Default Risk, Asset Pricing, and Debt Control

The pricing and control of firms' debt has become a major issue since Merton's (1974) seminal article. Yet Merton as well as other recent theories presume that the asset value of the firm is independent of the debt of the firm. However, when using debt finance, firms may have to pay a premium for an idiosyncratic default risk and may face debt constraints. We demonstrate that firm-specific debt constraints and endogenous risk premia, based on collateralized borrowing, affect the asset value of the firm and, in turn, the collateral value of the firm. In order to explore the interdependence of debt finance and asset pricing of firms, we endogenize default premia and borrowing constraints in a production-based asset pricing model. In this context then the dynamic decision problem of maximizing the present value of the firm faces an additional constraint giving rise to the debt-dependent firm value. We solve for the asset value of the firm with debt finance by the use of numerical dynamic programming. This allows us to solve the debt control problem and to compute sustainable debt as well as the firm's debt value. Copyright 2005, Oxford University Press.