Macroeconomic Risk and Debt Overhang PRELIMINARY AND INCOMPLETE

We demonstrate the impact of macroeconomic risk on the investment decisions of firms with risky debt and the costs of debt overhang. Debt overhang stems from the transfer between equity holders and debt holders after investment is made. The cyclicality of a firm’s assets in place and its growth options affects when such transfers are likely to occur and how much they can be, which provides a range of new predictions that link investment decisions, debt covenants, and capital structure to macroeconomic risk. Using a calibrated dynamic real option/capital structure model, we find that the costs of debt overhang can become 3-4 times higher when macroeconomic risk is taken into account. More cyclical assets in place amplify the impact of macroeconomic risk on debt overhang, while more cyclical growth opportunities may either amplify or reduce the impact of macroeconomic risk on debt overhang. We are grateful to Stew Myers, Chris Parsons, Antoinette Schoar, Ivo Welch and participants of the MIT Finance Lunch Seminar, Boston Fed, and the Third Risk Management Conference at Mont Tremblant for their comments. MIT Sloan School of Management. Email: [email protected]. Tel. 617-324-3896. MIT Sloan School of Management. Email: [email protected]. Tel. 617-253-7218.