The Journal of Finance Forthcoming Article Abstract

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Abstract:
We estimate firm-specific marginal cost of corporate debt functions for several thousand companies between 1980 and 2006. The positively sloped marginal cost curves are identified by observing exogenous shifts in simulated tax benefit curves. By integrating the area between the benefit and cost functions we estimate that the net benefit of debt is about 3% of asset value, resulting from a gross benefit of debt of about 10% of asset value and a cost of debt of about 7%. Our findings are consistent over time and when accounting for fixed adjustment costs of debt. The location of a given company’s cost of debt function varies with characteristics such as asset collateral, size, book-to-market, intangibility, cash flows, and whether the firm pays dividends. We provide easy to use algorithms that allow others to construct firm-specific cost of debt curves. Our framework allows us to make recommendations about firm-specific optimal debt ratios and to approximate the cost of being under- or overlevered. We find that the cost of being overlevered is asymmetrically higher than the cost of being underlevered and that the default cost of debt amounts to approximately half of total ex ante cost of debt.