Leverage Dynamics without Commitment

We analyze equilibrium leverage dynamics in a dynamic tradeoff model when the firm is unable to commit to a leverage policy ex ante. We develop a methodology to characterize equilibrium equity and debt prices in a general jump-diffusion framework, and apply our approach to the standard Leland (1998) setting. Absent commitment, the leverage ratchet effect (Admati et al. 2015) causes firms to take on debt gradually over time (rather than adjust immediately to a “target” leverage ratio). Firm leverage may go down via asset growth and debt maturity, but equity holders never reduce debt voluntarily. While equilibrium equity values match those in a model where the firm commits not to issue new debt, bond investors anticipate future leverage increases and hence price bonds lower uniformly, with significant credit spreads even when the distance to default is large. Ultimately, lower bond prices dissipate the tax benefits from future debt increases.