Journal of Finance 2013

The Leverage Ratchet Effect

Anat R. Admati¹; Peter M. DeMarzo¹; Martin Hellwig^2,3; Paul Pfleiderer¹

¹ Stanford University · ² Max Planck Society · ³ Max Planck Institute for Behavioral Economics

Abstract

Firms’ inability to commit to future funding choices has profound consequences for capital structure dynamics. With debt in place, shareholders pervasively resist leverage reductions no matter how much such reductions may enhance firm value. Shareholders would instead choose to increase leverage even if the new debt is junior and would reduce firm value. These asymmetric forces in leverage adjustments, which we call the leverage ratchet effect, cause equilibrium leverage outcomes to be history-dependent. If forced to reduce leverage, shareholders are biased toward selling assets relative to potentially more efficient alternatives such as pure recapitalizations.

DOI

10.1111/jofi.12588/full

Sources

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