Debt enforcement, investment, and risk taking across countries

Abstract

We argue that the prospect of an imperfect enforcement of debt contracts in default reduces shareholder-debtholder conflicts and induces leveraged firms to invest more and take on less risk as they approach financial distress. To test these predictions, we use a large panel of firms in 41 countries with heterogeneous debt enforcement characteristics. Consistent with our model, we find that the relation between debt enforcement and firms' investment and risk depends on the firm-specific probability of default. A differencesin-differences analysis of firms' investment and risk taking in response to bankruptcy reforms that make debt more renegotiable confirms the cross-country evidence.

Investment Decisions, Debt Renegotiation Friction, and Agency Conflicts

“…Apart from agency conflicts, a low probability of renegotiation failure induces shareholders to choose a lower investment threshold, that is, to invest more. This is consistent with the empirical result of Favara et al () where an imperfect debt enforcement causes shareholders to invest more. As stated in Favara et al (), bankruptcy codes that favor debt renegotiation increase shareholders’ expected cash flow upon default, and thus the benefits of investment to them.…”

“…This is consistent with the empirical result of Favara et al () where an imperfect debt enforcement causes shareholders to invest more. As stated in Favara et al (), bankruptcy codes that favor debt renegotiation increase shareholders’ expected cash flow upon default, and thus the benefits of investment to them. Hence, shareholders have incentives to invest more to internalize benefits of investment.…”

“…According to the empirical literature, this possibility of renegotiation failure or renegotiation friction is an important factor when explaining firm characteristics in a country or across countries . Partial examples of this literature include Davydenko and Strebulaev () on corporate debt spreads of the U.S. firms, Favara et al () on equity beta, and Favara et al () on investment across countries.…”

Debt, Innovation, and Growth

“…Our paper advances this literature by endogenizing not only firms dynamic capital structure choices but also their investment policy. In line with the evidence in Chava and Roberts (2008), Giroud, Mueller, Stomper, andWesterkamp (2012), or Favara, Morellec, Schroth, andValta (2017), we find that debt financing has a negative effect on innovation and investment at the firm level, due to debt overhang (Myers (1977)). The distortions in investment due to debt financing are large and imply important feedback effects of (endogenous) investment on dynamic capital structure choice.…”

In the Path of the Storm: Does Distress Risk Cause Industrial Firms to Risk-Shift?*

“…However, despite this "risk-shifting" hypothesis being well-known and thoroughly theoretically developed, 1 it has remained elusive to find empirical evidence suggesting that the managers of industrial firms risk-shift. Only very recently, a small number of studies, including Becker and Strömberg (2012), Gilje (2016), and Favara et al (2017), have made steps into this direction. While these studies show that high distress risk sometimes causes the managers of industrial firms to take on more risk, they offer only limited evidence on whether this behavior hurts creditors.…”