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http://ssrn.com/abstract=2304969
 
 

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The Leverage Ratchet Effect


Anat R. Admati


Stanford Graduate School of Business

Peter M. DeMarzo


Stanford Graduate School of Business; National Bureau of Economic Research (NBER)

Martin F. Hellwig


Max Planck Institute for Research on Collective Goods; University of Bonn - Department of Economics

Paul C. Pfleiderer


Stanford Graduate School of Business

December 31, 2015

Preprints of the Max Planck Institute for Research on Collective Goods Bonn 2013/13
Rock Center for Corporate Governance at Stanford University Working Paper No. 146

Abstract:     
This paper explores the dynamics of corporate leverage when funding decisions are made in the interests of shareholders. In the absence of prior commitments or regulations, shareholder-creditor conflicts give rise to a leverage ratchet effect, which induces shareholders to resist reductions while favoring increases in leverage even when total-value maximization calls for the opposite. Unlike inefficiencies based on asymmetric information, the leverage ratchet effect applies to all forms of leverage reduction, including earnings retentions and rights offerings.

The leverage ratchet effect is present even in the absence of frictions other than the inability to write complete contracts. The effect creates an agency cost of debt that lowers the value of the leveraged firm. Standard frictions magnify the impact of the effect. In a dynamic context, since leverage becomes effectively irreversible, firms may limit leverage initially but then ratchet it up in response to shocks. The resulting leverage dynamics lead to history-dependent capital structure that cannot be explained by simple tradeoff considerations.

Leverage can be adjusted in many ways. For example, leverage reductions can be achieved by issuing equity to either buy back debt or purchase new assets, or by selling assets to buy back debt. We study shareholders’ preferences over different ways to adjust leverage. A benchmark result gives conditions for shareholder indifference, but generally, shareholders have clear rankings over the alternatives. For example, shareholders prefer reducing leverage by selling assets, even at distressed prices, if by doing so they can benefit at the expense of senior creditors.

Number of Pages in PDF File: 58

Keywords: capital structure, leverage, agency costs of debt, dynamic capital structure, tradeoff theory of capital structure, capital regulation, bank equity, debt overhang, under-investment, recapitalization, deleveraging, bankruptcy costs

JEL Classification: G21, G28, G32, G33, G35, G38, H81, K23


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Date posted: August 2, 2013 ; Last revised: January 12, 2016

Suggested Citation

Admati, Anat R. and DeMarzo, Peter M. and Hellwig, Martin F. and Pfleiderer, Paul C., The Leverage Ratchet Effect (December 31, 2015). Preprints of the Max Planck Institute for Research on Collective Goods Bonn 2013/13; Rock Center for Corporate Governance at Stanford University Working Paper No. 146. Available at SSRN: http://ssrn.com/abstract=2304969 or http://dx.doi.org/10.2139/ssrn.2304969

Contact Information

Anat R. Admati (Contact Author)
Stanford Graduate School of Business ( email )
655 Knight Way
Stanford, CA 94305-5015
United States
650-723-4987 (Phone)
650-725-6152 (Fax)

Peter M. DeMarzo
Stanford Graduate School of Business ( email )
655 Knight Way
Stanford, CA 94305-5015
United States
650-736-1082 (Phone)
650-725-7979 (Fax)
HOME PAGE: http://www.stanford.edu/people/pdemarzo

National Bureau of Economic Research (NBER)
1050 Massachusetts Avenue
Cambridge, MA 02138
United States
Martin F. Hellwig
Max Planck Institute for Research on Collective Goods ( email )
Kurt-Schumacher-Str. 10
D-53113 Bonn, 53113
Germany

University of Bonn - Department of Economics
Adenauerallee 24-42
D-53113 Bonn
Germany
Paul C. Pfleiderer
Stanford Graduate School of Business ( email )
655 Knight Way
Stanford, CA 94305-5015
United States
650-723-4495 (Phone)
650-725-7979 (Fax)

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