The Leverage Ratchet Effect

The Leverage Ratchet Effect

  • ANAT R. ADMATI
  • PETER M. DEMARZO
  • MARTIN F. HELLWIG
  • PAUL PFLEIDERER

Article first published online: 12th October 2017 DOI: 10.1111/jofi.12588

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 , 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.

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