The COVID-19

Impact on Corporate
Leverage and
Financial Fragility
Sharjil M. Haque and Richard Varghese

WP/21/265

2021
NOV
 © 2021 International Monetary Fund

The COVID-19 Impact on Corporate Leverage and Financial Fragility*

WP/21/265

Sharjil M. Haque† and Richard Varghese‡

Authorized for distribution by Martin Cihak

IMF Working Papers describe research in progress by the author(s) and are published to elicit comments
and to encourage debate. The views expressed in IMF Working Papers are those of the author(s) and do
not necessarily represent the views of the IMF, its Executive Board, or IMF management.

Abstract

We study the impact of the COVID-19 recession on capital structure of publicly

listed U.S. firms. Our estimates suggest leverage (Net Debt/Asset) decreased by
5.3 percentage points from the pre-shock mean of 19.6 percent, while debt maturity
increased moderately. This de-leveraging effect is stronger for firms exposed to significant
rollover risk, while firms whose businesses were most vulnerable to social distancing
did not reduce leverage. We rationalize our evidence through a structural model of
firm value that shows lower expected growth rate and higher volatility of cash flows
following COVID-19 reduced optimal levels of corporate leverage. Model-implied optimal
leverage indicates firms which did not de-lever became over-leveraged. We
find default probability deteriorates most in large, over-leveraged firms and those that
were stressed pre-COVID. Additional stress tests predict value of these firms will be less
than one standard deviation away from default if cash flows decline by 20 percent.

978-1-51358-###-# (Paper)
ISBN 978-1-51358-###-# (ePub)
978-1-51358-###-# (PDF)

G00; G10; G30; G32; G33

JEL Classification Numbers:

COVID-19; Corporate Debt; Optimal Capital Structure;

Keywords: Rollover Risk; Distance-To-Default; Default Risk; Stress Tests;

Author’s E-Mail Address: [email protected], [email protected]

* The views expressed herein are those of the authors and should not be attributed to the IMF, its
Executive Board, or its management. We thank Martin Cihak, Fabian Valencia, German Villegas Bauer, Julian
Kozlowski, Larry Wall, Glenn Harrison, and participants at the IMF seminar and How is the Covid-19 experience
changing finance? conference organized jointly by the Federal Reserve Bank of Atlanta and Georgia State
University for helpful comments.
†University of North Carolina at Chapel Hill
‡International Monetary Fund
1 Introduction

The COVID-19 pandemic and associated efforts to combat its spread, caused a rapid
and unprecedented slowdown in the global economy, including a record drop in U.S.
GDP during 2020:Q2 (Hotchkiss et al., 2020).1 Cash flows were heavily impaired in
many industries, with adverse implications for corporate solvency. Recent research on
the corporate sector shows that flow of credit to non-financials remained robust through
drawdowns on existing credit lines (e.g. Deghi et al. (2021); Acharya and Steffen (2020))
and policy support from the Federal Reserve (Gilchrist et al. (2020); Haque and Varghese
(2021)), allowing most companies to remain operational. While these facilities may have
averted or delayed bankruptcies, in the face of structural changes viability assessments
remain fraught with difficulties. Therefore, the full impact of the recession on corporate
financial health requires a comprehensive examination of firm leverage, optimal capital
structure and default risk. We fill this gap in the literature.
Specifically, we ask three questions. First, how did firms’ capital structures (leverage
and debt maturity) evolve after the onset of the COVID-19 shock? Did all firms adjust
their capital structures or only those firms (i) highly exposed to financial risks pre-COVID,
and (ii) whose businesses were at greatest risk from social distancing? Finally, given
firms’ capital structure choices in response to the pandemic recession, how were default
probabilities affected? Our paper examines the interconnected relationships between the
choice of leverage, growth expectation, firm risk and default probability in the context
of an unprecedented public health crisis. To the best of our knowledge this is the first
paper to (i) document how heterogeneity in firm risk influenced capital structure adjust-
ments following the onset of COVID, (ii) structurally estimate optimal leverage, allowing
us to identify if firms became “over-leveraged” during the recession and (iii) estimate
probability of default.2
1U.S. GDP dropped by 9.5 percent quarter-over-quarter.
2Following much of the literature, we identify a firm as “Over-Leveraged” if its actual leverage is higher
than model-implied optimal leverage. See for instance, Korteweg (2010). It is also worth noting most

1
 In this paper, our focus is on net debt as a share of total assets for publicly listed U.S.
companies only. Net debt, which is debt net of cash, allows us to better capture cash flow
shortfalls or if companies are over-leveraged. We recognize, however, there are alternate
measures of leverage. For example, defining leverage as debt to income, IMF (2021)
document an increase in corporate leverage in both advanced and emerging economies
with a sample that aggregates information of both publicly active and private firms. We
focus on publicly listed firms because our structural model of a firm’s value-maximising
level of leverage, described subsequently, is more applicable for firms that have easy
access to secondary equity markets. Thus, our analysis is intended to complement existing
studies by offering an alternate way of examining leverage for publicly listed firms.
Our benchmark regressions show that firm leverage (Net Debt/Asset) declined by
5.3 percentage points due to Covid-related lockdowns.3 This is substantial considering
pre-crisis mean leverage in our sample is 19.6 percent. Moreover, we find debt maturity
increased marginally. Our regression specification controls for firm size, asset tangibility,
growth prospects, profitability and time-invariant firm-level factors that can affect lever-
age. Both the de-leveraging effect and rise in maturity are stronger among firms that were
already exposed to high financial risks pre-COVID, measured through the variation in
firms’ need to rollover the current portion of long-term debt.4 Strikingly, businesses most
severely affected by social distancing did not reduce leverage any more than those less
vulnerable, although they shortened their debt maturity structure. For ease of exposition,
existing studies on optimal capital structure rely on the concept of target debt using regressions rather than
firm value maximization (see Flannery and Rangan, 2006; Cook and Tang, 2010; Oztekin and Flannery).
However, as Haque (2021) and He and Yang (2021) argue, firm value maximization is central to capturing
the trade-off theory of debt (Kraus and Litzenberge, 1973).
3Note, by definition, we are measuring the share of firm value financed with debt adjusted for cash,
while widespread reports and other studies have documented that the supply of overall debt financing has
been unaffected because of policy support. Additionally our sample focuses on publicly listed firms in the
US only. Thus our results are not necessarily contradictory to studies suggesting overall corporate leverage
has increased.
4First introduced by Almeida et al. (2009), the current portion of long-term debt provides an exogenous
measure of rollover risk since the decision to issue long-term debt is typically made years in advance. In
contrast, other measures of rollover risk such as short-term debt suffer from standard endogeneity problems.
We elaborate more on this measure subsequently.

2
we label this risk as “business risk.” Our benchmark result is robust to a battery of robust-
ness checks including alternate measures of leverage (Gross Debt/Asset) and variation in
liquidity.
We find that a standard model of optimal capital structure estimated separately in the
pre-COVID and post-COVID samples is consistent with our benchmark results. The model
predicts a decline in the optimal level of corporate leverage driven by a deterioration in
expected growth rate of cash flows and spike in asset risk. However, comparing optimal
leverage post-COVID with the data shows firms exposed to business risk have become
over-leveraged.
Our structural estimates of distance-to-default (DTD) reveals firms that became over-
leveraged, i.e. those exposed to high business risk, experienced the sharpest deterioration
in credit risk.5 These effects are particularly concentrated among firms in the bottom
quartile (sorted on distance-to-default) as well as the largest firms. Simulated stress tests
confirm that these over-leveraged firms are most likely to default if growth slows down
or if they experience further spikes in risk. Our results, which are novel in the growing
COVID-19 literature, raises implications for financial stability and build up of systemic
risk.
We begin our analysis by building a large sample of firm-quarter level data of U.S.
publicly active firms from North America Compustat.6 Consistent with the large body of
literature on U.S. public firms that document debt and equity have an approximate 30:70
split, we show that mean Gross Debt/Asset is 33.43 percent in our pre-COVID sample.7
Next, we trace out the rising pattern in leverage, measured by Net Debt/Asset, since the
Global Financial Crisis. Median leverage ratio rose from 10 percent in early 2007 to 21
percent in 2019:Q4, followed by a decline beginning 2020:Q1. This decline is confirmed in
5Distance-to-default can be interpreted as the number of standard deviations between current asset
value and the insolvency point.
6Reliance on firm-level data is important because aggregate country-level data can mask underlying
heterogeneity in risk exposure that can drive the overall trends.
7See for example Axelson et al. (2013)

3
a standard pre-post regression controlling for capital structure determinants advocated
by Rajan and Zingales (1995).
We introduce two types of plausibly exogenous firm risk. First, we measure finan-
cial risk by establishing a causal liquidity channel during the COVID-19 pandemic, by
exploiting plausibly exogenous cross-sectional variation in the level of firm exposure to
liquidity shocks. More specifically, we utilize heterogeneity in firms’ need to rollover
current portion of long-term debt during the COVID shock to show that firms with higher
refinancing needs contract leverage levels more than similar firms that do not need to
rollover long-term debt. As Almeida et al. (2009) argue, the exogeneity of this measure
allow us to estimate the causal effect of being exposed to financial risk, emanating from an
unanticipated liquidity shock. Second, for business risk, we compute growth in sales in
2020:Q2, and classify firms in the bottom quartile as exposed to business risks from social
distancing. For robustness, we repeat this exercise with Return on Assets. The exogeneity
in this measure comes from the unanticipated nature of the pandemic.
A set of carefully specified difference-in-differences regressions reveal financial risks
played a key role in our benchmark de-leveraging effect. Firms with large share of long-
term debt maturing in the post-COVID sample reduced leverage by approximately 4
percentage points more than less-exposed firms. We document these firms also raised
their maturity structure consistent with the fact that they had lower share of long-term
debt pre-COVID, thus reducing refinancing risk. Our main surprising result is that we
fail to document any such de-leveraging among firms most seriously affected by the drop
in demand from social distancing, compared to firms less affected by shutdowns. While
these findings are novel, they do not shed light on whether firms are now closer or further
away from their value-maximizing level of leverage.
Consequently, the second part of the paper centers around computing optimal leverage
and default probability using structural models. We employ the structural model of Leland
and Toft (1996) (henceforth, the LT model). As summarised in Bartram et al. (2015), the

