Corporate Debt Value, Bond

Covenants, and Optimal

Capital Structure
Hayne E. Leland
Journal of Finance, 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 (1974); Black and Cox

(1976) models
Common Assumptions
Firm value follows a continuous time diffusion process.
Volatility and the risk free rate r are constant over time.
Net payout rate by the firm CF = 0 (Payouts to security
holders financed by additional equity issuance)
There are no default costs or tax advantages to debt (so no
optimal capital structure MM world)

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

Merton (1974); Black and Cox

(1976) models
Black & Cox model:
Perpetual debt (no principal repayment), constant coupon rate C
Default at any t, upon first passage of V(t) to default barrier VB
At default, bond holders get nonrandom VB, equity holders gets
zero

Merton, B & C Shortcomings:

Dont allow for debt that is coupon-paying and has finite
maturity
Dont allow analysis of optimal debt amount/maturity (capital
structure) without introduction of taxes, default costs
Have regularly-observed empirical difficulties:
Spreads too low for low-risk and low maturity debt (Jones, Mason, &
Rosenfeld (1984), others.)

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.

Securities with no explicit time dependence =>

Ft(V,t)=0.
Then, we have the solution:
Any time-independent claim with equityfinanced payout C must obey equation (4).

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).

Eq. (4) with appropriate boundary conditions gives

closed forms for BC(V) and TB(V).
Now, total value of the firms is given as:

And equity value is given as:

Specific Cases for VB

Two possible triggers of default are considered in
the paper.
1. Unprotected Debt, Endogenous Bankruptcy
Firm chooses VB so as to maximize equity value.

2. Protected Debt, Positive Net Worth Covenant

Bankruptcy when firm value falls below the face value of debt.

Well see the closed form solutions and comparative

statistics for each case.

Closed-Form Solutions: Unprotected Debt

Comparative Statics: Unprotected Debt

Table I: These are the comparative statics for an
arbitrary coupon C.

Comparative Statics: Unprotected Debt

Most signs as expected.
But when firm is close to bankruptcy (V VB),
some effects reversed (iff >0 or >0).
Since VB is endogenous and VB if or r or C
So, behavior of junk bonds different from investment
grade bonds!

Equity value results (last row) dont reverse near

bankruptcy!
Since bankruptcy costs borne by bondholders.

Comparative Statics: Unprotected Debt; D(V)

Comparative Statics: Unprotected Debt; D(V)

Comparative Statics: Unprotected Debt; D(V)

Comparative Statics: Unprotected Debt; Yield

Comparative Statics: Unprotected Debt; Yield

Comparative Statics: Unprotected Debt; Firm Value

Comparative Statics: Unprotected Debt; Firm Value

Optimal Leverage with Unprotected Debt

At a given asset value V, the coupon C determines
the debt level and hence the leverage ratio.
The optimal coupon which maximizes v is:

Other metrics computed at C* are:

Comparative Statics at Optimal

Leverage Ratio, Unprotected Debt
Table II

Comparative Statics at Optimal

Leverage Ratio, Unprotected Debt

Comparative Statics at Optimal

Leverage Ratio, Unprotected Debt

Now, Protected Debt

Bankruptcy triggered when firm value falls below
principal value of debt (D0).
If V0 is asset value when debt is initiated, then D0 is
given as:
No closed form solution unless = 0.

Plugging VB = D0 gives debt value as a function of

V0.

Protected Debt, Comparative Statics

Protected Debt, Comparative Statics

Protected Debt, Comparative Statics

Protected Debt, Comparative Statics

No closed-form solutions for = 0
Some differences when compared to unprotected
debt.

Comparing with observed values

Empirically Observed:
Leverage in companies with highly rated debt = 40%
Average yield spread of investment grade corporate
bonds during 1926-86 = 77 bps
Subtracting 25 bps for call provision premium, avg. yield
= 52 bps

Model parameters: 2=20%, =35%, r=6%, =50%

Unprotected Debt: Optimal leverage=75%, Yield
spread=75 bps, Equity return annual std. dev.=57%
Protected Debt: Optimal leverage=45%, Yield
spread=45 bps, Equity return annual std. dev.=34%

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.

When all these are incorporated together:

Unprotected Debt: Optimal leverage=47%, Yield
spread=69 bps, Equity return annual std. dev.=36%
Protected Debt: Optimal leverage=32%, Yield spread=52
bps, Equity return annual std. dev.=29%

Protected vs. Unprotected Debt

Asset substitution problem: Equity holders prefer to
make firms activities riskier to increase equity
value at the expense of debt.
But, higher risk benefits equity holders if equity is
convex function of V.
This is so with unprotected debt

With protected debt, equity is concave in V.

Numerically, suppose 2=20%, =35%, r=6%,
=50%

Protected vs. Unprotected Debt

Unprotected debt: optimal C = $6.5, firm
value=$128.4, VB=$52.8
Protected debt: optimal C = $3.26, firm
value=$113.3, VB=$50.6
If asset volatility is changed by managers, then:

Firm value with unprotected debt and 60% vol. is

$111.7 < $113.3.

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.