The Leverage Ratchet Effect

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

54 Pages Posted: 2 Aug 2013 Last revised: 12 Oct 2016

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

Date Written: October 11, 2016

Abstract

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 debt levels are already high and new debt must be junior to existing debt. These asymmetric forces in leverage adjustments, which we call the leverage ratchet effect, cause equilibrium leverage outcomes to be history-dependent. When forced to reduce leverage, shareholders are biased toward selling assets relative to potentially more efficient alternatives such as pure recapitalizations. This version: October 11, 2016

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

Admati, Anat R. and DeMarzo, Peter M. and Hellwig, Martin F. and Pfleiderer, Paul C., The Leverage Ratchet Effect (October 11, 2016). 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: https://ssrn.com/abstract=2304969 or http://dx.doi.org/10.2139/ssrn.2304969

Anat R. Admati (Contact Author)

Stanford Graduate School of Business ( email )

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Peter M. DeMarzo

Stanford Graduate School of Business ( email )

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HOME PAGE: http://www.stanford.edu/people/pdemarzo

National Bureau of Economic Research (NBER)

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Martin F. Hellwig

Max Planck Institute for Research on Collective Goods ( email )

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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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