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Leverage and Interest Rates

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  • Giovanna Nicodano
  • Luca Regis

Abstract

We study the sensitivity of optimal leverage to the level of the risk-free interest rate. Our trade-off model implies a heterogeneous response depending on the presence of a sponsor backing company debt. A highly-leveraged, backed company optimally increases debt when interest rates fall, while a company without a sponsor reduces it despite having lower initial leverage. This heterogeneity implies divergent bankruptcy probability and recovery-upondefault, in the same interest rate scenarios, for the two company types. We also show that a lower risk-free rate reduces the sponsor’s incentive to issue debt.

Suggested Citation

  • Giovanna Nicodano & Luca Regis, 2023. "Leverage and Interest Rates," Carlo Alberto Notebooks 692 JEL Classification: G, Collegio Carlo Alberto.
    • Handle: RePEc:cca:wpaper:692
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    References listed on IDEAS

    as
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    Keywords

    capital structure; tax-bankruptcy trade-off; default; LBO; subsidiaries; securitization; restructurings; risk transfer;
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