4
LT model builds upon the observation made by Black and Scholes (1973) and Merton
(1974) that the equity of a firm resembles a call option on the firm’s assets. The LT Model
generalizes the Merton model, in several ways. Bankruptcy can occur anytime (similar
to Black and Cox (1976)). In addition, bankruptcy is endogenously triggered by equity
holders to maximize equity value. In short, the Leland and Toft (1996) model embeds
both the trade-off theory and agency theory. The model is estimated, separately for the
pre-COVID and post-COVID samples, by minimizing the squared deviation of predicted
equity volatility from actual volatility. Not surprisingly, our estimates show the level
of optimal leverage decreased by 13 percent driven primarily by significant reductions in
expected growth and rise in asset return volatility, both of which we estimate directly from
the data. While the reduction in optimal leverage is consistent with the de-leveraging effect
we document in our benchmark regressions (for all firms and firms exposed to financial
risk), our model identifies firms that were most exposed to lockdown risks became over-
leveraged following the onset of the pandemic. This is intuitive since they do not de-lever
based on the differential impact on their cash flows from lockdowns compared to those
less affected.
A natural implication of becoming over-leveraged relates to change in default risk. We
estimate default probabilities using a canonical Merton (1974) credit risk model, which is
considered the benchmark starting point to evaluate distress risk. We rely on an iterative
algorithm introduced by Vassalou and Xing (2004) to estimate unobservable asset drift
and volatility, the key challenge in estimating structural credit risk models. We estimate
DTD and find significant deterioration in credit risk for firms exposed to business risk,
i.e., those that did not de-lever based on business risks and allowed actual debt to exceed
optimal leverage. When we restrict our analysis to only large firms, defined as firms
with an average size of at least USD 1 billion, we observe the deterioration in credit risk
is greater for those that were most impacted by social distancing. Among large firms
exposed to business risk, the 25𝑡 ℎ percentile value of DTD is 1.22 which is the lowest in all

5
the sub-samples we investigate. This subset of firms experienced a 50 percent deterioration
in distress risk.
We conclude by simulating two stress tests: we impose (i) a 20 percent decline in
expected growth rate of cash flows and (ii) a 20 percent rise in cash flow return volatility.
Since we impose these restrictions for all firms, in principle, our simulation can be viewed
as an aggregate economic shock. We re-estimate the model with each of these stress
scenarios and find, among companies exposed to business risk, 25𝑡 ℎ percentile DTD is
0.86. In other words, the asset value of the bottom quartile of these firms is less than one
standard deviation away from reaching insolvency.
Related Literature: While our findings exploit the COVID-19 shock as a natural labo-
ratory, our methodology is broadly applicable to any recessionary episode. We contribute
to several strands of literature. First, we contribute to the literature on the impact of re-
cessions on capital structure. Demirguc-Kunt et al. (2020) assessed the impact on capital
structure following the global financial crisis in 75 countries. They found evidence of
deleveraging and maturity reduction, which were particularly significant for non-listed
firms, including both SMEs as well as large non-listed companies. Relatedly, our paper
belongs to the growing literature on corporate debt in U.S. firms following the onset of
the COVID-19 shock. Hotchkiss et al. (2020) show that capital raising was particularly
strong among firms most affected by the pandemic, confirming that much of the new
issuance reflects demand for capital to replace cash flows lost to the economic disruption
from the pandemic. The extension to this observation relates to firms becoming over-
leveraged which we identify in this paper. Deghi et al. (2021) find that, among listed
firms, entities with weaker liquidity or solvency positions before the onset of COVID-19,
as well as smaller firms, suffered relatively more financial stress in some economies in the
early stages of the crisis. Acharya and Steffen (2020) document a mad “dash-for-cash” in
response to the crisis. To the best of our knowledge, our paper is the first to arrive at a
simple firm-level measure of risks due to social distancing which plays a key role in our

6
analysis.
Next, the paper relates to the vast literature on optimal capital structure based on
structural models. Merton (1974), Leland (1994) and Leland and Toft (1996) pioneer this
literature and we make two contributions: we identify the impact on model-implied op-
timal leverage following the coronavirus shock and we are able to use our analysis to
identify over-leveraged firms. As such our paper applies standard capital structure model
in the context of a recession shedding new light on our understanding of the dynamics of
optimal leverage as a function of external conditions. Finally, we contribute to the large
literature on structural estimation of credit risk. We contribute to this literature by docu-
menting the impact of the COVID-19 shock on default risk and identifying heterogeneity
across firms based on the type of risk they are exposed to.
Paper Roadmap: The rest of the paper proceeds as follows. Section 2 discusses the
data and the empirical strategy. Section 3 reports the benchmark regressions. Section 4
outlines the theoretical model used to solve for companies’ optimal leverage. Section 5
presents quantitative analysis of the model and identifies over-leveraged firms. Section 6
estimates default probability and the impact from stress tests. Finally, section 7 concludes.

2 Data and Methodology

2.1 Data Source and Summary Statistics

Our sample construction begins with publicly-held active firms that have accounting data
in the U.S. Compustat Quarterly Database till 2020Q4. To mitigate confounding effects
from other local and global shocks we begin our sample from 2018Q1. Following Bartram
et al. (2015) we exclude utilities and financial services companies since these firms are
regulated and may have different risk-taking incentives. In addition, we apply a variety
of screens to our sample. First, we exclude firms whose asset value is negative. Since we
seek to understand optimal choice of debt, we also exclude companies that do not hold

7
any debt in any firm-quarter during the sample period. 8 We require that our sample
has observations for all variables of interest in the post-COVID period, 2020Q2-2020Q4.
Finally, we winsorize our variables at the 1 percent and 99 percent respectively to mitigate
effects from outliers. After this filtering process, we are left with approximately 40,000
firm-quarter observations and approximately 3,100 unique firms.
The advantage of detailed balance sheet and income statement data at the firm level
is the information it provides on a number of variables, such as sales, profitability, debt
and assets. In addition, debt is broken down into short and long-term debt as well as the
amount of long-term debt due in the next 12 months. Each unit of observation includes
firm name, the year-quarter, accounting data for a number of variables which will be listed
in Table 2 and 6-digit North American Industry Classification. The data includes firms
from a wide range of industries including mining, basic manufacturing, accommodation,
airlines and other types of transportation, retail stores and energy distribution. We use
the firm-quarter variables to construct our measures of financial risk and business risk.
Our database allows us to construct several standard firm-level determinants of capital
structures that have been well established in the literature (see Rajan and Zingales, 1995;
Booth et al. 2001; Demirguc-Kunt and Maksimovic, 1996). These variables aim to capture
various factors underpinning firms’ capital structures that are related to agency models
of conflicts between insiders and outside financiers as in Klaus and Litzenberger (1973),
Jensen and Meckling (1976), Bradley et al. (1984), Hart and Moore (1995), Diamond (2004)
and asymmetric information models of external financing as in Myers and Majluf (1984).
Demirguc-Kunt et al. (2020) suggest that firm size is expected to have a positive impact on
firm’s capital structures since larger firms tend to have higher survival rates than smaller
firms, are generally less risky and more diversified, and hence less likely to default on
their debt obligations. Firms with good growth opportunities, are more likely to forego
profitable investment opportunities if they are more indebted and rely more on longer
8This is 2.5 percent of the sample. In unreported robustness checks, we confirm our results are not
affected by exclusion of “debt-free” firms.

8
maturity debt. This is due to the fact that the benefits from new investments financed with
risky debt accrue largely to existing debt holders rather than shareholders (Myers, 1977).
More profitable firms may be able to grow from retained earnings and would require less
external finance than other firms, according to the pecking order view (Myers and Majluf,
1984.
Table A2 in the Appendix shows the summary statistics for the selected firm-level
variables for the full sample. We report debt-related outcomes in Table 1 (presented
subsequently) and focus only on measures related to asset size, sales and growth in this
table. As documented widely, the size of public firms in the U.S. is quite large. The median
firm has total assets of USD 1.3 billion. We also observe that firm size is highly skewed:
the mean firm size of USD 9.48 billion is higher than the 75𝑡 ℎ percentile value of USD 5.53
billion. We note similar patterns in profitability which we proxy with Earnings Before
Interest Taxes Depreciation and Amortization (EBITDA) scaled by operating revenue. The
median firm has an EBITDA margin of 15.46 percent while the sample also includes some
highly unprofitable firms.

2.2 Empirical Fact: Rising Trend in Leverage post-GFC

Figure 1 presents quarterly trend in leverage post-GFC. We observe median Net Debt/Asset
has risen from 10 percent in 2007:Q1 to 22 percent in 2020:Q1. The trend in mean lever-
age is similar, albeit marginally less pronounced, and exhibits a cyclical behavior since
the GFC. These patterns are consistent with widespread reports of rising corporate debt.
For example, the IMF (2019) cautioned that easy financial conditions have extended the
corporate credit cycle, with further financial risk-taking by firms and continued buildup
of debt. It is also worth noting that both the mean and median dropped sharply begin-
ning 2020:Q1, co-inciding with the onset of the pandemic. The drop in mean leverage is
perhaps more pronounced than previous cycles of de-leveraging.

9
 Figure 1: Rising Trend in Leverage Post-GFC

The chart above reports mean and median leverage ratio defined as Net Debt/Asset. We winsorize
our data at the 1 and 99 percent level and aggregate across firms by each year-quarter.

2.3 Empirical Strategy

A visual inspection of debt levels suggests that following the onset of the pandemic,
debt levels may have come down. To formally examine the significance of the patterns
observed in Figure 1, we first test whether leverage levels decreased following the onset of
the pandemic. We consider this our baseline analysis. The literature on capital structure
typically models leverage as a function of observable firm characteristics. Following
Rajan and Zingales (1995) and numerous other studies our baseline leverage determinants
include: firm size proxied by log (Assets), Tangibility, Market/Book value of Equity and
Profitability proxied by EBIT/Asset. Larger firms and those with more tangible assets may
find it easier to borrow and therefore would tend to have higher debt since their expected
cost of distress is likely to be lower. Firms with higher profits may have higher retained

10
earnings and hence lower debt. Faster-growing firms, ceteris paribus, may need to raise
more external capital in the form of either debt or equity (Flannery et al. (2020)). To avoid
using information not yet known at the time of the adjustment decision, all traditional
capital structure determinants are lagged by one quarter. We begin with the following
benchmark specification:

0
𝑌𝑖𝑡 = 𝛽 1 𝑃𝑜𝑠𝑡𝑡 + 𝛾 X𝑖𝑡−1 + 𝛼 𝑖 + 𝛿 𝑦 + 𝜆 𝑗𝑡 + 𝜖 𝑖𝑡 (1)

