ABEL-2018-The Journal of Finance

THE JOURNAL OF FINANCE • VOL. LXXIII, NO.
1 • FEBRUARY 2018
Optimal Debt and Profitability in

the Trade-Off Theory
ANDREW B. ABEL∗
ABSTRACT
I develop a dynamic model of leverage with tax deductible interest and an endoge-
nous cost of default. The interest rate includes a premium to compensate lenders for
expected losses in default. A borrowing constraint is generated by lenders’ unwilling-
ness to lend an amount that would trigger immediate default. When the borrowing
constraint is not binding, the trade-off theory of debt holds: optimal debt equates
the marginal interest tax shield and the marginal expected cost of default. Contrary
to conventional interpretation, but consistent with empirical findings, increases in
current or future profitability reduce the optimal leverage ratio when the trade-off
theory holds.
THE TRADE-OFF THEORY OF capital structure is the longest standing theory of

capital structure1 and underlies much of the large body of empirical work on
capital structure. According to the trade-off theory, the optimal amount of debt
equates the marginal benefit of a dollar of debt arising from the tax deductibil-
ity of interest payments with the marginal cost of a dollar of debt arising from
increased exposure to default. This framework implies that changes in leverage
over time, or variation in leverage across firms, can be attributed to differences
in the marginal interest tax shield and/or differences in the marginal cost of
default. The trade-off theory has been conventionally interpreted2 as implying
that more profitable firms should have higher leverage ratios—a prediction
that runs counter to the empirical fact3 that more profitable firms tend to
∗ Andrew B. Abel is with the Department of Finance of the Wharton School of the University
of Pennsylvania and the National Bureau of Economic Research. I thank Jeff Campbell, Marco
Giometti, Vincent Glode, Joao Gomes, Christian Goulding, Richard Kihlstrom, Bob McDonald,
Adriano Rampini, Scott Richard, Michael Roberts, Ali Shourideh, Toni Whited, and seminar par-
ticipants at the Federal Reserve Bank of Chicago, Kellogg Finance, MIT Finance, Shanghai Ad-
vanced Institute of Finance, Wharton Finance, the Tepper/LAEF Conference on Macro-Finance,
and the Tel Aviv University Finance Conference for helpful comments and discussion. I also thank
the Editor, Associate Editor, and two referees for helpful comments. Part of this research was
conducted while I was a Visiting Scholar at Chicago Booth and I thank colleagues there for their
hospitality and support. I have read the Journal of Finance’s disclosure policy and have no conflicts
of interest to disclose.
1 See Robichek and Myers (1966), Kraus and Litzenberger (1973), and Scott (1976).
2 See Scott (1976), Fama and French (2002), and Frank and Goyal (2008).
3 See Fama and French (2002).
DOI: 10.1111/jofi.12590
95
96 The Journal of FinanceR
have lower leverage ratios.4 Notable exceptions to this interpretation are pre-
sented in quantitative models by Hennessy and Whited (2005) and Strebulaev
(2007). In the stochastic dynamic model presented in this paper, I analytically
demonstrate an alternative explanation of the negative relationship between
profitability and leverage that is found empirically.
In this paper, I develop and analyze a model of capital structure that in-
corporates an interest tax shield as well as the possibility of default. In some
situations, the optimal amount of debt is determined by the equality of the
marginal benefit of debt arising from the interest tax shield and the marginal
cost of debt associated with increased probability of default—that is, optimal
debt will be characterized by the trade-off theory. However, in other situa-
tions within the model, optimal debt is not characterized by the equality of the
marginal benefit and the marginal cost that epitomizes the trade-off theory.
Because the model allows for situations in which the trade-off theory holds
and situations in which it does not hold, it has the potential to guide empirical
tests by including both a null hypothesis in terms of the trade-off theory and
an alternative hypothesis that offers an explanation of leverage other than the
trade-off theory. In particular, I show that the model developed here accom-
modates situations in which higher profitability (either current profitability or
expected future profitability) is associated with lower leverage, specifically, a
lower value of market leverage, which is the ratio of debt to the market value of
the firm. Furthermore, if the probability of default is nonzero, these situations
arise when and only when the trade-off theory is operative. Thus, the empirical
finding that more profitable firms tend to have lower leverage ratios, which has
been interpreted by others as evidence against the trade-off theory, is viewed
as evidence in favor of the trade-off theory when seen through the lens of the
model presented here.
As the trade-off theory has been developed over the past half century, it
has become increasingly complex, especially in empirical structural models of
the firm designed to capture realistic features of a firm’s environment.5 The
model I develop here is stripped of these complexities so that I can focus on
its new features and implications in a framework that admits analytic results
without relying on numerical solution. The model’s biggest departure from
standard models of debt concerns the maturity of debt. Many standard models
of debt6 assume that debt has infinite maturity and pays a fixed coupon over the
infinite future, or until the firm defaults. The assumption of infinite maturity
is clearly extreme, but it has been used productively over the years. I also make
an extreme assumption about maturity, but in the opposite direction: I assume
that debt must be repaid an instant after it is issued. The standard specification
with infinite maturity can be viewed as the limiting case of long-term debt,
4 For instance, Myers (1993, p. 6) states that “The most telling evidence against the static trade-
off theory is the strong inverse correlation between profitability and financial leverage . . . . Yet the
static trade-off story would predict just the opposite relationship. Higher profits mean more dollars
for debt service and more taxable income to shield. They should mean higher target debt ratios.”
5 See Hennessy and Whited (2007).
6 See Modigliani and Miller (1958), Leland (1994), and Gorbenko and Strebulaev (2010).
Optimal Debt and Profitability in the Trade-off Theory 97
while my specification with zero maturity can be viewed as the limiting case of
short-term debt, such as commercial paper, much of which has a maturity of
only one to four days,7 as well as overnight repurchase agreements.
The specification of zero-maturity debt is motivated by two considerations.
First, it makes salient the recurrent nature of the financing decision, in contrast
to the once-and-for-all financing decision in many models of debt.8 At each
instant, the firm decides whether to repay its debt or to default; if it decides to
repay its debt, it also chooses the amount of debt to issue anew. Because I do not
include any flotation, issuance, or adjustment costs, the amount of debt issued
responds immediately and completely to changes in the firm’s environment,
and hence does not have the rich dynamics documented and analyzed by Leary
and Roberts (2005). Second, zero-maturity debt is always valued at par, which
alleviates the need to calculate the value of debt that would arise with long-
term debt. Therefore, the firm’s decision about whether to default on its debt,
which depends on a comparison of the total value of the firm and the value of
the firm’s debt, becomes transparent.
Because firms can default on their debt, rational lenders need to account
for the probability of default, as well as their losses in the event of default,
to determine the appropriate interest rate on loans to the firm. In this paper,
risk-neutral lenders have the same information as the firm’s shareholders, and
they require a premium above the riskless rate to compensate for their expected
losses in the event of default. In addition, if the amount of debt is sufficiently
large, it will trigger immediate default. In the current framework with zero-
maturity debt, lenders avoid being subject to immediate default by refusing
to lend an amount greater than the contemporaneous value of the firm, which
itself depends on the amount of debt issued.
An important component of the firm’s financing decision is the stochastic
process for the firm’s pretax preinterest cash flow, that is, earnings before inter-
est and taxes (EBIT). I specify a continuous-time continuous-state process for
EBIT. Instead of a diffusion process, as in Leland (1994), for example, I specify a
Markov process in which EBIT remains unchanged for a random length of time
and then a new value of EBIT arrives at a date governed by a Poisson process
with arrival intensity λ. On these dates, the value of EBIT changes by a discrete
amount, and a discrete decrease in the value of EBIT can lead the firm to default
on its debt. In the event of default, a fraction α > 0 of the firm’s value disappears
as a deadweight loss and creditors take ownership of the remaining fraction
1 − α of the firm. I do not consider renegotiation between shareholders and
creditors. Shareholders and creditors have common knowledge. If they were to
renegotiate when a new realization of EBIT leads to default, the result of that
renegotiation would simply be a function of the amount of debt and the level of
7 In March 2016, the average daily issuance of nonfinancial AA commercial paper was 210
issues, which amounted to $5.3 billion. Of these issues, 53%, which accounted for 55% of the dollar
volume, had a maturity of one to four days. Source: Board of Governors of the Federal Reserve
System, Volume Statistics for Commercial Paper Issuance, Data as of April 12, 2016.
8 See Merton (1974), Leland (1994), and Gorbenko and Strebulaev (2010).
EBIT at that time. But if shareholders and lenders were to agree on terms that
would apply when a new value of EBIT leads to default, they could simply write
those terms into the debt contract, in which case the debt contract would become
state-contingent in a way that would make the instrument not look like debt.
Since I want to focus on the leverage ratio as measured using conventional debt,
I do not consider renegotiation or the sort of “prenegotiation” just described.9
For simplification, the new values of EBIT are i.i.d. across arrivals. Never-
theless, EBIT displays persistence: EBIT remains constant during each regime,
and regimes have a mean duration of 1λ , which could potentially be quite large.
The unconditional correlation between two values of EBIT that occur x > 0
units of time apart is e−λx , which is positive and declines monotonically in x.
The advantage of using the i.i.d. specification is that it allows for persistence
in EBIT as well as analytic tractability.10 In particular, as I show below, the
optimal amount of debt is invariant to contemporaneous EBIT if the value
of EBIT is high enough that the trade-off theory of debt is operative. As a
result, the leverage ratio, which is the ratio of debt to the value of the firm,
is a decreasing function of EBIT, since the value of the firm is increasing in
EBIT. The stark result that optimal debt is invariant to EBIT when the trade-
off theory is operative is a consequence of the assumption that EBIT is i.i.d.
across regimes. In Section VII, I extend the model to allow for persistence in
EBIT across regimes. I show that optimal debt is no longer invariant to EBIT
when the trade-off theory is operative. I present a simple example in which
the conditional distribution of EBIT is uniform and show that, in this example,
optimal debt and the leverage ratio are both decreasing in contemporaneous
EBIT, which reinforces the major result of the paper. I also show that the con-
ditional probability of default is a decreasing function of EBIT when and only
when the trade-off theory is operative.
When EBIT is i.i.d. across regimes, the firm’s optimal capital structure de-
pends on whether EBIT exceeds or falls short of an endogenously determined
critical value. For values of EBIT that exceed the critical value, the trade-
off theory is operative, provided that the firm faces a positive probability of
default. When the trade-off theory is operative, the optimal level of debt is in-
variant to EBIT; since an increase in EBIT increases the total value of the firm,
the optimal leverage ratio falls as profitability, measured by EBIT, increases.
This negative relationship between profitability and the leverage ratio, which
9 The debt contract that I analyze is not an optimal contract, but rather is of the form commonly
used in practice and in analytical models. Although it is not optimal, it does have the important
feature that all participants in the debt instrument participate voluntarily and are not made worse
off by participating. Biais et al. (2007) derive “performance sensitive” debt as an optimal contract
in a dynamic framework.
10 In their analysis of the impact of temporary shocks on optimal debt issuance, Gorbenko and
Strebulaev (2010) specify temporary shocks as Poisson arrivals from a given distribution; when
they consider multiple shocks over time, they assume that they are i.i.d., as in the framework used
here. The temporary shocks in Gorbenko and Strebulaev are drawn from a double exponential dis-
tribution. In contrast, the shocks in the current model are drawn from a more general distribution
on finite support for which the density is finite and nondecreasing and the restriction in equation
(2) is satisfied.
arises from the invariance of debt to EBIT, is reminiscent of Strebulaev’s (2007)

finding that, when adjustment costs prevent the level of debt from changing,
an increase in profitability reduces the leverage ratio. However, the mecha-
nisms that make debt invariant to profitability are different between the cur-
rent model and Strebulaev’s model. Specifically, the invariance of optimal debt
arises in the current model in the complete absence of any flotation, issuance,
or adjustment costs that prevent debt from adjusting in Strebulaev’s model.
For values of EBIT below the critical value, the borrowing constraint that
prevents immediate default binds. In this situation, the trade-off theory is not
operative and the optimal leverage ratio is invariant to EBIT. To summarize,
the model predicts a negative relationship between the optimal leverage ratio
and contemporaneous EBIT (which is consistent with empirical findings) when
the trade-off theory is operative but not when the constraint on the firm’s
borrowing is binding.
To examine the relationship between the optimal amount of debt and ex-
pected future profitability, I analyze the impact of a rightward translation of
the unconditional distribution of profitability. This favorable shift of the un-
conditional distribution of profitability increases the continuation value of the
firm, which the firm’s current shareholders stand to lose in the event of default;
therefore, a favorable shift of the unconditional distribution increases the cost
of default that these shareholders face.11 In response to the increased cost of
default, the firm adjusts its capital structure to reduce the probability of de-
fault. Whether this change in capital structure reduces the optimal amount of
debt depends on the unconditional distribution of profitability. In the focal case
of a uniform distribution, a rightward translation of the distribution reduces
optimal debt when the trade-off theory is operative.12 Thus, whether one ana-
lyzes the relationship between the optimal leverage ratio and contemporaneous
EBIT (as described above) or between the optimal leverage ratio and long-run
average EBIT, the model predicts a negative relationship between the optimal
leverage ratio and EBIT if the trade-off theory is operative, but not if the firm
faces a binding constraint on its borrowing.
Section I presents the economic environment facing a firm, including the
opportunity to borrow and the ability to default on outstanding debt. The
availability and terms of loans to the firm depend on the valuation of the
firm. Section II characterizes the optimal level of debt and the associated value
11 To the extent that creditors recover a portion of their loans in the event of default, the social
cost of default is smaller than the loss to current shareholders. I assume that creditors receive a
fraction 1 − α of the continuation value of the firm in the event of default, so the social cost of default
is a fraction α of the continuation value. Therefore, the social cost of default, as well as private
cost to current shareholders, is increased by a favorable shift of the unconditional distribution of
profitability.
12 Section II in the Internet Appendix, which is available in the online version of this article
on the Journal of Finance website, shows that this finding holds more broadly within the class of
truncated exponential distributions for density functions that do not slope upward too steeply. Only
for sufficiently steeply upward-sloping density functions will optimal debt increase in response to
a rightward translation of the distribution function when the trade-off theory is operative.
of shareholders’ equity, which together equal the total valuation of the firm.
An important component of this analysis is the critical value of current EBIT,
which is the boundary between low values of EBIT for which the borrowing con-
straint binds and high values of EBIT for which the borrowing constraint does
not bind. Depending on whether this critical value of EBIT is at the minimum
value of the support of EBIT, the maximum value of the support of EBIT, or in
between, the firm will find itself in one of three scenarios, which I characterize
in Section III. Although optimal behavior in two of the three scenarios can be
derived easily, optimal behavior in one of the scenarios (Scenario II) entails
more extensive analysis, which I present in Section IV. Of particular interest
is Section IVA, which interprets the analytic results in terms of the trade-off
theory. Section V demonstrates that whether Scenario I, II, or III will prevail
depends on whether the tax rate is low, intermediate, or high, and it provides
explicit expressions for the values of the tax rate associated with the bound-
aries between adjacent scenarios. Section VI analyzes the impact of a rightward
translation of the unconditional distribution of EBIT on optimal debt, share-
holder equity, the critical value of EBIT, and the probability of default. Section
VII extends the model to allow for persistence in EBIT across regimes. In the
focal case of a uniform distribution, persistence strengthens the major result
of the paper that the optimal leverage ratio is a decreasing function of EBIT
if the trade-off theory is operative. Section VIII presents concluding remarks.
To avoid disruption in the narrative flow of the paper, the proofs of all lemmas,
propositions, and corollaries are in Appendix A. Appendix B presents details on
the calculation of the value of the firm. An Internet Appendix presents closed-
form solutions for optimal debt and the value of the firm in the special case in
which the unconditional distribution of EBIT is uniform and creditors recover
zero in the event of default. It also contains a section analyzing the impact
of a rightward translation of the unconditional distribution of EBIT when the
distribution is a truncated exponential distribution.
I. The Firm’s Economic Environment

Let φ(t) be EBIT, the pretax net cash flow from operations, before interest,
at time t. The realizations of φ(t) are generated by an exogenous stochastic
process and thus are independent of any actions taken by the firm. If EBIT
at time t0 is φ(t0 ), then φ(t) remains equal to φ(t0 ) until some random date
t1 > t0 . At time t1 , a new value of EBIT, φ(t1 ), is drawn from a distribution with
c.d.f. F(φ) that has F( L) = 0, F( H ) = 1, and finite density f (φ) = F (φ) > 0
everywhere on the support [ L, H ], where −∞ < L < H < ∞. In addition,
assume that f (φ) ≥ 0 for all φ in the support of F(φ), which ensures that the
firm’s objective function is concave in debt. The unconditional
H expected value of
EBIT is assumed to be positive, that is, E{φ} = L φdF(φ) > 0, which implies
H > 0 but does not place a restriction on the sign of L. The arrival date of a
new value of EBIT, that is, the timing of t1 , is governed by a Poisson process with
an instantaneous probability λ of an arrival of a new value of φ(t). Realizations

of new values of EBIT are i.i.d. across regimes.
I assume that the firm is managed on behalf of risk-neutral shareholders
with constant rate of time preference equal to ρ > 0. Shareholders have “deep
pockets” in the sense that they can infuse an unlimited amount of funds into
the firm if its after-tax cash flow from operations net of interest is negative.
The support of the distribution for EBIT may include negative values of EBIT,
since L may be negative. If a negative realization of EBIT is sufficiently large
in absolute value or is sufficiently persistent, current shareholders might de-
cide to abandon ownership of the firm to avoid a stream of future cash flows
with negative expected present value. In principle, the shareholders of a firm
might abandon ownership of the firm either in response to unfavorable current
and prospective future EBIT or to avoid repaying the firm’s debt. My focus
in this paper is on leverage and the potential default associated with it, so I
restrict the stochastic process for EBIT such that, in the complete absence of
borrowing, risk-neutral shareholders of the firm would never find it optimal
to abandon the firm.13 To formalize this restriction, define W(φ(t)) to be the
expected present value of current and future cash flows if the firm is an all-
equity firm that never issues any debt and continues to operate forever, regard-
∞
less of the realization of φ(t). Therefore, W(φ(t)) ≡ Et { t (1 − τ )φ(s)e−ρ(s−t) ds},
where Et {} denotes the expectation conditional on information available at
time t. The Poisson arrival process for new values of φ(s) implies that
Et {φ(s)} = e−λ(s−t) φ(t) + (1 − e−λ(s−t) )E{φ} for s ≥ t, so it is straightforward to
calculate the value of an all-equity firm that operates forever as

