On the effect of the term structure of interest rates on corporate capital structure: Theory and evidence

Abstract

This manuscript studies the impact of the term structure of interest rates on corporate optimal capital structure. First, I develop a dynamic model of capital structure in the presence of stochastic cash flows and stochastic interest rates. Using one-factor and two-factor Cox, Ingersoll, and Ross (1985b) interest rates dynamic, as well as a one-factor Feller cash flow process, the article solves for the value of the firm's contingent claims. After deriving closed-form solutions for the values of debt, tax benefits, bankruptcy costs and recapitalization costs, the paper numerically solves for the optimal total capital structure: leverage, debt service, maturity, call provisions and priority. I find that as the instantaneous rate rises, so does the leverage, maturity and periodic debt service. I also find that an increase in the level of long-term rate leads to a decrease in leverage, maturity and periodic debt service. In an attempt to understand the effect of macroeconomic conditions on corporate financing decisions, this manuscript then empirically investigates the effect of the term structure of interest rates--defined by a three-factor model which includes the Treasury bill yield, the Treasury bond yield, and the volatility of the yield curve--on the debt-equity choice. Having controlled for well-known microeconomic determinants of financing decisions, I document that as the Treasury bill yield rises, the incidence of debt financing increases. However, as the Treasury bond yield or the volatility of the yield curve rise, the incidence of debt financing drops. I find that the information content of the term structure of interest rates regarding aggregate corporate profitability (i.e. aggregate default risk) accounts for the stylized facts. I also find that tax shield distortions induced by changes of interest rates marginally affect the debt-equity choice. Additionally, inflation, corporate credit spreads, mortgage rates, and personal tax rates materially are shown to affect the firm's financing decisions materially.