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Please use this identifier to cite or link to this item:
http://hdl.handle.net/2451/26772
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| Title: | Leverage and Growth Opportunities: Risk-Avoidance Induced by Risky Debt |
| Authors: | Brito, José Almeida
John, Kose |
| Issue Date: | Jan-2001 |
| Series/Report no.: | S-CDM-02-01 |
| Abstract: | This paper shows that illiquid growth opportunities crucially impact the
agency costs of risky debt. If the value of these growth opportunities
is sufficiently high, they reverse riskshifting incentives into
risk-avoidance incentives, creating a new agency cost of debt. They can
also eliminate Myers’s underinvestment problem. It is widely
accepted in Corporate Finance that risky debt induces incentives for
risk-shifting by the residual equityholder. This paper shows that this
result is subject to important qualifications: risky debt does not
necessarily create risk-shifting incentives. For a relevant subset of
firms it creates instead the opposite effect: it induces risk-avoidance
behavior. With risky debt outstanding, the shareholders of a firm with
illiquid growth opportunities may optimally prefer safer, less valuable
projects to riskier projects with higher net present values. These
shareholders present risk-avoidance behavior to preserve control of the
firm and to appropriate the firm’s future economic rents. The
paper models the firm’s risk choices in a framework that shows the
ex-post optimality of both risk-avoidance and risk-shifting behavior.
The presence of illiquid growth opportunities extends the maturity of
the equity contract beyond the maturity of the debt contract, explicitly
accounting for the nature of the firm as a going concern. The paper
constitutes a contribution towards a multiperiod perspective in
Corporate Finance, while retaining the parsimony and elegance of
finite-period settings. |
| URI: | http://hdl.handle.net/2451/26772 |
| Appears in Collections: | Credit & Debt Markets
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