| Essay one. Stochastic cash flows, bankruptcy costs, and optimal capital structure. A model of levered firm for which the cash flow process is stochastic is derived. The model incorporates direct and indirect bankruptcy costs, liquidation value of the firm's assets, corporate taxes, interest rates, business risk, and debt and non-debt tax shields. An option of temporary suspension of the firm's operations, endogenous bankruptcy and liquidation decisions, and treatment for partial deductibility of the debt and non-debt tax deductions are also included in the model. The closed form expressions for risk premium and debt, equity, and firm values are derived. Interaction effects are identified. One important conclusion is that when volatility of the firm's cash flows is low, the higher the non-debt tax deductions, the higher is the level of optimal interest expenses, contrary to the classical predictions.; Essay two. An integrated approach to risk management, optimal capital structure, and pricing of swaps with endogenously determined levels of credit risk. It is often overlooked that imperfect hedging may drive a firm into a bankruptcy when the quantity hedged is stochastic and actual quantities sold drop well below notional amounts of the hedging instrument. Given this fact, the expected debt tax shields of a firm may decrease for any extent of hedging in some situations, contrary to current risk management literature. That can cause a decline in firm value.; A continuous-time stochastic model of a levered firm facing both hedgable (market) and not hedgable (business) risks is proposed. An agency problem arises when in the presence of debtholders, shareholders endogenously decide to declare bankruptcy at a trigger-point away from the first best trigger point. Consequently, firm value gets smaller when this divergence in operating policy occurs. To mitigate this problem and to increase the value of the firm, shareholders can credibly ex-ante (at the time of debt issuance) pre-commit to hedge with swap contracts. The model developed in this study uses the underlying cost structure of a firm to endogenously determine the joint optimal amount of leverage, notional amount of swap contracts, and agency and bankruptcy costs. Optimality occurs as a result of the trade-off between agency costs, bankruptcy costs, and debt tax shield benefits. The actuarially fair swap rate, when the swap counterparty is riskless, is determined subject to the simultaneous endogenously determined level of credit risk of the firm after hedging. In this manner, the interdependent endogenous nature of the swap rate, the firm's cost structure, the notional amount of the swap contract utilized, and firm leverage are precisely represented. The problem is solved by iterative numerical finite differencing. The swap credit spread found to be a small percentage of the swap price. |