1−τ λ
W(φ(t)) = φ(t) + E{φ} . (1)
ρ+λ ρ
Henceforth, I assume
λ
L > − E{φ}, (2)
ρ
so that W(φ(t)) > 0 for all φ(t) ≥ L and hence an all-equity firm would never
find it optimal to cease operation.14
The firm borrows by issuing bonds to risk-neutral lenders who have the
same rate of time preference, ρ, as shareholders. The maturity of these bonds
is vanishingly small. If the firm issues an amount Dt of bonds at time t, then
it must repay these bonds at time t + dt, where dt is infinitesimal. In effect,
these bonds have instantaneous maturity. The interest rate on these bonds,
r(t), is set at a level that compensates lenders for their expected losses in
the event of default. If the firm defaults on its debt, shareholders lose all
13 In contrast to this assumption, Gorbenko and Strebulaev (2010) allow the unlevered value of
the firm to become negative, in which case shareholders would abandon the firm.
14 Leland (1994, p. 1217) effectively makes the same assumption by specifying a stochastic
∞
process for the “asset value,” which corresponds to W (φ(t)) ≡ Et { t (1 − τ )φ(s)e−ρ(s−t) ds}, that is
bounded away from zero.
ownership interest in the firm and receive zero. Creditors take ownership of
the firm in default, but the act of default imposes a deadweight loss equal to
a fraction α of the value of the firm, where 0 < α ≤ 1. Therefore, in default
at time t + dt, creditors receive (1 − α)V (φ(t + dt)), where V (φ(t + dt)) is the
value of the firm, which I describe more formally in equation (7) below. Since
creditors lose the value of the bonds, Dt , but recover (1 − α)V (φ(t + dt)) in
default, the expected
loss to creditors due to default in the interval from t
to t + dt is λ V (φ(t+dt))<Dt [Dt − (1 − α)V (φ(t + dt))]dF(φ(t + dt)). Therefore, the
interest rate, r(t), that compensates lenders for the expected loss in default is

V (φ)
r(t) = ρ + λ 1 − (1 − α) dF(φ) ≥ ρ, (3)
V (φ)<Dt Dt
where the first term, ρ, is the riskless rate in the absence of any chance of
default, and the second term is the expected loss to creditors in default for each
dollar of debt they hold.
In addition to requiring an interest rate that includes compensation for the
expected loss in default, potential lenders to the firm never lend an amount
that is so large that the firm would default immediately upon receiving the
funds from issuing the bond. This limit on the amount the firm can borrow is
Dt ≤ V (φ(t)). (4)
I refer to the limit on borrowing in equation (4) as an endogenous borrowing

constraint, though it could also be described as a nonnegativity constraint on
the value of the firm’s equity, or equivalently, as limited liability.
The taxable income of the firm, denoted as y(t), is operating profit, φ(t),
minus interest payments, r(t)Dt , so using the interest rate given in equation
(3), taxable income is

y(t) = φ(t) − ρ Dt − λ [Dt − (1 − α)V (φ)]dF(φ). (5)
V (φ)<Dt
The tax rate on taxable income is constant and equal to τ , where 0 < τ < 1. If
taxable income is negative, the firm receives a tax rebate of −τ y(t) > 0.
I assume that shareholders do not retain any earnings in the firm, that is,
the firm pays out all net cash flows as dividends, dX(t), so
dX(t) = (1 − τ )y(t)dt + dDt , (6)
where dDt is the net increase in bonds at time t, which represents a net inflow
of funds to the firm. The notations dX(t) and dDt allow dividends and net
increases in bonds to be discrete amounts, rather than flows, at a point in time.
For instance, as I show below, the arrival of a new regime that increases φ(s)
by a discrete amount may increase the amount of bonds by a discrete amount
at a point in time, so that dDt and dX(t) are both positive.
The value of the firm at time t is

T
−ρ(s−t)
V (φ(t)) = max Et e dX(s) , (7)
dDs t
where T is the date at which shareholders decide to default on their debt, and
hence is endogenous. In equation (7), V (φ(t)) is the value of the firm at time t
if it arrives at time t with zero bonds outstanding. Equivalently, V (φ(t)) is the
value of the firm at time t immediately after it has paid off (with interest) its
outstanding debt issued at t − dt and before it issues new debt at time t.
To describe the timing of events around time t, it is useful to define Dt− ≡
limdt 0 Dt−dt as the amount of bonds issued by the firm an instant before time
t. The timing of events can then be summarized as follows.
1. The firm arrives at time t with Dt− bonds outstanding.

2. Profitability, φ(t), and the value of the firm, V (φ(t)), are realized and
observed by the firm and by lenders.
3. The firm decides whether to repay or default on its outstanding bonds.
(a) If V (φ(t)) < Dt− , the firm defaults on its bonds, creditors receive (1 −
α)V (φ(t)), and shareholders receive nothing.
(b) If V (φ(t)) ≥ Dt− , the firm repays its bonds and shareholders retain
ownership.
4. If shareholders retain ownership, the firm issues bonds Dt subject to the
borrowing constraint Dt ≤ V (φ(t)).
5. The firm receives φ(t), pays interest r(t)Dt , and pays taxes τ [φ(t) − r(t)Dt ].
6. The firm pays dividends dX(t) = (1 − τ )[φ(t) − r(t)Dt ] + dDt , where15
dDt = Dt − Dt− .
II. Optimal Debt, Firm Value, and Shareholder Equity

Consider the firm at time t immediately after it has repaid its bonds Dt− . At
this instant, the firm has no outstanding bonds and it decides how many bonds
to issue at time t to achieve the maximum on the right-hand side of equation (7).
The firm’s optimization problem can be represented by the Bellman equation
t1

V (φ(t)) = max Et e−ρ(s−t) dX(s) + e−ρ(t1 −t) max V (φ(t1 )) − Dt1− , 0 , (8)
Ds ≤V (φ(s)) t
where t1 is the date of the first arrival of a new regime after time t . The value of
the firm in equation (8) is the sum of two terms. The first term is the expected
present value of dividends, dX, over the interval between time t and the arrival
of a new regime at time t1 . The second term is the expected present value of the
firm at time t1 , after observing the new value of profitability, φ(t1 ). When the
15 As it turns out, the firm will change the amount of outstanding debt only at times of regime
change, when φ(s) changes. At these times, the amount of debt will change by a discrete amount,
dDt .
firm observes φ(t1 ), it can choose to become a firm with value V (φ(t1 )), but to
do so, it must repay its outstanding debt Dt1− , so the net value to shareholders
of continuing their ownership in the firm is V (φ(t1 )) − Dt1− . Provided that this
net value of continued ownership of the firm is nonnegative, shareholders will
repay their outstanding bonds and issue a new amount of bonds, Dt1 . Otherwise,
the firm will default on its bonds and shareholders lose their ownership of the
firm.
Other than deciding whether to default, the only decision that the firm makes
is how many bonds to issue at each point in time. The structure of the stochastic
process for φ(t) implies that the optimal value of Dt is simply a function of
contemporaneous φ(t). I use the notation D(φ(t)) to denote the optimal value
of Dt . Profitability is constant, and equal to φ(t), over the interval between
times t and t1 , so after-tax income, (1 − τ )y(s), and the optimal amount of
bonds outstanding, D(φ(s)), are constant and equal to (1 − τ )y(t) and D(φ(t)),
respectively, for all s in [t, t1 ). With
D(φ(s)) constant over this interval of time,
dDs = 0 for all s in (t, t1 ), but dDt =
D(φ(t)) for a firm at time t after it has repaid
its debt Dt1− .
It is straightforward but tedious to calculate the value of the firm, so I
relegate the derivation to Appendix B, where I show that
1
V (φ(t)) = max [(1 − τ )φ(t) + λv + A(Dt )], (9)
ρ+λ Dt ≤V (φ(t))
where

A(D) ≡ τ ρ + λ dF(φ) D − [α + τ (1 − α)]λ V (φ)dF(φ), (10)
V (φ)<D V (φ)<D

and v ≡ V (φ)dF(φ) is the unconditional mean of V (φ). To interpret the func-
tion A(D) in equation (10), which arises naturally in the derivation of the value
of the firm, use equation (3) to rewrite equation (10) as

A(Dt ) = τr(t)Dt − αλ V (φ)dF(φ). (11)
V (φ)<Dt
I refer to A(D) as the “trade-off function” because it contains the elements of the
trade-off theory of debt. The first term on the right-hand side of the expression
for A(Dt ) in equation (11), τr(t)Dt , is the interest tax shield, which is simply
the tax rate, τ , multiplied by interest payments, r(t)Dt . The second term is the
expected deadweight loss associated with default, where the deadweight loss
is αV (φ) if default occurs when profitability equals φ.
Equation (9) can be expressed in terms of flows at time t by multiplying
both sides by ρ + λ and then subtracting λV (φ(t)) from both sides to obtain the
Hamilton-Jacobi-Bellman equation
ρV (φ(t)) = max [(1 − τ )φ(t) + λ(v − V (φ(t))) + A(Dt )]. (12)

Dt ≤V (φ(t))
The left-hand side of equation (12), ρV (φ(t)), is the required return on the
firm, which is the product of the rate of return required by shareholders and the
value of the firm. The expected return to the firm, on the right-hand side, has
three components: the after-tax profit from operations, (1 − τ )φ(t); the expected
change in the value of the firm if the regime changes, which is the product
of λ, the instantaneous probability of a regime change, and v − V (φ(t)), the
expected change in the value of the firm when a new value of φ is drawn from
its unconditional distribution; and A(Dt ), the contribution of bond financing,
which consists of the interest tax shield, τr(t)Dt , less the expected deadweight
loss associated with default.
The optimal value of debt is the value of Dt that attains the maximum on the
right-hand side of equation (12). Since Dt enters the maximand on the right-
hand side of equation (12) only through A(D), the optimal amount of debt is16

D(φ(t)) ≡ arg max A(Dt ). (13)
Dt ≤V (φ(t))
Since A(Dt ) is independent of φ(t), the optimal value of debt, D(φ(t)), is indepen-
dent of φ(t) if the borrowing constraint, Dt ≤ V (φ(t)), is not binding. However, if
the borrowing constraint is binding, then D(φ(t)) = V (φ(t)), which is increasing
in φ(t), since, as shown in Proposition 1 below, V (φ(t)) is strictly increasing in
φ(t).
To obtain the value function, substitute the optimal amount of debt, D(φ(t)),
from equation (13) into equation (9), which yields
(1 − τ )φ(t) + λv + A(
D(φ(t)))
V (φ(t)) = . (14)
ρ+λ
PROPOSITION 1: V (φ(t)) is strictly increasing in φ(t). Moreover, for any φ2 > φ1

in the support [ L, H ], V (φφ22)−V
−φ1
(φ1 )
≥ ρ+λ
1−τ
> 0.
The proof of Proposition 1 is in Appendix A, but the logic of the proof is

straightforward. Suppose that φ2 > φ1 . If the firm were to maintain the same
level of debt at φ(t) = φ2 as at φ(t) = φ1 , which is D(φ1 ), the value of the firm
would increase by ρ+λ1−τ
(φ2 − φ1 ), so that
D(φ1 ) would be feasible when φ(t) = φ2 .
Allowing for the possibility that optimal debt changes when EBIT increases to
φ2 from φ1 implies that the value of the firm may increase by even more, so
1−τ
V (φ(t)) increases by at least ρ+λ (φ2 − φ1 ).
The following proposition is an immediate consequence of the definition of op-
timal debt, D(φ(t)), in equation (13) and the fact that V (φ) is strictly increasing
(Proposition 1).
16 Equivalently, the optimal value of D attains the maximum on the right-hand side of equation
t
(9), which, since ρ + λ > 0, is also given by equation (13).
PROPOSITION 2: The optimal value of bonds,

D(φ(t)), is
1. nondecreasing in the state, φ(t), and

2. nondecreasing in time, t, outside of default.
Proposition 2 states that the optimal value of debt never falls below previous
optimal values of debt as long as the firm does not default. This behavior is
consistent with the time path of debt in Goldstein, Ju, and Leland (2001), in
which it is assumed that, outside of default, the firm does not decrease its
debt.17
Since shareholders owe a liability of
D(φ(t)), the value of shareholders’ equity
in the firm, S(φ(t)), is
S(φ(t)) = V (φ(t)) −
D(φ(t)) ≥ 0, (15)
where the inequality is the borrowing constraint. Because shareholders receive

an amount D(φ(t)) immediately when they borrow, they choose D to maximize
V (φ(t)) = S(φ(t)) + D rather than to maximize shareholder equity exclusive of
D, S(φ(t)) = V (φ(t)) − D.
The following proposition provides bounds on the optimal amount of bonds.
Because the firm has the option to operate forever as an all-equity firm, V (φ(t))
is at least as large as W(φ(t)) in equation (1), and the assumption in equation (2)
that L > − ρλ E{φ} implies that W(φ(t)) > 0. Therefore, even the lowest value of
the firm, V ( L), is at least as high as W( L) > 0. It cannot be optimal to issue
an amount of bonds smaller than V ( L) because to do so would fail to take full
advantage of the interest tax shield, without any exposure to the possibility
of default. Therefore, the optimal amount of bonds is at least V ( L). The bor-
rowing constraint, D ≤ V (φ(t)) , implies that, even when the firm attains its
highest possible value, the firm can never issue an amount of bonds greater
than V ( H ).
PROPOSITION 3: If 0 < τ < 1, then 0 < V ( L) ≤
D(φ(t)) ≤ V ( H ).
COROLLARY 1: If 0 < τ < 1, then
D( L) = V ( L) and S( L) = 0.
Corollary 1 follows directly from Proposition 3, which implies that D( L) ≥
V ( L), and from the borrowing constraint
D( L) ≤ V ( L). Therefore,
D( L) =
V ( L). Hence, when φ(t) takes its minimum value L, the optimal amount of
debt equals V ( L), which implies that shareholders’ equity, S( L) = V ( L) −

D( L), is zero.
α
PROPOSITION 4: If (1) 0 < τ < 1+α and (2) f (φ) > 0 is nondecreasing for all
φ ∈ [ L, H ], then V (φ(t)) is concave in φ(t) on the domain [ L, H ].
17 The second paragraph of Goldstein, Ju, and Leland (2001, p. 483) begins “Below, we consider
only the option to increase future debt levels. While in theory management can both increase and
decrease future debt levels, Gilson (1997) finds that transactions costs discourage debt reductions
outside of Chapter 11.”
Proposition 4 provides sufficient conditions for the value function, V (φ(t)),

to be concave. One of the steps (formalized as Lemma A1 in Appendix A) in
the proof of Proposition 4 is to prove that if V (φ(t)) is concave, then the trade-
off function A(D) is strictly concave in D for V ( L) ≤ D ≤ V ( H ), which is
Corollary 2 below.18
α
COROLLARY 2 (to Proposition 4): If (1) 0 < τ < 1+α and (2) f (φ) > 0 is nonde-
creasing for all φ ∈ [ L, H ], then A(D) is strictly concave in D for V ( L) ≤ D ≤
V ( H ).
Define D∗ as the value of debt that maximizes the trade-off function A(D) over
D ∈ [V ( L), V ( H )], ignoring the borrowing constraint D ≤ V (φ(t)). Formally,
D∗ ≡ arg max A(D). (16)

V ( L )≤D≤V ( H )
The strict concavity of A(D) in D implies that D∗ is unique. Since A(D) is inde-
pendent of φ(t), D∗ is invariant to φ(t). If D∗ ≤ V (φ(t)), the borrowing constraint
does not bind, and optimal debt, D(φ(t)), equals D∗ . However, if D∗ > V (φ(t)),
the firm cannot borrow as much as D∗ and D(φ(t)) = V (φ(t)).
Define φ ∗ as the critical value of φ ∈ [ L, H ] above which V (φ)>D∗ and
below which V (φ)<D∗ . Formally,
φ ∗ ≡ V −1 (D∗ ). (17)
The following proposition characterizes optimal debt, D(φ(t)), shareholder

equity, S(φ(t)), and total firm valuation, V (φ(t)), first for φ(t) ≥ φ ∗ and then for
φ(t) ≤ φ ∗ .
PROPOSITION 5: Define φ ∗ so that V (φ ∗ ) = D∗ ≡ arg maxV (L)≤D≤V ( H ) A(D).
Then,
(1) for any φ(t) ≥ φ ∗ ,

(a)
D(φ(t)) = D∗ ,
(b) S(φ(t)) = ρ+λ
1−τ
[φ(t) − φ ∗ ], and
(c) V (φ(t)) = ρ+λ
1−τ
[φ(t) − φ ∗ ] + D∗ ;
∗
(2) for any φ(t) ≤ φ ,
(a)
D(φ(t)) ≡ V (φ(t)) is concave and strictly increasing in φ(t) and
(b) S(φ(t)) = 0.
Figure 1 illustrates optimal debt, shareholders’ equity, and the total value
of the firm, each as a function of φ, for V ( L) < φ ∗ < V ( H ). For φ(t) ≤ φ ∗ ,
18 Corollary 2 provides sufficient conditions for A(D) to be strictly concave in D. A necessary
condition for this strict concavity is that default imposes a deadweight cost, that is, α > 0. To see the
necessity of this condition, set α = 0 in the definition
of A(D) in equation (10) and differentiate twice
with respect to D to obtain A (D) = τ [ρ + λ V (φ)<D dF(φ)] and A (D) = τ λV −1 (D) f (V −1 (D)) > 0
because f (V −1 (D)) > 0 and V −1 (D) > 0. Therefore, if α = 0, then A(D) is strictly convex in D.
Thus, α > 0 is a necessary condition for strict concavity of A(D) in D.
Figure 1. Optimal debt, equity, and firm value. (Color figure can be viewed at wileyonlineli-
brary.com)
the borrowing constraint, D ≤ V (φ(t)), is binding, so shareholders’ equity,

S(φ(t)) = V (φ(t)) − D(φ(t)), is identically zero. In Figure 1, optimal debt, D(φ(t)),
and the value of the firm, V (φ(t)), are depicted for φ(t) ≤ φ ∗ as the upward-
sloping concave curve KL; shareholders’ equity is depicted as the horizontal line
segment on the horizontal axis for φ(t) ≤ φ ∗ . For higher values of φ(t), specif-
ically, for φ(t) ≥ φ ∗ , the borrowing constraint is not binding and D(φ(t)) = D∗ ,
as shown by the horizontal line segment starting at point L and extending to
the right. Shareholders’ equity is S(φ(t)) = ρ+λ 1−τ
[φ(t) − φ ∗ ], as shown by the line
segment starting on the horizontal axis at φ = φ ∗ and extending to the right
1−τ
with slope ρ+λ . The value of the firm is shown by the line segment LM with
1−τ
slope ρ+λ .

