Working Paper: NBER ID: w27747
Authors: Jesse Perla; Carolin Pflueger; Michal Szkup
Abstract: We investigate how a combination of limited liability and preexisting debt distort firms’ investment and equity payout decisions. We show that equity holders have incentives to “double-sell” cash flows in default, leading to overinvestment, provided that the firm has preexisting debt and the ability to issue new claims to the bankruptcy value of the firm. In a repeated version of the model, we show that the inability to commit to not double-sell cash flows leads to heterogeneous investment distortions, where high leverage firms tend to overinvest but low leverage firms tend to underinvest. Permitting equity payouts financed by new debt mitigates overinvestment for high leverage firms, but raises bankruptcy rates and exacerbates low leverage firms’ tendency to underinvest—as the anticipation of equity payouts from future debt raises their cost of debt issuance. Finally, we provide empirical evidence consistent with the model.
Keywords: Debt; Investment; Equity Payouts; Limited Liability
JEL Codes: E20; E22; E44
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| limited liability (K13) | overinvestment (G31) |
| preexisting debt (F34) | overinvestment (G31) |
| equity payouts (G35) | investment decisions (G11) |
| equity payouts financed by new debt (G35) | mitigates overinvestment (G31) |
| equity payouts financed by new debt (G35) | exacerbates underinvestment (E22) |
| low leverage and high investment opportunity arrival rates (G11) | underinvestment (G31) |