Debt Dilution and Debt Overhang

Immo Schott and Joachim Jungherr

No 997, Working Papers from Barcelona School of Economics

Abstract: We introduce risky long-term debt (and a maturity choice) to a dynamic model of firm financing and production. This allows us to study two distortions which are absent from standard models of short-term debt: (1.) Debt dilution distorts firms' choice of debt which has an indirect effect on investment; (2.) Debt overhang directly distorts investment. In a dynamic model of production, leverage, and debt maturity, we show that the two distortions interact to reduce investment, increase leverage, and increase the default rate. We provide empirical evidence from U.S. firms that is consistent with the model predictions. Debt dilution and debt overhang can overturn standard results: A financial reform which increases investment, employment, output, and welfare in a standard model of short-term debt can have the opposite effect in a model with short-term debt and long-term debt.

Keywords: investment; Debt Overhang; debt dilution (search for similar items in EconPapers)
JEL-codes: E22 E44 G32 (search for similar items in EconPapers)
Date: 2017-10
New Economics Papers: this item is included in nep-cfn and nep-mac
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Citations: View citations in EconPapers (2)

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Persistent link: https://EconPapers.repec.org/RePEc:bge:wpaper:997

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