[We examine the optimal mixture and priority structure of bank and market debt using a trade-off model in which banks have the unique ability to renegotiate outside formal bankruptcy. Flexible bank debt offers a superior trade-off between tax shields and bankruptcy costs. Ease of renegotiation limits bank debt capacity, however. Optimal debt structure hinges upon which party has bargaining power in private workouts. Weak firms have high bank debt capacity and utilize bank debt exclusively. Strong firms lever up to their (lower) bank debt capacity, augment with market debt, and place the bank senior. Therefore, the trade-off theory offers an explanation for: (i) why young/small firms use bank debt exclusively; (ii) why large/mature firms employ mixed debt financing; and (iii) why bank debt is senior. The trade-off theory also generates predictions consistent with international evidence. In countries in which the bankruptcy regime entails soft (tough) enforcement of contractual priority, bank debt capacity is low (high), implying greater (less) reliance on market debt.]

We develop a Q theory of investment under financing constraints. The firm invests and saves optimally facing convex costs of external equity, overhang from outstanding debt, and collateral constraints on new borrowing. Overhang and costs of external equity discourage investment. Conversely, firms anticipating collateral constraints experience a side benefit from investing as installed capital relaxes future constraints. Empirical tests support the model. Conditional on average Q, investment is lower for equity issuers and for firms with large debt overhang. The Kaplan and Zingales and the Whited and Wu indices are used as proxies for future collateral constraints. Consistent with the model, both indices enter investment regressions positively.

ABSTRACT We apply simulated method of moments to a dynamic model to infer the magnitude of financing costs. The model features endogenous investment, distributions, leverage, and default. The corporation faces taxation, costly bankruptcy, and linear‐quadratic equity flotation costs. For large (small) firms, estimated marginal equity flotation costs start at 5.0% (10.7%) and bankruptcy costs equal to 8.4% (15.1%) of capital. Estimated financing frictions are higher for low‐dividend firms and those identified as constrained by the Cleary and Whited‐Wu indexes. In simulated data, many common proxies for financing constraints actually decrease when we increase financing cost parameters.

We examine the optimal mixture and priority structure of bank and market debt using a trade-off model in which banks have the unique ability to renegotiate outside formal bankruptcy. Flexible bank debt offers a superior trade-off between tax shields and bankruptcy costs. Ease of renegotiation limits bank debt capacity, however. Optimal debt structure hinges upon which party has bargaining power in private workouts. Weak firms have high bank debt capacity and utilize bank debt exclusively. Strong firms lever up to their (lower) bank debt capacity, augment with market debt, and place the bank senior. Therefore, the trade-off theory offers an explanation for: (i) why young/small firms use bank debt exclusively; (ii) why large/mature firms employ mixed debt financing; and (iii) why bank debt is senior. The trade-off theory also generates predictions consistent with international evidence. In countries in which the bankruptcy regime entails soft (tough) enforcement of contractual priority, bank debt capacity is low (high), implying greater (less) reliance on market debt.