Doubling Down on Debt: Limited Liability as a Financial Friction

71 Pages Posted: 8 Sep 2020

See all articles by Jesse Perla

Jesse Perla

University of British Columbia (UBC)

Carolin E. Pflueger

University of Chicago - Harris School of Public Policy; National Bureau of Economic Research (NBER)

Michal Szkup

University of British Columbia

Multiple version iconThere are 3 versions of this paper

Date Written: August 31, 2020

Abstract

We investigate how a combination of limited liability and preexisting debt distort firms’ investment and equity payout decisions. We show that equity holders have incentives to “double-sell” cash flows in default, leading to overinvestment, provided that the firm has preexisting debt and the ability to issue new claims to the bankruptcy value of the firm. In a repeated version of the model, we show that the inability to commit to not double-sell cash flows leads to heterogeneous investment distortions, where high leverage firms tend to overinvest but low leverage firms tend to underinvest. Permitting equity payouts financed by new debt mitigates overinvestment for high leverage firms, but raises bankruptcy rates and exacerbates low leverage firms’ tendency to underinvest—as the anticipation of equity payouts from future debt raises their cost of debt issuance. Finally, we provide empirical evidence consistent with the model.

Suggested Citation

Perla, Jesse and Pflueger, Carolin E. and Szkup, Michal, Doubling Down on Debt: Limited Liability as a Financial Friction (August 31, 2020). University of Chicago, Becker Friedman Institute for Economics Working Paper No. 2020-122, Available at SSRN: https://ssrn.com/abstract=3686169 or http://dx.doi.org/10.2139/ssrn.3686169

Jesse Perla

University of British Columbia (UBC) ( email )

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Carolin E. Pflueger (Contact Author)

University of Chicago - Harris School of Public Policy ( email )

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National Bureau of Economic Research (NBER) ( email )

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Michal Szkup

University of British Columbia ( email )

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