COROLLARY 3: Define the optimal leverage ratio as L(φ(t)) ≡ VD(φ(t))
(φ(t))
. If φ(t) ≤
∗ ∗
φ , then L(φ(t)) ≡ 1; if φ(t) ≥ φ , then L(φ(t)) = 1−τ φ(t)−φ∗
1
, which is strictly
ρ+λ D∗
+1
decreasing in φ(t).
The trade-off theory is operative when optimal debt is determined by
equating the marginal tax shield associated with interest deductibility and
the marginal default cost. Formally, the trade-off theory is operative when
A (
D(φ(t))) = 0 so that
D(φ(t)) = D∗ . Proposition 5 implies that the trade-off
theory is operative when and only when φ(t) ≥ φ ∗ . Therefore, Corollary 3 im-
plies that, when and only when the trade-off theory is operative, the optimal
leverage ratio is a decreasing function of contemporaneous profitability. This
result is remarkable because, as noted in the introduction to this paper, it is
the opposite of the conventional interpretation of the trade-off theory, which
states that the leverage ratio is increasing in profitability. However, empirical
studies find a negative relationship between the leverage ratio and productiv-
ity, consistent with Corollary 3 when the trade-off theory is operative.
Proposition 2 states that, outside of default, D(φ(t)) is a weakly increasing
function of the state φ(t) and of time t. The leverage ratio, however, is weakly
decreasing in the state φ(t) and is not monotonic in time t. To see that the lever-
age ratio can either increase or decrease over time, consider several consecutive
regimes in which φ(t) ≥ φ ∗ . The optimal value of bonds, D(φ(t)) , remains con-
stant and equal to D∗ over time since φ(t) ≥ φ ∗ . When φ(t) increases from one
of these regimes to the next regime, V (φ(t)) increases and the leverage ratio
falls; when φ(t) decreases from one of these regimes to the next regime, V (φ(t))
falls and the leverage ratio increases.
Under the optimal debt policy, D(φ(t)), the instantaneous probability of de-
fault is

P(
D(φ(t))) ≡ λ dF(φ), (18)
V (φ)<
D(φ(t))
which is the probability that a new regime arrives that induces a value of the
firm lower than the currently outstanding debt,
D(φ(t)).
PROPOSITION 6: The instantaneous probability of default P(
D(φ(t))) =
λ min[F(φ(t)), F(φ ∗ )].
In the framework analyzed here, default occurs only at times of regime
change.19 If φ(t) < φ ∗ , then D(φ(t)) = V (φ(t)), so default occurs at the next
regime change if the new value of profitability is lower than φ(t), in which
case the new value of the firm is less than V (φ(t)) = D(φ(t)). Alternatively,
if φ(t) ≥ φ ∗ , then
D(φ(t)) = D∗ = V (φ ∗ ), so default occurs at the next regime
change if the new value of profitability is less than φ ∗ , in which case the new
value of the firm is less than V (φ ∗ ) = D(φ(t)). Thus, regardless of whether φ(t)
is above or below the critical value φ ∗ , default occurs at the next regime change
if and only if the new value of profitability is less than min[φ(t), φ ∗ ].
PROPOSITION 7: The instantaneous probability of default, P(
D(φ(t))), and the
interest rate, r(t), are
1. strictly increasing in D(φ(t)),

2. strictly increasing in φ(t), if φ(t)<φ ∗ , and
3. invariant to φ(t), if φ(t) ≥ φ ∗ .
In principle, there are two endogenous channels that can increase the prob-
ability of default at the time of the next regime change, t : channel (1) is an
increase in the current amount of bonds outstanding, D(φ(t)), and channel (2)
is a shift in the distribution of φ(t ) that shifts the distribution of V (φ(t )) in an
unfavorable way. Statement 1 of Proposition 7 captures channel (1). Channel
19 The model in Gorbenko and Strebulaev (2010) has a similar feature. Specifically, in their
model, default occurs only when a new value of the temporary shock has a Poisson arrival.
(2) is not operative in the current specification because profitability, φ, is i.i.d.

across regimes, so the distribution of V (φ(t )) is invariant to φ(t).
If φ(t) < φ ∗ , an increase in current profitability, φ(t), increases the probability
of default (Statement 2 of Proposition 7) because it leads the firm to increase
its bonds, D(φ(t)) (channel (1)), and the increase in current profitability does
not improve the distribution of V (φ(t )). If φ(t) ≥ φ ∗ , an increase in φ(t) has no
effect on the probability of default. These counterintuitive results are based on
the assumption that φ(t) is i.i.d. across regimes. In Section VII, I relax this i.i.d.
assumption and allow profitability to be persistent across regimes. I show that
an increase in φ(t) can reduce the probability of default if the trade-off theory
is operative.
The following proposition describes aspects of optimal behavior when the
borrowing constraint binds, so D(φ(t)) = V (φ(t)).
PROPOSITION 8: If
D(φ(t)) = V (φ(t)), then
1. after-tax income (1 − τ )y(t) ≡ (1 − τ )[φ(t) − r(t)

D(φ(t))] ≤ 0, with strict in-
equality if φ(t) < H ,
2. after-tax income (1 − τ )y(t) is strictly increasing in φ(t), and
3. if t is not a time of regime change, then dividends dX(t) = (1 − τ )y(t) ≤ 0.
Statement 1 of Proposition 8 implies that if the after-tax income of the firm

is positive, the borrowing constraint,
D(φ(t)) ≤ V (φ(t)), cannot bind. Statement
2 says that the after-tax income of the firm is strictly increasing in φ(t) if the
borrowing constraint is binding, that is, if φ(t) < φ ∗ .20 Statement 3 says that if
the borrowing constraint is binding, and if there is not a change in regime, the
shareholders of the firm will not receive positive dividends. Negative dividends
in this context means that the shareholders inject funds into the firm to cover
the negative flow of after-tax income because the binding borrowing constraint
prevents the firm from issuing additional debt to cover the negative after-tax
income.
III. Three Scenarios

∗
Equation (16) defines D as the value of D that maximizes A(D) over the in-
terval V ( L) ≤ D ≤ V ( H ). In this section, I define and analyze three scenarios
that are distinguished by whether the lower bound D ≥ V ( L) strictly binds,
the upper bound D ≤ V ( H ) strictly binds, or neither bound strictly binds. For-
mally, Scenario I is the set of configurations of λ, ρ, α, τ , and F(φ) for which
the lower bound on D strictly binds, Scenario II is the set of configurations for
which neither bound strictly binds, and Scenario III is the set of configurations
for which the upper bound on D strictly binds.
20 If φ(t) ≥ φ ∗ , after-tax income, (1 − τ )[φ(t) − r(t)

D(φ(t))], is also strictly increasing in φ(t) be-
cause r(t) and D(φ(t)) are invariant to φ(t) when φ(t) ≥ φ ∗ . Therefore, after-tax income is strictly
increasing in φ(t) regardless of whether the borrowing constraint binds.
The definition of D∗ in equation (16), D∗ ≡ arg maxV (L)≤D≤V ( H ) A(D), implies

that
D∗ = arg max A(D) + ω1 (D − V ( L)) + ω2 (V ( H ) − D), (19)

D
where ω1 ≥ 0 is the multiplier on the constraint V ( L) ≤ D and ω2 ≥ 0 is the

multiplier on the constraint D ≤ V ( H ). The first-order condition for optimal
D is
A (D∗ ) = ω2 − ω1 , (20)
and the complementary slackness conditions are
ω1 (D∗ − V ( L)) = 0 (21)
and
ω2 (V ( H ) − D∗ ) = 0. (22)
Three distinct scenarios are defined according to whether the multipliers ω1

and ω2 are positive or zero:21
r Scenario I: ω1 > 0 and ω2 = 0,
r Scenario II: ω1 = ω2 = 0, and
r Scenario III: ω1 = 0 and ω2 > 0.
In the remainder of this section, I focus on Scenarios I and III. I analyze

Scenario II in more detail in Section IV.
A. Scenario I
In Scenario I, ω1 > 0 and ω2 = 0, so the first-order condition in equation
(20) implies A (D∗ ) = −ω1 < 0. Thus, the marginal interest tax shield, which
provides an incentive to increase the amount of debt, is overwhelmed by the
marginal expected cost of losing the continuation value of the firm in default.
The complementary slackness condition in equation (21) implies D∗ = V ( L).
Therefore, the optimal value of debt is V ( L), which is the highest value of
debt that the firm can issue without facing a positive probability of default.
PROPOSITION 9: Define D0 ≡ ρ+λ 1
[ L + ρλ E{φ}]. In Scenario I (where ω1 > 0 and
ω2 = 0), for all φ(t) ∈ [ L, H ],
1.
D(φ(t)) = D∗ = D0 , which is invariant to φ(t) and τ ,
2. S(φ(t)) = ρ+λ
1−τ
(φ(t) − L), and
3. V (φ(t)) = D0 + ρ+λ
1−τ
(φ(t) − L).
21 Since V ( L) = V ( H ), ω1 and ω2 cannot both be positive.

Proposition 9 states that, in Scenario I, the optimal value of debt equals D0 ,

which is invariant to both the tax rate and the current value of EBIT. The
invariance of optimal debt with respect to the tax rate reflects the fact that at
the margin, the tax shield is so weak that it is completely outweighed by the
cost of default. Therefore, shareholders choose not to expose the firm to the
probability of default. Nevertheless, because the tax rate τ is positive, the firm
takes advantage of the tax shield on interest by choosing the maximal amount
of debt that does not risk default. In fact, when φ(t) = L, the firm uses the
tax shield to completely insulate its value from taxes. That is, when φ(t) = L,
the ability to issue bonds and deduct interest payments increases the total
value of the firm to V ( L) = D0 = ρ+λ1
[ L + ρλ E{φ}] from ρ+λ
1−τ
[ L + ρλ E{φ}] in
the absence of debt.
B. Scenario III
In Scenario III, ω1 = 0 and ω2 > 0, so the first-order condition in equation
(20) implies that A (D∗ ) > 0. The complementary slackness condition in equa-
tion (22) implies that D∗ = V ( H ). Therefore, since A(D) is strictly concave in
D, A (D) > 0 for all D ∈ [V ( L), V ( H )]. The marginal interest tax shield asso-
ciated with an increase in debt overwhelms the increased exposure to default
associated with an increase in debt. Therefore, the firm will issue as much debt
as it can, driving shareholders’ equity to zero, so that D(φ(t)) ≡ V (φ(t)) for all
φ(t) ∈ [ L, H ].
PROPOSITION 10: In Scenario III (where ω1 = 0 and ω2 > 0), V ( H ) = 1

ρ+λ
[ H +
(1 − α)λv].
The expression for the value of the firm at φ(t) = H depends on v as well
as on the exogenous parameters ρ, λ, H , and α. In the special case in which
default destroys the entire value of the firm (α = 1), Proposition 10 implies
V ( H ) = ρ+λ
1
H , which is simply the expected value of the flow of H from the
current time until the next regime change, which triggers default because the
new value of V (φ(t)) will be less than D( H ) = V ( H ). In this special case, firm
value, V ( H ), is completely insulated from taxes.
IV. Scenario II
Suppose that the firm is in Scenario II, so ω1 = ω1 = 0. Then, equation (20)
implies that A (D∗ ) = 0. Differentiating A(D) in equation (10) with respect to D
and evaluating A (D) at D = D∗ yields
A (D∗ ) = τ [ρ + λF(V −1 (D∗ ))] − (1 − τ )αλV −1 (D∗ )D∗ f (V −1 (D∗ )) = 0. (23)
The following lemma provides a simple expression for V −1 (D∗ ), which ap-
pears in the second term in equation (23).
ρ+λ
LEMMA 1: If ω1 = ω2 = 0, then V (φ ∗ ) = 1−τ
ρ+λ
and V −1 (D∗ ) = 1−τ
, where φ ∗ ≡
V −1 (D∗ ).
Use Lemma 1 to rewrite equation (23) as
A (D∗ ) = τ [ρ + λF(V −1 (D∗ ))] − (ρ + λ)αλD∗ f (V −1 (D∗ )) = 0. (24)
Because A(D) is strictly concave, there is at most one value of D∗ that sat-
isfies equation (24).22 For φ(t) ≥ φ ∗ ≡ V −1 (D∗ ), the borrowing constraint does
not bind and the optimal amount of debt is D∗ ; for φ(t) < φ ∗ ≡ V −1 (D∗ ), the
borrowing constraint binds and the optimal value of debt equals the value of
the firm, V (φ(t)).
A. The Trade-Off Theory

When the borrowing constraint is not binding, the optimal amount of debt
is D∗ , which satisfies the first-order condition, A (D∗ ) = 0, in equation (24).23
To interpret that first-order condition in terms of the trade-off theory, I rewrite
it as
τ (ρ + λF(φ ∗ )) = (ρ + λ)αλD∗ f (φ ∗ ), (25)
where φ ∗ ≡ V −1 (D∗ ). First, consider the special case in which α = 1, so that
default completely destroys the firm. In this case, the interest rate in equa-
tion (3) is ρ + λF(φ ∗ ), so the left-hand side of equation (25) is simply τr(t),
which is the marginal interest tax shield associated with an additional dollar
of debt. To see why, suppose that the firm issues an additional dollar of debt
at time t0 , pays interest ρ + λF(φ ∗ ), and then repays the dollar of debt at time
∗
t0 + dt with probability e−λF(φ )dt , which is the probability that it is not opti-
mal to default at t0 + dt or earlier. Then, if the interest rate were to remain
unchanged at ρ + λF(φ ∗ ), the additional dollar of debt would increase the ex-
pected present value of the firm’s after-tax cash flow over the next interval
22 There exists a value of D∗ that satisfies equation (24) if τ ≤ τ ≤ τ , where τ and τ

L H L H are
defined in Proposition 11.
23 Flotation costs for bonds can lead to a modification of the trade-off theory. For instance, let c(D)
be the cost of issuing D units of bonds, and assume that c(0) = 0, c (D) ≥ 0, and c (D) ≥ 0 for D ≥ 0.
Subtracting these flotation costs from operating profits, the value of the firm in equation (9) can
be written as V (φ(t)) = ρ+λ 1
max Dt ≤V (φ(t)) [(1 − τ )φ(t) + λv +
A(Dt )], where A(Dt ) ≡ A(Dt ) − c(Dt ) is a
“modified trade-off function.” Since A(Dt ) is strictly concave and c(Dt ) is convex, the modified trade-
off function, A(Dt ), is strictly concave. Define D∗ ≡ max Dt ≤V ( H ) A(Dt ). Suppose that c (V ( L)) <

τρ, so that if Dt ≤ V ( L), then A (Dt ) = A (Dt ) − c (Dt ) = τρ − c (Dt ) > 0, where the first equality
follows from the definition of A(Dt ), the second equality follows from the definition of A(D), which
implies A(D) ≡ τρ D for D ≤ V ( L), and the final inequality follows from c (V ( L)) < τρ and the
convexity of c(D). Therefore, V ( L) < D∗ ≤ V ( H ) and for any φ(t) ≥ V −1 ( D∗ ), the optimal amount
of debt,
D(φ(t)), equals D∗ and hence is invariant to φ(t). The optimal amount of debt for these
values of φ(t) satisfies A (
D(φ(t))) = 0, which can be viewed as a “modified trade-off theory.” Note
that, when A (D) = 0, A (D) = c (D) > 0. In this case, the marginal interest tax shield is equal to
the marginal expected cost of default, plus the marginal flotation cost, c (D). When this modified
trade-off theory holds, the optimal leverage ratio will be a declining function of φ(t), as in the text.
∗
dt of time by 1 − (1 − τ )(ρ + λF(φ ∗ ))dt − e−ρdt e−λF(φ )dt , which equals the left-
hand side of equation (25) for small dt. Thus, the left-hand side of equation
(25) is the marginal interest tax shield associated with an additional dollar of
debt.
The right-hand side of equation (25) is the marginal cost associated with the
increased probability of default resulting from an additional dollar of debt. By
increasing the probability of default, a one-dollar increase in debt increases
the default premium, and hence increases the interest rate, ρ + λF(φ ∗ ), paid
by the firm. To measure the increase in the probability of default, define ψ(D)
as the threshold value of φ that triggers default when outstanding debt is
D. Formally, D ≡ V (ψ(D)), so 1 = V (ψ(D))ψ (D). Since V (φ ∗ ) = 1−τ r+λ
(Lemma
∗ ρ+λ
1), ψ (D ) = 1−τ . Therefore, a one-unit increase in D increases the threshold
level of φ at which default occurs by ψ (D∗ ) = ρ+λ 1−τ
and thus increases the prob-
ability of default by λ f (φ ∗ )ψ (D∗ ) = λ f (φ ∗ ) ρ+λ
1−τ
, which, in the case in which
∗ ρ+λ
α = 1, increases the interest rate by λ f (φ ) 1−τ and increases the total flow of
after-tax interest payments at time t0 by λ f (φ ∗ )(ρ + λ)D∗ , which is the right-
hand side of equation (25) when α = 1. Therefore, equation (25) represents
the equality of the marginal interest tax shield and the marginal cost associ-
ated with increased exposure to default, which is the essence of the trade-off
theory.
In the more general case in which α ≤ 1, the interpretation of equation (25)
in terms of the trade-off theory is more nuanced. Define R(D, φ0 ) as the flow of
(pretax) interest payments at time t if the amount of outstanding debt is D and
if the firm defaults if and only if φ < φ0 . Then,
φ0
R(D, φ0 ) ≡ (ρ + λF(φ0 ))D − λ(1 − α) V (φ)dF(φ), (26)
L
so that R(Dt , ψ(Dt )) = r(t)Dt , where r(t) is the interest rate in equation (3). If
the value of φ that triggers default, φ0 , were to remain
∗
unchanged, an increase
in debt would increase interest payments by ∂ R(D ∂D
,φ0 )
= ρ + λF(φ0 ). Therefore,
when D = D∗ and φ0 = φ ∗ , a one-dollar increase in D increases the tax shield
associated with interest deductibility by
∂ R(D∗ , φ ∗ )
τ = τ (ρ + λF(φ ∗ )). (27)
∂D
Therefore, the left-hand side of equation (25) is the marginal tax shield.
Now consider the impact on interest payments of an increase in φ0 , holding
the amount of debt unchanged. Partially differentiating equation (26) with
respect to φ0 , evaluating this derivative at φ0 = φ ∗ , and using V (φ ∗ ) = D∗ yields
∂ R(D∗ , φ ∗ )
= αλ f (φ ∗ )D∗ . (28)
∂φ0
Equation (28) implies that if φ0 were to increase by ψ (D∗ ), as would be the case
if D were to increase by one dollar, after-tax interest payments would increase
by
∂ R(D∗ , φ ∗ ) ∗
(1 − τ ) ψ (D ) = (ρ + λ)αλ f (φ ∗ )D∗ . (29)
∂φ0
The left-hand side of equation (29) is the marginal expected default cost, mea-
sured in flow terms, which reflects the increased probability of default when
D increases by one dollar. Specifically, a one-dollar increase in D increases the
default threshold φ0 by ψ (D∗ ) = ρ+λ1−τ
, thereby increasing total interest costs by
∂ R(D∗ ,φ ∗ ) ∗ ∗
∂φ0
ψ (D ) and after-tax interest costs by (1 − τ ) ∂ R(D
∗
∂φ0
,φ )
ψ (D∗ ), which is the
left-hand side of equation (29). The right-hand side of equation (29) is identical
to the right-hand side of equation (25), so the right-hand side of equation (25)
is the marginal expected cost of default associated with a one-dollar increase
in D. Thus, equation (25) is a statement of the trade-off theory, equating the
value of the interest tax shield associated with an additional dollar of debt, ex-
pressed per unit of time, and the marginal cost of increased exposure to default
resulting from this increased debt, also expressed per unit of time.
B. Firm in Scenario II with φ(t) ≤ φ ∗

Suppose that the firm is in Scenario II and φ(t) ≤ φ ∗ . In this case, the firm
issues as much debt as it can, driving the equity value to zero, so V (φ(t)) =

