Accelerated Investment Effect of Risky Debt

Abstract

In this paper we examine a new effect of risky debt on a firm’s investment strategy. We call this effect “accelerated investment”. It stems from a potential loss of investment option in the event of default. The possibility of default reduces the value of the option to wait and provides an incentive to equityholders to speed up investment. Unlike the underinvestment (debt overhang) and asset substitution (risk shifting) effects of debt, the accelerated investment effect is not caused by any agency conflicts or potential wealth transfers among claim holders. Therefore, in the absence of wealth expropriation, the shareholders of a levered firm exercise their investment option earlier than the shareholders of an otherwise identical all-equity firm. This result is at odds with the generally accepted intuition that in the absence of potential wealth transfers the shareholders of a levered firm would follow the same investment policy as that of an unlevered firm. In addition to providing various illustrations of the accelerated investment effect, we relate its magnitude to the presence of competition for investment opportunities.