From Underleverage to Excess Debt: The Changing Environment of Corporate Debt

Abstract

We directly estimate the probability of default, the value of tax shields and expected cost of financial distress of firms, using a structural model calibrated and estimated from market prices (CDS and stock price data). This provides for high-frequency data on the major costs and benefits of debt, and allows to derive a unique estimate for target capital structure of firms, if the trade-off theory is valid. Our evidence contradicts the alleged "underleverage puzzle", which states that firms are too conservative in their debt policies. We find evidence that over the last decade, firms have been systematically overlevered. This is mainly due to the fact that CDS-implied loss-given-default estimates are far higher than the levels typically assumed in previous studies. In addition, the structural change in the risk-free interest level, which lowered the average level from some 8% to 2%, severely increased the cost of debt without an offsetting effect in tax benefits, thus strongly reducing target debt ratios.