D(φ(t)) and S(φ(t)) = 0. Substitute
D(φ(t)) for V (φ(t)) in equation (14), multiply
both sides of the resulting equation by ρ + λ, and subtract A( D(φ(t))) from both
sides to obtain
(ρ + λ)
D(φ(t)) − A(
D(φ(t))) = (1 − τ )φ(t) + λv, if φ(t) ≤ φ ∗ . (30)
Differentiate both sides of equation (30) with respect to φ(t) to obtain the
ordinary differential equation (ODE)24,25
(ρ + λ − A (
D(φ(t))))
D (φ(t)) = 1 − τ . (31)
The boundary condition for the ODE in equation (31), which takes the form of
a value-matching condition, is

D(φ ∗ ) = D∗ . (32)
24 This ODE is solved in the Internet Appendix in the special case in which α = 1 and the
distribution F is uniform.
25 Differentiate equation (31) with respect to φ(t) to obtain (ρ + λ − A ( D(φ(t))))
D (φ(t)) −
A (
D(φ(t)))(
D (φ(t)))2 = 0. Differentiating A(D) in equation (10) with respect to D implies that
A (D) < τ (ρ + λ) < ρ + λ, so that D (φ(t)) has the same sign as A (
D(φ(t))), which is negative if
α
τ < 1+α , and f (φ) ≥ 0.
Evaluate equation (31) at φ(t) = φ ∗ and use A (D∗ ) = 0 and the boundary con-
dition in equation (32) to obtain
1−τ
D (φ ∗ ) = . (33)
ρ+λ
Since equation (33) was derived from the ODE that holds for φ ≤ φ ∗ , the
derivative in equation (33) is actually the left-hand derivative. Since V (φ(t)) ≡

D(φ(t)) for L ≤ φ(t) ≤ φ ∗ , equation (33) implies that the left-hand derivative of
V (φ(t)) at φ(t) = φ ∗ is ρ+λ
1−τ
. Proposition 5 implies that the right-hand derivative
∗
of V (φ(t)) at φ(t) = φ is also ρ+λ
1−τ
. Therefore, the right- and left-hand derivatives
∗
of V (φ(t)) at φ(t) = φ are equal to each other.
The value-matching condition in equation (32) is illustrated in Figure 1 at
point L, where the curve through K and L, which represents V (φ) for φ ≤ φ ∗ ,
meets the line segment LM, which represents V (φ) for φ ≥ φ ∗ . As discussed,
the left- and right-hand derivatives of V (φ) are equal to each other at φ = φ ∗ , so
the meeting of the curve through K and L and the line segment LM is smooth,
that is, differentiable, at point L.26
V. Threshold Tax Rates

The tax rate, τ , determines whether the firm is in Scenario I, II, or III.
For low values of τ > 0, the marginal interest tax shield is so small that it is
overwhelmed by the marginal expected default cost, and hence the firm is in
Scenario I, where it does not expose itself to any chance of default. For high
values of τ , the marginal interest tax shield is so strong that the firm always
borrows as much as lenders are willing to lend, and hence the firm is in Scenario
III. For intermediate values of τ , defined in the following proposition, the firm
is in Scenario II, where the trade-off theory is operative if φ(t) ≥ φ ∗ and the
borrowing constraint binds if φ(t) < φ ∗ .
PROPOSITION 11: Define τ L ≡ α ρλ f ( L)( L + ρλ E{φ}) > 0 and τ H ≡ α ρ+λ
λ
f ( H )
( H + (1 − α)λv) > 0. Suppose τ L < τ H . Then:
27
26 This smooth meeting of the curve through K and L and the line segment LM is superficially
similar to the smooth-pasting condition that arises in optimal stopping problems with an under-
lying diffusion process. In those problems, the value-matching and smooth-pasting conditions are
two separate boundary conditions that pin down two parameters in the solution. In the current
framework, the fundamental stochastic variable has finite variation, whereas in optimal stopping
problems with a diffusion process, the stochastic variable has infinite variation. In the current
framework, equality of the left- and right-hand derivatives of V (φ(t)) at φ = φ ∗ arises as a conse-
quence of the value-matching condition. That equality does not impose any additional structure or
restriction on the solution.
27 The interval τ ≤ τ ≤ τ τL
L H is nonvacuous if τ ≤ 1. Using the definitions of τ L and τ H ,
H
λ λ λ λ
τL ρ ( L + ρ E{φ}) f ( L ) ρ ( L + ρ E{φ}) f ( L )
τH = λ ( +(1−α)λv) f ( H )
≤ λ f ( H )
, where the inequality follows from (1 − α)λv ≥ 0 .
ρ+λ H ρ+λ H
τL
Therefore, τH ≤ (1 + γ ) L+γ

E{φ} f ( L )
f ( H )
, where γ ≡ λ
ρ . As an example, if f (φ) is the density of a
H
f ( L ) 1 τL 1 (2 L +γ ( L + H ))
uniform distribution, then f ( H )
= 1 and E{φ} = 2 ( L + H ), so τ H ≤ 2 (1 + γ ) H =
Figure 2. Three scenarios. (Color figure can be viewed at wileyonlinelibrary.com)
(1) If τ < τ L, the firm is in Scenario I and D(φ(t)) = ρ+λ

1
[ L + ρλ E{φ}] for all
φ(t) ∈ [ L, H ].
(2) If τ L ≤ τ ≤ τ H , the firm is in Scenario II and
(a) D(φ(t)) = D∗ for φ(t) ≥ φ ∗ ,
(b) D(φ(t)) = V (φ(t)) for φ(t) ≤ φ ∗ .
(3) If τ H < τ < 1+αα
, the firm is in Scenario III and
D(φ(t)) = V (φ(t)) for all
φ(t) ∈ [ L, H ].
Figure 2 illustrates the three scenarios and displays the behavior of debt
and the leverage ratio in each scenario. The tax rate τ is measured along the
horizontal axis and φ is measured along the vertical axis. Scenario I prevails
for τ < τ L, Scenario II prevails for τ L ≤ τ ≤ τ H , and Scenario III prevails for
α
τ H < τ < 1+α . The ordinate of each point on the thick line that is horizontal at
φ = L in Scenario I, upward sloping in Scenario II, and horizontal at φ = H
in Scenario III is the value of φ ∗ for each value of τ . Everywhere above this line
(that is, in Scenario I and in the upper portion of Scenario II, which is labeled
IIA), φ(t) > φ ∗ , so the borrowing constraint is not binding and D(φ(t)) = D∗ .

Since D(φ(t)) is invariant to φ and V (φ(t)) is strictly increasing in φ, the optimal

leverage ratio, L(φ(t)) ≡ VD(φ(t))
(φ(t))
, is strictly decreasing in φ throughout Scenarios I
and IIA. Everywhere below this line (that is, in the lower portion of Scenario II,
which is labeled IIB, and in Scenario III), φ(t) < φ ∗ , so the borrowing constraint
is binding and the leverage ratio is invariant to φ.
L
1
+ γ ). A sufficient condition for ττ L ≤ 1 in this example is 12 (1 + γ )((2 + γ )
2 (1 + γ )((2 + γ ) H
L
+
H H
γ ) ≤ 1, which is satisfied if, for instance, L ≤ 0 and (1 + γ )γ ≤ 2, which is satisfied for 0 ≤ γ ≤ 1.
VI. Effect of a Rightward Translation of F(φ)

Above, I examined the relationship between optimal debt and contemporane-
ous profitability, φ(t). Now I turn attention to the relationship between optimal
debt and the prospects for future profitability represented by the distribution
function F(φ). Specifically, I examine an improvement in future prospects for
profitability that is a rightward translation of the distribution F(φ) to a new dis-
tribution, indexed by m ≥ 0, Gm(φ) ≡ F(φ − m) on the support [ L(m), H (m)],
where L(m) = L + m, H (m) = H + m, and [ L, H ] is the support of the
original distribution F(φ). For a given value of m , let V (φ(t); m) be the value of
the firm when φ = φ(t), D(φ(t); m) be the optimal value of debt when φ = φ(t),
P(φ(t); m) be the instantaneous probability of default when φ = φ(t), A(D; m) be
the trade-off function A(D), and φ ∗ (m) and D∗ (m) be the values of φ ∗ and D∗ ,
respectively.
The following proposition states that a rightward translation of the distribu-
tion F(φ) increases the value of the firm, V (φ(t); m), for any φ(t) in the intersec-
tion of the supports of the original distribution and the new distribution.
PROPOSITION 12: For 0 < m < H − L and any φ(t) ∈ [ L + m, H ] , V (φ(t); m)
> V (φ(t); 0).
A. Effect of a Rightward Translation of F(φ),in Scenario I

In Scenario I, the firm issues the amount of debt shown in Proposition 9,
which is the highest amount of debt it can issue without exposing itself to a
chance of default.
PROPOSITION 13: In Scenario I,
d
D(φ(t);m)
1. dm
= 1
ρ
> 0,
dS(φ(t);m)
2. dm
= − ρ+λ
1−τ
< 0,
dV (φ(t);m) τρ+λ
3. dm
= ρ(ρ+λ) > 0, and
dL(φ(t);m)
4. dm
> 0.
A rightward translation of the distribution F(φ) by one unit increases EBIT

by one unit in every state, which increases the expected present value of EBIT
by ρ1 , since the firm will never default and hence will receive a stream of EBIT
forever. Therefore, the optimal amount of debt increases by ρ1 units (Statement
1). A rightward translation of F(φ) reduces the value of equity for any given
φ(t) because the increase in the firm’s debt outweighs the increase in total firm
value resulting from improved future prospects (Statement 2).28 That is, the
decline in the value of equity for a given φ(t) is smaller than the increase in the
optimal amount of debt, so that, consistent with Proposition 12, a rightward
28 However, the entire distribution of φ(t) shifts to the right, so the unconditional expected value
1−τ
of S(φ(t)), which is ρ+λ (E{φ} − L) in Scenario I, is unchanged since ddmL (m)
= dE{φ}
dm = 1.
translation of F(φ) increases the total value of the firm for any given φ(t)
(Statement 3). Finally, the increase in debt and the decrease in the value of
equity increase the leverage ratio for any given φ(t) (Statement 4).
B. Effect of a Rightward Translation of F(φ), in Scenario II

∗
In Scenario II, ω1 = ω2 = 0, so that ∂ A(D∂ D
(m);m)
= 0, where D∗ (m) = V (φ ∗ (m), m).
Therefore, the first-order condition in equation (24) can be written as
∂ A(D∗ (m); m)
= τ (ρ + λF(φ ∗ (m) − m))
∂D
− α(ρ + λ)λV (φ ∗ (m); m) f (φ ∗ (m) − m) = 0. (34)
α
LEMMA 2: If 0 < τ < 1+α
and f (φ) ≥ 0 for all φ, then φ ∗ (m) < 1.
To understand why φ ∗ (m) < 1, suppose that φ ∗ (m) = φ ∗ (0) + m, so that a
rightward translation of the distribution by m increases φ ∗ by m, which would
leave F(φ ∗ (m) − m) and f (φ ∗ (m) − m) unchanged but would increase V (φ ∗ (m); m)
through the direct effect of an increase in φ on the firm’s value and through
the effect in Proposition 12. Then, the marginal interest tax shield in equation
(34) would remain unchanged but the marginal expected cost of default would
increase, which would reduce the optimal amount of debt and hence reduce the
associated critical value φ ∗ (m) below φ ∗ (0) + m.
To further explore the impact of a translation of the distribution F(φ − m),
differentiate
∗
equation (34) with respect to m and use equation (34) to substitute
τ ρ+λF(φ∗
(m)−m)
f (φ (m)−m)
for α(ρ + λ)λV (φ ∗ (m), m) to obtain 29
dV (φ ∗ (m); m)
τ [φ ∗ (m) − 1]χ (φ ∗ (m) − m) = α(ρ + λ)λ f (φ ∗ (m) − m) , (35)
dm
where
f (φ)
χ (φ) ≡ λ f (φ) − (ρ + λF(φ)) . (36)
f (φ)
The following proposition uses equation (35) to examine the impacts of a
rightward translation of the distribution F(φ) on P(φ(t); m), φ ∗ (m), and D∗ (m).
α
PROPOSITION 14: If (1) 0 < τ < 1+α
and (2) f (φ) ≥ 0 for all φ, then
1. dP(φ(t);m)
dm
< 0,
∗
2. sign( dV (φdm(m);m)
) = sign(D∗ (m)) = −sign(χ (φ ∗ (m) − m)), and
3. φ (m) < 0, if χ (φ ∗ (m) − m) ≥ 0.
∗
dV (φ ∗ (m);m) ∂ V (φ ∗ (m);m) ∗ ∗ (m);m)

29 The effect of a small increase in m on V (φ ∗ ) is dm = ∂φ φ (m) + ∂ V (φ∂m .
∂ V (φ ∗ (m);m) ∗ (m);m)
Proposition 12 implies that ∂m > 0, but does not imply that dV (φdm is positive. Indeed,
dV (φ ∗ (m);m)
as shown in Statement 2 of Proposition 14, dm is negative when χ (φ ∗ ), defined in equation
(36), is positive.
Figure 3. Rightward translation of F(φ) in Scenario II. (Color figure can be viewed at wiley-
onlinelibrary.com)
Since an increase in m does not increase φ ∗ (m) by an amount greater than

or equal to the increase in m, it reduces F(φ ∗ (m) − m) and hence reduces the
probability of default if D(φ(t); m) = D∗ (m). Alternatively, if
D(φ(t); m) < D∗ (m),
an increase in m also reduces the probability of default, which is λF(φ(t) − m).
Thus, for any φ(t), a rightward translation of the distribution of profitability
reduces P(φ(t); m) (Statement 1 of Proposition 14). A rightward translation of
the distribution, which is an increase in m, decreases ρ + λF(φ; m), which en-
ters the marginal interest tax shield, and, since f (φ; m) ≥ 0, decreases f (φ; m),
which enters the marginal expected cost of default. If χ (φ) > 0, then the per-
centage decrease in the marginal interest tax shield exceeds the percentage
decrease in f (φ) when m increases, and so the value of D∗ (m) falls. Since
D∗ (m) = V (φ ∗ (m); m), the fall in D∗ implies that V (φ ∗ (m); m) falls (Statement
2 of Proposition 14). Furthermore, since an increase in m increases V (φ; m),
the value of φ ∗ (m) falls to achieve the reduction in V (φ ∗ (m); m) (Statement 3 of
Proposition 14).
If the distribution F(φ) is uniform, so that f (φ) ≡ 0, it satisfies the condi-
tion in Proposition 14 that f (φ) is nondecreasing. With F(φ) being uniform,
λ
χ (φ) = λ f (φ) = H − L
> 0. Therefore, Statements 2 and 3 of Proposition 14 im-
ply that, with a uniform distribution, a rightward translation reduces D∗ , φ ∗ ,
and V (φ ∗ (m); m).
Figure 3 illustrates the impact of a rightward translation of F(φ) for the
case in which χ (φ ∗ (m) − m) > 0, which includes the uniform distribution. In
response to a rightward translation of F(φ), the value of φ ∗ falls from its initial
value of φ ∗ (0) to its new value of φ ∗ (m) (Statement 3). In addition, the curves
representing equity value, optimal debt, and the total value of the firm move
from the solid curves to the dashed curves. As shown, the rightward transla-
tion of F(φ) has no effect on equity for φ ≤ φ ∗ (m) and increases the equity value
by a constant amount, ρ+λ 1−τ

(φ ∗ (0) − φ ∗ (m)) > 0, for φ > φ ∗ (0). The total value
of the firm increases for all φ(t) (Proposition 12), as shown by the shift from
the solid curve through K, L, and M, to the dashed curve that lies above it.
The response of optimal debt to a rightward translation of F(φ) depends on
whether φ is high or low. For φ(t) ≥ φ ∗ (0), the optimal value of debt, which is
invariant to φ(t) in this range, falls in response to a rightward translation of
F(φ) (Statement 2). The continuation value of the firm increases, thereby in-
creasing the cost of losing this future value by defaulting on debt. In response
to this increased cost of default, the firm reduces its exposure to default by
reducing the amount of debt it issues and reduces the critical value φ ∗ . For
φ(t) ≤ φ ∗ (m), the optimal amount of debt increases in response to a rightward
translation of F(φ) because the borrowing constraint is binding for low values
of φ(t) and a rightward translation of F(φ) increases the total value of the
firm, which allows the firm to borrow an increased amount. Finally, there is
some φ ∈ (φ ∗ (m), φ ∗ (0)), not labeled in Figure 3, such that a rightward transla-
tion of F(φ) increases optimal debt for φ(t) < φ and decreases optimal debt for
φ(t) > φ .30
To understand the role of χ (φ) in determining the impact of a rightward
∗
translation of F(φ),31 it is helpful to recall that ∂ A(D∂ D (m),m)
in the first-order
condition in equation (34) equals the marginal interest tax shield minus the
marginal expected default cost. Holding φ ∗ (m) fixed, an increase in m(1) reduces
the marginal interest tax shield (by reducing F(φ ∗ (m) − m)) and (2) if F(φ)
is uniform so that f (φ ∗ (m)) is invariant to m, increases the marginal cost of
∗
default (by increasing V (φ ∗ (m), m)). Therefore, an increase in mmakes ∂ A(D∂ D (m),m)
negative. Because A(D; m) is strictly concave in D, a reduction in D is needed to

restore the first-order condition. To obtain the opposite effect, that is, in order
for an increase in m to increase the optimal value of D∗ , an increase in m must
reduce the marginal default cost—and must do so by more than the reduction
in the marginal interest tax shield. Such a reduction in the marginal default
cost requires that an increase in m reduces f (φ ∗ (m) − m), for a given φ ∗ (m),
by a sufficiently large amount, which occurs if f (φ ∗ ) is large enough to make
χ (φ ∗ ) < 0.
The trade-off theory of capital structure is operative only in Scenario II
and, indeed, only for φ(t) ≥ φ ∗ in Scenario II. When the trade-off theory is
operative, that is, when φ(t) ≥ φ ∗ , the optimal value of debt equals D∗ . In
the focal case of a uniform distribution, and more generally when χ (φ ∗ ) > 0,
Proposition 14 implies that a rightward translation of the distribution F(φ)
30 The text shows that, when χ (φ ∗ ) > 0, D∗ (m) < D∗ (0) = D(φ ∗ (0); 0). Note that D∗ (m) =

D(φ ∗ (m); m) = V (φ ∗ (m); m) > V (φ ∗ (m); 0) =
D(φ ∗ (m); 0), where the final equality follows from the fact
that the borrowing constraint binds for φ(t) = φ ∗ (m) under the original distribution F(φ). Therefore,

