Debt, Agency Costs, and Industry Equilibrium

Authors

  • VOJISLAV MAKSIMOVIC,

  • JOSEF ZECHNER

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    • Faculty of Commerce and Business Administration, University of British Columbia. We wish to thank Michael Fishman, David Hirshleifer, Darrell Lee, Art Raviv, Eduardo Schwartz, Sheridan Titman, Keith Wong, and the participants of Finance Workshops at Berkeley, British Columbia, Carnegie Mellon, University of Chicago, University of Columbia, University of Guelph, INSEAD, London Business School, Maryland, Minnesota, Stanford, USC, UC Irvine, Vanderbilt University, Wharton, the Federal Reserve Bank at Philadelphia and the 1990 WFA and AFA meetings. We are grateful for financial support from the Canadian Social Science and Humanities Research Council, Operating Grant number 410–91–0794.

ABSTRACT

We show that risk characteristics of projects' cash flows are endogenously determined by the investment decisions of all firms in an industry. As a result, in reasonable settings, financial structures which create incentives to expropriate debtholders by increasing risk are shown not to reduce value in an industry equilibrium. Without taxes, capital structure is irrelevant for individual firms despite its effect on the equityholders' incentives, but the maximum total amount of debt in the industry is determinate. Allowing for a corporate tax advantage of debt, capital structure becomes relevant but firms are indifferent between distinct alternative debt levels.

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