Debt Maturity and the Leverage Ratcheting Effect

37 Pages Posted: 31 Dec 2019

See all articles by Hayne E. Leland

Hayne E. Leland

University of California, Berkeley - Walter A. Haas School of Business

Dirk Hackbarth

Boston University - Department of Finance & Economics; Centre for Economic Policy Research (CEPR); European Corporate Governance Institute (ECGI)

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Date Written: December 9, 2019

Abstract

Admati, Demarzo, Hellwig, and Pfleiderer (ADHP, 2018) note that static models of optimal leverage have assumed firms have no prior debt. In this case, the leverage that maximizes firm value also maximizes value to the initial equity owners. However, using a simple two-period model with zero coupon debt and default possible only at maturity, ADHP prove two startling results: (i) when prior debt is extant, it will never benefit equity holders to retire debt, no matter how high the current leverage; and (ii) it will be in the equity owners’ interest to issue sequential rounds of additional debt, until all the tax advantages of debt are exhausted: the “Leverage Ratcheting Effect” (LRE). An immediate conclusion is that one-round (static) models of optimal debt issuance with no prior debt provide poor guidance as to a firm’s optimal leverage. We examine these contentions using an alternative model of debt, with rollover at a proportional rate m and average maturity = 1/m, introduced in Leland (1994a). We show that when the average maturity of debt is substantially longer than 5 years, considerable further debt will indeed be issued, although issuance ceases well before tax benefits are exhausted. With 5-year average maturity, very little additional debt is issued under reasonable calibrations. With 3-year average maturity, no additional debt is issued and it may actually be optimal for the firm to buy back debt, in contradiction to the LRE. We explain why our model gives differing results.

Keywords: Capital Structure, Leverage Ratcheting Effect, Debt Maturity, Dynamic Tax Tradeoff Model

JEL Classification: G3,G32, G12

Suggested Citation

Leland, Hayne E. and Hackbarth, Dirk, Debt Maturity and the Leverage Ratcheting Effect (December 9, 2019). Available at SSRN: https://ssrn.com/abstract=3501914 or http://dx.doi.org/10.2139/ssrn.3501914

Hayne E. Leland (Contact Author)

University of California, Berkeley - Walter A. Haas School of Business ( email )

Haas School of Business
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Dirk Hackbarth

Boston University - Department of Finance & Economics ( email )

Department of Finance
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Boston, MA 02215
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(617) 353-6667 (Fax)

HOME PAGE: http://people.bu.edu/dhackbar/

Centre for Economic Policy Research (CEPR) ( email )

London
United Kingdom

European Corporate Governance Institute (ECGI) ( email )

c/o the Royal Academies of Belgium
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1000 Brussels
Belgium

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