The Leverage Ratchet Effect
Journal of Finance, Volume 73, Issue 1, February 2018
56 Pages Posted: 2 Aug 2013 Last revised: 2 Mar 2018
Date Written: February 2018
Firms’ inability to commit to future funding choices has profound consequences for capital structure dynamics. With debt in place, shareholders pervasively resist leverage reductions no matter how much such reductions may enhance firm value. Shareholders would instead choose to increase leverage even if the new debt is junior and would reduce firm value. These asymmetric forces in leverage adjustments, which we call the leverage ratchet effect, cause equilibrium leverage outcomes to be history-dependent. If forced to reduce leverage, shareholders are biased toward selling assets relative to potentially more efficient alternatives such as pure recapitalizations.
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
Suggested Citation: Suggested Citation