Macroeconomic Conditions, Growth Opportunities and the Cross-Section of Credit Risk

This paper develops a dynamic trade-off model of optimal capital structure that takes into ac- count the fact that most firms have both invested assets and growth opportunities. These two sources of value react quite differently to business cycle risk. In particular, growth options are more sensitive to regime changes than invested assets. "Growth firms" are, therefore, endoge- nously more likely to default in recession, when doing so is expensive. This in turn raises their costs of debt. The model quantitatively matches average stylized facts regarding credit spreads, leverage, default and investment clustering. Importantly, it also makes predictions about the cross-section of all these features.