Seminar – The Private and Social Value of Capital Structure Commitment

Professor Timothy C. Johnson, University of Illinois

The study analyses dynamic stationary models of capital structure, in partial and general equilibrium, when managers cannot commit to firm value maximisation. The model permits us to quantify both the private cost to firms of the commitment problem and also the aggregate cost of its externality.

The research setting encompasses time-varying economic and firm characteristics, as well as valuation under generalised preferences. The model provides an explanation for the procyclical use of unprotected debt: the private costs of non-commitment increase in bad times. Likewise, expropriation incentives rise when firm valuations are low. Hence, without commitment, leverage can be countercyclical.

This dynamic amplifies the effect of excess debt on aggregate risk. A range of parameterisations suggests that the social cost of unprotected debt can be large. The evidence presented is supportive of the prediction that firms with unprotected debt increase their borrowing in bad times.

Speaker bio

Professor Timothy C. Johnson joined the UI Department of Finance in 2006 at the Gies College of Business, University of Illinois, he taught at the London Business School and for a year as a visiting associate professor at the Massachusetts Institute of Technology. He has also worked as a senior trader in global derivatives for Caxton Corporation and as director of quantitative research for Mabon Securities. Professor Johnson earned a bachelors degree in mathematics from MIT, an MS in operations research and an MBA from Columbia University, and a PhD in finance from the University of Chicago.