Leverage and Growth Opportunities: Risk-Avoidance Induced by Risky Debt

50 Pages Posted: 3 Nov 2008

See all articles by José Almeida Brito

José Almeida Brito

affiliation not provided to SSRN

Kose John

New York University (NYU) - Department of Finance

Multiple version iconThere are 2 versions of this paper

Date Written: January 2002

Abstract

This paper shows that illiquid growth opportunities crucially impact the agency costs of risky debt. If the value of these growth opportunities is sufficiently high, they reverse risk shifting incentives into risk-avoidance incentives, creating a new agency cost of debt. They can also eliminate Myers s underinvestment problem. It is widely accepted in Corporate Finance that risky debt induces incentives for risk-shifting by the residual equity holder. This paper shows that this result is subject to important qualifications: risky debt does not necessarily create risk-shifting incentives. For a relevant subset of firms it creates instead the opposite effect: it induces risk-avoidance behavior. Withrisky debt outstanding, the shareholders of a firm with illiquid growth opportunities mayoptimally prefer safer, less valuable projects to riskier projects with higher net present values. These shareholders present risk-avoidance behavior to preserve control of the firm and to appropriate the firm s future economic rents. The paper models the firm s risk choices in a framework that shows the ex-post optimality of both risk-avoidance and risk-shifting behavior. The presence of illiquid growth opportunities extends the maturity of the equity contract beyond the maturity of the debt contract, explicitly accounting for the nature of the firm as a going concern. The paper constitutes a contribution towards a multi period perspective in Corporate Finance, while retaining the parsimony and elegance of finite period settings.

Suggested Citation

Brito, José Almeida and John, Kose, Leverage and Growth Opportunities: Risk-Avoidance Induced by Risky Debt (January 2002). NYU Working Paper No. FIN-02-003. Available at SSRN: https://ssrn.com/abstract=1293667

José Almeida Brito (Contact Author)

affiliation not provided to SSRN

No Address Available

Kose John

New York University (NYU) - Department of Finance ( email )

Stern School of Business
44 West 4th Street
New York, NY 10012-1126
United States
212-998-0337 (Phone)
212-995-4233 (Fax)

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