Advertisement

Cash flows risk, capital structure, and corporate bond yields

  • Berardino PalazzoEmail author
Research Article
  • 10 Downloads

Abstract

This paper explores the effects of a firm’s cash flow systematic risk on its optimal capital structure. In a model where firms are allowed to borrow resources from a competitive lending sector, those with cash flows more correlated with the aggregate economy (i.e., firms with riskier assets in place) choose a lower leverage given their higher expected financing costs. On the other hand, less risky firms, having lower expected financing costs, optimally choose to issue more debt to exploit a tax advantage. The model predicts that cash flow systematic risk is negatively correlated with leverage and corporate bond yields.

Keywords

Systematic risk Optimal capital structure Assets prices 

JEL Classification

G12 G32 D92 

Notes

Acknowledgements

I am very grateful to Rui Albuquerque, Harjoat Bhamra, Barbara Bukhvalova, Andrea Buffa, Gian Luca Clementi, Dirk Hackbart, Siamak Javadi, Evgeny Lyanders, David McLean, Angelo Mele, Allen Michel, Ali Ozdagli, Marco Rossi, Lukas Schmid, Philip Strahan, Adam Zawadowski, as well as seminar attendants at Boston University, Green Line Macroeconomics Meeting, Midwest Finance Association, Society for Economics Dynamics, University of Alberta, and BI Oslo for their comments and suggestions. The views expressed are those of the author and do not necessarily reflect those of the Federal Reserve Board or the Federal Reserve System.

References

  1. Bagnoli, M., Bergstrom, T.: Log-concave probability and its applications. Econ Theory 26(2), 445–469 (2005)CrossRefGoogle Scholar
  2. Barlow, R.E., Marshall, A.W., Proschan, F.: Properties of probability distributions with monotone hazard rate. Ann Math Stat 34(2), 375–389 (1963)CrossRefGoogle Scholar
  3. Berk, J.B., Green, R.C., Naik, V.: Optimal investment, growth options, and security returns. J Finance 54(5), 1553–1607 (1999)CrossRefGoogle Scholar
  4. Bhamra, H.S., Kuehn, L.A., Strebulaev, I.A.: The levered equity risk premium and credit spreads: \(a\) unified framework. Rev Financ Stud 23(2), 645–703 (2010)CrossRefGoogle Scholar
  5. Epstein, L., Zin, S.: Substitution, risk aversion, and the temporal behavior of consumption and asset returns: a theoretical framework. Econometrica 57, 937–969 (1989)CrossRefGoogle Scholar
  6. Garlappi, L., Yan, H.: Financial distress and the cross-section of equity returns. J Finance 66(3), 789–822 (2011)CrossRefGoogle Scholar
  7. George, T.J., Hwang, C.Y.: A resolution of the distress risk and leverage puzzles in the cross section of stock returns. J Financ Econ 96, 56–79 (2010)CrossRefGoogle Scholar
  8. Glover, B.: The expected cost of default. J Financ Econ (forthcoming) (2015)Google Scholar
  9. Gomes, J.F., Schmid, L.: Levered returns. J Finance 65(2), 467–494 (2010)CrossRefGoogle Scholar
  10. Hackbarth, D., Miao, J., Morellec, E.: Capital structure, credit risk, and macroeconomic conditions. J Financ Econ 82, 519–550 (2006)CrossRefGoogle Scholar
  11. Imrohoroglu, A., Tuzel, S.: Firm level productivity, risk, and return. Manag Sci 60(8), 2073–2090 (2014)CrossRefGoogle Scholar
  12. Kuehn, L.A., Schmid, L.: Investment-based corporate bond pricing. J Finance 69(6), 2741–2776 (2014)CrossRefGoogle Scholar
  13. Leland, H.E.: Corporate debt value, bond covenants, and optimal capital structure. J Finance 49(4), 1213–1252 (1994)CrossRefGoogle Scholar
  14. Merton, R.C.: On the pricing of corporate debt: the risk structure of interest rates. J Finance 29(2), 449–470 (1974)Google Scholar
  15. Ozdagli, A.K.: Financial leverage, corporate investment, and stock returns. Rev Financ Stud 25(4), 1033–1069 (2012)CrossRefGoogle Scholar
  16. Ross, S.A.: Debt and taxes and uncertainty. J Finance 60(3), 637–657 (1985)CrossRefGoogle Scholar

Copyright information

© This is a U.S. government work and not under copyright protection in the U.S.; foreign copyright protection may apply 2019

Authors and Affiliations

  1. 1.Federal Reserve BoardWashingtonUSA

Personalised recommendations