lim pB .V / D 0 and lim pB .V / D 1 Thus,

V !1 V !1
Vdef .V / D VB pB .V / (60.41)
Thus,
x Note that Vsolv .V / C Vdef .V / D V , the present value of the
V
pB .V / D (60.35) claim to EBIT. Therefore, value is neither created nor de-
VB
stroyed by changes in the capital structure.
(1.2) Define Vsolv .V / a claim entitled to the entire payout ı Similar to the claims to funds during solvency, the default
as long as the firm remains solvent; that is, firm value claim can be divided among bankruptcy costs, debt, and gov-
remains above VB . ernment, and:

Vsolv D V C A1 V y C A2 V x BCdef .V / D ˛Vdef .V / (60.42)

60 Alternative Methods to Determine Optimal Capital Structure: Theory and Application 945

Ddef .V / D .1  ˛/.1  Teff /Vdef .V / (60.43) then use backward induction scheme to show that it is opti-
mal for each period’s coupon payments, restructuring thresh-
Gdef .V / D .1  ˛/Teff Vdef .V / (60.44)
old, and bankruptcy threshold to increase by the same factor
Note that Goldstein et al. (2001) assume that the portion of  D VU =V0 that the initial EBIT value increases by each pe-
the EBIT-generating machine not lost to bankruptcy cost can riod. All claims will also scale up by the same factor. Because
be sold to competitors in the event of bankruptcy. Thus, the of this scaling feature, the firm will be identical at every fu-
government can have a claim in bankruptcy due to the taxes ture restructuring date, except that all factors will be scaled
on future EBIT from competitors. up by  .
(1.6) The restructuring costs are assumed to be proportional (2.1) Define PU .V / as the present value of a claim that pays
to the initial value of the debt issuance: $1 contingent on firm value reaching VU . This claim
receives no dividend and therefore has the form
RC.V0 / D qŒDsolv .V0 / C Ddef .V0 / (60.45)
PU .V / D A1 V y C A2 V x
The restructuring costs are deducted from the proceeds of the
debt issuance before distribution to equity holders. with boundary conditions
ˇ
(1.7) Solving the smooth-pasting condition @E ˇ D 0,
@V V DVB pU .VB / D 0 and lim pB .V / D 0
one can obtain 
V !1
C
VB D  (60.46)
r Thus,
 
where  D x
. y
xC1
VBx y V
Note that while most comparative statics are similar to PU .V / D  V C B V x (60.47)
those in Leland (1994), equity is a decreasing function of ef- † †
fective tax rate. This is because an increase in Teff increases y y
where †  VB VUx  VU VBx .
the government claim at the expense of equity. In contrast,
previous capital structure models use unlevered firm value as (2.2) Similarly, define pB .V / as the present value of a claim
state variable and treat government claim as cash inflow. As that pays $1 contingent on firm value reaching VB .
a result, the tax benefits increase with tax rate and in turn in-
y
crease equity value. However, empirical evidence indicates VUx y V
pB .V / D  V C U V x (60.48)
that equity prices are a decreasing function of the tax rate. † †
y y
Under the characterization of Goldstein et al. (2001), even where †  VB VUx  VU VBx .
though the tax benefit is an increasing function of TC , equity
(2.3) From (2.1) and (2.2), all period 0 claims can be written
is a decreasing function of TC . This feature solves the prob-
in terms of pU .V / and pB .V /.
lem of the previous capital structure models and is supported
by empirical studies.
0
Vsolv .V / D V  pU .V /VU  pB .V /VB (60.49)
(current firm value remains between VU and VB )
60.4.2.2 Optimal Upward Dynamic Capital
Structure Strategy16 C0
0
Vint .V / D Œ1  pU .V /  pB .V / (60.50)
r
Goldstein et al. (2001) assume that there will be a threshold
VB , where the firm will optimally choose bankruptcy, and 0
Vdef .V / D pB .V /VB (60.51)
there be a threshold VU , where management will call the out-
standing debt issue at par, and sell a larger new issue.17 They 0
Vres .V / D pU .V /VU (60.52)

16
They mention that downward restructuring can be incorporated into
0
Note that the sum Vsolv .V / C Vdef
0
.V / C Vres
0
.V / D V .
their model. However, they argue that transaction costs can discourage
(2.4) Assuming full-loss offset, the values of period 0 claims
debt reduction outside Chap. 14 (see Gilson 1997). In addition, due to
the neglected issues such as asset substitution, asymmetric information, after the restructuring:
equity’s ability to force concessions, and Chap. 14 protection, they are
skeptical about the results for the downward restructuring.
