The Effects of Business Cycle and Debt Maturity on a Firm's Investment and Default Decisions

We propose a model that jointly determines the capital structure and investment decisions taking business cycle and debt maturity into account. It endogenously determines the triggers of investment/disinvestment and default, which depend on the state of the economy. The investment triggers can be unimodal or bimodal with respect to debt maturity depending on the volatility of the growth opportunities. The optimal leverage ratio tends to increase as recession shortens, which induces higher yield spreads for short-term debt; but long-term debt is more affected by increase of expected cash flow, and thus the yield spreads decrease.