www.elsevier.com/locate/jfi Credit risk and dynamic capital structure choice

This paper analyzes the effect of dynamic capital structure adjustments on credit risk. Firms may optimally adjust their leverage in response to stochastic changes in firm value. It is shown that capi-tal structure dynamics lower optimal initial leverage ratios but increase both, fair credit spreads and expected default probabilities for moderate levels of transactions costs. Numerical examples demon-strate that expected default frequencies do not decrease monotonically in the traditional distance to default measure. The magnitude of the effect of capital structure dynamics depends on firm charac-teristics such as asset volatility, the growth rate, the effective corporate tax rate, debt call features and transactions costs. We find that the underestimation of credit spreads and expected default fre-quencies is exacerbated when the risk-adjusted drift of the underlying stochastic process is inferred from a model which ignores the opportunity to recapitalize. Finally it is shown that the value-at-risk of corporate bonds increases with the distance to default (DD) both for very low and for very high values of DD whereas it decreases for intermediate values