Leverage Dynamics with Reputation
43 Pages Posted: 4 Mar 2020
Date Written: October 16, 2018
This work analyzes the classic trade-off theory of capital structure in a dynamic model where equity holders do not have any dynamic commitment power. The equilibrium analyzed in this paper depends on the firm's whole history instead of just the firm's current income and debt level. I have developed a methodology to determine whether a debt issuance policy is supportable in equilibrium. This work proves that under mild conditions, the equity value in non-Markov equilibrium is higher than the equity value in Markov equilibrium, the one depicted in DeMarzo and He (2017). The equity holders get benefits when the financial market considers the firm's whole history which I call as reputation. This work shows that equity holders can implement a Leverage Target policy in equilibrium under certain conditions. The Leverage Target policy breaks the Leverage Ratchet Effect discussed in Admati, DeMarzo, Hellwig and Pfleiderer (2018). With a specific leverage target and certain parameters, the equity value of the Leverage Target policy is the largest one among all equilibrium equity values.
Keywords: Leverage Dynamics, Path Dependency
JEL Classification: G33
Suggested Citation: Suggested Citation