Debt maturity and the dynamics of Leverage

This paper shows that short debt maturities commit equityholders to leverage reductions when refinancing expiring debt in low-profitability states. However, shorter maturities lead to higher transactions costs since larger amounts of expiring debt need to be refinanced. We show that this tradeoff between higher expected transactions costs against the commitment to reduce leverage in low-profitability states, motivates an optimal maturity structure of corporate debt. Since firms with high costs of financial distress and risky cash flows benefit most from committing to leverage reductions, they have a stronger motive to issue short-term debt. Empirical evidence supports the model predictions.