Macroeconomic Risk and Debt Overhang∗

Since corporate debt tends to be riskier in recessions, transfers from equity holders to debt holders that accompany corporate decisions also tend to concentrate in recessions. Such systematic risk exposures of debt overhang have important implications for corporate investment and financing decisions, and for the ex ante costs of debt overhang. Using a calibrated dynamic capital structure model, we show that the costs of debt overhang become higher in the presence of macroeconomic risk. We also provide several new predictions on how the cyclicality of a firm’s assets in place and growth options affect its investment and capital structure decisions. JEL Classification: G31, G33 ∗We are grateful to Santiago Bazdresch, Ian Dew-Becker, David Mauer, Erwan Morellec, Stew Myers, Chris Parsons, Michael Roberts, Antoinette Schoar, Neng Wang, Ivo Welch, and seminar participants at MIT, Federal Reserve Bank of Boston, Boston University, Dartmouth, University of Lausanne, University of Minnesota, the Risk Management Conference at Mont Tremblant, the Minnesota Corporate Finance Conference, the Western Finance Association Meeting at Victoria, and the American Economic Association Meeting at San Diego for their comments. Send correspondence to Gustavo Manso, University of California at Berkeley, 545 Student Services Building # 1900, Berkeley, CA 94705, United States; telephone: 510-643-6623. E-mail: [email protected]. Introduction How do firms make investment decisions? The classic net present value (NPV) rule prescribes that we value an investment opportunity by forecasting its future cash flows and discounting future cash flows at rates that appropriately reflect the embedded risks. However, deviations from the first-best can arise due to market frictions, such as agency problems. Most of the existing studies of agency problems primarily focus on the cash-flow effects of agency conflicts, while treating the discount rates as exogenous (often by adopting risk-neutral settings). In this paper, we demonstrate the important interactions between the cash-flow channels and discount rate channels. In particular, the presence of macroeconomic risk and time-varying risk premiums affects the timing and size of investment distortions, which endogenously determines the discount rate that should be used to evaluate such distortions. The ex ante magnitude of agency costs can become significantly higher as a result. We focus on a classic type of agency problem, debt overhang. Myers (1977) argued that, in the presence of risky debt, equity holders of a levered firm underinvest, because a fraction of the value generated by their new investment will accrue to the existing debt holders. Thus, from equity holders’ point of view, investment decisions not only depend on the cash flows from investment, but also the transfers between different stake holders. We connect the investment distortions to the cyclicality of assets-in-place and growth options. Moreover, we quantify the impact of macroeconomic risk on the ex ante costs of debt overhang in a dynamic model. In the context of debt overhang, the intuition for how macroeconomic risks and agency problems interact is as follows. First, recessions are times of high marginal utilities, and this means that the distortions caused by agency problems during such times will affect investors more than in booms. Second, the size of agency conflict due to debt overhang (as measured by the potential transfer from equity holders to debt holders) depends on the riskiness of debt. It is well documented that corporate credit spreads are strongly countercyclical. Specifically, credit spreads tends to rise significantly in aggregate bad times. Thus, for a given investment opportunity, the transfers from equity holders to debt holders in a typical procyclical firm See Stein (2003) for a recent survey on this massive body of research.