Commitment and Investment Distortions Under Limited Liability


We study how frictions originating from the presence of limited liability distort firms’ investment and financing choices. By financing new investments with debt, firms can use limited liability to credibly commit to defaulting earlier— allowing both firms’ owners and new creditors to benefit from diluting existing creditors. In a dynamic setup, this leads to a time-inconsistency, which increases the cost of external funds, and discourage investment. We show that the interaction of these two forces leads to heterogeneous investment distortions where highly-indebted firms overinvest and those with low levels of debt underinvest. Allowing direct payments to firms’ owners financed with debt can mitigate overinvestment but, in the presence of repeated.

NBER Working Paper