Leverage Dynamics under Managerial Discretion

51 Pages Posted: 11 Oct 2019 Last revised: 21 Nov 2019

See all articles by Tak-Yuen Wong

Tak-Yuen Wong

Shanghai University of Finance and Economics - Department of Finance

Date Written: November 20, 2019

Abstract

This paper studies leverage dynamics when managers cannot commit to future financing and default policies ex-ante. Managers derive private benefits of control but debt constrains their flexibility, and thus, they build up less excessive leverage and may even actively reduce debt over time. Governance frictions weaken the leverage ratchet effect and increase the funding advantage of debt. Optimal maturity structure trades off disciplines on the managers' leverage ratcheting incentives and default risks. Moreover, firms with weak governance and low managerial ownership favor long-term debt, have high debt capacity, maintain low target leverage, and adjust the debt level faster towards the target. Finally, firms with high agency costs remain persistently unlevered in the no-commitment equilibrium. This result offers a potential resolution for the zero leverage puzzle.

Keywords: leverage ratchet effect, commitment, managerial agency, governance, debt maturity, capital structure, zero leverage puzzle

JEL Classification: G3, G32, G34

Suggested Citation

Wong, Tak-Yuen, Leverage Dynamics under Managerial Discretion (November 20, 2019). Available at SSRN: https://ssrn.com/abstract=3462343 or http://dx.doi.org/10.2139/ssrn.3462343

Tak-Yuen Wong (Contact Author)

Shanghai University of Finance and Economics - Department of Finance ( email )

Shanghai, 200433
China

HOME PAGE: http://sites.google.com/site/etywong110/

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