The Leverage Ratchet Effect

The Leverage Ratchet Effect Firms’ inability to commit to future funding choices has profound consequences for capital structure dynamics. With debt in place, shareholders pervasively resist leverage reductions no matter how much such reductions may enhance firm value. Shareholders would instead choose to increase leverage even if the new debt is junior and would reduce firm value. These asymmetric forces in leverage adjustments, which we call the leverage ratchet effect, cause equilibrium leverage outcomes to be history‐dependent. If forced to reduce leverage, shareholders are biased toward selling assets relative to potentially more efficient alternatives such as pure recapitalizations. http://www.deepdyve.com/assets/images/DeepDyve-Logo-lg.png The Journal of Finance Wiley

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Publisher
Wiley
Copyright
© 2018 the American Finance Association
ISSN
0022-1082
eISSN
1540-6261
D.O.I.
10.1111/jofi.12588
Publisher site
See Article on Publisher Site

Abstract

Firms’ inability to commit to future funding choices has profound consequences for capital structure dynamics. With debt in place, shareholders pervasively resist leverage reductions no matter how much such reductions may enhance firm value. Shareholders would instead choose to increase leverage even if the new debt is junior and would reduce firm value. These asymmetric forces in leverage adjustments, which we call the leverage ratchet effect, cause equilibrium leverage outcomes to be history‐dependent. If forced to reduce leverage, shareholders are biased toward selling assets relative to potentially more efficient alternatives such as pure recapitalizations.

Journal

The Journal of FinanceWiley

Published: Jan 1, 2018

References

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