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Executive and professional education


by Dr Adelphe Ekponon, Research Associate, Cambridge Centre for Finance and Cambridge Endowment for Research in Finance

Balancing equity and debt.

Adelphe Ekponon
Dr Adelphe Ekponon

In addition to internal funds,
firms have two main sources of financing: equity and debt (in general, a mix of
both). The latter source of financing comes with tax benefits, and its costs
have been historically lower. However, relying heavily on debt financing could
increase a firm’s bankruptcy risk. This suggests that there should exist an
optimal leverage level (level of debt over the total value of the firm) as suggested
by the trade-off theory, i.e. Leland (1994).

There is still some debate as
to whether firms should use more debt than they do. According to Miller
(1977), taxes are large and certain, whereas bankruptcy is rare and its
dead-weight costs are low. Thus, firms should have higher leverage levels than what
we observe. Myers
(1977) argue that, in the presence of risky debt, equity holders underinvest
(debt overhang) because an important fraction of the value generated by these
new investments will accrue to debt holders. Debt overhang has also been shown to curb firms’ innovation and
investment (see Chava and Roberts, 2008). What
about the effects of debt financing at the industry/aggregate level?

Research that follows the
trade-off theory treats financing decisions as independent from investment
choices, as in Modigliani and Miller (1958), by assuming that the dynamic of
the firm’s assets is exogenously given. More generally, very few models
consider both financing and investment decisions, particularly when agents are risk
averse. Lambrecht and Myers (2017) show that different specifications of
managers’ preferences produce different predictions regarding the interactions
between financial decisions. With power utility, investment and financing
decisions are connected, but with exponential utility, managers separate
investment from financing decisions. In both cases, managers underinvest because
of risk aversion, confirming the debt overhang phenomenon.

A recent study by Geelen, Hajda, and Morellec (2019) shows that even if debt financing can have a negative effect on innovation and investment at the firm level, it also stimulates entry of new firms in the capital markets, thereby fostering innovation and growth at the aggregate level. What makes this new finding important? Recent productivity growth and job creation are the handiwork of start-ups and tech companies, particularly big tech. However, these firms heavily rely on R&D investments, which are now higher than CAPEX at the aggregate level for public firms (Doidge, Kahle, Karolyi, and Stulz, 2018). Debt is a key source of financing for large and small firms as well as for start-ups (Robb and Robinson, 2014).

To capture these empirical observations, Geelen, Hajda, and Morellec (2019) developed a Schumpeterian growth model (innovation makes existing products obsolete) in which firms’ dynamic R&D, investment, and financing choices are jointly and endogenously determined. The paper shows that although debt financing hampers investment at the firm level (debt overhang), it increases aggregate investment by stimulating creative destruction and entry of new firms.


Chava, S. and Roberts M. R. (2008)
“How does financing impact investment? The role of debt covenants.” Journal
of Finance
, 63: 2085-2121

Doidge, C., Kahle, K. M., Karolyi, G.
A. and Stulz R. M. (2018) “Eclipse of the public corporation or eclipse of
the public markets?” Journal of Applied Corporate Finance, 30: 8-16

Geelen, Hajda, and Morellec (2019) “Debt,
innovation, and growth.” EPFL Working Paper

B. M. and Myers, S. C. (2017) “The dynamics of investment, payout and debt.”
Journal of Financial Economics, 89: 209–231

M., and Robinson, D. T. (2014) “The capital structure decisions of new
firms.” Review of Financial Studies, 27: 153-179