Optimum Corporate Leverage with Risky Debt : A Demand Approach

Traditional static models of corporations' interior optimum leverage rely on institutional mechanisms such as taxes, bankruptcy costs, and agency costs. Theories of leverage indifference in the presence of risky debt depend on various features of perfect and complete markets and on the assumption that all investors hold a uniform portfolio. In the model developed here, corporate interior optimum leverage is obtained as a result of a fundamental risk-return trade-off for investors who hold non-uniform portfolios of risky equity and debt claims in the absence of market mechanisms that would force leverage indifference. The dynamic optimization solution accommodates bankruptcy costs and specialized institutional factors but does not rely on their presence