D(φ ∗ (m); 0) <D∗ (m) < D(φ ∗ (0); 0). Since D(φ; 0) is increasing in φ for φ < φ ∗ (0), there is a unique
∗ ∗
φ ∈ (φ (m), φ (0)) for which D(φ ; 0) = D (m). ∗
31 Section II in the Internet Appendix analyzes the case in which the unconditional distribution
of EBIT is a truncated exponential distribution and distinguishes situations in which D∗ falls in

response to a rightward translation of F(φ) from situations in which D∗ increases in response to a
rightward translation of F(φ).
Table I
Effects of Increased Profitability
This table summarizes the impact of increased profitability (an increase in φ(t) or a rightward
translation of F(φ)) on optimal debt when χ (φ) > 0. B.C. refers to the borrowing constraint D(φ) ≤
V (φ).
Scenario I Scenario IIA Scenario IIB Scenario III
Characteristics of Scenarios
B.C. not binding B.C. not binding B.C. binds B.C. binds
Pr{default}=0 Pr{default}>0 Pr{default}>0 Pr{default}>0
Not trade-off Trade-off operative Not trade-off Not trade-off
Increase in φ(t)

D unchanged
D unchanged
D↑ D↑
S↑ S↑ S≡0 S≡0
V ↑ V ↑ V ↑ V ↑
L↓ L↓ L≡1 L≡1
Rightward Translation of F(φ)

D↑
D ↓ if χ > 0
D↑ D↑
S↓ S↑ S≡0 S≡0
V ↑ V ↑ V ↑ V ↑
L↑ L ↓ if χ > 0 L≡1 L≡1
reduces the optimal amount of debt and hence reduces the optimal leverage
ratio. When φ(t) < φ ∗ , the trade-off theory is not operative and D(φ(t); m) =
V (φ(t); m). Therefore, Proposition 12 implies that the optimal value of debt
increases in response to a rightward translation of F(φ) in Scenario II when
φ(t) < φ ∗ . Of course, whenever φ(t) ≤ φ ∗ , the optimal leverage ratio equals one
and thus is invariant to a translation of F(φ).
C. Effect of a Rightward Translation of F(φ), in Scenario III

In Scenario III, the borrowing constraint binds, that is, D(φ(t); m) = V (φ(t); m)
for all φ(t). Therefore, Proposition 12 implies that, in Scenario III, a rightward
translation of F(φ) increases V (φ(t)) and hence increases D(φ(t)) for all φ(t).
Of course, with D(φ(t); m) = V (φ(t); m) for all φ(t), the optimal leverage ratio
equals one for all φ(t) in Scenario III.
D. Summary of Effects of Increased Profitability

Table I summarizes the findings about the impact of increased profitabil-
ity on optimal debt when χ (φ) > 0, which includes the case in which F(φ) is
uniform. The top third of the table summarizes characteristics of the differ-
ent scenarios. The trade-off theory is operative if and only if (1) the borrowing
constraint (B.C., in the table) is not binding and (2) the firm faces a positive
probability of default. Only Scenario IIA meets these two criteria, so the trade-
off theory is operative only in Scenario IIA. Among the scenarios in which
the firm faces a positive probability of default (Scenarios IIA, IIB, and III),
an increase in profitability—either an increase in current profitability, φ(t),

or a rightward translation of the unconditional distribution F(φ)—can reduce
the optimal leverage ratio only in Scenario IIA, that is, only when the trade-
off theory is operative. Thus, in the context of the model presented here, in
which the trade-off theory can be operative or not, the empirical finding of a
negative relationship between profitability and the leverage ratio is consistent
only with the trade-off theory being operative, if the probability of default is
positive.
VII. Persistence of Profitability across Regimes

I derived the main result of this paper—that the leverage ratio is negatively
related to profitability when the trade-off theory is operative—by assuming
that profitability is i.i.d. across regimes. Under this assumption, the trade-off
function A(D) defined in equation (10) is independent of φ(t) , which implies
that D∗ is independent of φ(t). And when the trade-off theory is operative,
optimal debt, D(φ(t)), equals D∗ , so the optimal level of debt is invariant to φ(t).

Therefore, the leverage ratio, VD(φ(t)) (φ(t))
, is decreasing in φ(t) because the value of
the firm is increasing in φ(t).
In this section, I show that, with persistence across regimes, the optimal
amount of debt can be a decreasing function of profitability when the trade-off
theory is operative. To the extent that higher profitability reduces the amount
of debt, it strengthens the major finding of this paper that, when the trade-off
theory is operative, the leverage ratio is a decreasing function of profitability. To
the extent that higher profitability reduces the amount of debt, the probability
of default is a decreasing function of profitability when the trade-off theory is
operative.
Suppose that the current time is t and let t denote the time of the first regime
change after t. Let F(φ(t ), φ(t)) be the distribution of φ(t ) conditional on φ(t),
∂ F(φ(t ),φ(t))
and let f (φ(t ), φ(t)) ≡ ∂φ(t )
be the associated conditional density. I model
stable persistence in profitability across regimes by assuming that
∂ F(φ(t ), φ(t)) ∂ F(φ(t ), φ(t))
0≤− ≤ . (37)
∂φ(t) ∂φ(t )
Persistence is captured by the first inequality in equation (37), which implies
that if φ2 > φ1 , then the distribution of φ(t ) conditional on φ(t) = φ2 first-order
stochastically dominates the distribution of φ(t ) conditional on φ(t) = φ1 . The
second inequality captures stability. For instance, it implies that a one-unit
increase in φ(t) increases each q-quantile of the conditional distribution of φ(t )
by less than one unit.32
32 Formally, define h( p, φ(t)) implicitly by p ≡ F(h( p, φ(t)), φ(t)). Stable positive first-order serial
dependence is described by 0 ≤ ∂h(∂φ(t)p,φ(t))

< 1. Implicitly differentiate p ≡ F(h( p, φ(t)), φ(t)) with
∂h( p,φ(t))
respect to φ(t) for a given p to obtain ∂φ(t)
= − ∂ F(φ(t ),φ(t)) ∂ F(φ(t ),φ(t)) −1
∂φ(t)
[ ∂φ(t ) ] . Then, equation (37)
∂h( p,φ(t))
implies that 0 ≤ ∂φ(t)
< 1.
Under the conditional distribution F(φ(t ), φ(t)), the trade-off function A(D)
in equation (10) is

τ ρ + λ V (φ(t ))<D f (φ(t ), φ(t))dφ(t ) D

A(D, φ(t)) ≡ (38)
−[α + τ (1 − α)]λ V (φ(t ))<D V (φ) f (φ(t ), φ(t))dφ(t ),
and the value function is

1
V (φ(t)) = max [(1 − τ )φ(t) + v + A(D, φ(t))]. (39)
ρ + λ D≤V (φ(t))
PROPOSITION 15: If F(φ(t ), φ(t)) is nonincreasing in φ(t), the value function

V (φ(t)) is strictly increasing in φ(t).
Because the conditional distribution of φ(t ) depends on φ(t), D(φ(t)) ≡
arg maxV (L)≤D≤V ( H ) A(D, φ(t)) depends on φ(t). If A(D, φ(t)) attains a local
maximum at D∗ (φ(t)) ∈ ( L, H ), then the associated first-order condition at
D = D∗ is
∂ A(D∗ , φ(t)) τ [ρ + λF(V −1 (D∗ ), φ(t))]
= = 0. (40)
∂D −(1 − τ )αλV −1 (D∗ )D∗ f (V −1 (D∗ ), φ(t))
The first of the two terms on the right-hand side of equation (40) is the
marginal interest tax shield. Equation (37) implies that a higher value of φ(t)
leads to a lower value of this marginal interest tax shield for any given value of
D, thereby reducing the incentive to issue debt. The second term on the right-
hand side of equation (40) is the marginal expected cost of default. A higher
value of φ(t) could lead to a higher or lower value of this cost by increasing or
decreasing the density, f (V −1 (D), φ(t)). If the impact on the marginal interest
tax shield outweighs the impact of any change in the marginal expected cost of
default, the value of D∗ falls.
The instantaneous conditional probability of default at time t in equation
(18) is
p(φ(t)) ≡ λF(V −1 (
D(φ(t))), φ(t)), (41)
which is the instantaneous conditional probability that a new regime will arrive
with a value of φ(t ) that is low enough that the new value of the firm, V (φ(t )),
is less than outstanding bonds, D(φ(t)). Therefore,
p (φ(t)) = λ f (V −1 (
D(φ(t))), φ(t))V −1 (
D(φ(t)))
D (φ(t))
∂ F(V −1 (
D(φ(t))), φ(t))
+λ . (42)
∂φ(t)
The two terms on the right-hand side of equation (42) correspond to channels
(1) and (2), respectively, introduced in the discussion following Proposition 7.
The first term captures the effect on the optimal amount of debt of an increase
in φ(t), and the consequent effect on the probability of default. The second term
captures the direct effect of a change in the conditional distribution on the

probability of default for a given value of debt. If φ(t) is i.i.d. across regimes, the
second term is zero and the sign of p (φ(t)) is the same as the sign of D (φ(t))—
positive when the borrowing constraint is binding, that is, D(φ(t)) = V (φ(t)),
and zero when the trade-off theory is operative, so D (φ(t)) = 0.
The following proposition describes optimal debt and the probability of de-
fault in a simple example in which profitability is persistent across regimes.
PROPOSITION 16: Suppose that F(φ(t ), φ(t)) is uniform on [g(φ(t)) − d, g(φ(t)) +
d],33 where d > 0 and 0 < g (φ(t)) < 1.
1. If the trade-off theory is operative in a neighborhood of φ(t), then

(a) D (φ(t)) < 0,
(b) L (φ(t)) < 0,
(c) p (φ(t)) < 0.
2. If the borrowing constraint is binding in a neighborhood of φ(t), then
(a) D (φ(t)) > 0,
(b) p (φ(t)) = 1−g2d(φ(t)) > 0.
Proposition 16 implies that the effect of the introduction of stable persistence

across regimes in the case of a uniform distribution depends on whether the
trade-off theory is operative or the borrowing constraint is binding. When the
borrowing constraint is binding, an increase in current profitability increases
the value of the firm and hence increases both the optimal amount of debt and
the instantaneous conditional probability of default, which is the same counter-
intuitive result that holds when profitability is i.i.d. across regimes.34 However,
when the trade-off theory is operative, an increase in current profitability re-
duces the optimal amount of debt and hence reduces the leverage ratio, which
reinforces the major result of this paper that profitability and leverage are neg-
atively related when the trade-off theory is operative. In addition, when the
trade-off theory is operative, an increase in current profitability reduces the
instantaneous conditional probability of default.
VIII. Concluding Remarks

The model of debt choice developed and analyzed here is simple enough to
be analytically tractable yet rich enough to include situations in which the
trade-off theory is operative and situations in which it is not. This model points
to factors, such as the tax rate and the level of profitability, that determine
whether the trade-off theory is operative. To the extent that optimal behav-
ior differs depending on whether the trade-off theory is operative, one could
33 To ensure that the support of the distribution of φ(t ) remains within [ L, H ], suppose that
L + d ≤ g( L) < g( H ) ≤ H − d.
34 These results in the case of binding borrowing constraints hold much more generally.
When the borrowing constraint binds, p(φ(t)) ≡ λF(V −1 ( D(φ(t))), φ(t)) = λF(V −1 (V (φ(t))), φ(t)) =
λF(φ(t), φ(t)), which is (weakly) increasing in φ(t) under the general condition for stable persis-
tence in equation (37).
potentially use such differences in behavior to empirically test the trade-off

theory.
The equality of the marginal tax shield resulting from interest deductibility
and the marginal cost of increased exposure to default associated with in-
creased debt is the defining feature of the trade-off theory of debt. The mere
presence of interest deductibility and deadweight costs of default is not suffi-
cient to ensure that the trade-off theory is operative. I highlight three situations
in which the trade-off theory is not operative despite the presence of interest
deductibility and deadweight default costs. First, if the tax rate is very low
(Scenario I), the marginal benefit of the interest tax shield associated with an
additional dollar of debt is completely overwhelmed by the marginal cost asso-
ciated with increased exposure to default resulting from an additional dollar of
debt. In this case, the firm takes advantage of the tax shield offered by interest
deductibility, but only borrows as much as it can without exposing itself to any
possibility of default. Thus, the trade-off theory is not operative for tax rates
that are sufficiently low. Second, if the tax rate is sufficiently high (but not so
high as to violate conditions for concavity of the value function), the marginal
benefit of the interest tax shield associated with an additional dollar of debt
completely overwhelms the marginal cost associated with increased exposure
to default resulting from an additional dollar of debt. In this case, the firm
borrows as much as lenders are willing to lend. The trade-off theory is not
operative because the borrowing constraint is strictly binding, so the marginal
benefit of the interest tax shield fails to equal the marginal cost of increased
default probability. Third, even if the tax rate is neither too low nor too high,
the trade-off theory will fail to be operative if the current value of EBIT is lower
than the critical value, denoted by φ ∗ in the model. In this situation, a low value
of EBIT implies that the current value of the firm is low, which implies that
the constraint on how much the firm can borrow is strictly binding. In this
situation, the marginal benefit of the interest tax shield exceeds the marginal
cost of increased default probability, so again, the trade-off theory is not opera-
tive. The only situation in the model in which the trade-off theory is operative
is when the tax rate is neither too low nor too high and the current value of
EBIT is higher than the critical value φ ∗ . In this case, the optimal value of
debt equates the marginal benefit of the interest tax shield and the marginal
cost of increased exposure to default. In the baseline stochastic specification in
which EBIT is i.i.d. across regimes, the optimal value of debt is invariant to
the contemporaneous value of EBIT when the trade-off theory is operative.
The relationship between profitability and optimal borrowing depends on
whether the trade-off theory is operative. Table I summarizes the impact of
an increase in profitability on optimal borrowing. In this table, there are two
measures of leverage—the amount of debt issued and the market leverage
ratio—and two measures of profitability—current EBIT and the unconditional
distribution from which new values of EBIT are drawn. Two major observa-
tions emerge from this table. First, when the trade-off theory is operative,
the leverage ratio is a decreasing function of current EBIT; provided that the
unconditional density function of EBIT does not slope upward too steeply, a
rightward translation of the unconditional distribution of EBIT reduces both

the level of optimal debt and the optimal leverage ratio. The finding that an
increase in profitability leads to a reduction in the leverage ratio is consistent
with empirical analyses of this relationship. Second, provided that the firm
faces a positive probability of default, the optimal leverage ratio is negatively
related to profitability only if the trade-off theory is operative. So, the empirical
finding of a negative relationship between borrowing and profitability is not
consistent with the alternatives to the trade-off theory in this model.
I conclude by describing four potential extensions of the analysis in this pa-
per. First, the stochastic specification for EBIT can be generalized in various
ways. For instance, the arrival rate of new regimes, λ, can be a random vari-
able. In particular, the arrival of a new regime could be specified as a new
realization of the vector (φt , λt ) drawn from a distribution F(φt , λt ). If the re-
alizations of (φt , λt ) are i.i.d. across regimes, the analysis of this paper can be
easily extended, and would allow for an added dimension of cross-sectional
heterogeneity across firms.35 An alternative generalization of the stochastic
structure can be to allow for persistence in EBIT across regimes, as in Sec-
tion VII. The analysis in Section VII suggests that persistence across regimes
strengthens the appeal of the trade-off theory, at least in the example in which
the conditional distribution of EBIT is uniform. In that case, when the trade-off
theory is operative, the optimal amount of bonds is decreasing in profitability,
which reinforces the finding that the leverage ratio is decreasing in profitabil-
ity, consistent with empirical findings. In addition, when the trade-off theory
is operative, the probability of default is decreasing in profitability.
Second, an important extension of the current model is to incorporate the
capital investment decision. In ongoing work (Abel (2016)), I develop and ana-
lyze a model in which a firm can accumulate (or decumulate) physical capital
subject to convex costs of adjustment. In that framework, it continues to be the
case that the optimal leverage ratio is a declining function of profitability when
the trade-off theory is operative.
A third type of extension is to include flotation costs for bonds. Footnote 23
outlines a simple extension with flotation costs specified as a convex function
of the amount of bonds. In that case, the trade-off theory is easily extended to
a “modified trade-off theory.” Future research could analyze a broader variety
of flotation costs, including, perhaps, a fixed cost component of these costs.
Fourth, the assumption of instantaneous maturity of bonds is analytically
convenient and seems appropriate for overnight repos and commercial paper.
Future research, however, could examine bonds of longer maturity and address
the optimal maturity of bonds.
Initial submission: June 29, 2015; Accepted: September 24, 2016

Editors: Bruno Biais, Michael R. Roberts, and Kenneth J. Singleton
35 I thank an anonymous referee for pointing out this extension.

