Dynamic Investment, Debt Structure and Debt Overhang

Abstract

We study the impact of the optimal debt and priority structure on corporate financing and investment decisions in a dynamic trade-off model, where a firm simultaneously issues bank and market debt. Private bank debt is renegotiable during financial distress; thus it avoids inefficient and costly bankruptcy losses. Our model shows that the debt priority structure between bank and market debt has significant implications on ex post corporate policies, market leverage and firm valuation. Bank debt substitutes market debt in most cases except when firms face a low tax rate environment. Further, firms with stronger bargaining power, more valuable growth opportunities, or higher renegotiation frictions, facing lower cash flow risks, larger bankruptcy costs, or operating in a higher tax rate environment tend to rely more on market debt. We also demonstrate that the issuance of bank debt along with market debt mitigates the ex post debt overhang compared to the exclusive market debt structure, the effect of which is much stronger when the firm faces less renegotiation friction, lower bankruptcy costs, or higher corporate tax rate. These model predictions reconcile several empirical findings and generate a rich set of novel empirical tests.