Heterogeneous Beliefs, Collateral, and Endogenous Debt Maturity
47 Pages Posted: 14 Feb 2016 Last revised: 26 Jan 2018
Date Written: October 23, 2017
This paper studies optimal debt maturity when firms must use collateral to back non-contingent claims and investors disagree about repayment probabilities. Long-term debt insulates the firm from changes in the price of credit risk but is costly when collateral is insufficient to ensure full repayment. Shortterm debt may be risk free conditional on good states, but exposes the firm to credit spread spikes in bad states. The optimal debt maturity choice to finance investment combines long- and short-term debt. Issuing multiple debt maturities allows firms to cater risky promises across time to investors most willing to hold risk. Collateral frictions and heterogeneous investors directly contrasts theories of debt predicated on agency costs, information frictions, or liquidity risk. Lastly, we show that covenants that prevent dilution may not affect real outcomes when collateral is scarce because they do not allow the firm to create new collateral. They simply reallocate collateral from short-term to long-term debt holders.
Keywords: Collateral, Debt Maturity, Investment, Cost of Capital, Debt Covenants, Seniority
JEL Classification: D92, G11, G12, G31, G32, E22
Suggested Citation: Suggested Citation