Debt Maturity and the Dynamics of Leverage

Abstract

This paper shows that short debt maturities commit equityholders to leverage reductions when refinancing expiring debt in low-profitability states. However, shorter maturities lead to higher transaction costs since larger amounts of expiring debt need to be refinanced. We show that this trade-off between higher expected transaction costs against the commitment to reduce leverage in low-profitability states motivates an optimal maturity structure of corporate debt. Since firms with high costs of financial distress and risky cash flows benefit most from committing to leverage reductions, they have a stronger motive to issue short-term debt. Evidence supports the model’s predictions.