Long-term debt and overinvestment agency problem

Ranjan D'Mello and Mercedes Miranda

Journal of Banking & Finance, 2010, vol. 34, issue 2, 324-335

Abstract: We investigate the role of long-term debt in influencing overinvestments by analyzing the pattern of abnormal investments around a new debt offering by unlevered firms. Before being levered when the disciplining role of debt is missing, firms retain excessive amounts of cash. The introduction of debt leads to a dramatic decline in cash ratios and the relation is stronger for firms classified as having poor investment opportunities. For the sub-sample of firms that overinvest in real assets, issuing debt leads to a reduction in abnormal capital expenditures. The decline in overinvestments is explained by debt service obligations that reduce discretionary funds under managerial control. Further, the reduction in overinvestments has a positive impact on equity value. These conclusions hold in other settings where there is a dramatic change in firms' capital structures providing strong support for the hypothesis that debt reduces overinvestments.

Keywords: Debt; issues; Agency; costs; Overinvestments (search for similar items in EconPapers)
Date: 2010
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Citations: View citations in EconPapers (41)

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Persistent link: https://EconPapers.repec.org/RePEc:eee:jbfina:v:34:y:2010:i:2:p:324-335

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