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CFGT-4: Dynamic Financing and Investment
1Shanghai University of Finance and Economics, China, People's Republic of; 2Boston University; 3University of Texas at Dallas
This paper studies incentives in a dynamic contracting framework of a levered firm. In particular, the manager selects long-term and short-term efforts, while shareholders choose initially optimal leverage and ex-post optimal default policies. Notably, a resource constraint that binds the agent's effort captures the essence of short-termism: an increase in short-term effort makes long-term effort costlier thereby undermining long-term performance. There are three results. First, shareholders trade off the benefits of short-termism (current cash flows) against the benefits of higher growth from the long-term effort (future cash flows), but because shareholders only split the latter with bondholders, excessive short-termism ex-post is optimal for shareholders. Second, bright (grim) growth prospects imply lower (higher) optimal levels of short-termism. Third, the endogenous default threshold rises with the substitutability of tasks and, for a positive correlation of shocks, the endogenous default threshold is hump-shaped in the volatility of permanent shocks, but increases monotonically with the volatility of transitory shocks. Finally, we quantify the agency cost of excessive short-termism, which underscores the economic significance of our results.
Debt, Innovation, and Growth
1EPFL, Switzerland; 2Copenhagen Business School; 3University of Lausanne, Switzerland
Recent empirical studies show that innovative firms heavily rely on debt financing. This paper develops a Schumpeterian growth model in which firms' dynamic R\&D, investment, and financing choices are jointly and endogenously determined. It then investigates the relation between debt financing and innovation and growth. The paper features a rich interaction between firm policies and predicts substantial intra-industry variation in leverage and innovation, consistent with the empirical evidence. It also demonstrates that while debt hampers innovation by incumbents due to debt overhang, it also stimulates entry, thereby fostering innovation and growth at the aggregate level.
Debt covenants and the value of commitment
1University of Warwick, UK; 2Chinese University of Hong Kong, Shenzhen, China, People's Republic of
We analyze the value of shareholders' commitment created by empirically observed debt covenants. We show that the renegotiation following covenant violation improves the ex post firm value at an ex ante cost and can lead to value losses similar to those under no commitment. Therefore, renegotiation frictions are key for covenants to increase the ex ante firm value. In a dynamic model, the main driver of the value loss is the no-commitment issue and the rigid debt policy ensuing from it. Hence, combined with renegotiation frictions, covenants that discipline the leverage improve firm value the most because they restore the flexibility of the debt policy. Instead, debt and asset sweeps, which are designed as ex post debt protections, are less efficient because they do not discipline the leverage policy. An efficient covenant has positive effects also on firm investment, and alleviate the agency conflicts between existing claim holders.
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