Optimal capital structure and investment decisions under time-inconsistent preferences

Yuan Tian

Journal of Economic Dynamics and Control, 2016, vol. 65, issue C, 83-104

Abstract: Based on a continuous-time model of quasi-hyperbolic discounting, this paper provides an analytically tractable framework of entrepreneurial firms׳ capital structure and investment decisions under time-inconsistent preferences. Inefficiency in both investment and default is caused due to time inconsistency, if we view the time-consistent benchmark as efficient. Compared to the standard trade-off theory in corporate finance, we clarify that debt financing under time-inconsistent preferences brings a new trade-off between the alleviation effect on investment inefficiency and the aggravation effect on default inefficiency. The impact of time-inconsistent preferences depends on the entrepreneurs׳ belief regarding their future time-inconsistent behavior (i.e., sophisticated or naive). Concretely, we find that naive entrepreneurs always choose higher leverages, while sophisticated ones are more likely to choose lower leverages, compared to the time-consistent benchmark. Therefore, time inconsistency can explain the observed leverage puzzle (i.e., why firms choose different leverages even with similar fundamentals). Moreover, we demonstrate that time-inconsistent preferences delay investment and hasten default, due to the interaction among the three effects: option value effect, payoff value effect, and leverage effect. In particular, naive entrepreneurs invest later and default earlier than sophisticated ones, leading to a shorter operating period. These results support the empirical findings in entrepreneurial finance.

Keywords: Capital structure; Investment; Default; Quasi-hyperbolic discounting; Time inconsistency (search for similar items in EconPapers)
JEL-codes: D92 G02 G11 G32 (search for similar items in EconPapers)
Date: 2016
References: View references in EconPapers View complete reference list from CitEc
Citations: View citations in EconPapers (23)

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Persistent link: https://EconPapers.repec.org/RePEc:eee:dyncon:v:65:y:2016:i:c:p:83-104

DOI: 10.1016/j.jedc.2016.02.001

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