Observations are at the firm-quarter level. The dependant variables are (i) Net
Debt/Asset, (ii) Net Long-term Debt/Asset and, to proxy maturity, Long-term Debt/Total
Debt, following Demirguc-Kunt et al. (2020). The vector 𝑋𝑖,𝑡−1 includes controls outlined
above. The variable of interest is 𝑃𝑜𝑠𝑡𝑡 which takes a value of 1 for the three complete
quarters in our sample following the onset of the pandemic: 2020:Q2-2020:Q4. A negative
coefficient suggests a decline in leverage following the recessionary shock. We include
firm 𝛼 𝑖 , year 𝛿 𝑦 , and sector-time 𝜆 𝑗𝑡 fixed effects.
Defining Exposure to Business Risk and Financial Risk: Next, in order to gain a
more granular understanding of how pre-shock exposure to different risks affects cap-
ital structure post-COVID, we introduce two types of risk: (i) business-risk from social
distancing and (ii) financial risk. First, to identify firms whose businesses were most
impacted by social distancing, we define business risk based on a firm’s realized sales
growth in 2020Q2 relative to 2019Q2. Specifically, we consider firms in the lowest quartile
of sales growth in 2020Q2 exposed to “business risk”. Since COVID-19 was an exogenous
shock in demand, the drop in sales in 2020Q2 should not be confounded by any other
effect that systematically affected the same industries. We choose only 2020Q2 instead of
aggregating over 2020Q2-Q4 to avoid any anticipation effects confounding our measure.
To check the validity of our measure, Figure 2 plots growth in sales in the first two quarters
of 2020 aggregated across 2-digit NAICS industries. Since industries such as Airlines were
particularly affected, we plot this sector separately. The figure shows that sales growth

11
 Figure 2: Exposure to Business Risk based on Sales Growth

Notes: Firm-level growth in sales, aggregated to the industry-level in 2020:Q1 and 2020:Q2
compared to 2019:Q1 and 2019:Q2 respectively.

is capturing industries that have been widely documented as those worst hit by COVID.
For example, we see an 80 percent drop in sales in Airlines and a 10 percent increase in
sales for supermarkets, likely reflecting the increase in demand for online shopping. We
also see significant drop in sales in the sector classified as “Accommodation”, reflecting
the drop in demand for hotels, Airbnbs etc which is also consistent with conventional
wisdom. As robustness we also utilize the change in Return on Assets: firms with change
in ROA in the lowest quartile in 2020Q2 relative to 2019Q2 are now classified as exposed
to high Business Risk. Figure 3 documents similar patterns for ROA. We are reassured
of the accuracy of our measure since the patterns in sales and ROA are consistent with

12
conventional wisdom regarding the type of firms most severely hurt by social distancing.

Figure 3: Exposure to Business Risk based on ROA Change

Notes: ROA change for each quarter relative to corresponding quarter of previous year. ROA is
defined as EBITDA/Total Assets.

Second, to identify firms who were exposed to significant financial risk pre-COVID,
we exploit heterogeneity in firms’ need to rollover the current portion of long-term debt.
Specifically, we sort firms based on their ratio of long-term debt due in one year over total
debt. Firms in the top quartile are classified as exposed to financial risk.9 Our hypothesis
is that firms with large shares of long-term debt due in the next 12 months would need to
retract debt levels more than the average firm due to much tighter liquidity conditions. As
Gilchrist et al. (2020) note, the onset of the pandemic resulted in liquidity drying up and
9The cutoff at the 75th percentile is 20.1 percent meaning companies are exposed to financial risk if their
share of the current portion of long-term debt in total debt is 20.1 percent or higher.

13
credit spreads surging amid a global flight to safety. The main advantage of this measure
is that it is largely predetermined at the moment of debt issuance (potentially years in
advance) and as such is less affected by recent developments. This is a key advantage in
that it allows us to get around the issue of endogeneity that confounds most alternative
measures of rollover risk such as share of short-term debt. Thus, this measure allows us
to identify a causal liquidity shock on leverage. As already mentioned, we label this type
of liquidity risk stemming from refinancing needs broadly as “financial risk.”

Figure 4: Distribution of Leverage Ratio by Risk Exposure

Notes: The chart above plots leverage ratio (Net Debt/Asset) for companies exposed to financial
risk and business risk for the overall sample period. Each type of risk is defined in Table A1 in the
Appendix. We restrict the plot to companies with leverage ratios between -1 to +1 to reduce loss in
visual clarity due to outliers.

Armed with these two measures, we estimate the following difference-in-differences

(DiD) specification where 𝐸𝑥𝑝𝑜𝑠𝑒𝑑 𝑖 will alternatively take the value of 1 if a firm is exposed
to these risks.

14
 0
𝑌𝑖𝑡 = 𝛽 1 𝑃𝑜𝑠𝑡𝑡 + 𝛽 2 𝑃𝑜𝑠𝑡𝑡 × 𝐸𝑥𝑝𝑜𝑠𝑒𝑑 𝑖 + 𝛾 X𝑖𝑡−1 + 𝛼 𝑖 + 𝛿 𝑦 + 𝜆 𝑗𝑡 + 𝜖 𝑖𝑡 (2)

In Eq. (2) the coefficient of interest is 𝛽 2 , the DiD estimate of the causal impact of
exposure to business or financial risk on capital structure post-covid.

3 Benchmark Results

3.1 Impact of COVID-19 on Capital Structure

We begin by first tabulating sample means of leverage, gross debt and maturity for our
entire sample, firms exposed to financial risk and those exposed to business risk. We
summarize these in Table 1. While gross debt/asset does not reveal any significant de-
leveraging, we note our primary variable of interest Net Debt/Asset reveals significant
reduction in leverage post-COVID in firms exposed to financial risk. The difference
between gross and net debt ratio is particularly pronounced for these subset of firms
indicating they tend to hold large amount of cash. We also note the simple raw mean
does not show any de-leveraging in firms exposed to business risk from social distancing.
In fact, the Gross Debt/Asset measure suggests these firms increased their debt levels
post-COVID. Observe that firms exposed to business risk, according to our definition,
comprise a non-trivial 10.5 percent of total assets in U.S. publicly listed firms, as shown
in Panel C. It is worth mentioning our measure of business risk is conceptually similar,
though not identical, to Boyerchenko et al. (2020) who also measure firm-level stress due
to COVID-19 using Compustat data. Figure 4 plots the cross-section in leverage by each
firm type showing firms with rollover risk had lower leverage.
To formally examine the significance of these patterns observed in Table 1, we be-
gin with our benchmark regression evaluating the systematic impact on debt due to the
COVID-19 shock. Columns (1) to (3) of Table 2 summarize our initial results. On average,

15
 Table 1: Capital Structure of U.S. Firms

Panel A: Pre-COVID Gross Debt/Asset (%) Net Debt/Asset (%) Maturity

Full Sample 33.43 19.56 0.74
Firms Exposed to Financial Risk 29.28 2.92 0.52
Firms Exposed to Business Risk 38.65 23.32 0.77

Panel B: Post-COVID Onset

Full Sample 33.91 16.99 0.77
Firms Exposed to Financial Risk 26.11 -5.79 0.56
Firms Exposed to Business Risk 43.37 23.75 0.75

Panel C: Share of Assets by Risk-type (% of total assets)

Firms exposed to Financial Risk 6.09 - -
Firms exposed to Business Risk 10.48 - -

Notes: This table reports capital structure before and after the onset of the COVID-19 Recession.
All variables are defined in Table A1 in the Appendix. Pre-COVID sample is 2018:Q1-2020:Q1.
Post-COVID sample is 2020:Q2-2020Q4. Debt Maturity is the share of long-term debt in total
debt following Demirguc-Kunt et al. (2020). In panel C, we report the share of assets held by firms
exposed to financial risk and firms exposed to business risk as a percentage of total assets in our full
sample. Note in Panel C, we do not distinguish between pre and post-covid sub-samples and only
highlight the relative importance of these subset of firms.

we observe a negative effect on leverage ratio. The effects are non-trivial. Our baseline
specification suggests leverage ratio decreases by 5.3 percent, controlling for standard
determinants of capital structure. This effect is non-trivial considering the pre-shock un-
conditional mean was 19.56 percent. Column (2) suggests a decline in long-term leverage
of 2.6 percent. These results are consistent with Demirguc-Kunt et al. (2020). Turning
to our measure of debt maturity, we observe that average maturity of outstanding debt
increases after controlling for standard determinants and time-invariant unobservables.
This is consistent with Diamond and He (2014) who show that borrowers should aim at
lengthening debt maturity during period of financial crisis, because the rollover-costs of
short-term debt increase. Demirguc-Kunt et al. (2015) on the other hand document a

16
decline in debt maturity following the global financial crisis. 10 These results indicate the
change in risk and growth profiles of companies due to COVID has an effect on both the
level and maturity of debt, and is consistent with dynamic trade-off theory models such
as Leland and Toft (1996), which is estimated subsequently in Section 5.
We also document that the de-leveraging effect we document in our benchmark results
is much higher compared to the last two major recessions in the United States. Specifically,
we find only a reduction of 1.5 percent in leverage following the global financial crisis and
an insignificant change in leverage following the dotcom bubble. We find a less conclusive
pattern when we investigate maturity. These results are reported in Appendix C.

Table 2: The COVID-19 Impact on Capital Structure

𝐿𝑒𝑣𝑒𝑟𝑎 𝑔𝑒 𝐿𝑜𝑛 𝑔 − 𝑡𝑒𝑟𝑚 𝐿𝑒𝑣𝑒𝑟𝑎 𝑔𝑒 𝐷𝑒𝑏𝑡 𝑀𝑎𝑡𝑢𝑟𝑖𝑡 𝑦

𝑃𝑜𝑠𝑡 -0.053∗∗∗ -0.026∗∗∗ 0.015∗∗∗
(0.005) (0.003) (0.004)
R2 0.039 0.039 0.018
Firm FE Y Y Y
Year FE Y Y Y
Sector x Quarter FE Y Y Y
Controls Y Y Y
N 38520 41650 39257

This table summarizes results of OLS regressions on amount and maturity of leverage. 𝑃𝑜𝑠𝑡 takes
value 1 during the first three full-quarters following the onset of the pandemic (2020Q2-2020Q4).
The baseline results are presented in Columns (1) to (3). Standard errors are clustered at the firm
level.

Despite our rich set of controls, there could be concerns that we are capturing a spurious
correlation since conventional wisdom is that debt and leverage has been rising for the
past decade supported by easy financing conditions. We highlight one of the important
ones in Table 3, and discuss the rest in Section 3.3 on robustness tests. Specifically we
conduct a placebo analysis, which probes whether spurious trends rather than COVID-
effect might explain the result. To do this we first drop our post-COVID sample. Next,
10Their primary sample centers around private firms and SMEs. They find weaker evidence of declines
in debt maturity for listed firms that are larger and have easier access to capital market financing.

