The Effects Of Business Cycle And Debt Maturity On A Firms Investment And Default Decisions

We propose a model that jointly determines the capital structure and investment decisions taking business cycle and debt maturity into account. Namely, the firm can switch the diffusion regime of asset value, which involves switching costs, and the state of the economy that generates cyclical cash flow switches via Markov chain. We endogenously determine the triggers of investment, disinvestment, and default, which depend on the state of the economy. The level of investment triggers can be unimodal or bimodal with respect to debt maturity depending on the volatility of growth opportunities, and the sensitivity also dffers depending on the reversibility of the investment. The optimal leverage ratio is countercyclical, and the gap between the leverage ratio in each state widens as the volatility of growth opportunity increases. In terms of the effects of persistence of the business cycle, the optimal leverage ratio tends to increase as recession shortens, which induces higher yield spreads for short-term debt; but long-term debt is more affected by increase of expected cash flow, and thus the yield spreads decrease.