Optimal Capital Structure and the Term Structure of Interest Rates

In this paper we study corporate debt values, capital structure, and the term structure of interest rates in a unified framework. We employ numerical techniques to compute the firm's optimal capital structure and the value of its long-term risky debt and yield spreads when the value of the firm's unleveraged assets and the instantaneous default-free interest rate are risk factors. Debt and leveraged firm value are thus explicitly linked to properties of the firm's unleveraged assets, the term structure of default-free interest rates, taxes, bankruptcy costs, payout rates, and bond covenants. The results clarify the relationship between a firm's capital structure and movements in the term structure and other important aspects of the capital structure decision