17 d 0 .V / D .1  Ti /Vint
0
.V / C .1  ˛/.1  Teff /Vdef
0
.V /
Goldstein et al. (2001) claim that given management’s strategy, the
value of the debt issue would be the same even if it were not callable, (60.53)
as long as all debt issues receives the same recovery rate in the event of
bankruptcy. e 0 .V / D .1  Teff /ŒVsolv
0
.V /  Vint
0
.V / (60.54)
946 S.-S. Chen et al.

g 0 .V / D Teff ŒVsolv
0
.V /  Vint
0
.V / C Ti Vint
0 The total equity claim, E(V), just before the initial debt is-
suance, is the sum of the intertemporal claims of debt and
C.1  ˛/Teff Vdef
0
.V / (60.55) equity, less the claim of restructuring costs:

bc0 .V / D ˛Vdef
0
.V / (60.56) e 0 .V0 / C d 0 .V0 /  qD 0 .V0 /
E.V0 / D (60.62)
(2.5) Define e.V / as the equity claim to intertemporal EBIT 1  PU .V0 /
flows for all periods. Note that e.V / is not the total eq-
And after the initial debt issuance during period 0,
uity claim. Since the claims to future debt issues are
currently owned by equity and restructuring costs, fu-
E.V / D PU .V /E.V0 / C e 0 .V /  PU .V /D 0 .V0 /
ture debt holders will have to pay fair price for these
(60.63)
claims in the future. As a result, there are also cash
This reduces to
transfers between the claimants at each restructuring
date.
E.V0C / D E.V0 /  .1  q/D 0 .V0 / (60.64)
The scaling feature inherent in the model implies
It also reduces to
e.V0 / d.V0 / g.V0 /
0
D 0 D 0
e .V0 / d .V0 / g .V0 / E.VU  / D E.V0 /  D 0 .V0 / (60.65)
V0 1
D D
V0  VU .V0 /PU .V0 /
0 1  PU .V0 / just before the next issuance.
Finally, managers choose C ,   VU =V0 ,  VB =V0
(60.57)
in order to maximize the wealth of equity holder, subject to
limited liability.
The equity claim to intertemporal cash flows is
In the Goldstein, Ju, and Leland model, the optimal initial
leverage ratio is substantially lower than that obtained in the
e 0 .V0 /
e.V0 / D static model and is more in line with the historical average.
1  PU .V0 /
˚  This is a result of that the firm has the option to increase its
D e 0 .V0 / 1 C PU .V0 / C ŒPU .V0 / 2 C : : : leverage in the future. Thus, it will wait until it becomes op-
8 9 timal to exercise it. The possibility of increasing leverage in
<X 1 =
the future decreases the initial optimal leverage. In addition,
D e 0 .V0 / ŒPU .V0 / j (60.58)
: ; the bankruptcy triggered level VB also drops significantly
j D0
since a firm that has an option to adjust its capital structure is
(2.6) Next, they determine the portion of the future debt more valuable than the one without this option. Moreover, the
claims that currently belong to equity and restructuring model also implies reasonable and lower bankruptcy cost for
costs. The management will call the outstanding debt the optimal leverage. The tax benefits to debt also increase
issue at par at restructuring date. Therefore, the initial significantly over the prediction of static models.
value of the debt claim equals the sum of the claim to
period 0 cash flows plus the present value of the call
value 60.4.3 Other Important Extensions
D 0 .V0 / D d 0 .V0 / C pU .V0 /D 0 .V0 / (60.59)
In this section, we will briefly present some other exten-
Hence, sions with the introduction of investment risk, alternative
d 0 .V0 / bankruptcy procedures, as well as alternative stochastic pro-
D 0 .V0 / D (60.60)
1  pU .V0 / cesses, and will outline key results of these models.
D 0 .V0 / is the fair value debt holders must pay at the time of
issuance. The proceeds are then divided between equity and
restructuring cost. By the scaling argument, the total restruc- 60.4.3.1 Investment Risk – Leland (1998)
turing claim is
One possible agency problem, asset substitution, has been
˚ 
RC.V0 / D qD .V0 / 1 C PU .V0 / C ŒPU .V0 / 2 C : : :
0 discussed in Leland (1994) and Leland and Toft (1996).
