Leverage and Growth Opportunities: Risk-Avoidance Induced by Risky Debt

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.