Strategic debt service and investment decisions

Shih-Chuan Tsai

Applied Economics, 2007, vol. 39, issue 11, 1409-1424

Abstract: Firms alter investing decisions when there is debt in the capital structure. Security design features can exacerbate the situation. This article studies how strategic debt service may affect investment distortions resulting from debt financing in a dynamic framework. When the production decision involves an expansion option, the shareholders' option to strategically default on the outstanding debt eliminates bankruptcy costs but, in contrast to previous literature where production decisions are fixed, leads to suboptimal investing decisions. This is due to higher wealth transfers from shareholders to debt holders upon exercise of the growth option. Strategic debt service, therefore, may reduce the value of the firm. The setting of an endogenous production set offers a potential explanation for empirical observations of wide credit spreads and low leverage.

Date: 2007
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DOI: 10.1080/00036840600592890

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