Review of Quantitative Finance and Accounting, 20: 5–34, 2003
2003 Kluwer Academic Publishers. Manufactured in The Netherlands.
Trade-off Model of Debt Maturity Structure
School of Business, Hanyang University, Seoul, Korea 133-791 Tel.: +82-2-2290-1650, Fax: +82-2-2290-1169
FRANK C. JEN
355 Jacobs Center, School of Management, State University of New York, Buffalo, NY 14260
Tel.: (716) 645-3272, Fax: (716) 645-3823
Abstract. In this paper, we suggest the trade-off model to explain the choice of debt maturity. This model is
based on balancing between risk and reward of using shorter-term loans. Shorter-term loans have cost advantage
over, but incur higher reﬁnancing and interest rate risk than longer-term loans. Using the Compustat data, we
show that the principal components of ﬁnancial attributes are ﬁnancial ﬂexibility and ﬁnancial strength. Therefore,
only ﬁrms with greater ﬁnancial ﬂexibility and ﬁnancial strength can use proportionately more short-term loans.
We also document that ﬁnancially strong ﬁrms take advantage of lower interest rates of short-term debt. They
use proportionately more short-term loans when the term premium is high. The results of our study also provide
evidence supporting the agency cost hypothesis, which is strongly supported by current literature.
Keywords: debt maturity, agency cost, ﬁnancial ﬂexibility, ﬁnancial strength, ﬁnancing decision
JEL Classiﬁcation: G32, M21
The ﬁnance literature has made signiﬁcant progress in explaining corporate ﬁnancing deci-
sions. Increasingly, the focus has been moving beyond an examination of the basic leverage
choice to more detailed aspects of ﬁnancing decision such as debt-priority, debt-maturity
structure, and contract provisions. In this paper, we follow this trend by examining factors
affecting the maturity structure of debt, and how these factors can explain characteristics
of debt ﬁnancing. Pursuant to a review of existing hypotheses on debt maturity choice,
we propose that borrowers use short-term loans to reduce interest costs. However, because
shorter-term loans carry signiﬁcant reﬁnancing risk borrowers must either be ﬁnancially
strong or own assets with small liquidity risk. We empirically show that ﬁnancially strong
borrowers carry higher proportion of shorter-term debt and that heavy users of short-term
loans pay lower interest cost per dollar borrowed.
Existing theories on debt maturity choice could be classiﬁed into three categories: agency
cost hypothesis, signaling hypothesis, and tax hypothesis.
Myers (1977), Barnea, Haugen,
and Senbet (1980), Fama (1990) and Harris and Raviv (1990) argue that ﬁrms choose debt