Commitment, agency costs and dynamic capital structure

This paper studies leverage dynamics when shareholders commit to optimizing total enterprise value and face debt adjustment friction. Debt adjustment costs render the leverage commitment a double-edged sword. High-levered firms benefit from the commitment due to active debt repurchase. However, such debt buyback incurs a heavy burden and constrains financial flexibility. With high debt adjustment costs, it could be inefficient for the enterprise to maintain a firm-optimal debt policy. Interestingly, the incentive alignment effect from commitment makes shareholders act as if creditors in normal times. For instance, shareholders exhibit precautionary motives and overinvest. Finally, we show that dynamic risk management exacerbates the debt-equity conflicts and improves the commitment value.