Thursday, November 03, 2005

Leverage and Investment

Leverage and OVER investment--Yet another "ARGHHHH--why didn't I think of that!" paper

Showing that leverage leads to underinvestment is standard fare for any corporate finance class. Indeed, I had planned on doing it today. However, as Lyandres and Zhdanov point out, it might be better to say that leverage influences investment, but that the direction of the bias is firm-dependent (which once pointed out is very obvious, but I for one have not considered it!).

Super short version: The option to delay investment is only valuable for firms that will be around. Excessive leverage increases the likelihood of bankruptcy (where shareholders are likely to lose their claim) so levered firms will be biased to invest in projects earlier than a similar all-equity firm.

Longer version: Myers (1977) made an important contribution by showing that leverage can lead to underinvestment because shareholders will opt to not invest in projects if the firm is near bankruptcy and the results of the investment would accrue to debt holders. This idea was widely picked up on in the field and is now widely used to explain why growth firms have less debt than firms with "assets-in-place."

Lyandres and Zhdanov show that this underinvestment is only part of the story. Leverage can also lead to an "overinvestment" problem whereby firms speed-up their investment to realize teh gains prior to a potential bankruptcy.

In the authors' words:
"a firm may optimally delay an investment in a positive NPV project, if by waiting and making the investment at a future date, it is able to increase the value of the investment opportunity. In other words, the value of the option to wait must be taken into account when accessing the profitability of a project. However, when a firm is financially levered, its shareholders face the threat of bankruptcy. Upon bankruptcy, the control of the firm passes over to the debtholders. Hence, if bankruptcy happens, the shareholders lose the option to realize their investment opportunities. This is true regardless of whether bankruptcy is exogenous or endogenous. Thus, the presence of debt makes the option to wait less valuable, and forces the equityholders to speed up the investment, leading to a positive relation between the firm’s financial leverage and its investment intensity. Therefore, this overinvestment effect works in exactly the opposite direction from Myers’ (1977) underinvestment effect."
Which once pointed out is obvious. However, we owe the authors a debt for pointing this out to us! So from all of us, THANK-YOU!

Cite: Zhdanov, Alexi and Evgeny Lyandres, Underinvestment or Overinvestment? The effect of Debt Maturity on Investment, Southern Finance Meeting paper (Upload date: Nov 02, 2005).

Topic: Corporate, Leverage, Real Options

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