Financing Investment: The Choice between Public and Private Debt∗

We study the choice between public and private debt in a firm’s marginal financing decision and its effects on corporate investment. To do so, we build a dynamic model of investment and financing decisions in which firms can choose not only the amount but also the type of debt to issue to finance investment. The paper shows how various firm and industry characteristics, such as liquidation costs, renegotiation frictions, cash flow volatility, product market competition, or credit supply, affect the costs and benefits of each debt source and the mix of debt ownership that borrowers demand. It also demonstrates that, by changing the cost of financing, these characteristics affect corporate investment. We test the predictions of the model using a large sample of U.S. firms for the period 1986-2007 and present new evidence on firms’ debt choices and investment decisions, which is strongly supportive of our theory.