The Overhang Cost of Long and Short Term Debt in the Presence of Default Risk

45 Pages Posted: 19 Aug 2013 Last revised: 9 Dec 2013

See all articles by Van Hoang Vu

Van Hoang Vu

Royal Melbourne Institute of Technolog (RMIT University) - School of Economics, Finance and Marketing

Christine A. Brown

Department of Banking and Finance; Financial Research Network (FIRN)

Daniel Chai

Monash University

Date Written: August 19, 2013

Abstract

This research studies the implications of short term debt for firm investment decisions on a sample of U.S. non-financial firms from 1985-2011. We argue that short term debt does not always help to reduce the overhang cost of leverage as is the case in Myers (1977) model. Our empirical results show that short term debt has a negative effect on subsequent investment, which is further amplified in the presence of high default risk. Moreover, a high proportion of short term debt also intensifies the negative impact of default risk on investment. This finding is consistent with our argument that short term debt overhang becomes more dominant than long term debt overhang when the firm faces high risk of bankruptcy. This finding provides another explanation for corporate failures during the 2007-2009 crisis in the U.S. It is the prolonged implications of the under-investment problem that delay recovery, and this problem is more severe for firms with short term debt because short term debt intensifies the negative impact of financial distress on firm investments. Finally, our results provide support for the model in Diamond and He (2011).

Keywords: corporate finance, agency conflicts, debt overhang, debt maturity, financial distress

JEL Classification: G31, G32, G33

Suggested Citation

Vu, Van Hoang and Brown, Christine A. and Chai, Daniel, The Overhang Cost of Long and Short Term Debt in the Presence of Default Risk (August 19, 2013). 26th Australasian Finance and Banking Conference 2013, Available at SSRN: https://ssrn.com/abstract=2312158 or http://dx.doi.org/10.2139/ssrn.2312158

Van Hoang Vu (Contact Author)

Royal Melbourne Institute of Technolog (RMIT University) - School of Economics, Finance and Marketing ( email )

Level 12, 239 Bourke Street
Melbourne, Victoria 3000
Australia

Christine A. Brown

Department of Banking and Finance ( email )

Building 11E
Clayton, Victoria 3800
Australia
+61 3 99031793 (Phone)
+61 3 99055475 (Fax)

Financial Research Network (FIRN)

C/- University of Queensland Business School
St Lucia, 4071 Brisbane
Queensland
Australia

HOME PAGE: www.firn.org.au

Daniel Chai

Monash University ( email )

23 Innovation Walk
Wellington Road
Clayton, Victoria 3800
Australia

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