Investment and Credit Risk: a Structural Approach

The paper investigates the impact on credit risk of capital structure choices driven by firm’s investments and financing decisions. We propose a realistic dynamic structural model featuring endogenous investment, capital structure and default. We calibrate the model on accounting and market data. Using simulation, we find that, credit spreads as well as other standard metrics of credit worthiness, like quasi-market leverage, default rate, and the distribution of firms across rating classes, are well fitted by the model. We find that the introduction of investment flexibility has the largest impact on credit risk among the studied features, because of an inherent under-investment agency cost created by debt and because equityholders do not follow a value maximizing capital structure policy. JEL Classification: G12, G31, G32, E22.