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A Target Zone Model For Corporate Debt

We study the dynamic corporate structure by considering the role of commitment on firm's side. We show that if the firm can credibly commit to preserve the equity value up to a given threshold, it can afford higher level of debt than those associated to bankruptcy. Our model borrows from a well consolidated literature originated from Leland (1994, 1996), Goldstein,Ju and Leland (2001), Hackbarth, Miao, Morellec (2006), where we model a framework to analyze capital structure and credit risk in a continuous time setting. Our innovative point consists in mixing the existing framework with the Target Zone literature originated by Krugman (1991), Bertola and Caballero (1992), in the exchange rate dynamics context. We extend the traditional capital structure models to a log-normal setting. We identify the upper bound for the debt value associated to bankruptcy by adopting a different strategy based on the 'smooth pasting condition'. This new methodology allows to identify different levels of debt associated to bankruptcy, higher than the corresponding level identified in the current literature. The commitment to keep the bankruptcy value stable within a target zone, allows the firm to issue larger level of debt. If the company can successfully commit to preserve its value, the optimal level of debt can be higher.