The Shock of Debt: A Behavioral Perspective

Increasing the debt ratio significantly overnight may reduce a firm's cost of capital but it does change the characteristics of the firm. Managers who are accustomed to operating in the relatively low-stress environment of a predominantly equity funded firm have t to adjust quickly to the cash-flow demands of a highly levered firm. While the argument posed by Jensen and others is that this will lead to the more discipline on the part of management in risk assessment and project selection, there are potentially unhealthy responses to having to making larger debt payments:

a. Decision paralysis: Since every risky investment or decision can potentially cause default, managers may hold back on committing to new investments that they perceive as uncertain.

b. Short term focus: The need to make interest and principal payments on debt may induce managers to choose projects that generate short term payoffs over longer terms investments that create more value for the business.

c. Self-selection problem: In earlier chapters, we noted that some managers are more prone to over optimism than others. These over optimistic managers are more likely to perceive higher earnings in the future and follow up by borrowing large amounts of money.

Studies that have looked at firms that have gone through significant increases in debt (in leveraged recapitalization and leveraged buyouts) find, at least on average, that managers are able to cope reasonably well with the demands of debt payments and that operating performance improves after the leverage increase.

Argument posed by Jensen and others is that this will lead to the more discipline on the part of management in risk assessment and project selection, there are potentially unhealthy responses to having to making larger debt payments:

d. Decision paralysis: Since every risky investment or decision can potentially cause default, managers may hold back on committing to new investments that they perceive as uncertain.

e. Short term focus: The need to make interest and principal payments on debt may induce managers to choose projects that generate short term payoffs over longer terms investments that create more value for the business.

f. Self-selection problem: In earlier chapters, we noted that some managers are more prone to over optimism than others. These over optimistic managers are more likely to perceive higher earnings in the future and follow up by borrowing large amounts of money.

Studies that have looked at firms that have gone through significant increases in debt (in leveraged recapitalization and leveraged buyouts) find, at least on average, that managers are able to cope reasonably well with the demands of debt payments and that operating performance improves after the leverage increase.