The role of firm's net cash payouts in Leland's (1994) model

We study the effects of introducing payouts on corporate debt and optimal capital structure in a structural credit risk model à laLeland (1994). We find that increasing the payout parameter not only affects the endogenous bankruptcy level, which is decreased, but modifies the magnitude of a change on the endogenous failure level as a consequence of an increase in risk-free rate, corporate tax rate, riskiness of the firm and coupon payments. This simple analytical framework is able to capture realistic insights about optimal leverage, spreads and default probabilities more in line with historical norms (if compared to Leland’s results) and closer to predictions obtained through more sophisticated models.