Leland (1998) explicitly models this issue by allowing the
qD 0 .V0 / firm to choose its risk strategy and examines the interaction
D (60.61)
1  PU .V0 / between capital structure and risk choice. To capture the
60 Alternative Methods to Determine Optimal Capital Structure: Theory and Application
agency cost, Leland (1998) assumes that risk choices are
made ex post; that is, after debt is in place. The risk choices
cannot be precontracted in the debt covenants or credibly
precommitted.
The environment with ex post risk choice can be con-
trast with the hypothetical ex ante, in which the firm simul-
taneously chooses its risk strategy and its debt structure to
maximize initial firm value. The measure of agency costs is
therefore the difference in maximal values between the ex
ante and ex post cases. This reflects the loss in value fol-
lows from the risk strategies chosen to maximize equity value
rather than firm value.
In this paper, optimal capital structure reflects both the
tax advantages less default costs and the agency costs result-
ing from asset substitution (Jensen and Meckling 1976). The
joint determination of capital structure and investment risk
is examined. Leland (1998) finds that agency costs restrict
leverage and debt maturity and increase yield spreads.
60.4.3.2 Chapter 11 Protection – Francois
and Morellec (2004)
Francois and Morellec (2004) extend the Fan and
Sundaresan (2000) model to incorporate the possibility of
Chap. 14 filings. Under their setup, shareholders hold a
Parisian down-and-out option on the firm’s asset; that is,
shareholders have a residual claim on the cash flows gen-
erated by the firm unless the value of these assets reaches
the default threshold and remains below that threshold for
the exclusive period. It is generally acknowledged that there
are two types of defaulting firms: First, firms that are eco-
nomically sound but default only due to temporary financial
distress, and recover under Chap. 14. Second, firms that are
economically unsound, keep on losing value under Chap. 14,
and are eventually liquidated under Chap. 10. The modeling
philosophy comes from the empirical studies that show that
most firms emerge from Chap. 14. Only a few are eventually
liquidated under Chap. 10 after filing Chap. 14.
Following the Nash bargaining game of Fan and Sun-
daresan’s approach,18 Francois and Morellec presume the
firm renegotiates its debt obligations whenever the asset
value falls below a constant threshold VB . However, a major
18
Note that the specification for the bargaining game within Francois
and Morellec’s framework is slightly different from that of Fan and
Sundaresan (2000). Francois and Morellec focus on Chapter 11 filings
– court-supervised debt renegotiation in contrast to the private workouts
by Fan and Sundaresan. Therefore, the automatic stay of assets prevents
shareholders from liquidating the firm’s assets. Nevertheless, renegoti-
ation plan requires each participant to receive a payoff that exceeds the
liquidating value of its claims. As a result, bondholders’ payoff has to
exceed .1  ˛/VB and this results in the difference of the specification
for the bargaining game.
947
difference from Fan and Sundaresan’s model is that Francois
and Morellec assume that a proportional costs ' are borne by
the company during the renegotiation process. The costs of
financial distress incurred by the firm filing Chap. 14 are ig-
nored in the prior research. Even though the costs implied by
private workouts are generally low, Chap. 14 filings are as-
sociated with large costs of financial distress that may affect
shareholder’s default decision. Note that Leland (1994) only
allows liquidation while Fan and Sundaresan (2000) only
permit private workouts.
Francois and Morellec solve the endogenous default bar-
rier by maximizing equity value and providing closed-form
solutions for corporate debt and equity values. They find that
the possibility to renegotiate the debt contract has ambigu-
ous impact on leverage choices and increases credit spreads
on corporate debt. The sharing rule of cash flows during
bankruptcy has a large impact on optimal leverage, while
credit spread on corporate debt shows little sensitivity to the
varying bargaining power.
60.4.3.3 Chapter 11 vs. Chapter 7 – Broadie et al.
(2007)
Broadie et al. (2007) propose framework in which optimal
debt and equity values are determined in the presence of
Chaps. 10 and 14 under the U.S. bankruptcy code. They ex-
plicitly consider two separate barriers for default and liqui-
dation for the more realistic bankruptcy procedures. They
model the key feature of bankruptcy proceedings by auto-
matic stay provision – suspending the dividends while en-
tering bankruptcy (Chap. 14) and the imposition of APR
(Chap. 10) upon liquidation. To facilitate the analysis, they
follow the EBIT process by Goldstein et al. (2001)19 and as-
sume the firm issues a single consol bond.