17
 Table 3: Placebo Tests on Benchmark Specification

𝐿𝑒𝑣𝑒𝑟𝑎 𝑔𝑒 𝐿𝑜𝑛 𝑔 − 𝑇𝑒𝑟𝑚 𝐿𝑒𝑣𝑒𝑟𝑎 𝑔𝑒 𝑀𝑎𝑡𝑢𝑟𝑖𝑡 𝑦

𝑃𝑜𝑠𝑡 -0.002 -0.002 0.001 0.004 0.010∗∗∗ 0.004
(0.005) (0.005) (0.003) (0.003) (0.004) (0.004)
R2 0.044 0.044 0.054 0.054 0.022 0.022
Firm FE Y Y Y Y Y Y
Year FE Y Y Y Y Y Y
Sector x Quarter FE Y Y Y Y Y Y
Controls Y Y Y Y Y Y
N 28886 28886 31114 31114 28926 28926

This table summarizes results of OLS regressions of Placebo Tests on amount and maturity of
leverage. We drop the post-COVID sample and randomly assign 𝑃𝑜𝑠𝑡 = 1 to different sub-samples
in our time series. In the odd columns, 𝑃𝑜𝑠𝑡 = 1 in 2019:Q3-2020Q1. In the even columns,
𝑃𝑜𝑠𝑡 = 1 in 2019:Q4-2020Q1. All controls are identical to the benchmark specification. Standard
errors are clustered at the firm-level.

we randomly set 𝑃𝑜𝑠𝑡 = 1 from 2019Q3-2020Q1 and, in another iteration this is set to
2019Q4-2020Q1. We hypothesize that if a spurious trend is driving our result we should
see similar declines in leverage in pre-covid sample periods, when there is no systematic
effect to induce de-leveraging. Table 3 presents these placebo estimates. We find a small
and insignificant estimate for both leverage and long-term leverage. Importantly, we do
not pickup a decline in leverage in the pre-COVID sample for randomly assigned values
for 𝑃𝑜𝑠𝑡. These results strongly indicate that our baseline result documenting a decline in
leverage is not a spurious correlation and reflects the change in firm behavior post-COVID.
On debt maturity, we note a significant coefficient in one of the randomly selected post-
COVID samples, suggesting there may have been some rising trend in maturity before
COVID.11

18
 Table 4: Difference-in-Differences Regressions on Leverage

𝐿𝑒𝑣𝑒𝑟𝑎 𝑔𝑒 𝐿𝑜𝑛 𝑔 − 𝑡𝑒𝑟𝑚 𝐷𝑒𝑏𝑡

(1) (2) (3) (4) (5) (6)
𝑃𝑜𝑠𝑡 -0.055∗∗∗ -0.046∗∗∗ -0.049∗∗∗ -0.029∗∗∗ -0.021∗∗∗ -0.024∗∗∗
(0.006) (0.006) (0.006) (0.004) (0.004) (0.004)

𝑃𝑜𝑠𝑡 × 𝐵𝑢𝑠𝑖𝑛𝑒𝑠𝑠 𝑅𝑖𝑠 𝑘 0.010 0.012 0.010 0.010

(0.010) (0.010) (0.006) (0.006)

𝑃𝑜𝑠𝑡 × 𝐹𝑖𝑛𝑎𝑛𝑐𝑖𝑎𝑙 𝑅𝑖𝑠 𝑘 -0.039∗∗∗ -0.037∗∗∗ -0.025∗∗∗ -0.024∗∗∗

(0.010) (0.010) (0.007) (0.007)
R2 0.037 0.042 0.042 0.041 0.040 0.042
Firm FE Y Y Y Y Y Y
Year FE Y Y Y Y Y Y
Sector x Quarter FE Y Y Y Y Y Y
Controls Y Y Y Y Y Y
N 36268 36538 34838 39379 39486 37773

This table summarizes results of within-firm Difference-in-Differences regressions on leverage ratio.

𝑃𝑜𝑠𝑡 takes value 1 during the first three full-quarters following the onset of the pandemic (2020Q2-
2020Q4). Business Risk and Financial Risk are indicator variables that equal 1 based on definitions
outlined in the text as well as Appendix Table A1. Standard errors are clustered at the firm level.

3.2 Risk-Exposure and Impact of COVID-19 on Capital Structure

Table 4 presents the results of estimating Eq. (2) that captures differential effect of being
exposed to business risk and financial risk during the COVID shock. Our hypothesis is
that exposure to financial risk will induce firms to de-lever more compared to firms that
are not exposed to financial risk. Recall we exploit plausibly exogenous variation in firms’
needs to rollover the current portion of long-term debt to measure exposure to financial
risk. We also hypothesize firms most severely affected by the pandemic are likely to
reduce their leverage ratios faced with greater uncertainty in expected payoffs. We begin
by looking at the impact on leverage in columns (1) and (3).
Column (1) suggests firms exposed to the unanticipated business risk from social dis-
11Our focus in Table 3 is on ensuring robustness of the primary de-leveraging effect since media reports
document increase in debt levels for much of the post-GFC period, while there is less conclusive trend on
maturity.

19
 Table 5: Difference-in-Differences Regression on Debt Maturity

𝑌𝑗𝑡 : 𝐷𝑒𝑏𝑡 𝑀𝑎𝑡𝑢𝑟𝑖𝑡 𝑦 (1) (2) (3)

𝑃𝑜𝑠𝑡 0.026∗∗∗ 0.002 0.011∗∗
(0.004) (0.004) (0.005)

𝑃𝑜𝑠𝑡 × 𝐵𝑢𝑠𝑖𝑛𝑒𝑠𝑠 𝑅𝑖𝑠 𝑘 -0.038∗∗∗ -0.030∗∗∗

(0.007) (0.007)

𝑃𝑜𝑠𝑡 × 𝐹𝑖𝑛𝑎𝑛𝑐𝑖𝑎𝑙 𝑅𝑖𝑠 𝑘 0.034∗∗∗ 0.037∗∗∗

(0.009) (0.009)
R-squared 0.020 0.012 0.014
Firm FE Y Y Y
Year FE Y Y Y
Sector x Quarter FE Y Y Y
Controls Y Y Y
N 37733 33847 32480
∗ 𝑝 < .10, ∗∗ 𝑝 < .05, ∗∗∗ 𝑝 < .01

Notes: This table summarizes results of within-firm Difference-in-Differences regressions on debt

maturity proxied by the share of long-term debt in total debt. 𝑃𝑜𝑠𝑡 takes value 1 during the first
three full-quarters following the onset of the pandemic (2020Q2-2020Q4). Business Risk and
Financial Risk are indicator variables that equal 1 based on definitions outlined in the text as well
as Appendix Table A1. Standard errors are clustered at the firm level.

tancing did not change their debt levels controlling for standard capital structure determi-
nants.12 This was surprising at least to us since the risk-return profile of these companies
are most severely affected. As will be shown in the subsequent section, in the absence of
additional de-leveraging relative to less exposed firms, these companies run the risk of
becoming over-indebted since their optimal levels of leverage are likely to decline due to
the shock.
Next, we turn to column (2) to examine the impact on companies exposed to financial
risk. There is a large, economically and statistically significant effect of exposure to
financial or rollover risk during the shock from the pandemic. Looking at the coefficients,
we observe leverage is lower by 3.9 percent in response to the shock for companies exposed
to financial risk. Combined with the -4.6 percent coefficient on 𝑃𝑜𝑠𝑡, these findings
12Note this difference-in-differences interpretation is only relative to firms less exposed, since we indeed
document that 𝑃𝑜𝑠𝑡 is statistically significant and negative.

20
 Figure 5: Debt Maturity by Sector

Notes: This chart plots debt maturity by sector in 2019Q2 and 2020Q2. Debt Maturity is proxied
by the share of long-term debt in total debt.

indicate a total reduction in leverage of approximately 8.5 percent for companies exposed
to financial risk.
We then turn to column (3) to jointly test the effect on financial and business risk. We
again find there is no differential effect from being exposed to risks from social distancing
but the large negative effect from financial risk persists. Taken together our findings
suggests financial risks tend to matter more for capital structure adjustment decisions.
Next, we repeat the exercise with long-term leverage in columns (4)-(6). The results
display similar patterns though the magnitudes are relatively smaller.
We next turn to Table 5 to investigate the impact on debt maturity, proxied by share of
long-term debt. Looking at column (1) in Table 5, we note that firms exposed to business
risk lower their maturity structure. In contrast, we see in column (2) firms exposed
to financial risk raised their maturity structure. We note similar patterns in column (3).

21
Naturally this raises the question why firms exposed to risks from social distancing display
opposing patterns. One explanation offered by Leland and Toft (1996) is that firms with
very high levels of risk find it optimal to shorten their maturity structure. This is because,
for higher risk, the increase in value from optimally using long term versus short term
debt falls, while the agency costs of using long term debt are greater. Figure 7, plots
debt maturity in 2019Q2 and 2020Q2 by sector. We note that the sectors affected most
severely from social distancing such as Education and Entertainment lower their maturity
structure consistent with the theory proposed in the literature. An alternate explanation
is that these firms chose to reduce interest costs by lowering their maturity structure.

3.3 Robustness Tests

In this section we explore alternative measures and robustness checks and their impact
on capital structure.

Table 6: Alternate Tests on Leverage

(1) (2) (3) (4)

𝑃𝑜𝑠𝑡 -0.030∗∗∗ -0.032∗∗∗ -0.023∗∗∗ -0.046∗∗∗
(0.004) (0.006) (0.006) (0.007)
R-squared 0.052 0.053 0.124 0.037
Firm FE Y Y Y Y
Year FE Y Y Y Y
Sector x Quarter FE Y Y Y Y
Controls Y Y Y Y
Additional Controls N Y Y N
N 42822 38475 35436 23868

Notes: The table above reports alternate tests on our baseline pre-post regression of the impact
of COVID-19 on leverage. In column (1) the dependant variable is gross debt ratio defined as
the sum of long-term and short-term debt scaled by assets. In column (2) we add the log of
quarterly closing stock price to further control for valuation effects. In column (3) we add cash ratio
defined in Table A1 in the Appendix. Finally, in column (4) we restrict the pre-COVID window to
2019Q1-2020:Q1. Standard errors are clustered at the firm level.

An Alternate Measure of Leverage: Gross Debt/Asset. First, we establish that the effect
on leverage from the COVID-shock was not influenced by our measure of debt. We

22
introduce Gross Debt/Total Assets, which is also a measure of leverage used in the capital
structure literature, to see if the baseline results were driven merely by variation in cash
holdings. Table 6, column (1) examines this issue using our baseline pre-post specification.
We find gross debt, scaled by asset, declined by 3 percentage points post-COVID. Thus
the impact on leverage is not sensitive to our choice of measure.
Control Variables. We have thus far used standard capital structure determinants widely
used in the literature. We now add additional controls to our benchmark specification.
Two factors that may lead to confounding effects are changing stock prices and corporate
sector liquidity. Note, we already include Market/Book ratio in our benchmark specifi-
cation. To further confirm our results are not confounded by rising valuations from low
central bank interest rates, we include the log of quarterly stock prices in column (2). As
can be seen, the results are nearly identical. Next, in column (3) we add cash ratio and
find similar results. We note our point estimate is marginally smaller at this stage, but our
overall qualitative result holds.
Sample Time-Frame. Since, by construction, our pre-post estimate is based on the history
of information between 2018 to 2020:Q1, one concern can be that there can be unobserved
time-series variation that we are unable to pick up that could affect our results. We
believe this is unlikely considering that we are using both Year and Quarter fixed effects in
addition to our time-varying control. Nevertheless, to minimize any remaining concern,
we repeat the analysis using 2019:Q1-2020:Q1 as our pre-COVID window. We present
these results in column (4). As can be seen, the point estimate is quite similar to our
benchmark result.
Alternate measure for Business Risk from Social Distancing. We also repeat our analysis
on exposure to business risk from social distancing using Return on Assets as mentioned
previously. All of our primary results are unchanged. These regressions are available
upon request.

