Voluntary Debt Reductions

According to existing dynamic capital structure trade off theories equity holders never find it in their best interest to reduce debt voluntarily before bankruptcy or without renegotiating with creditors. This paper develops a model in which firms optimize the maturity structure of debt to commit to future downward restructurings. It is demonstrated that equityholders of firms with short-term debt may find it optimal not to replace maturing debt with new debt even if bond indentures allow them to do so. Committing to refinance existing debt effectively endogenizes the costs associated with high leverage, such as expected bankruptcy costs. Ex ante, a short maturity of debt therefore serves as a commitment to reduce leverage following a decrease in firm's cash flows. This advantage of short-term debt in avoiding costs of financial distress is not considered in the existing literature and motivates an optimal term-structure of corporate debt. Closed form solutions for the value of equity and debt are derived and it is shown that the debt capacity of firms increases when choosing a shorter maturity.