Doubling Down on Debt: Limited Liability as a Financial Friction

Jesse Perla (), Carolin Pflueger and Michal Szkup

No 27747, NBER Working Papers from National Bureau of Economic Research, Inc

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.

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
Note: CF EFG ME
References: View references in EconPapers View complete reference list from CitEc
Citations: View citations in EconPapers (1)

Downloads: (external link)
http://www.nber.org/papers/w27747.pdf (application/pdf)

Related works:
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)
This item may be available elsewhere in EconPapers: Search for items with the same title.

Export reference: BibTeX RIS (EndNote, ProCite, RefMan) HTML/Text

Persistent link: https://EconPapers.repec.org/RePEc:nbr:nberwo:27747

Ordering information: This working paper can be ordered from
http://www.nber.org/papers/w27747

Access Statistics for this paper

More papers in NBER Working Papers from National Bureau of Economic Research, Inc National Bureau of Economic Research, 1050 Massachusetts Avenue Cambridge, MA 02138, U.S.A.. Contact information at EDIRC.
Bibliographic data for series maintained by ().