Agency Costs, Risk Management, and Capital Structure

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