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Illiquidity and indebtedness: optimal capital structure under realistic default triggers in a double barrier option framework

  • Existing dynamic capital structure models are based on a single barrier determining bankruptcy, e.g. overindebtedness or illiquidity. However, it is observable that these approaches do not perform well empirically and omit a variety of constraints faced by equity and debt holders. This article incorporates these constraints examining corporate debt value and optimal capital structure in a double barrier world with knock-in and knock-out barrier options. The results elucidate why considering only one barrier distorts the estimates of risks for default and bankruptcy. In fact, the single barriers illiquidity and overindebtedness take the role of boundary conditions. Incorporating both conditions in this novel double barrier approach allows for capital structure estimations that are in better accordance with empirical findings. Beyond capital structure theory, other fields of economics and even medical science or the humanities are in context of problems that can be solved with such a double barrier approach._x000D_ Keywords: Dynamic models, structural estimation, first hitting time, second hitting time, default risk, optimal leverage_x000D_ JEL Classification: G12, G31, G32, G33

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Document Type:Working Paper
Author:Tim Kutzker, Alexander LahmannORCiD, Maximilian Schreiter
Chairs and Professorships:Chair of Financial Management
Year of Completion:2017
SSRN, 2017