Doubling Down on Debt: Limited Liability as a Financial Friction


We show that limited liability and preexisting debt lead to heterogeneous investment distortions, where high leverage firms tend to overinvest in the manner of zombie firms but low leverage firms tend to underinvest. In a model with a single investment opportunity, limited liability provides equity holders with an incentive to ``double-sell’’ cash flows in default and encourages overinvestment, provided that the firm has preexisting debt and can finance new investment with debt. With repeated investment opportunities, high leverage firms continue to overinvest, but low leverage firms tend to underinvest because debt investors anticipate equity holders’ inability to commit to not double-sell cash flows. Restricting debt financed equity payouts has ambiguous efficiency implications, mitigating low leverage firms’ underinvestment but exacerbating overinvestment at highly levered firms. Consistent with model predictions, we find that highly levered firms invest more than low leverage firms in Compustat data 2004-2018, despite lower profitability and investment opportunities.

NBER Working Paper