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Debt Overhang, Costly Expandability and Reversibility, and Optimal Financial Structure
Author(s) -
Jou JyhBang,
Lee Tan
Publication year - 2004
Publication title -
journal of business finance and accounting
Language(s) - English
Resource type - Journals
SCImago Journal Rank - 1.282
H-Index - 77
eISSN - 1468-5957
pISSN - 0306-686X
DOI - 10.1111/j.0306-686x.2004.00572.x
Subject(s) - debt overhang , debt , bond , agency cost , agency (philosophy) , investment (military) , value (mathematics) , business , monetary economics , finance , economics , microeconomics , external debt , computer science , machine learning , politics , political science , law , shareholder , corporate governance , philosophy , epistemology
This article compares the investment and financing decisions of a firm that adopts a ‘first‐best’ strategy with those of a firm that adopts a ‘second‐best’ strategy. The former issues bonds upon deciding an initial capacity, while the latter issues bonds, and only then decides an initial capacity. The former is thus able to avoid the agency cost associated with the ‘debt overhang’ problem. Accordingly, the former will both issue more bonds and install a larger initial capacity than the latter. However, the agency cost of debt, i.e., firm value difference between these two strategies, is modest for plausible parameter values.