The Private and Social Value of Capital Structure Commitment

63 Pages Posted: 29 Dec 2018 Last revised: 25 Jun 2019

See all articles by Timothy C. Johnson

Timothy C. Johnson

University of Illinois at Urbana-Champaign

Ping Liu

Krannert School of Management, Purdue University

Yingjie Yu

University of Illinois at Urbana-Champaign

Date Written: June 2019

Abstract

We analyze dynamic stationary models of capital structure, in partial and general equilibrium, when managers cannot commit to firm-value maximization. The model permits us to quantify both the private cost to firms of the commitment problem, and also the aggregate cost of its externality. Our setting encompasses time-varying economic and firm characteristics, as well as valuation under generalized preferences. The model provides an explanation for the procyclical use of unprotected debt: the private costs of non-commitment increase in bad times. Likewise, expropriation incentives rise when firm valuations are low. Hence, without commitment, leverage can be countercyclical. This dynamic amplifies the effect of excess debt on aggregate risk. A range of parameterizations suggests that the social cost of unprotected debt can be large. We present evidence supportive of the prediction that firms with unprotected debt increase their borrowing in bad times.

Keywords: capital structure, covenant valuation, general equilibrium, social cost of contracting frictions

JEL Classification: E21, E32, G12, G32

Suggested Citation

Johnson, Timothy C. and Liu, Ping and Yu, Yingjie, The Private and Social Value of Capital Structure Commitment (June 2019). Available at SSRN: https://ssrn.com/abstract=3300371 or http://dx.doi.org/10.2139/ssrn.3300371

Timothy C. Johnson (Contact Author)

University of Illinois at Urbana-Champaign ( email )

601 E John St
Champaign, IL 61820
United States

Ping Liu

Krannert School of Management, Purdue University ( email )

1310 Krannert Building
West Lafayette, IN 47907-1310
United States
7654944691 (Phone)

Yingjie Yu

University of Illinois at Urbana-Champaign ( email )

601 E John St
Champaign, IL 61820
United States

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