A Review of Merton’s Model of the Firm’s Capital Structure with Its Wide Applications

Since its publication, the seminal structural model of default by Merton (1974) has become the workhorse for gaining insights about how firms choose their capital structure, a “bread and butter” topic for financial economists. Capital structure theory is inevitably linked to several important empirical issues such as (a) the term structure of credit spreads, (b) the level of credit spreads implied by structural models in relation to the ones that we observe in the data, (c) the cross-sectional variations in leverage ratios, (d) the types of defaults and renegotiations that one observes in real life, (e) the manner in which investment and financial structure decisions interact, (f) the link between corporate liquidity and corporate capital structure, (g) the design of capital structure of banks [contingent capital (CC)], (h) linkages between business cycles and capital structure, etc. The literature, building on Merton’s insights, has attempted to tackle these issues by significantly enhancing the original framework proposed in his model to make the theoretical framework richer (by modeling frictions such as agency costs, moral hazard, bankruptcy codes, renegotiations, investments, state of the macroeconomy, etc.) and in greater accordance with stylized facts. In this review, I summarize these developments.