Endogenous Bankruptcy, Endogenous Restructuring, and Dynamic Capital Structure

An acceptable model of capital structure theory must be able to explain both the wide range of debt ratios observed, and the apparently large tax advantage to debt, as evidenced by the large premiums paid during leveraged buyouts. Generalizing the framework of Leland (1994b), this paper investigates optimal dynamic capital structure strategy. In contrast to Fischer, Heinkel and Zechner (1989), the value of the unlevered firm is specified exogenously, permitting an accurate estimate of the tax advantage to debt. Implications for the asset substitution problem are also examined