Investment Distortions Caused by Debt Financing

52 Pages Posted: 17 Aug 2000

See all articles by Nathalie Moyen

Nathalie Moyen

University of Colorado at Boulder - Department of Finance

Date Written: July 2000


The presence of debt in a firm's capital structure may induce equity claimants to choose an investment policy that is not in the best interest of all claimants. Since Myers (1977) and Jensen and Meckling (1976), the debt overhang and asset substitution investment distortions are well recognized. However, the previous literature did not reach a consensus as to the magnitude of such costs. This paper re-examines the debt overhang problem, but in a framework where the firm is allowed to recapitalize at any point in time and where the investment level rather than the binary operating policy is used to measure the size of the underinvestment caused by debt financing. The debt overhang problem is shown to do little harm to equity claimants. In bad economic conditions when the marginal productivity of capital is low, equity claimants actually benefit from the underinvestment. They only suffer in better economic conditions.

Keywords: Debt Overhang, Investment Policy, Capital Structure

JEL Classification: G31, G32

Suggested Citation

Moyen, Nathalie, Investment Distortions Caused by Debt Financing (July 2000). Available at SSRN: or

Nathalie Moyen (Contact Author)

University of Colorado at Boulder - Department of Finance ( email )

Campus Box 419
Boulder, CO 80309
United States
303-735-4931 (Phone)
303-492-5962 (Fax)

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