Events

Prof. Neng Wang
Chong Khoon Lin Professor of Real Estate and Professor of Finance
Columbia Business School
Columbia University

We propose a parsimonious model of leverage and investment dynamics featuring a jump- diffusion cash-ow process, retained earnings, short-term debt, and crucially costly external equity. Paradoxically, it is the cost of equity issuance that causes the firm to keep leverage low, in contrast to the predictions of Modigliani-Miller and Leland trade off and Myers’ pecking-order theories. We show that firms’ efforts to preserve financial flexibility generate lower target leverage and nonlinear, non-monotonic leverage dynamics. When the firm is at its target leverage, profits are paid out, but losses cause leverage to drift up. When leverage is low, it tends to revert to the target and the marginal source of external financing is debt, but when leverage is high, the firm diverges into a debt death spiral and may have to deleverage by issuing equity at a cost. When leverage is too high and/or the firm is hit by a large EBIT loss, it defaults.