Working Paper: NBER ID: w23055
Authors: Douglas W Diamond; Yunzhi Hu; Raghuram G Rajan
Abstract: Why do firms choose high debt when they anticipate high valuations, and underperform subsequently? We propose a theory of financing cycles where the importance of creditors’ control rights over cash flows (“pledgeability”) varies with industry liquidity. The market allows firms take on more debt when they anticipate higher future liquidity. However, both high anticipated liquidity and the resulting high debt limit their incentives to enhance pledgeability. This has prolonged adverse effects in a downturn. Because these effects are hard to contract upon, higher anticipated liquidity can also reduce a firm’s current access to finance.
Keywords: financing cycles; debt; liquidity; pledgeability
JEL Codes: E00; E02; E59; G20; G21; G31; G33
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| High anticipated liquidity (E41) | Increased debt levels (H63) |
| Increased debt levels (H63) | Decreased incentives for enhancing pledgeability (G19) |
| Decreased incentives for enhancing pledgeability (G19) | Reduced access to finance during downturns (F65) |
| High anticipated liquidity (E41) | Reduced access to finance during downturns (F65) |