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Long-term debt and overinvestment agency problem

  • D'Mello, Ranjan
  • Miranda, Mercedes
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    We investigate the role of long-term debt in influencing overinvestments by analyzing the pattern of abnormal investments around a new debt offering by unlevered firms. Before being levered when the disciplining role of debt is missing, firms retain excessive amounts of cash. The introduction of debt leads to a dramatic decline in cash ratios and the relation is stronger for firms classified as having poor investment opportunities. For the sub-sample of firms that overinvest in real assets, issuing debt leads to a reduction in abnormal capital expenditures. The decline in overinvestments is explained by debt service obligations that reduce discretionary funds under managerial control. Further, the reduction in overinvestments has a positive impact on equity value. These conclusions hold in other settings where there is a dramatic change in firms' capital structures providing strong support for the hypothesis that debt reduces overinvestments.

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    Article provided by Elsevier in its journal Journal of Banking & Finance.

    Volume (Year): 34 (2010)
    Issue (Month): 2 (February)
    Pages: 324-335

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    Handle: RePEc:eee:jbfina:v:34:y:2010:i:2:p:324-335
    Contact details of provider: Web page: http://www.elsevier.com/locate/jbf

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