23
4 A Model of Optimal Capital Structure

In this section we outline a model of optimal capital structure that will be used to explain
the patterns documented thus far. We hypothesize that the reduction in leverage is
consistent with a decline in the optimal level of leverage following the recessionary shock.
Furthermore, since we documented that firms facing business risk did not alter their capital
structure relative to those less exposed to business risk, an estimate of optimal leverage
will allow us to determine if these companies have become over-leveraged post-COVID.
Over-leveraged firms are naturally more vulnerable to financial shocks, debt-overhang
and raise systemic economic risks.
Determining a firm’s optimal capital structure is challenging. Most existing studies on
optimal capital structure focus on the concept of a target debt level using predicted values
from a regression rather than maximizing firm value with respect to leverage. However,
firm value maximisation is central to the trade-off theory of capital structure. We thus
estimate a structural model of optimal capital structure following Leland and Toft (1996).

4.1 Model Outline

The relation between risk stemming from an aggregate shock and capital structure is likely
to be affected by the endogenous nature of financial decision-making (eg: firms with stable
cash flows can afford higher debt levels). Studies by Kim, Ramaswamy, and Sundaresan
(1993), Longstaff and Schwartz (1995), and Nielsen et al. (1993) assume bankruptcy occurs
at an exogenously specified asset value, such as debt principal value or when cash flow
fails to cover interest payments. Yet neither approach correctly describes bankruptcy as an
optimal decision by equity holders to surrender control to bond holders (Leland, (1994)).
Much of the recent capital structure literature emphasizes “endogenous default”, where
agents can decide default timing ex post. It is straight forward to see the appeal of this
framework given that our sample covers public firms that can issue additional equity as

24
long as it is optimal for equity-holders, despite a dilution of holdings. Detailed derivation
of the model is outlined in Appendix B. We describe the essential elements of the model
below:
All agents are risk-neutral. Consider a firm that has productive assets whose unlever-
aged value 𝐴𝑡 , follows standard geometric brownian motion:

𝑑𝐴𝑡
= [𝜇𝑎 (𝐴, 𝑡) − 𝛿]𝑑𝑡 + 𝜎𝑎 𝑑𝐵𝑡𝐴 (3)
𝐴𝑡

where 𝜇𝑎 (𝐴, 𝑡) is the total expected rate of return on asset value; 𝛿 is the constant fraction
of value paid out to security holders; 𝑑𝐵 is the increment of the standard brownian motion.
The stochastic process of 𝐴 is assumed to be unaffected with the choice of leverage (eg:
coupons after tax benefits). The continuously paid coupons 𝐶 are tax-deductible at rate
𝜏 and the realized cost of financial distress amount to a fraction 𝛼 of firm value. In this
setting the value of the firm is shown below:

𝑣(𝐴) = 𝐴 + 𝑇𝐵(𝐴) − 𝐵𝐶(𝐴) =

𝜏𝐶 𝐴 𝐴 (4)
𝐴+ [1 − ( )−𝑥 ] − 𝛼𝐴𝐵 ( )−𝑥
𝑟 𝐴𝐵 𝐴𝐵
Shareholders are residual claimants to the value of the firm and their payoffs are
expressed by:

𝐸(𝐴; 𝐴𝐵 ; 𝑇) = 𝑣(𝐴; 𝐴𝐵 ) − 𝐷(𝐴; 𝐴𝐵 ; 𝑇) (5)

where the value of debt is given by:

∫ 𝑡
𝑑(𝐴; 𝐴𝐵 ; 𝑡) = 𝑒 −𝑟𝑠 𝑐(𝑡)[1 − 𝐹(𝑠; 𝐴; 𝐴𝐵 )]𝑑𝑠 + 𝑒 −𝑟𝑡 𝜌(𝑡)[1 − 𝐹(𝑡; 𝐴; 𝐴𝐵 )]
0
∫ 𝑡
(6)
+ 𝑒 −𝑟𝑠 𝑝(𝑡)𝐴𝐵 [1 − 𝐹(𝑠; 𝐴; 𝐴𝐵 )]𝑑𝑠
0

The default 𝐴𝐵 is chosen endogenously ex post to maximize the value of equity at

25
𝐴 = 𝐴𝐵 , given the limited liability of equity and the debt structure. The public company
chooses debt with face value 𝑃 and default-triggering asset level to solve the following
optimization problem:

𝑚𝑎𝑥 𝑣(𝐴, 𝐴𝐵 , 𝑃, 𝑇) 𝐴=𝐴 (7)

𝑃,𝐴𝐵 0

subject to the endogenous bankruptcy trigger and the return process of the fundamental
value of the underlying asset.

4.2 Estimation Strategy

Estimation follows two steps. Parameters that do not require the model structure such as
risk-free rate or tax rate are calibrated outside of the model or borrowed from the literature.
We use the 20-year constant maturity U.S. Treasury yield (compiled by the Federal Reserve
Board) as a proxy for the risk-free rate, r. For the corporate income tax rate, 𝜏 , we use 30
percent. Following Goldstein et al. (2001), we assume a value of 0.05 for 𝛼, the fraction
of firm value lost in bankruptcy13. Second, we estimate key parameters using maximum
likelihood directly from our firm-level data. We normalize our initial sample values to
100, which simplifies numerical estimation and inference.
Following Bartram et al. (2015) we estimate the model by minimizing the squared de-
viation of predicted equity volatility (𝜎𝑒 ) from actual volatility. We define equity volatility
as 𝜎𝑒 = 𝑙(𝜎𝑎 ) × 𝜎𝑎 , where 𝑙(𝜎𝑎 ) transforms asset volatility to equity volatility.14. Equity
and asset volatility are defined as the standard deviation of equity and asset returns
13We choose not to use the LT (1996) calibrated value for bankruptcy cost because it has been criticized
in the literature as much higher than what is observed in the data.
14𝑙(𝜎𝑎 ) is also defined similar to Bartram et al. (2015). 𝑙(𝜎𝑎 ) = [1 + 𝐷(𝐴, 𝐴𝑏 , T)/𝐸(𝐴, 𝐴𝑏 , T)]*(𝑘(𝜎𝑎 )). This
estimation procedure is consistent with the original LT model where asset risk value was chosen to achieve
the equity volatility that is observed in the data.

26
respectively. We model firm asset volatility as a function of firm-level characteristics:

𝑛
Õ
𝜎𝑎 = 𝑒𝑥𝑝(𝛽 0 + 𝛽 𝑖 𝑋𝑖 ) (8)

where 𝑋𝑖 is a set of covariates including firm size, tangibility, profitability, liquidity

and profit volatility; 𝛽 𝑖 are the estimated coefficients using maximum likelihood. The
exponential function ensures positive values for 𝜎𝑎 . Next, debt maturity is parameterized
between 1 and 10 years using the following expression:

𝐿𝑜𝑛 𝑔 𝑡𝑒𝑟𝑚 𝐷𝑒𝑏𝑡

𝑇 =1+9 (9)
𝑇𝑜𝑡𝑎𝑙 𝐷𝑒𝑏𝑡

The face value of all outstanding debt is (𝑃) is calculated as net book leverage. Similar
to previous studies we proxy the drift rate with long-term risk-free rate under risk-neutral
valuation and the payout rate 𝛿 at 0.5 percent. These observable variables allow for
the calculation of all other variables in our optimization problem described in detail in
Section B of the Appendix. As summarized in previous studies, this estimation procedure
calibrates the model in a way that allows for the endogenous nature of the bankruptcy
decision.
All calibrated and estimated parameter values are summarized in Table 7. We estimate
the model separately for the pre and post-covid sample for three groups of firms: (i) all
firms, (ii) firms exposed to financial risk and (iii) firms exposed to business risk from
social distancing. Note that we retain the same values for tax rates, bankruptcy costs
and dividend payouts rates for both periods. Since our focus is not on the determinants
of firm risk we do not report individual coefficient estimates from Eq. (8) and instead
focus on predicted values of 𝜎𝑎 .15 It is worth noting that 𝜎𝑎 is much higher for firms
exposed to high financial risk and this level rises further post-COVID. On the other hand,
estimated risk for firms with business risk is closer to the overall sample means. Finally
15To compute predicted asset risk, we use only economic variables that are statistically significant. These
estimates are available upon request.

27
we note that our estimate of 𝜎𝑎 of 0.31 for the full sample lies within the range of values
used in previous studies. For example, Leland and Toft (1996) sets asset risk at 0.2, while
Ju et al. (2005) sets asset risk at 0.38 (or 38 percent). Leland (1998) uses 0.2 and 0.3 to
denote two different risk levels. We are thus reassured of our estimated parameter since
the capital structure literature has established that volatility of the asset return process
greatly influences estimates of optimal leverage.

Table 7: Model Parameter Values

Pre-COVID Post-COVID Source

Panel A: Calibrated Values
Risk-free Rate (%) 2.5 1.3 20-year Risk-free Rate
Tax Rate (%) 30 30 Standard
Payout Rate (%) 0.5 0.5 Standard
Bankruptcy Cost 0.05 0.05 Goldstein et al. (2001)

Panel B: Estimated Values Mean (Std. Dev) Mean (Std. Dev)

𝜎𝑎 , full sample 0.31 (2.39) 0.35 (2.31) Estimated
𝜎𝑎 , firms exposed to FR 0.42 (3.06) 0.52 (9.1) Estimated
𝜎𝑎 , firms exposed to BR 0.32 (1.3) 0.29 (0.67) Estimated
Maturity, full sample 7.68 (2.88) 7.9 (2.5) Estimated
Maturity, firms exposed to FR 5.66 (2.9) 6.0 (2.55) Estimated
Maturity, firms exposed to BR 7.92 (2.7) 7.76 (2.6) Estimated

Notes: This table reports calibrated and estimated parameters in Panels A and B respectively to
compute optimal leverage following Leland and Toft (1996) model. 𝜎𝑎 is defined as the standard
deviation of asset return and is estimated as outlined in the text. Panel B reports predicted values
and standard deviations for 𝜎 and debt maturity. 𝐹𝑅 denotes Financial Risk, 𝐵𝑅 denote Business
Risk. 20-year risk-free rate is retrieved from the Federal Reserve Bank of St. Louis.

