The Leverage Ratchet Effect
AbstractShareholder-creditor conflicts can create leverage ratchet effects, resulting in inefficient capital structures. Once debt is in place, shareholders may inefficiently increase leverage but avoid reducing it no matter how beneficial leverage reduction might be to total firm value. We present conditions for an irrelevance result under which shareholders view asset sales, pure recapitalization and asset expansion with new equity as equally undesirable. We then analyze how seniority, asset heterogeneity, and asymmetric information affect shareholders’ choice of leverage-reduction method. Our results are particularly relevant to banking and highlight the benefit and importance of capital regulation to constrain inefficient excessive borrowing.
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Bibliographic InfoPaper provided by Max Planck Institute for Research on Collective Goods in its series Working Paper Series of the Max Planck Institute for Research on Collective Goods with number 2013_13.
Date of creation: Aug 2013
Date of revision:
This paper has been announced in the following NEP Reports:
- NEP-ALL-2013-10-05 (All new papers)
- NEP-BAN-2013-10-05 (Banking)
- NEP-MIC-2013-10-05 (Microeconomics)
- NEP-REG-2013-10-05 (Regulation)
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