Long-term debt and overinvestment agency problem

We investigate the role of long-term debt in influencing overinvestments by analyzing the pattern of abnormal investments around a new debt offering by unlevered firms. Before being levered when the disciplining role of debt is missing, firms retain excessive amounts of cash. The introduction of debt leads to a dramatic decline in cash ratios and the relation is stronger for firms classified as having poor investment opportunities. For the sub-sample of firms that overinvest in real assets, issuing debt leads to a reduction in abnormal capital expenditures. The decline in overinvestments is explained by debt service obligations that reduce discretionary funds under managerial control. Further, the reduction in overinvestments has a positive impact on equity value. These conclusions hold in other settings where there is a dramatic change in firms’ capital structures providing strong support for the hypothesis that debt reduces overinvestments.