The Propensity to Save and Incentives to Reduce Debt

Abstract

We explain large cash holdings in levered rms by low incentives to reduce debt. In the absence of frictions such as bankruptcy costs, transaction costs, dispersed debt ownership, nancing constraints, and taxes, debt reduction cannot be rationalized. The minimum price at which lenders agree to sell the marginal dollar of risky debt is equal to its face value and the probability of bankruptcy remains the same. On the other hand, bankruptcy costs and dispersion of debt ownership increase incentives to repurchase debt. Although debt reduction in this case is bene cial to shareholders, they optimally delay the exercise of this option to obtain the best price. Finally, by introducing investment into the model, we nd that nancing constraints and the debt overhang problem accelerate debt repurchases only if low prices can be negotiated. Our analysis yields several important predictions concerning a rm’s saving behavior that we test empirically. JEL codes: G32