Debt Dilution and Debt Overhang


We introduce risky long-term debt (and a maturity choice) to a dynamic model of firm financing and production. This allows us to study two distortions which are absent from standard models of short-term debt: (1.) Debt dilution distorts firms’ choice of debt which has an indirect effect on investment; (2.) Debt overhang directly distorts investment. In a dynamic model of production, leverage, and debt maturity, we show that the two distortions interact to reduce investment, increase leverage, and increase the default rate. We provide empirical evidence from U.S. firms that is consistent with the model predictions. Debt dilution and debt overhang can overturn standard results: A financial reform which increases investment, employment, output, and welfare in a standard model of short-term debt can have the opposite effect in a model with short-term debt and long-term debt.