Credit Risk and Dynamic Capital Structure Choice

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Abstract
This paper presents an analysis of the effect of dynamic capital structure adjustments on credit risk. Firms may optimally adjust their leverage in response to stochastic changes in firm value. This is shown to influence a bond's expected default frequency and its fair credit spread. Generally capital structure dynamics significantly increase both credit spreads and and expected default probabilities. Numerical examples demonstrate that there exists a u-shaped relationship between the traditional distance to default measure and expected default frequencies. The magnitude of the effect of capital structure dynamics is shown to depend on firm characteristics such as asset volatility, the growth rate, the effective corporate tax rate, call features and transactions costs. The results therefore suggest a cross-sectional variation of the relationship between the distance to default and expected default frequencies. Finally we extend the analysis to include the estimation of the firm's asset value and its volatility from observed equity prices. We find that the underestimation of credit spreads and expected default frequencies is exacerbated when the asset value and volatility are inferred from a model which ignores the opportunity to recapitalize.

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