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Tobin's Q, Debt Overhang, and Investment


  • Christopher A. Hennessy

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    • Christopher A. Hennessy is at Walter A. Haas School of Business, University of California at Berkeley. I am grateful to Jonathan Berk, Terry Hendershott, Amnon Levy, Ben Bernanke, Jose Scheinkman, and especially my dissertation adviser Patrick Bolton. Thanks to Toni Whited and Timothy Erickson for providing me with their data. The empirical section of this paper benefited greatly from suggestions provided by an anonymous referee.


Incorporating debt in a dynamic real options framework, we show that underinvestment stems from truncation of equity's horizon at default. Debt overhang distorts both the level and composition of investment, with underinvestment being more severe for long-lived assets. An empirical proxy for the shadow price of capital to equity is derived. Use of this proxy yields a structural test for debt overhang and its mitigation through issuance of additional secured debt. Using measurement error-consistent GMM estimators, we find a statistically significant debt overhang effect regardless of firms' ability to issue additional secured debt.