An extension of the Merton model : The effect of including the cost of operating leverage

Abstract

We ask whether the Merton’s structural model of credit risk is improved by including the cost of operating leverage. We test this by extending the Merton model and testing whether the estimated credit spread is closer to the observed credit spread before or after the extension. We present two different extensions where the difference is the assumption of seniority of the costs of operating leverage. In the first we assume that the costs have the highest seniority, while in the other, the costs rank pari passu with interests and dividends. We find that both models improve the model slightly. Therefore, we conclude that our findings are a small step in finding the complete model for estimating credit spreads. Keywords: Merton model, Operating leverage, Credit spread puzzle, Default probabilities