Optimal Debt Maturity and Firm Investment

Immo Schott and Joachim Jungherr

No 943, Working Papers from Barcelona School of Economics

Abstract: This paper introduces a maturity choice to the standard model of firm financing and investment. Long-term debt renders the optimal firm policy time-inconsistent. Lack of commitment gives rise to debt dilution. This problem becomes more severe during downturns. We show that cyclical debt dilution generates the observed counter-cyclical behavior of default, bond spreads, leverage, and debt maturity. It also generates the pro-cyclical term structure of corporate bond spreads. Debt dilution renders the equilibrium outcome constrained-inefficient: credit spreads are too high and investment is too low. In two policy experiments we find the following: (1) an outright ban of long-term debt improves welfare in our model economy, and (2.) debt dilution accounts for 84% of the credit spread and 25% of the welfare gap with respect to the first best allocation.

Keywords: firm financing; investment; debt maturity; credit spreads; debt dilution (search for similar items in EconPapers)
JEL-codes: E22 E32 E44 G32 (search for similar items in EconPapers)
Date: 2016-12
New Economics Papers: this item is included in nep-ban and nep-mac
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Journal Article: Optimal Debt Maturity and Firm Investment (2021)
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Persistent link: https://EconPapers.repec.org/RePEc:bge:wpaper:943

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