Download this Paper Open PDF in Browser

The Leverage Ratchet Effect

Forthcoming, Journal of Finance

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

53 Pages Posted: 2 Aug 2013 Last revised: 18 Sep 2017

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: September 12, 2017

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 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

Admati, Anat R. and DeMarzo, Peter M. and Hellwig, Martin F. and Pfleiderer, Paul C., The Leverage Ratchet Effect (September 12, 2017). Forthcoming, Journal of Finance; 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 )

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)

Paper statistics

Downloads
1,127
Rank
14,479
Abstract Views
6,937