The Overhang Cost of Long and Short Term Debt in the Presence of Default Risk

Abstract

This research studies the implications of short term debt for firm investment decisions on a sample of U.S. non-financial firms from 1985-2011. We argue that short term debt does not always help to reduce the overhang cost of leverage as is the case in Myers (1977) model. Our empirical results show that short term debt has a negative effect on subsequent investment, which is further amplified in the presence of high default risk. Moreover, a high proportion of short term debt also intensifies the negative impact of default risk on investment. This finding is consistent with our argument that short term debt overhang becomes more dominant than long term debt overhang when the firm faces high risk of bankruptcy. This finding provides another explanation for corporate failures during the 2007-2009 crisis in the U.S. It is the prolonged implications of the under-investment problem that delay recovery, and this problem is more severe for firms with short term debt because short term debt intensifies the negative impact of financial distress on firm investments. Finally, our results provide support for the model in Diamond and He (2011).

Keywords: corporate finance, agency conflicts, debt overhang, debt maturity, financial distress

JEL Classification: G31, G32, G33