Dynamic Recapitalization Policies and the Role of Call Premia and Issue Discounts

In a dynamic framework, the advantage of leverage depends upon the firm's recapitalization policy. We show that if bonds are callable at par, then equityholders have an incentive to recapitalize too early. Call premia and issue discounts, however, mitigate the agency problem of early recapitalization. The model provides the optimal call premium and issue discount as a function of firm-specific characteristics. An analysis of a bond sample supports the model's prediction that the optimal call premium is positively related to firm risk.