Appendix A: Proofs
PROOF OF PROPOSITION 1: Assume that φ2 > φ1 . If D(φ1 ) is feasible when

(1−τ )φ2 +λv+A(
D(φ1 ))
φ(t) = φ2 , then equation (9) implies that V (φ2 ) ≥ ρ+λ
and V (φ1 ) =
(1−τ )φ1 +λv+A(
D(φ1 )) (1−τ )(φ2 −φ1 )
ρ+λ
, so V (φ2 ) − V (φ1 ) ≥ ρ+λ
> 0. Note that D(φ1 ) ≤ V (φ1 ) <
V (φ2 ) confirms that D(φ1 ) is feasible when φ(t) = φ2 . Also, V (φ2 ) − V (φ1 ) ≥
(1−τ )(φ2 −φ1 )
ρ+λ
implies that V (φφ22)−V
−φ1
(φ2 )
≥ ρ+λ
1−τ
.
PROOF OF PROPOSITION 2: Assume that φ2 > φ1 . Suppose, contrary to what
is to be proved, that D(φ2 ) ≤ D(φ1 ). Therefore, D(φ2 ) ≤ D(φ1 ) ≤ V (φ1 ) ≤ V (φ2 ),
so both D(φ1 ) and D(φ2 ) are feasible both when φ = φ1 and when φ = φ2 .
Since D(φ1 ) is chosen by the firm when φ = φ1 , A( D(φ1 )) > A( D(φ2 )) because
A(D) is strictly concave. Since D(φ2 ) is chosen by the firm when φ = φ2 ,
D(φ2 )) > A(
A( D(φ1 )) because A(D) is strictly concave, which is a contradiction.
Therefore, D(φ2 ) ≥ D(φ1 ) (Statement 1). To prove that D(φ(t)) is nondecreasing
in time, it suffices to prove that for any t2 > t1 , where t1 and t2 are in consec-
utive regimes, D(φ(t2 )) ≥ D(φ(t1 )). Suppose, contrary to what is to be proved,
that D(φ(t2 )) <
D(φ(t1 )). Since D(φ(t2 )) <
D(φ(t1 )) ≤ V (φ(t1 )), the firm chooses
D(φ(t1 )) in preference to
D(φ(t2 )) when both are feasible. It would only choose
D(φ(t2 )) in preference to
D(φ(t1 )) when φ = φ(t2 ) if
D(φ(t1 )) were not feasible, that
is, if
D(φ(t1 )) > V (φ(t2 )) . In this situation, the firm would default on its debt,

D(φ(t1 )), when the regime changes and φ changes from φ(t1 ) to φ(t2 ) (Statement
2).
PROOF OF PROPOSITION 3: To prove the first inequality, 0 < V ( L), observe
that a feasible policy would be for the firm to never issue any bonds and to
stay in operation forever, because the assumption L > − ρλ E{φ} in equation (2)
implies that W( L) > 0. If φ(t) = L and the firm followed this all-equity policy
forever, its value would be W( L). Therefore, V ( L) ≥ W( L) > 0. To prove
the second inequality, V ( L) ≤ D(φ(t)), observe that if the firm’s outstanding
bonds are D0 < V ( L), there is no possibility that the firm will choose to default
on the debt. In this case, A(D0 ) = τρ D0 , so that (1 − τ )φ(t) + λv + A(D0 ) = (1 −
τ )φ(t) + λv + τρ D0 . If D0 < V ( L), then (1 − τ )φ(t) + λv + τρ D0 < (1 − τ )φ(t) +
λv + τρV ( L), so D0 < V ( L) cannot be optimal. Therefore, V ( L) ≤ D(φ(t)).
The third inequality, D(φ(t)) ≤ V ( H ), is a direct consequence of the borrowing
constraint, D ≤ V (t ), and the fact that V (φ) is strictly increasing (Proposition
1), so that V (φ(t)) ≤ V ( H ).
PROOF OF COROLLARY 1: Note that V ( L) ≥ D( L) ≥ V ( L), where the first
inequality is the borrowing constraint that prevents the firm from borrowing
an amount that leads to immediate default and the second inequality follows
from Proposition 3. Since S(φ(t)) = V (φ(t)) −
D(φ(t)), S( L) = 0.
Lemma A1 is stated (and proved) here, immediately preceding the proof of
Proposition 4, rather than in the text, because its only role is to help prove
Proposition 4 and Corollary 2.
α
LEMMA A1: If (1) f (φ(t)) ≥ 0 for all φ ∈ [ L, H ], (2) τ < 1+α , and (3) V (φ(t))
is concave and strictly increasing, then A(Dt ) is strictly concave in Dt for Dt ≥ 0.
PROOF OF LEMMA A1: Assume that V (φ(t)) is concave and strictly in-
creasing. Twice differentiate V −1 (V (φ)) ≡ φ with respect to φ to obtain
V −1 (V (φ))V (φ) ≡ 1 and V −1 (V (φ))[V (φ)]2 + V −1 (V (φ))V (φ) = 0. Since
V (φ(t)) is concave and strictly increasing, V (φ) > 0, V −1 (V (φ)) > 0, and
V (φ) ≤ 0, so that V −1 (Dt ) ≥ 0. Twice partially differentiating A(Dt ) ≡ τ [ρ +
λ V (φ)<Dt dF(φ)]Dt − [α + τ (1 − α)]λ V (φ)<Dt V (φ)dF(φ) with respect to Dt yields

A (Dt ) = τ [ρ + λ V (φ)<Dt dF(φ)] − α(1 − τ )λV −1 (Dt )Dt f (V −1 (Dt )) and A (Dt )
= [(1 + α)τ − α]λV −1 (Dt ) f (V −1 (Dt )) − α(1 − τ )λDt (V −1 (Dt ) f (V −1 (Dt )) +
α
f (V −1 (Dt ))[V −1 (Dt )]2 ) < 0 for Dt ≥ 0 since τ < 1+α implies that the first
term, [(1 + α)τ − α]λV (Dt ) f (V (Dt )), is negative, and V −1 (Dt ) ≥ 0 and
−1 −1
f (V −1 (Dt )) ≥ 0 imply that the second term, which follows (but does not in-
clude) a minus sign, is nonnegative. Therefore, A (Dt ) < 0, so A(Dt ) is strictly
concave in Dt for Dt ≥ 0.
PROOF OF PROPOSITION 4: The proof begins by defining an operator T and

proving that T maps concave, strictly increasing functions into concave, strictly
α
increasing functions. Assume that (1) f (φ(t)) ≥ 0 is nondecreasing, (2) τ < 1+α ,
and (3) V (φ(t)) is concave and strictly increasing. Lemma A1 implies that A(Dt )
is strictly concave in Dt for Dt ≥ 0. Define the operator T by

(1 − τ )φ(t) + λv + A(D)
(T V )(φ(t)) = max , (A1)
D≤V (φ(t)) ρ+λ
where A(D(φ(t))) defined in equation (10) depends on V (φ(t)). Consider φ1 and

φ2 and the respective corresponding optimal values of debt D(φ1 ) and D(φ2 ).
(1−τ )φi +λv+A(
D(φi ))
Equation (14) implies T V (φi ) = ρ+λ
and D(φi ) ≤ V (φi ), i = 1, 2.
Now consider φ(γ ) = γ φ1 + (1 − γ )φ2 and D(γ ) = γ D(φ1 ) + (1 − γ )
D(φ2 ), for

0 ≤ γ ≤ 1. Note that D(γ ) = γ D(φ1 ) + (1 − γ ) D(φ2 ) ≤ γ V (φ1 ) + (1 − γ )V (φ2 )
≤ V (φ(γ )), which implies that D(γ ) is a feasible level of debt when φ =

φ(γ ). Note further that γ T V (φ1 ) + (1 − γ )T V (φ2 ) = γ [ (1−τ )φ1 +λv+A(
ρ+λ
D(φ1 ))
] + (1 −

γ )[ (1−τ )φ2 +λv+A(
ρ+λ
D(φ2 ))
] ≤ (1−τ )φ(γ )+λv+A(D(γ
ρ+λ
))
≤ (1−τ )φ(γ )+λv+γ
ρ+λ
A( D(φ(γ )))
= T V (φ(γ )),
where the first inequality follows from the concavity of A(D) and the sec-
ond inequality follows from the fact that D(φ(γ )) maximizes A(D) subject to
D ≤ V (φ(γ )). Therefore, T V (φ(t)) is concave. To prove that T V (φ) is strictly
increasing, consider φ2 > φ1 , and observe that D(φ1 ) ≤ V (φ1 ) < V (φ2 ) so that

D(φ1 ) is feasible when φ = φ2 . Then, T V (φ2 ) ≥ (1−τ )φ2 +λv+A( D(φ1 ))
and T V (φ1 ) =
ρ+λ
(1−τ )φ1 +λv+A(
D(φ1 )) )(φ2 −φ1 )
ρ+λ
so T V (φ2 ) − T V (φ1 ) ≥ (1−τρ+λ
, > 0. Therefore, T V (φ) is
strictly increasing. It thus follows that the operator T maps concave strictly in-
creasing functions into concave strictly increasing functions. It remains to show
that T is a contraction, so that there is a unique concave strictly increasing
function that is a fixed point of T .
Monotonicity: I show that if V2 (φ(t)) ≥ V1 (φ(t)), then T V2 (φ(t)) ≥ T V1 (φ(t)) .

Suppose that V2 (φ(t)) ≥ V1 (φ(t)). Using equation (A1),
(1 − τ )φ(t) + λv i + Ai (
Di (φ(t)))
T Vi (φ(t)) = , (A2)
ρ+λ
where Di (φ(t)) is the optimal value of debt when the value function is Vi (φ) and
φ = φ(t). Using the definition of A(D) in equation (10), rewrite equation (A2) as

(1 − τ )φ(t) + gi (φ, D)dF(φ)
T Vi (φ(t)) = , (A3)
ρ+λ
where
τρ D + τ λD + (1 − α)(1 − τ )λVi (φ), if Vi (φ) < D
gi (φ, D) ≡ . (A4)
τρ D + λVi (φ), if Vi (φ) ≥ D
The definition of gi (φ, D) in equation (A4) implies
(1 − α)(1 − τ )λ(V2 (φ) − V1 (φ)) ≥ 0, if V2 (φ) < D

g2 (φ, D) − g1 (φ, D) = λV2 (φ) − [τ λD + (1 − α)(1 − τ )λV1 (φ)], if V1 (φ) < D ≤ V2 (φ) .
λ(V2 (φ) − V1 (φ)) ≥ 0, if V1 (φ) ≥ D
(A5)
When V1 (φ) < D ≤ V2 (φ), g2 (φ, D) − g1 (φ, D) = λV2 (φ) − [τ λD + (1 − α)(1 −

τ )λV1 (φ)] ≥ λV2 (φ) − [τ + (1 − α)(1 − τ )]λD ≥ 0, so equation (A5) implies that
g2 (φ, D) ≥ g1 (φ, D). Since D1 (φ(t)) ≤ V1 (φ(t)) ≤ V2 (φ(t)),
D1 (φ(t)) is feasible
under V2 (φ(t)). Therefore,

(1 − τ )φ(t) + g2 (φ, D1 (φ(t)))dF(φ)
T V2 (φ(t)) ≥ (A6)
ρ+λ
and since g2 (φ, D) ≥ g1 (φ, D) ,

(1 − τ )φ(t) + g1 (φ,
D1 (φ(t)))dF(φ)
T V2 (φ(t)) ≥ . (A7)
ρ+λ
The right-hand side of equation (A7) equals T V1 (φ(t)), so T V2 (φ(t)) ≥ T V1 (φ(t)).

Therefore, the operator T satisfies the monotonicity property of the Blackwell
conditions.
Discounting: For a ≥ 0,

(1 − τ )φ(t) + ga φ,
Da (φ(t)) dF(φ)
[T (V + a)](φ(t)) = , (A8)
ρ+λ
where Da (φ(t)) is the optimal amount of debt under the value function V (φ(t)) +
a, and, following equation (A4),
τρ D + τ λD + (1 − α)(1 − τ )λ(V (φ) + a), if V (φ) + a < D

ga (φ, D) ≡ . (A9)
τρ D + λ(V (φ) + a), if V (φ) + a ≥ D
Since Da (φ(t)) is feasible under V (φ) + a, it follows that Da (φ(t)) ≤ V (φ(t)) +

a, which implies that Da (φ(t)) − a ≤ V (φ(t)), so Da (φ(t)) − a is feasible under
V (φ(t)) and hence,

(1 − τ )φ(t) + g0 (φ, Da (φ(t) − a))dF(φ)
T V (φ(t)) ≥ . (A10)
ρ+λ
Subtracting equation (A10) from equation (A8) yields,

[ga (φ,
Da (φ(t))) − g0 (φ,
Da (φ(t) − a))]dF(φ)
[T (V + a)](φ(t)) − T V (φ(t)) ≤ .
ρ+λ
(A11)
The definition of ga (φ, D) in equation (A9) implies
ga (φ,
Da (φ(t))) − g0 (φ,
Da (φ(t) − a))
[τρ + (1 − α(1 − τ ))λ]a, if V (φ) + a < D̂a (φ(t))
= . (A12)
[τρ + λ]a, if V (φ) + a ≥ D̂a (φ(t))
Equations (A11) and (A12) imply that

τρ + λ
[T (V + a)](φ(t)) − T V (φ(t)) ≤ a, (A13)
ρ+λ
which can be written as
[T (V + a)](φ(t)) ≤ T V (φ(t)) + βa, (A14)
where β ≡ τρ+λ ρ+λ

< 1. Hence, the operator T satisfies the discounting property
of the Blackwell conditions.
Therefore, the operator T takes concave, strictly increasing functions on
the domain [ L, H ] into concave, strictly increasing functions on the domain
[ L, H ], and it has a unique fixed point V (φ(t)). Therefore, V (φ(t)) is concave
on the domain [ L, H ].
PROOF OF COROLLARY 2: Lemma A1 and Proposition 4 immediately imply that
A(D) is strictly concave in D for V ( L) ≤ D ≤ V ( H ) under the conditions in
this corollary.
PROOF OF PROPOSITION 5: If φ(t) ≥ φ ∗ , then V (φ(t)) ≥ V (φ ∗ ) = D∗ , so the con-
straint D ≤ V (φ(t)) will not bind and hence the optimal value of debt is

D(φ(t)) = D∗ . Therefore, for any φ(t) ≥ φ ∗ , the value of V (φ(t)) defined in equa-
(1−τ )φ(t)+λv+A(D∗ )
tion (14) is V (φ(t)) = ρ+λ
, so
1−τ
V (φ2 ) − V (φ1 ) = (φ2 − φ1 ) for φ1 ≥ φ ∗ and φ2 ≥ φ ∗ . (A15)
ρ+λ
Setting φ1 in equation (A15) equal to φ ∗ and using V (φ ∗ ) = D∗ yields
1−τ
V (φ(t)) = [φ(t) − φ ∗ ] + D∗ , for φ(t) ≥ φ ∗ . (A16)
ρ+λ
Since
D(φ(t)) = D∗ when φ(t) ≥ φ ∗ , equations (A16) and (15) imply
1−τ
S(φ(t)) = [φ(t) − φ ∗ ], for φ(t) ≥ φ ∗ . (A17)
ρ+λ
For values of φ(t) < φ ∗ , setting D = D∗ would violate the constraint D ≤
V (φ(t)) because V (φ(t)) ≤ V (φ ∗ ) = D∗ , so the optimal value of D,
D(φ(t)), will
be less than D∗ . Since A(D) is strictly concave in D (Corollary 2), the constraint
V (φ(t)) ≥ D will strictly bind for any φ(t) < φ ∗ so that
V (φ) ≡
D(φ), for φ(t) ≤ φ ∗ ,
and
S(φ(t)) = 0, for φ(t) ≤ φ ∗ . (A18)

PROOF OF COROLLARY 3: For φ(t) ≥ φ ∗ , use Proposition 5 to substitute D∗ for
1−τ
D(φ(t)) and ρ+λ [φ(t) − φ ∗ ] + D∗ for V (φ(t)) in the definition of the leverage ra-

tio, L(φ(t)) ≡ D(φ(t))
V (φ(t))
, and divide numerator and denominator by D∗ to obtain
L(φ(t)) = 1
φ(t)−φ ∗ . For φ(t) ≤ φ ∗ , Proposition 5 implies
D(φ(t)) = V (φ(t)), so
1−τ
ρ+λ D∗
+1
the leverage ratio equals one.
PROOF OF PROPOSITION 6: If φ(t) < φ ∗ , then D(φ(t)) = V (φ(t)), so V (φ) < D(φ(t))
if and only if V (φ) < V (φ(t)), that is, if and only if φ < φ(t), since V (φ) is strictly
increasing. Therefore, P(φ(t)) = λF(φ(t)) < λF(φ ∗ ). If φ(t) ≥ φ ∗ , then D(φ(t)) =
D∗ , so V (φ) < D(φ(t)) = D∗ = V (φ ∗ ) if and only if V (φ) < V (φ ∗ ), that is, if and
only if φ < φ ∗ , since V (φ) is strictly increasing. Therefore, P(φ(t)) = λF(φ ∗ ) ≤
λF(φ(t)). It thus follows that P(φ(t)) = λ min[F(φ(t)), F(φ ∗ )].

PROOF OF PROPOSITION 7: From equation (18), P( D(φ(t))) ≡ λ V (φ)<D(φ(t)) dF(φ)

= λ φ<V −1 (D(φ(t))) dF(φ), so dD(φ(t)) = V ( D(φ(t))) f (V −1 (
dP −1
D(φ(t)))) > 0. If φ(t) < φ ∗ ,
d d
then D(φ(t))
dφ(t)
> 0, so dφ(t)
dP
= dD(φ(t))
dP D(φ(t))
dφ(t)
> 0. If φ(t) ≥ φ ∗ , then dD(φ(t))
dφ(t)
≡ 0,
d
D(φ(t))

so dφ(t) = dD(φ(t)) dφ(t) ≡ 0. From equation (3), r(t) = ρ + λ V (φ)<D(φ(t)) [1 −
dP dP
V (φ)
V (φ)
(1 − α) D(φ(t)) ]dF(φ) = ρ + λ φ<V −1 (D(φ(t))) [1 − (1 − α) D(φ(t)) dr(t)
]dF(φ), so dD(φ(t)) =

λV −1 (
D(φ(t)))α f (V −1 (
V (φ)
D(φ(t)))) + λ D(φ(t))) [(1 − α) [
φ<V −1 ( D(φ(t))]2
]dF(φ) > 0. If
∗ dr(t) d
φ(t) < φ , then dD(φ(t))
dφ(t)
> 0, so dφ(t)
dr(t)
= d
D(φ(t))
D(φ(t)) dφ(t)
> 0. If φ(t) ≥ φ ∗ , then dD(φ(t))
dφ(t)
≡
dr(t) dD(φ(t))
dr(t)
0, so dφ(t) = dD(φ(t)) dφ(t)
≡ 0.
PROOF OF PROPOSITION 8: Suppose that D(φ(t)) = V (φ(t)). Substitute V (φ(t))

for
D(φ(t)) in the definition of A(Dt ) in equation (11) and then substitute the
resulting equation into equation (12) to obtain
ρV (φ(t)) = (1 − τ )φ(t) + λ(v − V (φ(t))) + τr(t)V (φ(t))

− αλ V (φ)dF(φ). (A19)
V (φ)<V (φ(t))
Now substitute V (φ(t)) for Dt in equation (3) to obtain

r(t)V (φ(t)) = ρV (φ(t)) + λ [V (φ(t)) − (1 − α)V (φ)]dF(φ). (A20)
V (φ)<V (φ(t))
Combine equations (A19) and (A20) to eliminate ρV (φ(t)) and obtain

0 = (1 − τ )φ(t) + λ(v − V (φ(t))) − (1 − τ )r(t)V (φ(t)) + λ [V (φ(t))
V (φ)<V (φ(t))
− V (φ)]dF(φ). (A21)

Substitute [V (φ) − V (φ(t))]dF(φ) for v − V (φ(t)) in equation (A21) and rear-
range to obtain

(1 − τ )[φ(t) − r(t)V (φ(t))] = −λ [V (φ) − V (φ(t))]dF(φ) ≤ 0. (A22)
V (φ)≥V (φ(t))
When D(φ(t)) = V (φ(t)), (1 − τ )y(t) = (1 − τ )[φ(t) − r(t)V (φ(t))], so equation

(A22) implies that

(1 − τ )y(t) = −λ [V (φ) − V (φ(t))]dF(φ) ≤ 0, (A23)
V (φ)≥V (φ(t))
with strict inequality if φ(t) < H , which proves Statement 1.

Differentiate equation (A23) with respect to φ(t) to obtain

d[(1 − τ )y(t)]
= λV (φ(t)) dF(φ) > 0, (A24)
dφ(t) V (φ)≥V (φ(t))
which proves Statement 2. Finally, to prove Statement 3, if t is not a time of

regime change, then dDt = 0, so equation (6) implies that dX(t) = (1 − τ )y(t)dt,
which is nonpositive from Statement 1.
PROOF OF PROPOSITION 9: Assume that the firm is in Scenario I, so that ω1 > 0.

