Leverage Dynamics with Reputation

43 Pages Posted: 4 Mar 2020

See all articles by Xuyuanda Qi

Xuyuanda Qi

University of Rochester - Simon Business School, Students

Date Written: October 16, 2018

Abstract

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

Qi, Xuyuanda, Leverage Dynamics with Reputation (October 16, 2018). Available at SSRN: https://ssrn.com/abstract=3533611 or http://dx.doi.org/10.2139/ssrn.3533611

Xuyuanda Qi (Contact Author)

University of Rochester - Simon Business School, Students ( email )

Rochester, NY
United States

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