Article

Debt Maturity and the dynamics of leverage

Vienna Univ. of Technology; Dept. of Finance, University of Vienna; Vienna University of Technology, A-1040, Vienna, Austria; Department of Finance, University of Vienna, A-1210, Vienna, Austria
12/2007; DOI: 10.2139/ssrn.890228

ABSTRACT This paper shows that long debt maturities destroy equityholders' incentives to re-duce leverage in response to poor firm performance. By contrast, a sufficiently short debt maturity commits equityholders to implement such leverage reductions. However, a short debt maturity also generates transactions costs associated with rolling over matur-ing bonds. We show that this tradeoff between higher expected transactions costs against the commitment to reduce leverage when the firm is doing poorly motivates an optimal maturity-structure of corporate debt. Since firms with high costs of financial distress benefit most from committing to leverage reductions, they have a stronger incentive to issue short-term debt. The debt maturity required to commit to future leverage reductions decreases with the volatility of the firm's cash flows. We also find that the equityholders' incentives to reduce debt is non-monotonic in the firm's leverage. If the firm is pushed towards bankruptcy by a persistent series of low cash flows, then equityholders resume issuing debt to refinance maturing bonds, even when debt maturities are short.daresan participants of the seminars at London Business School, Norwegian School of Economics and Business Administration, participants of the 2005 European Finance Association Meeting in Zürich, 2004 Annual Sum-mer UBC Finance Conference, 2004 Annual Meeting of the German Finance Association in Tübingen for their suggestions and comments.

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