Leverage Dynamics under Managerial Discretion
51 Pages Posted: 11 Oct 2019 Last revised: 21 Nov 2019
Date Written: November 20, 2019
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: Suggested Citation