Investment, Capital Structure and Default Risk


This paper studies how a firm’s capital structure shapes the investment response during a sovereign debt crisis. To estimate the heterogeneous effect of capital structure on investment response to default risk, we use balance-sheet data for Italian firms during 2007-2015. We find that changes in default risk produce a negative response to investment, which changes with the capital structure. Specifically, the negative response of investment is amplified by at least 55% with higher leverage. However, investment sensitivity could be heightened or attenuated by about 15% with higher maturity, depending on whether firms are highly indebted. We build a partial equilibrium model of investment, short-term and long-term debt, and limited commitment to understanding the mechanisms that explain our empirical results. Our model shows that the effect of debt overhang, rollover risk and its interaction can qualitatively capture the empirical results obtained with Italian data for firms.

Click the Slides button above to demo Academic’s Markdown slides feature.

#Supplementary notes can be added here, including code and math.

Jose Villegas
Jose Villegas
Postdoctoral Research Fellow