Doubling Down on Debt: Limited Liability as a Financial Friction

Carolin Pflueger, Jesse Perla () and Michal Szkup

No 15238, CEPR Discussion Papers from C.E.P.R. Discussion Papers

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: Leverage; Debt overhang; Overinvestment; Underinvestment; Equity payout restrictions (search for similar items in EconPapers)
JEL-codes: E20 E22 E44 (search for similar items in EconPapers)
Date: 2020-08
New Economics Papers: this item is included in nep-cfn and nep-mac
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Citations: View citations in EconPapers (1)

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Working Paper: Doubling Down on Debt: Limited Liability as a Financial Friction (2020)
Working Paper: Doubling Down on Debt: Limited Liability as a Financial Friction (2020)
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