Leverage and risk-taking in a dynamic model

Tobias Berg and Florian Heider

No 423, SAFE Working Paper Series from Leibniz Institute for Financial Research SAFE

Abstract: This paper examines the dynamic relationship between firm leverage and risktaking. We embed the traditional agency problem of asset substitution within a multi-period model, revealing a U-shaped relationship between leverage and risktaking, evident in data from both the U.S. and Europe. Firms with medium leverage avoid risk to preserve the option of issuing safe debt in the future. This option is valuable because safe debt does not incur the expected cost of bankruptcy, anticipated by debt-holders due to future risk-taking incentives. Our model offers new insights on the interaction between companies' debt financing and their risk profiles.

Keywords: leverage; risk-taking incentives; dynamic model (search for similar items in EconPapers)
JEL-codes: G3 G31 G32 G33 (search for similar items in EconPapers)
Date: 2024
New Economics Papers: this item is included in nep-cfn and nep-rmg
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Persistent link: https://EconPapers.repec.org/RePEc:zbw:safewp:300645

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