5 Quantitative Analysis

5.1 Model-Implied Optimal Leverage

We summarize the preliminary findings of the model in Table 8 below. We observe

a striking reduction in the level of optimal leverage following the onset of the COVID

28
recession, consistent with our benchmark regressions. The model predicts a decline in
the value-maximizing level of leverage of approximately 13 percent, from 31.50 to 18.73
percent. Both the rise in estimated volatility (standard deviation of asset return) and
sharp decline in expected growth rate (proxied by the long-term risk-free rate) drove this
decline. However, we also note that greater impact was attributable to the decline in
expected growth rate, which is consistent with the idea that social distancing adversely
impacted aggregate demand.

Table 8: Model Results: Optimal Leverage (%)

Pre-Covid Post-Covid Over-Leveraged

Full Sample 31.50 18.73 No
Firms Exposed to Financial Risk 17.60 8.30 No
Firms Exposed to Business Risk 31.10 19.16 Yes

Notes: The table above reports estimated optimal leverage based on the structural Leland and Toft
(1996) model under risk-neutral valuation. Optimal Leverage is defined as the payoff received by
debt-holders (value of debt) over the value of the levered firm. A firm is classified as Over-Leveraged
if its actual minus model-implied leverage is greater than 0, where actual leverage ratios are reported
in Table 1.

Recall from Table 1 that leverage ratio pre-COVID was 19.56 percent followed by a
decline to around 16.99 percent post-COVID for the full sample. Thus, the model predicts
that firms, on average, were under-leveraged prior to the COVID-shock and the decline in
optimal leverage greatly reduced this difference between actual debt and model-implied
optimal debt. We note that model does a particularly good job of matching the data
post-covid.
We have thus far established that the results from the benchmark regressions in section
3 are consistent with the view that firms experienced a decline in their optimal leverage
ratios. We next evaluate patterns for firms exposed to business risk from social distancing,
and those exposed to financial risk from rollover risk. We find companies exposed to
financial risk also experienced a significant reduction in optimal leverage. In fact, the
model predicts optimal leverage ratio declines by around 50 percent for this type of firms.

29
This is primarily driven by the large increase in estimated firm risk reported in Table 7, in
addition to the decline in growth expectations. Companies exposed to financial risk tend
to exhibit greater asset return volatility, leading to lower optimized leverage. Note that
this finding is also consistent with the patterns documented in the benchmark regressions
where the decline in leverage was greater for firms exposed to rollover risk.
Next, we turn to firms whose businesses were most severely impacted by COVID-19.
The difference-in-differences regressions indicated these companies did not significantly
adjust debt levels relative to non-exposed peers, and only shortened their maturity struc-
ture. In fact, raw means based on Gross Debt suggest these firms raised their debt level
post-COVID as shown in Table 1. Not surprisingly though, the model however documents
a large decline in optimal leverage for these companies as well. The decline is largely com-
parable to that for the entire sample with optimal leverage ratio of around 18.73 percent
post-COVID. Regardless of the accounting measure of debt we use, it is straight-forward to
see these companies have become over-leveraged following the onset of the COVID shock.
We classify a firm as over-leveraged if their actual leverage exceeds model-implied opti-
mal leverage. This finding has natural implications for corporate fragility and financial
stability since over-leveraged firms are more vulnerable to future shocks and contribute
to systemic risk in an economy. We look at this in more detail in the following section.

6 Structural Estimation of Default Probability

6.1 Methodology

In this section we outline the procedure to estimate Distance-To-Default (DTD) and prob-
ability of default. The structural approach to estimating default revolves around the
intuition developed by Merton (1974), which is that a firm’s securities can be priced as
contingent claims on the value process of the firm. Merton (1977) points out the applicabil-
ity of the contingent claims approach to pricing deposit insurance in the banking context.

30
The approach has been applied by Ronn and Verma (1986) and Duan (1994). Using the
estimation procedure in Vassalou and Xing (2004) and Bharath and Shumway (2008), we
use equity prices and balance sheet data from pre-COVID and post-COVID onset periods
to infer the implied changes in default probabilities for companies16.
Following Vassalou and Xing (2004) and Bharath and Shumway (2008), we use an
iterative algorithm that requires making an initial guess of drift and volatility. Using the
Black and Scholes (1973) option pricing formula, equity value can be calculated according
to:

𝐸 = 𝑁(𝑑1 )𝐴 + 𝐷𝑒 −𝑟𝑇 𝑁(𝑑2 ) (10)

𝐴
𝐷 +(𝑟+0.5𝜎𝐴 𝑇)
2 √
where 𝑑1 = √ and 𝑑2 = 𝑑1 − 𝜎𝐴 𝑇. As is well-known in the credit risk literature,
𝜎𝐴 𝑇
𝐷 is the firm’s debt, all of which is assumed to mature at the same time 𝑇, 𝑁(·) the
cumulative distribution function of the standard normal under the risk neutral measure.
The default probability 𝑃𝑑𝑒 𝑓 is the probability that the firm’s assets will be less than
the book value of the firm’s liabilities. In other words:

𝑃𝑑𝑒 𝑓 ,𝑡 = 𝑃𝑟𝑜𝑏(𝑉𝐴,𝑡+𝑇 ≤ 𝐷𝑡 |𝑉𝐴,𝑡 ) = 𝑃𝑟𝑜𝑏(𝑙𝑛(𝑉𝐴,𝑡+𝑇 ) ≤ 𝑙𝑛(𝐷𝑡 |𝑉𝐴,𝑡 ) (11)

We can then express the value of assets based on standard GBM process:

𝜎𝐴
2 √
𝑙𝑛(𝑉𝐴,𝑡+𝑇 ) = 𝑙𝑛(𝑉𝐴,𝑡 ) + (𝜇 − 𝑇 + 𝜎𝐴 𝑇𝜖 𝑡+𝑇 ) (12)
2

where 𝜖 𝑡+𝑇 ≈ 𝑁(0, 1). Let 𝑉𝐴,𝑡 = 𝐴𝑡 , we can then express the DTD metric as follows:

𝑙𝑛( 𝐴𝐷𝑡 ) + (𝑢𝐴 + 0.5𝜎𝐴

2
)𝑇
𝐷𝐷 = √ (13)
𝜎𝐴 𝑇
16An alternative approach can be to estimate default probability from the Leland and Toft (1996) model.
We choose to use the Merton (1974) framework since it is still the more popular approach in estimating
credit risk in the literature. The main difference between the two models in terms of calculating default
likelihood is the default barrier, in addition to the payout rate.

31
 where 𝑢𝐴 is used under the physical probability measure. We link equity values to
asset values using the following expressions:

𝐴
𝜎𝐸 = 𝑁(𝑑1 )𝜎𝐴 (14)
𝐷

Equity volatility is estimated as the standard deviation of equity value return for each
company. The default barrier is again set net of cash and cash-like assets:

𝐷 = 𝑆ℎ𝑜𝑟𝑡 𝑇𝑒𝑟𝑚 𝐷𝑒𝑏𝑡 + 0.5 ∗ 𝐿𝑜𝑛 𝑔 𝑇𝑒𝑟𝑚 𝐷𝑒𝑏𝑡 − 𝐶𝑎𝑠 ℎ 𝑎𝑛𝑑 𝐶𝑎𝑠 ℎ 𝐸𝑞𝑢𝑖𝑣𝑎𝑙𝑒𝑛𝑡𝑠 (15)

Next, the iterative algorithm starts by guessing an initial value for 𝜎𝐴 , which we set
𝜎𝐸
equal to 𝜎𝐴
0
= 𝜎𝐸 𝐸+𝐷 , where E is the book value of equity at the end of the year-quarter, and
D is the book value of debt as defined earlier. Initial drift is proxied by 10-year constant
treasury rate. Given these estimates and initial values, we can solve Eq. (14) for 𝐴 to
obtain the first iteration. We repeat this exercise until we achieve a standard convergence
criterion. Defining 𝜖 < 0.001, we stop the algorithm when we achieve this criterion shown
in Eq. (16) and estimate Distance-To-Default, shown in Eq. (17). According to Vassalou
and Xing, there are two main differences between this approach and the one used by
KMV. KMV uses Bayesian adjustments for the country, industry, and size of the firm.
Additionally, they also allow for convertibles and preferred stocks in the capital structure
of the firm.

|𝜎𝐴𝑛 − 𝜎𝐴𝑛−1 < 𝜖| (16)

𝑙𝑛( 𝐴𝐴𝐵𝑡 ) + (𝜇𝐴 − 𝛿 + 0.5𝜎𝐴

2
)𝑇
𝐷𝑇𝐷 = √ (17)
𝜎𝐴 𝑇

𝑙𝑛( 𝐴𝐷𝑡 ) + (𝜇𝐴 + 0.5𝜎𝐴

2
)𝑇
𝑃𝑑𝑒 𝑓 = 𝑁(−𝐷𝑇𝐷) = 𝑁(− √ ) (18)
𝜎𝐴 𝑇

32
Finally we aggregate our estimates of default probability using a simple unweighted
average by each year-quarter and plot a time-series to assess its consistency with the
literature.

6.2 Structural Model Estimates: Default Risks Concentrated Among

Larger Over-Leveraged Firms

Figure 6: Estimated Probability of Default

Notes: Expected Default Frequency estimated from the structural model of Merton (1974). For
estimating the asset volatilities, the assumed maturity is 1 year, the default barrier is assumed to
be short-term debt plus half of long-term debt minus cash and cash equivalents. Risk-free rate is
proxied by the 10-year constant maturity treasury rate.

