The joint determination of capital structure and investment risk is examined. Optimal capital structure reflects both the tax advantages of debt less default costs (Modigliani and Miller (1958, 1963)), and the agency costs resulting from asset substitution (Jensen and Meckling (1976)). Agency costs restrict leverage and debt maturity and increase yield spreads, but their importance is small for the range of environments considered. Risk management is also examined. Hedging permits greater leverage. Even when a firm cannot precommit to hedging, it will still do so. Surprisingly, hedging benefits often are greater when agency costs are low.

This article examines corporate debt values and capital structure in a unified analytical framework. It derives closed-form results for the value of long-term risky debt and yield spreads, and for optimal capital structure, when firm asset value follows a diffusion process with constant volatility. Debt values and optimal leverage are explicitly linked to firm risk, taxes, bankruptcy costs, risk-free interest rates, payout rates, and bond covenants. The results elucidate the different behavior of junk bonds versus investment-grade bonds, and aspects of asset substitution, debt repurchase, and debt renegotiation.

Insider trading moves forward the resolution of uncertainty. Using a rational expectations model with endogenous investment level, I show that, when insider trading is permitted, (i) stock prices better reflect information and will be higher on average, (ii) expected real investment will rise, (iii) markets are less liquid, (iv) owners of investment projects and insiders will benefit, and (v) outside investors and liquidity traders will be hurt. Total welfare may increase or decrease depending on the economic environment. Factors that favor the prohibition of insider trading are identified.

I consider markets with asymmetric information. As suggested by Akerlof, quality deterioration in such markets may take place. I show that this is a general phenomenon. Minimum quality constraints (or "licensing requirements") are examined as a possible solution to the problem. Although not generally a first-best solution, such constraints will increase welfare in a number of cases. The types of markets that are likely to benefit from minimum quality standards are identified. It is then shown that, if quality standards are set by the profession (or industry) itself, it is likely that the standards will be too high.

Journal Article Optimal Growth in a Stochastic Environment Get access Hayne E. Leland Hayne E. Leland Stanford University Search for other works by this author on: Oxford Academic Google Scholar The Review of Economic Studies, Volume 41, Issue 1, January 1974, Pages 75–86, https://doi.org/10.2307/2296400 Published: 01 January 1974

Journal Article Optimal Risk Sharing and the Leasing of Natural Resources, with Application to Oil and Gas Leasing on the OCS Get access Hayne E. Leland Hayne E. Leland University of California, Berkeley Search for other works by this author on: Oxford Academic Google Scholar The Quarterly Journal of Economics, Volume 92, Issue 3, August 1978, Pages 413–437, https://doi.org/10.2307/1883152 Published: 01 August 1978

I. Introduction, 465. — II. A two period model of consumption, 466. — III. The effect of uncertainty on saving, 467. — IV. Decreasing risk aversion and precautionary saving, 468. — V. Speculations on the consumption function, 470. — VI. Conclusion, 472.

[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.]