They model the critical characteristics of the U.S.
bankruptcy proceeding – grace period, automatic stay, debt
forgiveness, absolute priority, and transfer of control rights
from equity to debt holders. Some prior models, for exam-
ple, such as the Francois and Morellec (2004) model, also
make a distinction between default and liquidation. However,
Broadie et al. (2007) argue that in their model the firm can-
not be liquidated even if the unlevered firm value is too low
during the grace period. As a result, limited liability could be
violated. Therefore, under the setup of Broadie, Chernov, and
Sundaresan, liquidation could happen as the firm value either
19
Note that they assume the same process for EBIT before and after de-
fault. Therefore, their framework models financial rather than economi-
cal distress since bankruptcy by itself does not cause poor performance.
The work by Goldstein et al. (2001) does not need this assumption since
there is no difference between default (bankruptcy) and liquidation un-
der their setup.
948
reaches the liquidation barrier or stays under the bankruptcy
barrier for longer than the grace period.
In addition, they explicitly model the automatic stay pro-
vision by recording the accumulated unpaid coupons plus in-
terest in arrears, denoted as At . When a firm recovers from
Chap. 14, the debt holders will forgive a fraction 1  ,
0    1 of arrears and receive an amount At . More-
over, the firm does not pay dividends to shareholders while
it is in the default state. The entire EBIT while in default is
accumulated in a separated account St . If St is not sufficient
to repay the arrears, equity holders must raise the remain-
ing at the cost of diluting equity. If St > At , the leftover is
distributed to shareholders.20
In this paper, they focus on the issues of bankruptcy pro-
ceedings and the optimal choice of these two boundaries
driven by different objectives.21 They show that the first-best
outcome, the total firm value maximization ex-ante upon fil-
ing Chap. 14, is different from the equity value maximization
outcome. They also show that the first-best outcome can be
restored in large measure by giving creditors either the con-
trol to declare Chap. 14 or the right to liquidate the firm once
it is taken to Chap. 14 by the equity holders. This serves as
the threat from debtholders to prevent equity holders from fil-
ing for Chap. 14 too soon to get debt relief. Finally, they also
find that on average the firms are more likely to default and
are less likely to liquidate relative to the benchmark model of
Leland (1994).
60.4.3.4 Optimal Debt Maturity – Ju
and Ou-Yang (2006)
In the work by Leland and Toft (1996), debt maturity is
shown to be crucial to the leverage ratio and credit spreads.
In practice, the optimal capital structure and optimal maturity
structure are interdependent decisions. However, in Leland
and Toft (1996), debt maturity is exogenously specified. In
addition, Goldstein et al. (2001) show that the optimal capi-
tal structure is very sensitive to the input level of the interest
rate. Therefore, Ju and Ou-Yang (2006) propose a dynamic
model in which the optimal structure and an optimal debt
maturity are jointly determined in a Vasicek (1977) mean-
reverting interest rate process.22
20
Note that in order to accommodate the complex feature of bankruptcy
proceedings, numerical approach is necessary to solve the model. The
detailed binomial lattice methodology is developed by Broadie and
Kaya (2007).
21
To determine if a distressed firm would choose the reorganization
option under nearly perfect market assumption, they first ignore taxes
to emphasize the impact of bankruptcy and return to this issue later in
their paper.
22
We should note that the default boundary is exogenously specified in
their model for tractability. The design of recapitalization of the firm’s
S.-S. Chen et al.
In their model, the tradeoff between the gains from dy-
namically adjusting the debt amount and the restructuring
costs if adjusting it yield the optimal debt maturity. In other
words, the tax rate and the transaction costs are the most two
important parameters in determining the optimal maturity.
They find that a higher transaction cost yields a longer debt
maturity since it is more expensive to rebalance a firm’s cap-
ital structure. On the other hand, a higher tax rate yields a
shorter optimal debt maturity because it is more valuable to
recapitalize the capital structure.
They also find that the initial level and long-run mean
of the interest rate process are key variables in determining
both optimal capital structure and optimal maturity structure.
When the interest rate is higher (lower), coupon and principal
are higher (lower). The coupon and principal are determined
in such a way that the market value of debt is independent
of the spot interest rate level. This is in sharp contrast to the
fact that the level of spot interest rate is a key parameter in
the constant interest rate model. Finally, the volatility of the
interest rate process and the correlation between the interest
rate process and the firm asset value process play important
roles in determining the debt maturity structure.
