The Private and Social Value of Capital Structure Commitment

We analyze dynamic stationary models of capital structure, in partial and general equilibrium, when managers cannot commit to firm-value maximization. The model permits us to quantify both the private cost to firms of the commitment problem, and also the aggregate cost of its externality. Our setting encompasses time-varying economic and firm characteristics, as well as valuation under generalized preferences. The model provides an explanation for the procyclical use of unprotected debt: the private costs of non-commitment increase in bad times. Likewise, expropriation incentives rise when firm valuations are low. Hence, without commitment, leverage can be countercyclical. This dynamic amplifies the effect of excess debt on aggregate risk. A range of parameterizations suggests that the social cost of unprotected debt can be large. We present evidence supportive of the prediction that firms with unprotected debt increase their borrowing in bad times