Underinvestment and the design of performance-sensitive debt

Sarkar, Sudipto; Zhang, Chuanqian
May 2015
International Review of Economics & Finance;May2015, Vol. 37, p240
Academic Journal
This paper examines the investment decision of a firm that uses performance-sensitive debt (PSD) financing. Using a real-option model of investment, we show that PSD can mitigate the well-known underinvestment problem (Myers, 1977) because of its risk-compensating nature. We also show how to design the PSD so that the underinvestment incentive is completely eliminated, thus reducing the “underinvestment” agency cost to zero. Finally, we show how to identify the optimal leverage ratio with PSD financing. Because of the complexity of the model, the results are illustrated with numerical solutions. However, the results are quite robust, and are consistent over a wide range of parameter values. The main results are (i) the “optimal” performance-sensitivity level (i.e., that eliminates underinvestment) can be significantly larger than zero, which implies that PSD is superior to the traditional fixed-coupon debt and thus provides a rationale for the use of PSD; (ii) using PSD rather than fixed-coupon financing can increase shareholder wealth by economically significant amounts; and (iii) the optimal performance-sensitivity level is an increasing function of debt level and a decreasing function of earnings growth rate and investment cost, hence firms/projects with high debt level and low earnings growth rate and investment cost are more likely to benefit from using PSD rather than the traditional fixed-coupon debt.


Related Articles

  • Serbia, Kosovo fail to find accord at EU talks.  // Regional Today;04/04/2013, p5 

    The article reports on the failure by Serbia and Kosovo to find common ground on tensions at marathon European Union (EU)-sponsored talks in 2013.

  • U.S. wants China to resolve sea dispute through peaceful dialogue.  // Filipino Reporter;4/27/2012, Vol. 40 Issue 21, p8 

    The article reports that U.S. Secretary Department wants the dispute between the Philippines and China over the latter's intrusion into Panatag Shoal be resolved peacefully and handled with restraint.

  • THE SINAI AGREEMENT AND BEYOND. Sam'O, Elias // World Affairs;Jun76, Vol. 139 Issue 1, p40 

    Focuses on the Sinai agreement between the U.S., Egypt and Israel. Determination of countries to reach a final and peaceful means settlement by means of negotiation; Commitment of Egypt in the agreement; Characteristic of the agreement.

  • Study Times: "No Political and Security Conditions for North Korea to Give up Their Nuclear Weapons".  // Chinascope;Nov/Dec2013, Issue 66, p42 

    The article presents a report from the October 28, 2013 issue of "Study Times," which tackled the resumption of six-party negotiations over North Korea's nuclear weapons program.

  • How To Boost Pay For Performance. O'Byrne, Stephen F. // Financial Executive;Nov2004, Vol. 20 Issue 8, p46 

    This article discusses how companies could build better incentives in their executive compensation plans. One must look at wealth, not just annual pay, to understand executive incentives and executive pay. It is vital to compare the value of stock and options of executives who are largely...

  • INTRODUCTION: THE PACIFIC SALMON DISPUTE. Picker, Colin // Canada-United States Law Journal;2001, Vol. 27, p257 

    Focuses on the Pacific Salmon fishing dispute between the United States and Canada. Relevance of the issue in comparative federalism; Entrance of American fishing boats in Canadian waters; Creation of the Pacific Salmon Commission to solve the dispute.

  • BIBLIOGRAPHY.  // Leiden Journal of International Law;2009, Vol. 22 Issue 1, p171 

    A bibliography on the subject of prevention and peaceful settlement of international disputes is presented which includes books and articles "Restoring Justice After Large-Scale Violent Conflicts: Kosovo, DR Congo and the Israeli-Palestinian Case," edited by I. Aersten, "Law Enforcement Within...

  • BIBLIOGRAPHY.  // Leiden Journal of International Law;2010, Vol. 23 Issue 1, p263 

    A bibliography related to the peaceful settlement of international disputes is presented which includes the book "Human Rights and Conflict Resolution in Context," edited by E.F. Babbit and E.L. Lutzr, the article "Peace-Building and the Role of International Tribunals," by R. Arnold, and the...

  • BIBLIOGRAPHY.  // Leiden Journal of International Law;2008, Vol. 21 Issue 2, p539 

    A bibliography on the subject of the prevention and peaceful settlement of international disputes is presented which includes the books "Paths to International Justice," edited by M. B. Dembour, "A Possible Peace Between Israel and Palestine: An Insider's Account of the Geneva Initiative," by M....


Read the Article


Sorry, but this item is not currently available from your library.

Try another library?
Sign out of this library

Other Topics