We begin by plotting default probability aggregated across firms by year-quarter start-

ing from 2006. Figure 6 shows default probabilities were elevated around the financial
crisis. We note a dip around 2009 before default probabilities picked up sharply again
coinciding with the Eurozone sovereign debt crisis. Default probabilities declined since

33
 Table 9: Structural Model Distance-To-Default Estimates

All Firms Firms with FR Firms with BR

p(50) p(25) p(50) p(25) p(50) p(25)
Panel A: All Firms
Pre-COVID 9.76 1.76 7.76 1.43 9.34 1.88
Post-COVID 10.51 1.40 8.83 1.33 9.39 1.51
Δ(𝑃𝑜𝑠𝑡 − 𝑃𝑟𝑒) 0.75 -0.36 1.07 -0.10 0.05 -0.37

Panel B: Large Firms

Pre-COVID 10.09 1.90 11.97 3.86 10.2 2.37
Post-COVID 10.77 1.52 13.15 2.81 9.14 1.22
Δ(𝑃𝑜𝑠𝑡 − 𝑃𝑟𝑒) 0.68 -0.38 1.18 -1.05 -1.06 -1.15

Notes: This table shows estimates of the distance to default metric using the asset volatility and
implied asset values from the structural model for pre and post-COVID onset samples. FR denotes
“Financial Risk”, BR denotes “Business Risk”. It shows how many standard deviations a company’s
asset value has to deviate from its mean before it defaults. For estimating the asset volatilities,
the assumed maturity is 1 year, the default barrier is assumed to be short-term debt plus half of
long-term debt minus cash and cash equivalents. Risk-free rate is proxied by the 10-year constant
maturity treasury rate. Large firms are defined as those with average total asset value greater than
USD 1 billion.

then somewhat until 2017 around the time of major unexpected political turbulence (e.g.
Brexit). Finally, we see the sharpest single-quarter increase in default probability in 2020
coinciding with the onset of the COVID recession. These trends are consistent with
conventional wisdom, reassuring us of the validity of our structural estimation.
We summarize our results on the impact of COVID-19 on default likelihood in Table
9. We rely on the DTD metric widely used in the credit risk literature. Column 1 in Panel
A shows the median firm reduced default likelihood post-COVID consistent with the
de-leveraging effect documented in the benchmark specifications. DTD rises by about 10
percent from 9.76, in other words the median firm is further away from default. However,
we uncover an opposing trend when we focus on firms in the bottom quartile sorted on
DTD. Specifically, the firm in the 25𝑡 ℎ percentile experiences a decline in DTD from 1.76
to 1.40, a deterioration by around 20.5 percent. Thus, firms which were already stressed
pre-COVID became more vulnerable to bankruptcy. We observe similar trends for firms

34
exposed to rollover risk and business risk. We note however that the change is highest for
firms exposed to business risk: a decline of 0.37 to 1.51 as can be seen in Column (6).
Table 9, Panel B repeats the analysis for firms with asset value greater or equal to USD
1 billion, which we classify as 𝐿𝑎𝑟 𝑔𝑒 firms. We note that the patterns documented in
Panel A are amplified for 𝐿𝑎𝑟 𝑔𝑒 firms. For example firms in the 25𝑡 ℎ percentile in the
sample experienced a decline of 0.38. More crucially for our analysis we note the highest
deterioration is associated with firms exposed to business risk originating from social
distancing. Both in levels and change, we note these firms became the most vulnerable
post-COVID. For example, the firm in the 25𝑡 ℎ percentile has a DTD value of 1.22, the
lowest in all sub-samples reported. These patterns are reflective of the rise in default risk
from becoming over-leveraged as shown in Section 5. Alfaro et al. (2019) argue large
firms have the greatest potential to generate systemic risk. Our results raise important
implications consistent with this view which show the largest firms exposed to risks from
social distancing are much closer to default following the onset of the pandemic recession.

6.3 Stress Tests

The previous analysis reveals important patterns about the level and change in risk in
US corporations following their capital structure decisions in response to the pandemic
recession. From a regulatory perspective, it is also useful to gain an idea of the resilience of
these companies to systemic downturns. In this section we ask, how resilient are compa-
nies if growth slowed down or asset risk increased, given leverage adjustments following
the COVID-19 shock? To simulate stress tests, we re-estimate default probabilities using
counterfactuals. Specifically, for each company, we add a 20 percent decline in expected
growth rate and, for the second stress test, a 20 percent rise in cash flow volatility and trace
out DTD pre and post-COVID. Note that these simulations are over and above the effect
arising from the COVID recession or other macroeconomic effects. By design, it takes into
account the fact that some firms adjusted leverage while others did not.

35
 Table 10: Stress Tests on Distance-To-Default Estimates

All Firms Firms with FR Firms with BR

p(50) p(25) p(50) p(25) p(50) p(25)
Shock 1: Growth Slowdown
Panel A1: All Firms
Pre-COVID 7.96 1.44 6.95 1.20 7.82 1.53
Post-COVID 8.76 1.01 7.23 1.01 7.95 1.06
Δ(𝑃𝑜𝑠𝑡 − 𝑃𝑟𝑒) 0.80 -0.43 0.28 -0.19 0.13 -0.47

Panel A2: Large Firms

Pre-COVID 8.39 1.56 10.34 3.19 8.57 2.01
Post-COVID 9.01 1.11 11.13 2.22 7.45 0.86
Δ(𝑃𝑜𝑠𝑡 − 𝑃𝑟𝑒) 0.62 -0.45 0.79 -0.97 -1.12 -1.15

Shock 2: Higher Uncertainty (Asset Volatility)

Panel B1: All Firms
Pre-COVID 7.86 1.31 6.43 0.97 7.74 1.35
Post-COVID 8.73 1.03 7.3 0.96 7.79 1.17
Δ(𝑃𝑜𝑠𝑡 − 𝑃𝑟𝑒) 0.87 -0.28 0.87 -0.01 0.05 -0.18

Panel B2: Large Firms

Pre-COVID 8.38 1.41 9.94 3.16 8.47 1.72
Post-COVID 8.96 1.11 10.94 2.28 7.58 0.89
Δ(𝑃𝑜𝑠𝑡 − 𝑃𝑟𝑒) 0.58 -0.30 1.00 -0.88 -0.89 -0.83

Notes: This table shows estimates of the distance to default metric using the asset volatilities and
implied asset values from the structural model for pre and post-COVID onset samples subject to two
stress tests. FR denotes “Financial Risk”, BR denotes “Business Risk”. The table shows number
of standard deviations a company’s asset value has to deviate from its mean before it defaults. In
Panels A1 and A2, the estimated drift rate, 𝜇 , for each company is reduced by 20 percent. In Panels
B1 and B2, the estimated volatility 𝜎 , for each company is raised by 20 percent. For estimating
the asset volatilities, the assumed maturity is 1 year, the default barrier is assumed to be short-term
debt plus half of long-term debt minus cash and cash equivalents. Risk-free rate is proxied by the
10-year constant maturity treasury rate. Large firms are defined as those with average total asset
value greater than USD 1 billion.

We summarize our results in Table 10. Panel A1 presents results with a simulated
20 percent slowdown in growth. Looking at firms in the 25𝑡 ℎ percentile again reveals
significant deterioration in credit risk following COVID. However, the levels are much

36
lower relative to the estimates reported in Table 9, without a simulated growth slowdown.
For example, post-COVID DTD for firms exposed to business risk in the 25𝑡 ℎ percentile
is 1.06, or only one-standard deviation away from the default barrier. Panel A2 shows
each of the simulated effects are amplified for larger firms. Specifically, we see a DTD
decline of 0.97 for 25𝑡 ℎ percentile firms with rollover risk to 2.22 and a decline of 1.15 for
25𝑡 ℎ percentile firms with business risk to 0.86. These estimates suggest, there is a small
subset of relatively large firms that are over-leveraged and their asset value is less than
one-standard deviation away from the default barrier. Finally, Panel B1 and B2 repeat the
same exercise for an alternate stress test: a 20 percent spike in cash flow return volatility
which is our proxy for uncertainty. We document very similar patterns thus underscoring
the risks of becoming over-leveraged.

7 Conclusion

In this paper, we provide the first large sample evidence on the impact of COVID-19 on
optimal capital structure in US public firms. We suggest that the recessionary nature of
the shock impact default probabilities and by extension, expected cost of distress. Tradi-
tional capital structure theory indicate a resultant change in optimal level of debt. Using
data through 2020Q4, we exploit within-firm variation to estimate an empirical model of
leverage. Our estimates show the shock from COVID decreased the level of leverage by
5.3 percent relative to the pre-shock mean of 19 percent, while debt maturity increased
marginally. Several iterations and alternate measures of debt confirm our estimates. We
show that the results were mostly driven by firms exposed to significant rollover risk
pre-COVID, while those affected by social distancing maintained their leverage ratios and
only shortened their debt maturity structure.
We find that a model of optimal capital structure characterized by a deterioration in
expected growth rate of firm cash flows and surge in volatility of asset return is consistent

37
with our benchmark de-leveraging results. Estimating drift and volatility directly from the
data pre and post-COVID shows a significant reduction in the optimal levels of corporate
leverage, a novel contribution to the literature. A key contribution of this paper is that
we document firms most severely affected by social distancing chose to maintain their
leverage levels and thus became over-leveraged. Using standard structural models of
credit risk we confirm these firms experienced the largest deterioration in credit risk. Our
simulation tests show the bottom quartile of these firms (sorted on default likelihood) are
particularly vulnerable to future downturns. Distress Risk is also larger for the largest
firms affected by social distancing. From a policy perspective, our results clearly raise
serious implications for financial stability and systemic risk since large firms have the
potential to generate a wave of defaults.

38
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Appendix A
Data Appendix

42
 Table A1: Variable Definition

Variable Definition
Total Debt Debt in Current Liabilities + Total Long-term Debt

Leverage Ratio Total Debt Net of Cash /Total Assets

Long-term Debt Ratio Total Long-term Debt Net of Cash /Total Assets

Debt Maturity Total Long-term Debt/Total Debt

EBITDA Margin Earnings Before Interest, Taxes, Depreciation and Amortization/Operating Revenue
43

Return on Assets Earnings Before Interest and Taxes/Assets

Cash Ratio Cash/Current Liabilities

Tangibility Share of Tangible Assets

Market-to-Book Market Value of Equity/(Book Value of Equity)

Exposure to Rollover Risk (Long-Term Debt due in 1 year)/Total Debt ≥ 75th percentile of all firms in
2019Q4: 20.1 percent

Highly Vulnerable to Social Distancing Sales Growth (ROA change) ≤ 25th percentile in 2020Q2 relative to 2019Q2.
 Table A2: Summary Statistics: Full Sample

Variable Obs Mean Std. Dev 50th Percentile 75th Percentile

Total Assets ($ Mn) 44744 9481 27720 1343 5534
EBITDA Margin 40157 -65 14391 15.46 33.06
Sales Growth (%) 38799 61.69 2556 -0.18 13.58
Tangibility 43995 0.83 0.22 0.95 0.99
Share of LT Debt due in 12 Months 32032 0.15 0.21 0.07 0.2
Cash Ratio 33326 1.24 3.48 0.4 1.09

44
 8 Appendix B
Building Blocks of Leland and Toft (1996) Model

In this section we outline the Leland and Toft (1996) Model. We point readers to the
original paper for a detailed discussion. The LT model builds on the trade-off theory of
capital structure (i.e. corporate tax benefits versus bankruptcy costs and agency costs).
Debt issues provide tax benefits that are balanced with higher probabilities of default.
Equity holders aim to achieve the lowest bankruptcy trigger (equity value is maximized at
the expense of the debt holders). This is the well-known asset substitution problem where
around the optimal bankruptcy trigger, equity holders would want to take on riskier
projects. Consider a firm that has productive assets whose unleveraged value 𝐴𝑡 , follows
standard geometric brownian motion:

𝑑𝐴𝑡
= [𝜇𝑎 (𝐴, 𝑡) − 𝛿]𝑑𝑡 + 𝜎𝑎 𝑑𝐵𝑡𝐴 (19)
𝐴𝑡
where 𝜇𝑎 (𝐴, 𝑡) is the total expected rate of return on asset value; 𝛿 is the constant
fraction of value paid out to security holders; 𝑑𝐵 is the increment of the standard brownian
motion. The stochastic process of 𝐴 is assumed to be unaffected with the choice of leverage
(eg: coupons after tax benefits). Following Modigliani and Miller (1957), Merton (1975),
Leland (1994) and Leland and Toft (1996), we assume that a riskless asset exists and pays
a constant rate of interest 𝑟. Now consider any claim on the firm that continuously pays
a non-negative coupon, 𝑐(𝑡), per instant of time when the firm is solvent, has maturity
𝑡 periods from the present and principal 𝑝(𝑡). Let 𝜌(𝑡) represent the fraction of asset
value 𝐴𝐵 which debt of maturity 𝑡 receives in the event of bankruptcy. Under risk-neutral
valuation and letting 𝑓 (𝑠; 𝐴, 𝐴𝐵 ) denote the density of the first passage time s to 𝐴𝐵 from
𝐴 when the drift rate is 𝑟 − 𝛿, gives debt the following value:
∫ 𝑡
𝑑(𝐴; 𝐴𝐵 ; 𝑡) = 𝑒 −𝑟𝑠 𝑐(𝑡)[1 − 𝐹(𝑠; 𝐴; 𝐴𝐵 )]𝑑𝑠 + 𝑒 −𝑟𝑡 𝜌(𝑡)[1 − 𝐹(𝑡; 𝐴; 𝐴𝐵 )]
0
∫ 𝑡
(20)
+ 𝑒 −𝑟𝑠 𝑝(𝑡)𝐴𝐵 [1 − 𝐹(𝑠; 𝐴; 𝐴𝐵 )]𝑑𝑠
0

Eq. (4) can be integrated by parts to obtain a closed-form solution, as outlined below.

