Incorporating debt in a dynamic real options framework, we show that underinvestment stems from truncation of equity's horizon at default. Debt overhang distorts both the level and composition of investment, with underinvestment being more severe for long-lived assets. An empirical proxy for the shadow price of capital to equity is derived. Use of this proxy yields a structural test for debt overhang and its mitigation through issuance of additional secured debt. Using measurement error-consistent GMM estimators, we find a statistically significant debt overhang effect regardless of firms' ability to issue additional secured debt. Copyright 2004 by The American Finance Association.
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Volume (Year): 59 (2004) Issue (Month): 4 (08) Pages: 1717-1742 Download reference. The following formats are available: HTML
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