Collateral and Capital Structure

Abstract

This paper develops a dynamic model of the capital structure based on the need to collateralize loans with tangible assets. The model provides a unified theory of optimal firm financing in terms of the optimal capital structure, investment, leasing, and risk management policy. Tangible assets are a key determinant of the cross section and dynamic behavior of the capital structure. Firms with low tangible capital are constrained longer, lease more of their physical capital, and borrow less. Leasing of tangible assets enables faster firm growth. The model helps explain the “zero debt puzzle” as well as other stylized facts about the capital structure. For risk management the model implies that incomplete hedging of net worth is optimal.