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The Leverage Ratchet Effect

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  • ANAT R. ADMATI
  • PETER M. DEMARZO
  • MARTIN F. HELLWIG
  • PAUL PFLEIDERER

Abstract

Firms’ inability to commit to future funding choices has profound consequences for capital structure dynamics. With debt in place, shareholders pervasively resist leverage reductions no matter how much such reductions may enhance firm value. Shareholders would instead choose to increase leverage even if the new debt is junior and would reduce firm value. These asymmetric forces in leverage adjustments, which we call the leverage ratchet effect, cause equilibrium leverage outcomes to be history†dependent. If forced to reduce leverage, shareholders are biased toward selling assets relative to potentially more efficient alternatives such as pure recapitalizations.

Suggested Citation

  • Anat R. Admati & Peter M. Demarzo & Martin F. Hellwig & Paul Pfleiderer, 2018. "The Leverage Ratchet Effect," Journal of Finance, American Finance Association, vol. 73(1), pages 145-198, February.
  • Handle: RePEc:bla:jfinan:v:73:y:2018:i:1:p:145-198
    DOI: 10.1111/jofi.12588
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    6. Ilya A. Strebulaev & Baozhong Yang, 2012. "The Mystery of Zero-Leverage Firms," NBER Working Papers 17946, National Bureau of Economic Research, Inc.
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