Optimal debt maturity and firm investment

Juggler, Joachim; Schott, Immo

Optimal debt maturity and firm investment

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Citation

Juggler, J, Schott, I. Optimal debt maturity and firm investment. 2016. handle: http://hdl.handle.net/10230/27888

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Abstract

This paper introduces a maturity choice to the standard model of firm financing and investment. Longterm debt renders the optimal firm policy time-inconsistent. Lack of commitment gives rise to debt dilution. This problem becomes more severe during downturns. We show that cyclical debt dilution generates the observed counter-cyclical behavior of default, bond spreads, leverage, and debt maturity. It also generates the pro-cyclical term structure of corporate bond spreads. Debt dilution renders the equilibrium outcome constrained-inefficient: credit spreads are too high and investment is too low. In two policy experiments we find the following: (1) an outright ban of long-term debt improves welfare in our model economy, and (2.) debt dilution accounts for 84% of the credit spread and 25% of the welfare gap with respect to the first best allocation.