Premium
The Leverage Ratchet Effect
Author(s) -
ADMATI ANAT R.,
DEMARZO PETER M.,
HELLWIG MARTIN F.,
PFLEIDERER PAUL
Publication year - 2018
Publication title -
the journal of finance
Language(s) - English
Resource type - Journals
SCImago Journal Rank - 18.151
H-Index - 299
eISSN - 1540-6261
pISSN - 0022-1082
DOI - 10.1111/jofi.12588
Subject(s) - leverage (statistics) , capital structure , debt , shareholder , recapitalization , monetary economics , ratchet effect , business , ratchet , commit , economics , microeconomics , financial economics , finance , corporate governance , computer science , management , database , machine learning , chaotic
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 leverage ratchet effect , 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.