Dynamic Risk Shifting, Debt Maturity and Negotiation Tactics
London Business School Accounting Subject Area Working Paper
44 Pages Posted: 20 May 1997
Date Written: May 1997
Abstract
We examine the risk shifting problem of capital investments in a dynamic context. We find that when a firm has a long- lived project and may issue debt in the future, the risk- shifting problem is partially ameliorated early in the project life. In fact, if the potential future cash flows associated with the firm are sufficiently large relative to current cash flows, then the firm may actually underinvest in the risky asset early in the project life. We also consider the case when the firm issues both short- and long-term debt upfront, and find implications for the optimal strategy of debt negotiation. Four debt issuance strategies are considered and the optimal debt maturity mix is derived for each. These strategies are rank-ordered. Rolled-over debt is most efficient, simultaneous debt issuance is next preferred, followed by the two policies of sequentially issuing short and long-term debt. The policy of issuing long-term debt before short-term debt is typically the least preferred.
JEL Classification: G31, G32
Suggested Citation: Suggested Citation