The complementary slackness condition in equation (21) implies D∗ = V ( L).
Therefore, φ ∗ = V −1 (D∗ ) = V −1 (V ( L)) = L. Proposition 5 implies that
1−τ
V (φ(t)) = [φ(t) − L] + V ( L). (A25)
ρ+λ
Taking the unconditional expectation of both sides of equation (A25) yields
1−τ
v= [E{φ} − L] + V ( L), (A26)
ρ+λ
where v ≡ E{V (φ)}. Evaluate A(D) in equation (10) at D = V ( L) to obtain

A(V ( L)) = τρV ( L), so that equation (14) implies
(1 − τ ) L + λv + τρV ( L)
V ( L) = . (A27)
ρ+λ
Equations (A26) and (A27) are two linear equations in V ( L) and v, which
can be solved to obtain V ( L) = ρ+λ 1
[ L + ρλ E{φ}]. Therefore,
D(φ(t)) = D∗ =
V ( L) = ρ+λ
1
[ L + ρλ E{φ}]. Since φ ∗ = L, Proposition 5 implies that S(φ(t)) =
1−τ
ρ+λ
[φ(t) − L] and V (φ(t)) = D∗ + S(φ(t)).
PROOF OF PROPOSITION 10: Since ω2 > 0, equation (22) implies that D∗ = V ( H )

and hence D( H ) = V ( H ). Evaluating equation (14) at φ(t) = H , and setting

D( H ) = V ( H ), yields V ( H ) = (1−τ ) H +λv+A(V ( H ))
. The definition of A(D) in
ρ+λ
equation (10) implies that A(V ( H )) ≡ τ (ρ + λ)V ( H ) − [α + τ (1 − α)]λv. Sub-
stituting this expression for A(V ( H )) into the preceding equation, V ( H ) =
(1−τ ) H +λv+A(V ( H ))
ρ+λ
, yields V ( H ) = (1−τ ) H +λv+τ (ρ+λ)V
ρ+λ
( H )−[α+τ (1−α)]λv
. Multiply
both sides by ρ + λ and then subtract τ (ρ + λ)V ( H ) from both sides to
obtain (1 − τ )(ρ + λ)V ( H ) = (1 − τ ) H + λ(1 − τ )(1 − α)v, which implies (ρ +
λ)V ( H ) = H + λ(1 − α)v, or equivalently, V ( H ) = H +λ(1−α)v ρ+λ
.
PROOF OF LEMMA 1: Since ω1 = ω1 = 0, equation (20) implies that A (D∗ ) = 0.

Since V ( L) ≤ D∗ ≤ V ( H ) and V (φ) is strictly increasing in φ, there is
a unique φ ∗ ∈ [ L, H ] such that V (φ ∗ ) = D∗ . Therefore, D(φ ∗ ) = D∗ . Dif-
ferentiating V (φ(t)) in equation (14) with respect to φ(t) yields V (φ(t)) =
1
ρ+λ
[1 − τ + A (
D(φ(t)))
D (φ(t))]. Evaluating this derivative at φ(t) = φ ∗ , where

D(φ(t)) = D(φ ) = D , and using A (D∗ ) = 0 yields V (φ ∗ ) = 1−τ . Therefore,
∗ ∗
ρ+λ
ρ+λ
V −1 (D∗ ) = 1−τ
.
PROOF OF PROPOSITION 11: The proof proceeds by presenting, for each scenario,
the value of D∗ that satisfies the first-order condition in equation (20) and the
values of ω1 and ω2 that, along with D∗ , lead to satisfaction of the complemen-
tary slackness conditions in equations (21) and (22). Because the maximand in
equation (19) is strictly concave in D, a value of D that satisfies equations (20)
to (22) is the unique value of D∗ .
(I) Assume that τ < τ L. Suppose that D∗ = V ( L), ω1 > 0, and ω2 = 0. Since
D∗ = V ( L), the complementary slackness condition in equation (21) is
satisfied, and since ω2 = 0, the complementary slackness condition in
equation (22) is satisfied. Since ω2 − ω1 < 0, the first-order condition
in equation (20) implies that A (D∗ ) < 0. Thus, it suffices to show that
A (V ( L)) < 0. Differentiating A(D) in equation (10) with respect to D,
evaluating the derivative at D = D∗ = V ( L), and using φ ∗ = V −1 (D∗ ) =
V −1 (V ( L)) = L yields

A (D∗ ) = τρ − α(1 − τ )λV −1 (V ( L)) f ( L)V ( L). (A28)
Since ω1 > 0 and ω2 = 0, the firm is in Scenario I. Therefore, Statement

3 of Proposition 9 implies that V ( L) = D∗ = ρ+λ
1
[ L + ρλ E{φ}] and also
for all φ(t), so V −1 (V ( L)) = ρ+λ

that V (φ(t)) = ρ+λ
1−τ
1−τ
. Therefore, equation
(A28) can be written as

∗ λ
A (D ) = τρ − α L + E{φ} λ f ( L). (A29)
ρ
Use the definition τ L ≡ α ρλ f ( L)( L + ρλ E{φ}) to rewrite equation (A29)

as
A (D∗ ) = (τ − τ L)ρ < 0, (A30)
where the inequality follows from ρ > 0 and the assumption that τ < τ L.
Therefore, D∗ = V ( L), ω1 > 0, and ω2 = 0 satisfy the first-order con-
dition in equation (20) and the complementary slackness conditions in
equations (21) and (22), and the firm is in Scenario I.
(II) Assume that τ L ≤ τ ≤ τ H . Suppose that ω1 = ω2 = 0. Therefore, the com-
plementary slackness conditions in equations (21) and (22) are satis-
fied. Since ω2 − ω1 = 0, the first-order condition in equation (20) implies
that A (D∗ ) = 0. Thus, it suffices to show that A (D) = 0 for some D ∈
[V ( L), V ( H )]. The proof proceeds by showing that if D∗ = V ( L), so
that φ ∗ = L, then A (D∗ ) ≥ 0, and if D∗ = V ( H ), so that φ ∗ = H , then
A (D∗ ) ≤ 0, so there is a D∗ ∈ [V ( L), V ( H )] that satisfies A (D∗ ) = 0.
Differentiate A(D) in equation (10) with respect to D and use Lemma 1
to obtain
A (D∗ ) = τ (ρ + λF(V −1 (D∗ ))) − (ρ + λ)αλD∗ f (V −1 (D∗ )). (A31)
Consider the possibility that D∗ = V ( L), which implies φ ∗ = L. Eval-

uate A(D) in equation (10) at D = V ( L) to obtain A(V ( L)) = τρV ( L),
so equation (14) evaluated at φ(t) = L and D(φ(t)) = D∗ = V ( L) yields
(1−τ ) L +λv+τρV ( L )
V ( L) = ρ+λ
, which implies
((1 − τ )ρ + λ)V ( L) = (1 − τ ) L + λv. (A32)

Taking the expectation of both sides of V (φ(t)) = 1−τ

ρ+λ
[φ(t) − φ ∗ ] + D∗ from
Proposition 5 yields
1−τ
v= [E{φ} − L] + V ( L), when D∗ = V ( L) and φ ∗ = L. (A33)
ρ+λ
Substituting equation (A33) into equation (A32) and rearranging yields
1 λ/ρ
V ( L) = L + E{φ}. (A34)
ρ+λ ρ+λ
Now evaluate A (D∗ ) in equation (A31) at D∗ = V ( L) and use the ex-
pression for V ( L) in equation (A34) to obtain

λ
A (V ( L)) = τρ − αλ L + E{φ} f ( L). (A35)
ρ
Use the definition τ L ≡ α ρλ f ( L)( L + ρλ E{φ}) to rewrite equation (A35)

as
A (V ( L)) = (τ − τ L)ρ ≥ 0, (A36)
where the inequality follows from ρ > 0 and the assumption that τ ≥ τ L.
Evaluate A (D) at D = V ( H ) to obtain
A (V ( H )) = (τ − αλV ( H ) f ( H ))(ρ + λ). (A37)
Evaluate A(D) in equation (10) at D = V ( H ) to obtain A(V ( H )) = τ (ρ +

λ)V ( H ) − [α + τ (1 − α)]λv, so equation (14) evaluated at φ(t) = H and

D(φ(t)) = D∗ = V ( H ) yields V ( H ) = (1−τ ) H +λv+τ (ρ+λ)V ( H )−[α+τ (1−α)]λv
,
ρ+λ
which implies
1
V ( H ) = [ H + (1 − α)λv]. (A38)
ρ+λ
Substitute equation (A38) into equation (A37) and use the definition
λ
τ H ≡ α ρ+λ f ( H )( H + (1 − α)λv) to obtain
A (V ( H )) = (τ − τ H )(ρ + λ) ≤ 0, (A39)
where the inequality follows from ρ + λ > 0 and the assumption τ ≤ τ H .

Therefore, there is a D∗ ∈ [V ( L), V ( H )] for which A (D∗ ) = 0 when
ω1 = ω2 = 0. Hence, the firm is in Scenario II. Proposition 5 immediately
implies that D(φ(t)) = D∗ for φ(t) ≥ φ ∗ and
D(φ(t)) = V (φ(t)) for φ(t) ≤ φ ∗ .
α
(III) Assume that 1+α > τ > τ H . Suppose that D∗ = V ( H ), ω1 = 0, and ω2 >
0, so the firm is in Scenario III. Since ω1 = 0, the complementary slack-
ness condition in equation (21) is satisfied. Since D∗ = V ( H ), the comple-
mentary slackness condition in equation (22) is satisfied. Since ω2 − ω1 >
0, the first-order condition in equation (20) implies that A (D∗ ) > 0. Thus,
it suffices to show that A (V ( H )) > 0. Differentiating A(D) in equation

(10) with respect to D, evaluating the derivative at D = D∗ = V ( H ), and
using φ ∗ = V −1 (D∗ ) = V −1 (V ( H )) = H yields
A (V ( H )) = τ (ρ + λ) − α(1 − τ )λV −1 (V ( H )) f ( H )V ( H ). (A40)

ρ+λ
Proposition 1 implies that V (V ( H )) ≥ 1−τ
ρ+λ
, so V −1 (V ( H )) < 1−τ
, and
equation (A40) implies that
A (V ( H )) ≥ τ (ρ + λ) − α(ρ + λ)λ f ( H )V ( H ). (A41)
Use V ( H ) = ρ+λ1
[ H + (1 − α)λv] from Proposition 10 and the definition
λ
τ H ≡ α ρ+λ f ( H )( H + (1 − α)λv) to rewrite equation (A41) as
A (V ( H )) ≥ (τ − τ H )(ρ + λ) > 0, (A42)
where the second inequality follows from ρ + λ > 0 and τ > τ H . Thus,
D∗ = V ( H ), ω1 = 0, and ω2 > 0 satisfy the first-order condition in equa-
tion (20) and the complementary slackness conditions in equations (21)
and (22), and the firm is in Scenario III.
PROOF OF PROPOSITION 12: Let y(φ(t); 0) be the optimal taxable income under
the original distribution (m = 0) and recall from Statement 2 of Proposition
8 and footnote 20 that y(φ(t); 0) is strictly increasing in φ(t). Consider the
following feasible financing plan under Gm(φ). (1) If φ(t) ∈ [ L(m), H (0)], set
D(φ(t); m) = D(φ(t); 0), where D(φ(t); 0) is the optimal amount of debt under
G0 (φ), and pay the same default premium that would be paid under G0 (φ),
so that taxable income y(φ(t); m) = y(φ(t); 0). I verify below that the default
premium under the new distribution, Gm(φ), is no higher than under the origi-
nal distribution, G0 (φ). (2) If φ(t) ∈ ( H (0), H (m)], set D(φ(t); m) = D( H (0); 0)
and pay the same default premium that would be paid under G0 (φ) when
φ(t) = H (0), so that y(φ(t); m) =y( H (0); m) + φ(t) − H (0) = y( H (0); 0) +
φ(t) − H (0) > y( H (0); 0). (3) At any future date of regime change, t j , (a) if
φ(t j ) ∈ [ L(m), H (0)], default if and only if the firm would optimally default
under G0 (φ) when φ = φ(t j ) and (b) if φ(t j ) ∈ ( H (0), H (m)], do not default. For
φ(t0 ) ∈ [ L(m), H (0)], the firm will have the same cash flow Gm(φ) as it would
under the optimal policy under G0 (φ). However, with the financing plan under
Gm(φ), the continuation value under Gm(φ) will exceed the continuation value
(m) (m)
under G0 (φ) by HH(0) (1 − τ )y(φ(t); m)dF(φ − m) − LL(0) (1 − τ )y(φ(t); 0)dF(φ)
(m) (m)
> (1 − τ )y( H (0); 0) HH(0) dF(φ − m) − (1 − τ )y( L(m); 0) LL(0) dF(φ) = (1 −
(0) (0)+m
τ )y( H (0); 0) HH(0)−m dF(φ) − (1 − τ )y( L(m); 0) LL(0) dF(φ) > 0 , where the
first inequality follows from y(φ(t); m) > y( H (0); 0) if φ(t) > H (0), as shown
above, and from the fact that y(φ(t); 0) is strictly increasing in φ(t) as shown ear-
lier in this proof; the second inequality follows from y( H (0); 0) > y( L(m); 0)
(0) (0)+m
and HH(0)−m dF(φ) ≥ LL(0) dF(φ) since f (φ) ≡ F (φ) is nondecreasing. There-
fore, the continuation value under Gm(φ) exceeds the continuation value under
G0 (φ), and hence V (φ(t); m) > V (φ(t); 0) for m > 0. Finally, because the contin-
uation value of the firm for any given φ(t) is higher under Gm(φ) than under
G0 (φ), the default premium under Gm(φ) is no higher than under G0 (φ).
PROOF OF PROPOSITION 13: From Proposition 9,

D(φ(t); m) = 1
ρ+λ
[ L(m) +
λ
ρ
E{φ; m}] in Scenario I, so dD(φ(t);m) dm
= ρ+λ1
[ ddm
L (m)
+ ρλ dE{φ;m}
dm
], where E{φ; m} =
H (m)
L (m) φdF(φ − m). Since
d L (m)
dm
dE{φ;m}
= dm = 1, d D(φ(t);m)
dm
= ρ+λ (1 + ρλ ) = ρ1 (State-
1
ment 1). From Proposition 9, S(φ(t); m) = ρ+λ 1−τ

(φ(t) − L(m)) in Scenario I, so
dS(φ(t);m) dS(φ(t);m)
dm
= − 1−τ d L (m)
ρ+λ dm
. Since d L (m)
dm
= 1, dm
= − ρ+λ1−τ
(Statement 2). Since

V (φ(t); m) = D(φ(t); m) + S(φ(t); m), dV (φ(t);m)dm
= dD(φ(t);m)
dm
+ dS(φ(t);m)
dm
= ρ1 − ρ+λ 1−τ
=
1 ρτ +λ D(φ(t);m) dL(φ(t);m)
ρ ρ+λ
> 0 (Statement 3). Since L(φ(t); m) ≡ V (φ(t);m) , dm
= V (φ(t);m) ρ [1 −
1 1
τρ+λ
L(φ(t); m) ρ+λ ] > 0, where the inequality follows from L(φ(t); m) ≤ 1 and τ < 1
(Statement 4).
PROOF OF LEMMA 2: Suppose that the distribution shifts to the right by

d > 0 and consider whether φ ≡ φ ∗ (m) + d satisfies the first-order condition
in equation (34) under the new distribution. That is, consider whether ≡
τ (ρ + λF( φ − (m + d))) − αλ(ρ + λ)V ( φ , m + d) f (
φ − (m + d)) equals zero. The
definition of φ implies that φ − (m + d) = φ ∗ (m) − m, so = τ (ρ + λF(φ ∗ (m) −
m))− αλ(ρ + λ)V (φ ∗ (m) + d, m + d) f (φ ∗ (m) − m). Use equation (34) to replace
τ (ρ + λF(φ ∗ (m) − m)) by αλ(ρ + λ)V (φ ∗ (m), m) f (φ ∗ (m) − m) in to obtain
= αλ(ρ + λ) f (φ ∗ (m) − m)[V (φ ∗ (m), m) − V (φ ∗ (m) + d, m + d)]. Since d > 0 , we
have V (φ ∗ (m) + d, m + d) > V (φ ∗ (m), m + d) > V (φ ∗ (m), m), where the first
inequality follows from Proposition 1 and the second inequality follows
from Proposition 12. Since αλ f (φ ∗ (m) − m) > 0 and V (φ ∗ (m) + d, m + d) >

V (φ ∗ (m), m), we have < 0, that is, ∂ A(V (φ ,m+d);m+d)
∂D
< 0, and since (from Corol-
lary 2) A(D; m) is strictly concave in D, the value of D∗ is less∗ than V∗ ( φ , m + d),
so φ ∗ (m + d) < φ ≡ φ ∗ (m) + d. Therefore, for any d > 0, φ (m+d)−φ d
(m)
< 1, so
φ ∗ (m) < 1.
PROOF OF PROPOSITION 14: Proposition 6 ∗

implies that P(φ(t); m)=
λ min[F(φ(t) − m), F(φ ∗ (m) − m)]. Note that dF(φ dm (m)−m)
= f (φ ∗ (m) − m)(φ ∗ (m) −
∗
1) < 0, where the strict inequality follows from f (φ (m) − m) > 0 and Lemma
2. Also, dF(φ(t)−m)
dm
= − f (φ(t) − m) < 0. Therefore, dP(φ(t);m) dm
< 0 (Statement 1).
∗ ∗ ∗ dV (φ ∗ (m);m)
Since D (m) ≡ V (φ (m); m), sign(D (m)) = sign( dm
). Since τ >
0, αλ(ρ + λ) f (φ ∗ (0)) ∗
> 0, and φ ∗
(m) < 1 (Lemma 2), equation (35)
∗
im-
plies that sign( dV (φdm (m);m)
) = −sign(χ (φ ∗ (m) − m)). Therefore, sign( dV (φdm (m);m)
)=

sign(D∗ (m)) = −sign(χ (φ ∗ (m) − m)) (Statement 2). ∗
Statement 2 implies that if χ (φ ∗ (m) − m) ≥ 0, then dV (φdm (m);m)
≤ 0. Since
dV (φ ∗ (m);m) ∂ V (φ ∗ (m);m) ∗ ∂ V (φ ∗ (m);m) ∗
dm
= ∂φ
φ (m) + ∂m
, it follows that if χ (φ (m) − m) ≥ 0,
∂ V (φ ∗ (m);m) ∗ dV (φ ∗ (m);m) ∂ V (φ ∗ (m);m) ∗
then ∂φ
φ (m) = dm
− ∂m
≤ − ∂ V (φ∂m
(m);m)
< 0, where the final
∂ V (φ ∗ (m);m)
inequality follows from Proposition 12. Finally, since ∂φ
> 0 (Proposition
∂ V (φ ∗ (m);m)
1), φ ∗ (m) ≤ − ∂m
∂ V (φ ∗ (m);m) < 0 (Statement 3).
∂φ
PROOF OF PROPOSITION 15: Define the operator T as

(1−τ )φ(t)+λ V (φ(t)) f (φ(t ),φ(t))dφ(t )+A(D,φ(t))
T V (φ(t)) = max D≤V (φ(t)) ρ+λ
. I first prove that
T maps nondecreasing functions into strictly increasing functions. I then prove
that T is a contraction by proving that it satisfies monotonicity and discounting.
Mapping nondecreasing functions into strictly increasing functions: Assume
that V (φ) is nondecreasing in φ. Therefore, for φ2 > φ1 , V (φ2 ) ≥ V (φ1 ), so
D(φ1 ) ≤ V (φ1 ) ≤ V (φ2 ) and hence
D(φ1 ) is feasible when φ(t) = φ2 .
Substituting the definition of A(D, φ(t)) from equation (38) into the expres-
sion for T V (φ(t)) and
evaluating the resulting expression at D = D(φ(t)) yields
(1−τ )φ(t)+ g(φ(t ),
D(φ(t))) f (φ(t ),φ(t))dφ(t )
T V (φ(t)) = ρ+λ
, where
τρ D + λτ D + (1 − τ )(1 − α)λV (φ), if V (φ) < D

g(φ, D) ≡ . (A43)
τρ D + λV (φ), if V (φ) ≥ D
Note that
g(φ, D) is nondecreasing in φ.36 Therefore, T V (φ2 )

