Debt Maturity and Commitment on Firm Policies
Abstract: When firms can trade debt only at discrete dates, debt maturity becomes an effective tool to address the commitment problem related to debt and investment policies. In the absence of other market frictions, single-period debt restores first-best investment. With market freezes, underinvestment worsens the leverage ratchet effect, which in turn increases investment distortions for long debt maturities. A calibrated model shows that choosing the right maturity can reduce the cost of commitment problems and market frictions by up to 4% of firm value. A decomposition of the equilibrium credit spread reveals that the portion driven by the commitment problem on future debt issuance is significant when leverage and default risk are low, and is smaller for short maturities.
DOI: https://doi.org/10.24149/wp2303r1