by Dr Adelphe Ekponon, Research Associate, Cambridge Centre for Finance and Cambridge Endowment for Research in Finance
In addition to internal funds, firms have two main sources of financing: equity and debt (in general, a mix of both). The latter source of financing comes with tax benefits, and its costs have been historically lower. However, relying heavily on debt financing could increase a firm’s bankruptcy risk. This suggests that there should exist an optimal leverage level (level of debt over the total value of the firm) as suggested by the trade-off theory, i.e. Leland (1994).
There is still some debate as to whether firms should use more debt than they do. According to Miller (1977), taxes are large and certain, whereas bankruptcy is rare and its dead-weight costs are low. Thus, firms should have higher leverage levels than what we observe. Myers (1977) argue that, in the presence of risky debt, equity holders underinvest (debt overhang) because an important fraction of the value generated by these new investments will accrue to debt holders. Debt overhang has also been shown to curb firms’ innovation and investment (see Chava and Roberts, 2008). What about the effects of debt financing at the industry/aggregate level?
Research that follows the trade-off theory treats financing decisions as independent from investment choices, as in Modigliani and Miller (1958), by assuming that the dynamic of the firm’s assets is exogenously given. More generally, very few models consider both financing and investment decisions, particularly when agents are risk averse. Lambrecht and Myers (2017) show that different specifications of managers’ preferences produce different predictions regarding the interactions between financial decisions. With power utility, investment and financing decisions are connected, but with exponential utility, managers separate investment from financing decisions. In both cases, managers underinvest because of risk aversion, confirming the debt overhang phenomenon.
A recent study by Geelen, Hajda, and Morellec (2019) shows that even if debt financing can have a negative effect on innovation and investment at the firm level, it also stimulates entry of new firms in the capital markets, thereby fostering innovation and growth at the aggregate level. What makes this new finding important? Recent productivity growth and job creation are the handiwork of start-ups and tech companies, particularly big tech. However, these firms heavily rely on R&D investments, which are now higher than CAPEX at the aggregate level for public firms (Doidge, Kahle, Karolyi, and Stulz, 2018). Debt is a key source of financing for large and small firms as well as for start-ups (Robb and Robinson, 2014).
To capture these empirical observations, Geelen, Hajda, and Morellec (2019) developed a Schumpeterian growth model (innovation makes existing products obsolete) in which firms’ dynamic R&D, investment, and financing choices are jointly and endogenously determined. The paper shows that although debt financing hampers investment at the firm level (debt overhang), it increases aggregate investment by stimulating creative destruction and entry of new firms.
Chava, S. and Roberts M. R. (2008) “How does financing impact investment? The role of debt covenants.” Journal of Finance, 63: 2085-2121
Doidge, C., Kahle, K. M., Karolyi, G. A. and Stulz R. M. (2018) “Eclipse of the public corporation or eclipse of the public markets?” Journal of Applied Corporate Finance, 30: 8-16
Geelen, Hajda, and Morellec (2019) “Debt, innovation, and growth.” EPFL Working Paper
Lambrecht, B. M. and Myers, S. C. (2017) “The dynamics of investment, payout and debt.” Journal of Financial Economics, 89: 209–231
Robb, M., and Robinson, D. T. (2014) “The capital structure decisions of new firms.” Review of Financial Studies, 27: 153-179