(1−τ )φ2 + g(φ(t ), D(φ1 )) f (φ(t ),φ2 )dφ(t ) (1−τ )φ1 + g(φ(t ),
D(φ1 )) f (φ(t ),φ2 )dφ(t )
≥ ρ+λ
> ρ+λ
≥

(1−τ )φ1 + g(φ(t ),
D(φ1 )) f (φ(t ),φ1 )dφ(t )
ρ+λ
= T V (φ1 ), where the first inequality follows
from the fact that D(φ1 ) is feasible when φ(t) = φ2 , the second inequality fol-
lows from φ2 > φ1 , and the third inequality follows from the facts that g(φ, D)
is nondecreasing in φ and F(φ(t ), φ2 ) first-order stochastically dominates
F(φ(t ), φ1 ). Therefore, T maps nondecreasing functions into strictly increasing
functions.
Monotonicity: Suppose that V2 (φ(t)) ≥ V1 (φ(t)). Define gi (φ, D) to be the
function g(φ, D) defined in equation (A43),
where V (φ) is replaced by Vi (φ),
(1−τ )φ(t)+ g2 (φ(t ),
D1 (φ(t))) f (φ(t ),φ(t))dφ(t )
i = 1, 2. Therefore, T V2 (φ(t)) ≥ ρ+λ
and T V1 (φ(t))

(1−τ )φ(t)+ g1 (φ(t ), D1 (φ(t))) f (φ(t ),φ(t))dφ(t )
= ρ+λ
, where
D1 (φ(t)) attains the maximum of

(1−τ )φ(t)+ g1 (φ(t ),D) f (φ(t ),φ(t))dφ(t )
ρ+λ
, subject to D ≤ V1 (φ(t)), and D1 (φ(t)) is feasible
under V2 (φ(t))
because D1 (φ(t)) ≤ V1 (φ(t)) ≤ V2 (φ(t)). Therefore, T V2 (φ(t)) −
[g2 (φ(t ),
D1 (φ(t)))−g1 (φ(t ),
D1 (φ(t)))] f (φ(t ),φ(t))dφ(t )
T V1 (φ(t)) ≥ ρ+λ
. To prove that T V2 (φ(t)) −
T V1 (φ(t)) ≥ 0, it suffices to prove that g2 (φ(t ), D1 (φ(t))) − g1 (φ(t ),

D1 (φ(t))) ≥ 0
for all φ(t) in the support of F. The definition of g(φ, D) implies that
(1 − τ )(1 − α)λ[V2 (φ) − V1 (φ)] ≥ 0, if V2 (φ) < D

g2 (φ, D)
= λV2 (φ) − [λτ D + (1 − τ )(1 − α)λV1 (φ)], if V1 (φ) < D ≤ V2 (φ) .
−g1 (φ, D)
λ[V2 (φ) − V1 (φ)] ≥ 0, if V1 (φ) ≥ D
36 To show that g(φ, D) is nondecreasing in φ, it suffices to show that τρ D + λτ D + (1 − τ )(1 −
α)λD ≤ τρ D + λD, or equivalently that 0 ≤ (1 − τ )λD − (1 − τ )(1 − α)λD = α(1 − τ )λD, which fol-
lows from α > 0, τ < 1, λ > 0, and D ≥ 0.
It remains to prove that g2 (φ, D) − g1 (φ, D) ≥ 0 when V1 (φ) < D ≤ V2 (φ).

Observe that when V1 (φ) < D ≤ V2 (φ), g2 (φ, D) − g1 (φ, D) = λV2 (φ) − [λτ D +
(1 − τ )(1 − α)λV1 (φ)] > λV2 (φ) − [λτ D + (1 − τ )(1 − α)λD] = λ(V2 (φ) − [1 − (1 −
τ )α]D) ≥ 0. Therefore, the operator T is monotonic.
Discounting: Define g(a) (φ, D) to be the function g(φ, D) defined in equation
(A43), where V (φ) is replaced by V (φ) + a, so that
⎡ ⎤
τρ( D(a) (φ(t)) − a)
⎣ +λτ ( D(a) (φ(t)) − a) ⎦ , if V (φ) <
D(a) (φ(t)) − a
g (φ,
(0)
D (φ(t)) − a) ≡ +(1 − τ )(1 − α)λV
(a)
(φ)

τρ( D (φ(t)) − a)
(a)
, if V (φ) ≥
D(a) (φ(t)) − a
+λV (φ)
and

D(a) (φ(t)) + λτ
τρ D(a) (φ(t))
, if V (φ) + a <
D(a) (φ(t))
g(a) (φ,
D(a) (φ(t))) ≡ +(1 − τ )(1 − α)λ(V (φ) + a) .
τρ
D(a) (φ(t)) + λ(V (φ) + a), if V (φ) + a ≥
D(a) (φ(t))

(1−τ )φ(t)+ g(a) (φ(t ),
D(a) (φ(t))) f (φ(t ),φ(t))dφ(t )
For a ≥ 0,[T (V + a)](φ(t)) = ρ+λ
. Since

D (φ(t)) ≤ V (φ(t)) + a, D (φ(t)) − a ≤ V (φ(t)) and is feasible under V (φ(t)).
(a) (a)
(1−τ )φ(t)+ g(0) (φ(t ),
D(a) (φ(t))−a) f (φ(t ),φ(t))dφ(t )
Therefore, T V (φ(t)) ≥ ρ+λ
. Therefore,

[g(a) (φ(t ),
D(a) (φ(t)))−g(0) (φ(t ),
D(a) (φ(t))−a)] f (φ(t ),φ(t))dφ(t )
[T (v + a)](φ(t)) − T v(φ(t)) ≤ ρ+λ
,
where
g(a) (φ,
D(a) (φ(t))) τρa + [1 − α(1 − τ )]λa, if V (φ) + a <
D(a) (φ(t))
= .
−g(0) (φ,
D(a) (φ(t)) − a) τρa + λa, if V (φ) + a ≥
D(a) (φ(t))
Therefore, [T (V + a)](φ(t)) − T V (φ(t)) ≤ βa, where β ≡ τρ+λ

ρ+λ
< 1. It follows
that T satisfies the discounting property and hence T is a contraction. There-
fore, V (φ) is strictly increasing.
PROOF OF PROPOSITION
16: The uniform distribution in this proposition is
F(φ(t ), φ(t)) = φ(t )−g(φ(t))+d
2d
. First, consider the case in which the trade-off theory
is operative in a neighborhood of φ(t), which implies that D(φ(t)) satisfies the
first-order condition in equation (40). This first-order condition can be written
−1
as τ [ρ + λ V (D)−g(φ(t))+d
2d
] − (1 − τ )αλV −1 (D)D 2d1
= 0. The second-order condi-
tion that must hold for the trade-off theory to be operative is that the left-hand
side of this first-order condition is decreasing in D. An increase in φ(t) reduces
the first term on the left-hand side, which is the marginal interest tax shield.
Therefore, the value of D must fall to satisfy the first-order condition. Hence,
D (φ(t)) < 0 (Statement 1a). Since
D (φ(t)) < 0 and from Proposition 15 V (φ(t))

is strictly increasing in φ(t), the leverage ratio, L(φ(t)) ≡ VD(φ(t)) (φ(t))
, is strictly de-
φ(t )−g(φ(t))+d
creasing in φ(t) (Statement 1b). With F(φ(t ), φ(t)) = 2d
, the conditional
V −1 (
D(φ(t)))−g(φ(t))+d
probability of default in equation (41) is p(φ(t)) = λ 2d
regardless
of whether the trade-off theory is operative or the borrowing constraint is
binding. If the trade-off theory is operative, D (φ(t)) < 0, so an increase in φ(t)

−1
reduces V ( D(φ(t))). An increase in φ(t) increases g(φ(t)). Therefore, because
V −1 (
D(φ(t))) decreases and g(φ(t)) increases, the probability of default, p(φ(t)),
falls (Statement 1c).
Now consider the case in which the borrowing constraint is binding in a neigh-
borhood of φ(t). Then, D(φ(t)) ≡ V (φ(t)), and hence Proposition 15 implies that
D (φ(t)) > 0 (Statement 2a). Since
D(φ(t)) ≡ V (φ(t)), we have V −1 ( D(φ(t))) =
φ(t), so the expression for p(φ(t)) can be written as p(φ(t)) = φ(t)−g(φ(t))+d
2d
. There-

fore, p (φ(t)) = 1−g2d(φ(t)) > 0, where the inequality follows from the assumption
0 < g (φ(t)) < 1 (Statement 2b).
Appendix B: Calculation of the Value of the Firm

This appendix derives the expression for the value of the firm in equation
(9). First, substitute equation (6) into equation (8) to obtain
t1 t1 −ρ(s−t)
−ρ(s−t)
t (1 − τ )y(s)e ds + t e dDs
V (φ(t)) = max Et . (B1)
Ds ≤V (φ(s)) + e−ρ(t1 −t) max[V (φ(t1 )) − Dt1− , 0]
Set y(s) = y(t) for all s in [t, t1 ), dDt = Dt , dDs = 0 for all s in (t, t1 ), and
Dt1− = Dt , to obtain
t1
V (φ(t)) = max Et (1 − τ )y(t) e−ρ(s−t) ds + Dt + e−ρ(t1 −t) max[V (φ(t1 ))
Dt ≤V (φ(t)) t

− Dt , 0] . (B2)
The density of t1 is λe−λ(t1 −t) , so

λ
Et {e−ρ(t1 −t) ds} = (B3)
ρ+λ
and
t1
−ρ(s−t) 1
Et e ds = . (B4)
t ρ+λ
Use the expectations in equations (B3) and (B4) to calculate the expectation
in equation (B2) and rearrange to obtain

1
V (φ(t)) = max Et (1 − τ )yt + (ρ + λ)Dt + λ [V (φ)
ρ + λ Dt ≤V (φ(t)) V (φ)≥Dt

− Dt ]dF(φ) . (B5)
Substitute the expression for taxable income, y(t), from equation (5) into
equation (B5) to obtain

1 (1 − τ ) φ(t) − ρ Dt − λ V (φ)<Dt [Dt − (1 − α)V (φ)]dF(φ)
V (φ(t)) = max Et .
ρ+λ Dt ≤V (φ(t)) + (ρ + λ)Dt + λ V (φ)≥Dt [V (φ) − Dt ]dF(φ)
(B6)
Collect terms in Dt and separately collect terms in V (φ) to obtain

⎧ ⎫
⎪
⎪ (1 − τ )φ(t) ⎪
⎪
1 ⎨ ⎬
V (φ(t)) = max Et τρ Dt + λDt − λ(1 − τ )Dt V (φ)<Dt dF(φ) − λDt V (φ)≥Dt dF(φ) .
⎪
ρ + λ Dt ≤V (φ(t)) ⎪ ⎪
⎩+λ V (φ)dF(φ) + λ(1 − τ )(1 − α)
⎪
V (φ)dF(φ) ⎭
V (φ)≥Dt V (φ)<Dt
(B7)

Use 1 − V (φ)≥Dt dF(φ) = V (φ)<Dt dF(φ) and V (φ)≥Dt V (φ)dF(φ) = V (φ)dF

(φ) − V (φ)<Dt V (φ)dF(φ) and rearrange to rewrite equation (B7) as
⎧ ⎫
⎪
⎪ (1 − τ )φ(t) ⎪
⎪
1 ⎨
⎬
V (φ(t)) = max Et τ ρ + λ V (φ)<D dF(φ) Dt .
ρ + λ Dt ≤V (φ(t)) ⎪
⎪ t
⎪
⎪
⎩ ⎭
+ λ V (φ)dF(φ) − [1 − (1 − τ )(1 − α)]λ V (φ)<Dt V (φ)dF(φ)
(B8)

Use the definitions A(D) ≡ τ [ρ + λ V (φ)<D dF(φ)]D − [α + τ (1 − α)]λ
V (φ)<D
V (φ)dF(φ) and v ≡ V (φ)dF(φ) to rewrite equation (B8) as
(1 − τ )φ(t) + λv + A(Dt )
V (φ(t)) = max . (B9)
Dt ≤V (φ(t)) ρ+λ
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Supporting Information
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article at the publisher’s website:
Appendix S1: Internet Appendix.

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THE JOURNAL OF FINANCE • VOL. LXXIII, NO.

Optimal Debt and Profitability in

THE TRADE-OFF THEORY OF capital structure is the longest standing theory of

arises from the invariance of debt to EBIT, is reminiscent of Strebulaev’s (2007)

I. The Firm’s Economic Environment

an instantaneous probability λ of an arrival of a new value of φ(t). Realizations

I refer to the limit on borrowing in equation (4) as an endogenous borrowing

dX(t) = (1 − τ )y(t)dt + dDt , (6)

The value of the firm at time t is

1. The firm arrives at time t with Dt− bonds outstanding.

II. Optimal Debt, Firm Value, and Shareholder Equity

ρV (φ(t)) = max [(1 − τ )φ(t) + λ(v − V (φ(t))) + A(Dt )]. (12)

PROPOSITION 1: V (φ(t)) is strictly increasing in φ(t). Moreover, for any φ2 > φ1

The proof of Proposition 1 is in Appendix A, but the logic of the proof is

PROPOSITION 2: The optimal value of bonds,

1. nondecreasing in the state, φ(t), and

where the inequality is the borrowing constraint. Because shareholders receive

Proposition 4 provides sufficient conditions for the value function, V (φ(t)),

D∗ ≡ arg max A(D). (16)

The following proposition characterizes optimal debt, D(φ(t)), shareholder

(1) for any φ(t) ≥ φ ∗ ,

18 Corollary 2 provides sufficient conditions for A(D) to be strictly concave in D. A necessary

the borrowing constraint, D ≤ V (φ(t)), is binding, so shareholders’ equity,

1. strictly increasing in D(φ(t)),

(2) is not operative in the current specification because profitability, φ, is i.i.d.

1. after-tax income (1 − τ )y(t) ≡ (1 − τ )[φ(t) − r(t)

Statement 1 of Proposition 8 implies that if the after-tax income of the firm

III. Three Scenarios

20 If φ(t) ≥ φ ∗ , after-tax income, (1 − τ )[φ(t) − r(t)

The definition of D∗ in equation (16), D∗ ≡ arg maxV (L)≤D≤V ( H ) A(D), implies

D∗ = arg max A(D) + ω1 (D − V ( L)) + ω2 (V ( H ) − D), (19)

where ω1 ≥ 0 is the multiplier on the constraint V ( L) ≤ D and ω2 ≥ 0 is the

and the complementary slackness conditions are

ω1 (D∗ − V ( L)) = 0 (21)

Three distinct scenarios are defined according to whether the multipliers ω1

In the remainder of this section, I focus on Scenarios I and III. I analyze

21 Since V ( L) = V ( H ), ω1 and ω2 cannot both be positive.

Proposition 9 states that, in Scenario I, the optimal value of debt equals D0 ,

PROPOSITION 10: In Scenario III (where ω1 = 0 and ω2 > 0), V ( H ) = 1

A. The Trade-Off Theory

22 There exists a value of D∗ that satisfies equation (24) if τ ≤ τ ≤ τ , where τ and τ

B. Firm in Scenario II with φ(t) ≤ φ ∗

V. Threshold Tax Rates

Figure 2. Three scenarios. (Color figure can be viewed at wileyonlinelibrary.com)

(1) If τ < τ L, the firm is in Scenario I and D(φ(t)) = ρ+λ

VI. Effect of a Rightward Translation of F(φ)

A. Effect of a Rightward Translation of F(φ),in Scenario I

A rightward translation of the distribution F(φ) by one unit increases EBIT

B. Effect of a Rightward Translation of F(φ), in Scenario II

dV (φ ∗ (m);m) ∂ V (φ ∗ (m);m) ∗ ∗ (m);m)

Since an increase in m does not increase φ ∗ (m) by an amount greater than

by a constant amount, ρ+λ 1−τ

negative. Because A(D; m) is strictly concave in D, a reduction in D is needed to

of EBIT is a truncated exponential distribution and distinguishes situations in which D∗ falls in

Scenario I Scenario IIA Scenario IIB Scenario III

C. Effect of a Rightward Translation of F(φ), in Scenario III

D. Summary of Effects of Increased Profitability

an increase in profitability—either an increase in current profitability, φ(t),

VII. Persistence of Profitability across Regimes

dependence is described by 0 ≤ ∂h(∂φ(t)p,φ(t))

τ ρ + λ V (φ(t ))<D f (φ(t ), φ(t))dφ(t ) D

and the value function is

PROPOSITION 15: If F(φ(t ), φ(t)) is nonincreasing in φ(t), the value function

captures the direct effect of a change in the conditional distribution on the

The definition of D∗ in equation (16), D∗ ≡ arg maxV (L)≤D≤V ( H ) A(D), implies

D∗ = arg max A(D) + ω1 (D − V ( L)) + ω2 (V ( H ) − D), (19)

where ω1 ≥ 0 is the multiplier on the constraint V ( L) ≤ D and ω2 ≥ 0 is the

ω1 (D∗ − V ( L)) = 0 (21)

21 Since V ( L) = V ( H ), ω1 and ω2 cannot both be positive.

PROPOSITION 10: In Scenario III (where ω1 = 0 and ω2 > 0), V ( H ) = 1

with strict inequality if φ(t) < H , which proves Statement 1.

where v ≡ E{V (φ)}. Evaluate A(D) in equation (10) at D = V ( L) to obtain

PROOF OF PROPOSITION 10: Since ω2 > 0, equation (22) implies that D∗ = V ( H )

Use the definition τ L ≡ α ρλ f ( L)( L + ρλ E{φ}) to rewrite equation (A29)

Consider the possibility that D∗ = V ( L), which implies φ ∗ = L. Eval-

((1 − τ )ρ + λ)V ( L) = (1 − τ ) L + λv. (A32)

Use the definition τ L ≡ α ρλ f ( L)( L + ρλ E{φ}) to rewrite equation (A35)

A (V ( L)) = (τ − τ L)ρ ≥ 0, (A36)

A (V ( H )) = (τ − αλV ( H ) f ( H ))(ρ + λ). (A37)

Evaluate A(D) in equation (10) at D = V ( H ) to obtain A(V ( H )) = τ (ρ +

it suffices to show that A (V ( H )) > 0. Differentiating A(D) in equation

A (V ( H )) = τ (ρ + λ) − α(1 − τ )λV −1 (V ( H )) f ( H )V ( H ). (A40)

A (V ( H )) ≥ τ (ρ + λ) − α(ρ + λ)λ f ( H )V ( H ). (A41)

A (V ( H )) ≥ (τ − τ H )(ρ + λ) > 0, (A42)