We investigate the dynamic game between equity and debt holders in a trade-off model with proportional debt issuance costs. Both with and without ex ante commitment there is an optimal capital structure and debt maturity. In equilibrium the firm only issues debt infrequently and in a lumpy fashion. Even without issuance costs, the firm retains positive tax benefits because creditors observe when the firm issues debt and therefore discipline equity holders not to deviate to more aggressive policies. High credit risk firms cannot always issue debt without commitment whereas low credit risk firms are practically indifferent between committing or not.

This paper analyzes optimal leverage dynamics with personal and corporate taxes and financial distress costs. The marginal tax benefit of debt depends on whether the debt is used for financing operational or investment needs or financial restructuring. The theory features continuous leverage adjustments and no security issuance costs. There are two local leverage targets for firms with leverage above or below a threshold. The model generates a leverage distribution that matches the data, including many zero-leverage firms. Policymakers can reduce distress costs without losing tax revenue by raising personal tax rates and lowering corporate tax rates. A new empirical measure finds no benefit to borrowing for seemingly underleveraged U.S. firms.

We examine the interplay between information disclosure and security design when auditing firm cash flows is costly. The optimal information structure induces a combination of convertible and/or performance-sensitive debt. The former enhances financing probability, while the latter reduces auditing costs. We find that the investor is persuaded to audit less, mitigating financing hold-ups and increasing the entrepreneur’s payoff. Consistent with empirical evidence, the probability of default is shown to decrease with default costs, as disclosure prevents inefficient investments. And when the default risk decreases, our model also predicts a strictly larger firm value.