60.5 Application and Empirical Evidence
of Capital Structure Models
Capital structure models are intended to quantitatively exam-
ine the capital structure theories. In capital structure models,
the corporate debt value and capital structure are interlinked
variables. Therefore, the valuation of corporate securities and
financial decisions are jointly determined. Through the struc-
tural approach, researchers can conduct a detailed analysis of
the behavior of bond prices and optimal leverage ratios as fi-
nancial variables (such as taxes, interest rates, payout rates
or bankruptcy costs) change.
While theoretically elegant, capital structure models must
be able to explain observed capital structure and bond prices
in practice. As a result, the most commonly used measures
for a capital structure model are the predicted leverage ra-
tio and yield spreads. Most of the capital structure mod-
els illustrate the performance by numerical examples us-
ing the historical average as model input parameters. In
general, the early capital structure models predicted opti-
mal leverage rates that were too high. The recent models
such as those incorporating dynamic capital structure set-
tings have predicted optimal leverage more in line with the
capital structure is different from that of Goldstein et al. (2001). In con-
trast to the recapitalization barrier assumed in Goldstein et al. (2001), Ju
and Ou-Yang (2006) assumes that the firm rebalances its capital struc-
ture periodically as long as the firm is solvent.
60 Alternative Methods to Determine Optimal Capital Structure: Theory and Application
observed average under reasonable bankruptcy cost. Never-
theless, capital structure models (as well as corporate bond
pricing models using structural approach) still predict credit
spreads too low, especially for the short-term debt.
There are only a few empirical studies on the models em-
ploying structural approach. Among them, a large portion of
the empirical tests of structural models focus on the risky
debt pricing performance of the bond pricing models, such as
Longstaff and Schwartz (1995). The empirical performance
in pricing risky debt is generally unsatisfactory (see Wei and
Guo 1997; Anderson and Sundaresan 2000; Delianedis and
Geske 2001; Huang and Huang 2003, among others.). The
empirical investigations for capital structure models are even
rare due to their complexity. The most well-known study in-
cluding capital structure models is by Eom et al. (2004).
Eom et al. (2004) carry out an empirical analysis of five
structure models including Merton (1974), Geske (1977),
Longstaff and Schwartz (1995), Leland and Toft (1996), and
Collin-Dufresne and Goldstein (2001). They test these mod-
els with bond data of firms with simple capital structure on
the last trading day of each December from 1986 to 1997.
They calibrate these models using the book value of total
liabilities in the balance sheet as the default boundary, and
calculate the corresponding asset value as the sum of the mar-
ket value of equity and the book value of total debt. Then
they estimate the asset return volatility using bond-implied
volatility as well as six equity return volatilities measured by
different time horizons before and after the bond price ob-
servation. In contrast to previous studies that have suggested
that structural models generally predict yield spreads too low,
the result of Eom et al. (2004) shows more complicated phe-
nomena, although all of these models make significant er-
rors in predicting the credit spread. The Merton (1974) and
Geske (1977) models underestimate the spreads, while the
Longstaff and Schwartz (1995), Leland and Toft (1996), and
Collin-Dufresne and Goldstein (2001) models all overesti-
mate the spreads.
Huang and Huang (2003) use several structural mod-
els to predict yield spread, including the Longstaff and
Schwartz (1995) model, the strategic model, the endogenous-
default model, the stationary leverage model as well as two
models they propose: one with a time-varying asset risk pre-
mium and one with a double exponential jump-diffusion firm
value process. They calibrate inputs, including asset volatil-
ity, for each model so that target variables, including lever-
age, equity premium, recovery rate, and the cumulative de-
fault probability at a single time horizon, are matched. They
show that the models make quite similar predictions on yield
spreads. In addition, the observed yield spreads relative to
Treasury bonds are considerably greater than the predicted
spreads, especially for highly rated debt. Hence, they con-
clude that additional factors such as liquidity and taxes must
be important in explaining market yield spreads.
949
By adopting a different estimation method, Ericsson
et al. (2006) use the MLE approach proposed by Duan (1994)
to perform an empirical test on both CDS spreads and bond
spreads, including three structural models – Leland (1994),
Leland and Toft (1996), and Fan and Sundaresan (2000).
In contrast to previous evidence from corporate bond data,
CDS premia are not systematically underestimated. Also, as
expected, bond spreads are systematically underestimated,
which is consistent with the fact they are driven by significant
non-default factors. In addition, they also conduct regression
analysis on residuals against default and non-default proxies.
