Working Paper: NBER ID: w22799
Authors: Peter DeMarzo; Zhiguo He
Abstract: We analyze equilibrium leverage dynamics in a dynamic tradeoff model when the firm is unable to commit to a leverage policy ex ante. We develop a methodology to characterize equilibrium equity and debt prices in a general jump-diffusion framework, and apply our approach to the standard Leland (1998) setting. Absent commitment, the leverage ratchet effect (Admati et al. 2015) distorts capital structure decisions, leading shareholders to take on debt gradually over time and never voluntarily reduce debt. On the other hand, countervailing effects of asset growth and debt maturity cause leverage to mean-revert towards a long run target. In equilibrium, bond investors anticipate future leverage increases and require significant credit spreads even when the distance to default is large. As a result, the tax benefits of future debt increases are fully dissipated, and equilibrium equity values match those in a model where the firm commits not to issue new debt. \nIn our model, leverage is dependent on the full history of the firm’s earnings. Despite the absence of transactions costs, an increase in profitability causes leverage to decline in the short-run, but the rate of new debt issuance endogenously increases so that leverage ultimately mean-reverts. The target level of leverage, and the speed of adjustment depends critically on debt maturity; nonetheless, in equilibrium shareholders are indifferent toward the debt maturity structure.
Keywords: leverage dynamics; corporate finance; equity; debt; dynamic tradeoff model
JEL Codes: G32
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| profitability shocks (D89) | debt issuance (H63) |
| leverage dynamics (C69) | equity values (G12) |
| anticipated increase in leverage (G32) | higher credit spreads (G19) |
| higher credit spreads (G19) | diminished tax benefits of debt (G32) |
| past performance (C52) | future leverage decisions (G32) |
| increased profitability (L21) | higher debt issuance (H63) |
| excessive leverage (G32) | lower price of debt (H63) |