Commitment, agency costs and dynamic capital structure

Abstract

This paper studies leverage dynamics when shareholders commit to optimizing total enterprise value and face debt adjustment friction. Debt adjustment costs render the leverage commitment a double-edged sword. High-levered firms benefit from the commitment due to active debt repurchase. However, such debt buyback incurs a heavy burden and constrains financial flexibility. With high debt adjustment costs, it could be inefficient for the enterprise to maintain a firm-optimal debt policy. Interestingly, the incentive alignment effect from commitment makes shareholders act as if creditors in normal times. For instance, shareholders exhibit precautionary motives and overinvest. Finally, we show that dynamic risk management exacerbates the debt-equity conflicts and improves the commitment value. Highlights The firm-optimal debt policy eliminates the leverage ratchet effect by accelerating debt repayment should the firm's fundamental deteriorates. The commitment to the firm-optimal debt policy hurts enterprise value when facing high debt adjustment costs and short-term debt. Incentive alignment effect from the firm-optimal commitment causes shareholders to overinvest and exhibit risk-aversion in normal times.