RFS Advance Access originally published online on January 4, 2007
Review of Financial Studies 2007 20(5):1389-1428; doi:10.1093/revfin/hhl047
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Can the Trade-off Theory Explain Debt Structure?
Washington University in St.Louis
University of California, Berkeley
University of California, Berkeley
Address correspondence to Dirk Hackbarth, Finance Department, Olin School of Business, Washington University in St. Louis, One Brookings Drive, St. Louis, MO 63130, USA or e-mail: hackbarth{at}wustl.edu
JEL: G13, G32, G33
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Abstract |
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We examine the optimal mixture and priority structure of bank and market debt using a trade-off model in which banks have the unique ability to renegotiate outside formal bankruptcy. Flexible bank debt offers a superior trade-off between tax shields and bankruptcy costs. Ease of renegotiation limits bank debt capacity, however. Optimal debt structure hinges upon which party has bargaining power in private workouts. Weak firms have high bank debt capacity and utilize bank debt exclusively. Strong firms lever up to their (lower) bank debt capacity, augment with market debt, and place the bank senior. Therefore, the trade-off theory offers an explanation for: (i) why young/small firms use bank debt exclusively; (ii) why large/mature firms employ mixed debt financing; and (iii) why bank debt is senior. The trade-off theory also generates predictions consistent with international evidence. In countries in which the bankruptcy regime entails soft (tough) enforcement of contractual priority, bank debt capacity is low (high), implying greater (less) reliance on market debt.
We would like to thank seminar participants at the University of Wisconsin, University of Arizona, University of Houston, Humboldt University, Stanford University, the 2003 EFA Meetings, and the 2005 AFA Meetings. Special thanks to Paul Pfleiderer, Felix Meschke, and Ilya Strebulaev who served as discussants on this article.