Dynamic optimal capital structure with regime switching

We investigate the optimal capital structure of a corporate when the dynamics of the assets (both growth rate and volatility) change following different states of the economy. Two structural models are examined in the paper. The first considers the case when the firm is not facing tax benefit and bankruptcy costs with a regime switching dynamics. This model extends the Black and Cox (J Financ 31:351–367, 1976) model to allow for regime switching risk. The second model incorporates both tax benefit and bankruptcy costs with a regime switching dynamics. This is is more realistic, and is an extension of the Leland (J Financ 49(4):1213–1252, 1994) model with regime switching risk. We obtain closed-form analytic solutions for the optimal capital structure and default barrier for both models.