Precautionary Debt Capacity

Abstract

The determinants of debt capacity are a central theme in finance and macroeconomics, yet it remains unclear why firms leave some of their debt capacity unused and whether this affects investment and growth. Textbook theory suggests that firms should not leave their debt capacity unused (Tirole, 2006). Possible explanations include a lack of investment opportunities and cash flow volatility (Fama, 1990). An ideal experiment would expand debt capacity for firms with similar characteristics, helping to disentangle these motives. In this paper, we conduct such an experiment in the field. Despite most firms having substantial unused debt capacity before the intervention, expanding capacity leads to persistent increases in borrowing, investment, and sales. Contrary to textbook theory, these effects are strongest among firms farthest from their debt limits. The evidence points to precautionary motives, as firms appear to preserve debt capacity as insurance against negative cash-flow shocks and default risk. Our findings provide a novel explanation for why financing constrains firm growth, even for firms that appear financially sound.