Macroeconomic Risk and Debt Overhang

Since debt is typically riskier in recessions, transfers from equity holders to debt holders associated with each investment also tend to concentrate in recessions. Such systematic risk exposure of debt overhang has important implications for the investment and financing decisions of firms and on the ex ante costs of debt overhang. Using a calibrated dynamic capital structure/real option model, we show that the costs of debt overhang become significantly higher in the presence of macroeconomic risk. We also provide several new predictions that relate the cyclicality of a firm's assets in place and growth options to its investment and capital structure decisions