Precautionary Debt Capacity

57 Pages Posted: 29 Jan 2024 Last revised: 23 Mar 2025

See all articles by Deniz Aydin

Deniz Aydin

Washington University in St. Louis - John M. Olin Business School

Olivia Kim

Harvard Business School

Date Written: January 19, 2024

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.

Suggested Citation

Aydin, Deniz and Kim, Olivia, Precautionary Debt Capacity (January 19, 2024). Olin Business School Center for Finance & Accounting Research Paper No. 2024/01, Available at SSRN: https://ssrn.com/abstract=4700903 or http://dx.doi.org/10.2139/ssrn.4700903

Deniz Aydin

Washington University in St. Louis - John M. Olin Business School ( email )

One Brookings Drive
St. Louis, MO 63130
United States

HOME PAGE: http://sites.wustl.edu/denizaydin

Olivia Kim (Contact Author)

Harvard Business School ( email )

Soldiers Field Road
Boston, MA 02163
United States

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