The expression for debt in Eq. (4) can be integrated by part to obtain:

𝑐(𝑡) 𝑐(𝑡) 𝑐(𝑡)

𝑑(𝐴; 𝐴𝐵 ; 𝑡) = + 𝑒 −𝑟𝑡 [𝑝(𝑡) − )][1 − 𝐹(𝑡)] + [𝜌(𝑡)𝐴𝐵 − ]𝐺(𝑡) (21)
𝑟 𝑟 𝑟

45
where
𝐴 (−𝑎+𝑧) 𝐴
𝐺(𝑡) = ( ) 𝑁[𝑞1 (𝑡)] + ( )(−𝑎−𝑧) 𝑁[𝑞 2 (𝑡)] (22)
𝐴𝐵 𝐴𝐵
𝐴 (−2𝑎)
𝐹(𝑡) = 𝑁[ℎ1 (𝑡)] + ( ) 𝑁[ℎ2 (𝑡)] (23)
𝐴𝐵
−𝑏−𝑧𝜎 2 𝑡 2𝑡
𝑞 1 (𝑡) = 𝜎𝑡 ; 𝑞 2 (𝑡) = −𝑏+𝑧𝜎
𝜎𝑡 ;
(−𝑏−𝑎𝜎2 𝑡) (−𝑏+𝑎𝜎2 𝑡)
ℎ1 (𝑡) = 𝜎𝑡 ; ℎ2 (𝑡) = 𝜎𝑡

𝑎 = (𝑟 − 𝛿 − (𝜎 2 /2))/𝜎 2 ; 𝑧 = ((𝑎𝜎 2 )2 + 2𝑟𝜎 2 )1/2 /𝜎 2

As in Leland and Toft (1996), the value-process for company continues until maturity of
debt unless 𝐴 falls to a default-triggering value 𝐴𝐵 . Assuming that the firm continuously
issues a constant principal amount of new debt with maturity 𝑇 and simultaneously
retires the same amount of debt, then the debt structure becomes independent of 𝑡, and
the value of all outstanding bonds 𝐷(𝐴; 𝐴𝐵 , 𝑇) can be determined by integrating the debt
flow, 𝑑(𝐴; 𝐴𝐵 , 𝑡), over a period of 𝑇:

𝑇
𝐶 𝐶 1 − 𝑒 −𝑟𝑇 𝐶
∫
𝐷(𝐴; 𝐴𝐵 ; 𝑡) = 𝑑(𝐴; 𝐴𝐵 ; 𝑡) = + (𝑃 − )( − 𝐼(𝑇)) + ((1 − 𝛼)𝐴𝐵 − )𝐽(𝑇) (24)
𝑡 𝑟 𝑟 𝑟𝑇 𝑟

where
𝐺(𝑇) − 𝐹(𝑇)𝑒 −𝑟𝑇
𝐼(𝑇) =
𝑟𝑇
𝐴 −𝑎−𝑧
√
J(T) = [-(A/A𝐵 )𝑎+𝑧 𝑁(𝑞 1 (𝑇))𝑞 1 (𝑇) + 𝐴𝐵 ) 𝑁(𝑞 2 (𝑇))𝑞 2 (𝑇)]/𝑏𝜎 𝑇
(25)

The fraction of firm value lost in bankruptcy is 𝛼. We hypothesize 𝛼 = 𝛼(𝑟) where 𝑟

represents the borrower’s bargaining power. Intuitively we predict that firm’s with higher
bargaining power can reduce bankruptcy costs. Considering the difficulty in estimating
this bargaining power parameter, we estimate our baseline model holding 𝛼 constant. This
is typically ignored in the literature and we aim to explore the heterogeneity it introduced
in future drafts. Firm value is captured as the function of the unlevered value of assets,
tax benefits and bankruptcy costs.

𝑣(𝐴) = 𝐴 + 𝑇𝐵(𝐴) − 𝐵𝐶(𝐴) =

𝜏𝐶 𝐴 𝐴 𝐶 𝐴 (26)
𝐴+ [1 − ( )−𝑥 ] − 𝛼𝐴𝐵 ( )−𝑥 + [1 − ( )−𝑥 ]
𝑟 𝐴𝐵 𝐴𝐵 𝑟 𝐴𝐵

46
 where x = 𝑎 + 𝑧. The Equity Value 𝐸(𝐴) is the difference between firm value 𝑣(𝐴) and
debt value 𝑑(𝐴):

𝐸(𝐴; 𝐴𝐵 ; 𝑇) = 𝑣(𝐴; 𝐴𝐵 ) − 𝐷(𝐴; 𝐴𝐵 ; 𝑇) (27)

The default 𝐴𝐵 is chosen endogenously ex post to maximize the value of equity at

𝐴 = 𝐴𝐵 , given the limited liability of equity and the debt structure. To determine the
equilibrium bankruptcy-triggering asset value 𝐴𝐵 endogenously, we invoke the smooth-
pasting condition. 𝐴𝐵 solves the equation

𝜕𝐸(𝐴, 𝐴𝐵 )
ℎ(𝑃, 𝐴𝐵 ) = =0 (28)
𝜕𝑉 𝐴=𝐴𝐵

Using the expressions for debt, total firm value and equity, we can derive the default-
triggering asset level. The result is similar to Leland and Toft (1996) apart from the
parameter capturing reduced incentive-misalignment, 𝜖 :

𝐶 𝑀 𝑀𝑃 (𝜖+𝜏)𝐶𝑥
𝑟 ( 𝑟𝑇−𝐺 ) − 𝑟𝑇 − 𝑟
𝐴𝐵 = (29)
1 + 𝑎𝑥 − (1 − 𝑎)𝐺
where
√ √ 2 √
𝑀 = 2𝑎𝑒 −𝑟𝑇 𝑁(𝑎𝜎 𝑇) − 2𝑧𝑁(𝑧𝜎 𝑇) − √ 𝑛(𝑧𝜎 𝑇)
𝜎 𝑇
2𝑒 −𝑟𝑇 √
+ √ 𝑛(𝑎𝜎 𝑇) + (𝑧 − 𝑎)
𝜎 𝑇
2 √ 2 2 1
𝐺 = −(2𝑧 + 2 )𝑁(𝑧𝜎 𝑇) − √ − √ 𝑛(𝑧𝜎 2𝑇) + (𝑧 − 𝑎) + √
𝑧𝜎 𝑇 𝜎 𝑇 𝜎 𝑇 𝑧𝜎 𝑇
and n(·), N(·) denote the standard normal density function and cumulative standard
normal density function respectively. We can now define the optimization problem for
the firm. The public company solves the following problem at 𝑇0 :

𝑚𝑎𝑥 𝑣(𝐴, 𝐴𝐵 , 𝑃, 𝑚) 𝐴=𝐴 (30)

𝑃,𝐴𝐵 0

subject to optimal bankruptcy condition and return process of the fundamental value of
the underlying asset.

47
9 Appendix C
Comparing Baseline Regressions with Past Recessions

To understand the significance of the reduction in debt and increase in maturity presented
in our baseline results in Section 3, we repeat the benchmark regressions with a longer
time-series to document capital structure response during past recessions. We augment
our baseline dataset with similar firm-level data around the time of the Global Financial
Crisis (GFC) and the Dotcom crash. The data is cleaned and filtered as described in section
3. Specifically, we estimate a similar pre-post regression for the GFC and the Dotcom crash
in 2001.

Figure A1: This chart plots coefficient estimates of 𝑃𝑜𝑠𝑡 outlined in Eq. (1) for three recessions:
the dot-come crash, GFC and COVID-19. The outcome is leverage ratio. We follow the NBER’s
timeline of recession onset to construct our pre-post dummy variable. For both GFC and the
dot-com crash recession, we retain 6 quarters for the pre-recession phase. For GFC we examine 8
post-recession quarters (2008 and 2009) consistent with past studies such as Demirguc-Asli Kunt
(2015). For the dotcom crash, we look at 6 quarters post-recession.

We observe that both the amount and maturity of debt declined during GFC. However,
the reduction is significantly lower post-GFC compared to post-COVID. The point estimate
is reported at -0.015 or a 1.5 percent decline. We also observe that the change in leverage
during the dotcom crash was statistically insignificant.

48
Figure A2: This chart plots coefficient estimates of 𝑃𝑜𝑠𝑡 outlined in Eq. (1) for three recessions:
the dot-come crash, GFC and COVID-19. The outcome is debt maturity. We follow the NBER’s
timeline of recession onset to construct our pre-post dummy variable. For both GFC and the
dot-com crash recession, we retain 6 quarters for the pre-recession phase. For GFC we examine 8
post-recession quarters (2008 and 2009) consistent with past studies such as Demirguc-Asli Kunt
(2015). For the dotcom crash, we look at 6 quarters post-recession.

We next repeat the analysis on maturity structure. Post-COVID, we document a mod-

erate increase in the share of long-term debt in total debt, although previous studies
document a decline in maturity post-GFC. Figure 5 reports out estimates for debt ma-
turity. We find debt maturity remained relatively unchanged for our sample of publicly
listed firms post-GFC consistent with Demirguc-Kunt (2015). However, we note that
maturity increased following the dot-come crash. Overall we do not observe any clear
patterns and find very different firm responses since the onset of the COVID-19 pandemic
compared to other major recessions.

49