Little evidence is found for any default risk components in ei-
ther CDS or bond residuals, while strong evidence, in partic-
ular, an illiquidity premium, is related to the bond residuals.
They conclude that structural models are able to capture the
credit risk price in the markets but they fail to price corporate
bonds adequately due to omitted risks.
Also using the MLE approach, Ericsson and Reneby
(2004b) estimate yield spreads between 1 and 50 months
out of sample by an extended version of the Leland (1994)
model, which allows for violation of the absolute priority rule
and future debt issues. In addition to the stock price series,
they also include the bond price and dividend information in
estimating their model. The bond samples consist of 141 U.S.
corporate issues and a total of 5,594 dealer quotes. Their em-
pirical results show that, for the 1 month-ahead prediction, a
mean error is merely 2 basis points. This is similar to the
fitting error of those reduced-form models in Duffee (1999).
Therefore, they conclude that the inferior performance of
structural models may result from the estimation approaches
used in the existing empirical studies.
Finally, another potentially important application of cap-
ital structure model is to predict the credit quality of a
corporate security. For example, Leland (2004) examines
the default probabilities predicted by the Longstaff and
Schwartz (1995) model with the exogenous default bound-
ary, and the Leland and Toft (1996) model with endogenous
default boundary. As Leland stated
We focus on default probabilities rather than credit spreads be-
cause (i) they are not affected by additional factors such as liq-
uidity, tax differences, and recovery rates; and (ii) prediction of
the relative likelihood of default is often stated as the objective
of bond ratings.
Leland uses Moody’s corporate bond default data from
1970 to 2000 in his study and follows a similar calibra-
tion approach by Huang and Huang (2003). Rather than
matching the observed default frequencies, Leland instead
chooses common inputs across models to observe how well
they match observed default statistics. The empirical re-
sults show that when costs and recovery rates are matched,
the exogenous and the endogenous default boundary mod-
els fit observed default frequencies equally. The models pre-
dict longer-term default frequencies quite accurately, while
950
shorter-term default frequencies tend to be underestimated.
Thus, he suggests that a jump component should be included
in asset value dynamics.23
In summary, the empirical performance of capital struc-
ture models in pricing risky debt is not satisfactory. Even
with the incorporation of jump process, the illiquid corporate
bond market still hinders structural models from accurately
pricing risky debt. However, predicting the credit quality of
a corporate security could be a good application of capital
structure models because they are less affected by the mi-
cro structure issues. Since recent capital structure models put
numerous efforts on the event of bankruptcy, prediction of
default probabilities or default events shall be potentially im-
portant applications.24
60.6 Conclusion
In this paper, we review the most important and represen-
tative capital structure models. The capital structure mod-
els incorporate contingent claim valuation theory to quan-
titatively analyze prevailing determinants of capital structure
in corporate finance literature. In capital structure models,
the valuation of corporate securities and financial decisions
are jointly determined. Most of the capital structure models
provide closed-form expressions of corporate debt as well as
the endogenously determined bankruptcy level, which are ex-
plicitly linked to taxes, firm risk, bankruptcy costs, risk-free
interest rate, payout rates, and other important variables. The
behavior of how debt values (and therefore yield spreads) and
optimal leverage ratios change with these variables can thus
be investigated in detail.
While theoretically elegant, capital structure models do
not perform well empirically in risky corporate bond pricing.
Researchers have been attempting to resolve the yield spread
underestimates by introducing jumps and liquidity premium.
On the other hand, since recent capital structure models put
numerous efforts on the event of bankruptcy, we suggest
that prediction of default probabilities or default events shall
be potentially important applications. Furthermore, some re-
searchers argue that the past poor performance of capital
structure models may come from the estimation approaches
historically used in the empirical studies (Ericsson and
Reneby 2005, Ericsson, Reneby, and Wang 2006). And we
have seen some innovative estimation methods for solving
23
We should note that Zhou (2001) show that jumps can explain why
yield spreads remain strictly positive even as maturity approaches zero.
24
In default prediction, some researchers have conducted empirical in-
vestigation on a company basis analysis such as Chen et al. (2006) and
Chen et al. (2008), though the models they tested are mainly bond pric-
ing models.
S.-S. Chen et al.
the estimation problem in models employing structural ap-
proach (see Bruche 2005) and the reference therein). Thus,
we hope to see more rigorous empirical studies for capital
structure models in the future.
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