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Agency Costs , Credit Constraints and Default Spreads

We present a model for the valuation of risky debt that accounts for the endogeneity of the borrower’s investment choice as well as possible borrowing constraints. The model also extends previous research by assuming that changes in the borrower’s cash flows have both permanent and temporary components and illustrates why this is relevant in a setting with market imperfections. The paper presents numerical simulations that allow us to quantify the extent to which incentive problems and credit constraints affect borrowing rates.