Optimal Debt Maturity and Firm Investment

• Authors: Joachim Jungherr.
• BSE Working Paper: 112145 | December 16
• Keywords: firm financing; investment; debt maturity; credit spreads; debt dilution
• JEL codes: E22, E32, E44, G32
• firm financing; investment; debt maturity; credit spreads; debt dilution

This paper introduces a maturity choice to the standard model of firm financing and investment. Long-term debt renders the optimal firm policy time-inconsistent. Lack of commitment gives rise to debt dilution. This problem becomes more severe during downturns. We show that cyclical debt dilution generates the observed counter-cyclical behavior of default, bond spreads, leverage, and debt maturity. It also generates the pro-cyclical term structure of corporate bond spreads. Debt dilution renders the equilibrium outcome constrained-inefficient: credit spreads are too high and investment is too low. In two policy experiments we find the following: (1) an outright ban of long-term debt improves welfare in our model economy, and (2.) debt dilution accounts for 84% of the credit spread and 25% of the welfare gap with respect to the first best allocation.