How big is the debt overhang problem?

I re-examine the debt overhang problem where the flexible investment level, rather than the irreversible decision whether or not to operate, is used to measure the underinvestment caused by debt financing. I measure a large overhang cost with long-term debt or short-term debt. As is standard, underinvestment with long-term debt is more severe when investment opportunities are poor and is mitigated as opportunities improve. In contrast, underinvestment with short-term debt remains significant even when investment opportunities are good. Firms lever up as opportunities improve to take advantage of tax shields, so that equity claimants still face the incentive to underinvest. (C) 2006 Elsevier B.V. All rights reserved.