Secured Debt Financing and Leverage: Theory and Evidence

Abstract

This paper provides a model of how secured debt financing impacts both the asset substitution and underinvestment problems and empirical evidence in support of the model. The model considers a firm with a mix of secured and unsecured risky debt claims against an asset in place and the opportunity to acquire another asset. It is shown that (1) the underinvestment problem does not depend on the proportion of the original debt that is secured and (2) the asset substitution problem decreases in the proportion of the original debt that is secured. Debt capacity increases with the proportion of debt that is secured as the asset substitution problem is lower for a given level of debt. An analysis of a large sample of firms with data available on COMPUSTAT supports the model predictions. First, leverage is positively and significantly related to the fraction of the debt that is secured controlling for other variables known to affect leverage. Second, attaching collateral to the debt, unlike shortening maturity (Johnson (2003)) or including protective covenants (Billett, King and Mauer (2006)) does not increase debt capacity by mitigating the underinvestment problem.