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Secured Debt, Agency Problems, and the Classic Model of the Firm

Author

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  • Javier F. Navas

    (Department of Financial Economics and Accounting, Universidad Pablo de Olavide, Ctra. de Utrera, Km. 1, 41013 Seville, Spain)

Abstract

In the traditional literature on firm models it is generally accepted that secured debt reduces the agency costs of debt, as it alleviates the underinvestment and overinvestment problems. We demonstrate that secured debt can also produce the opposite effects. Under the [Merton 1974, On the Pricing of Corporate Debt: The Risk Structure of Interest Rates, Journal of Finance 29, 442–470] framework, we provide numerical examples where junior secured debt produces underinvestment and senior and all-assets secured debt bring about overinvestment. Project financing and independent-firm financing eliminate these problems but may induce suboptimal decisions for shareholders. We show that shareholders will finance a project as an independent firm if its net present value is sufficiently high. Otherwise, they are better off financing the project with all-assets secured debt.

Suggested Citation

  • Javier F. Navas, 2021. "Secured Debt, Agency Problems, and the Classic Model of the Firm," Quarterly Journal of Finance (QJF), World Scientific Publishing Co. Pte. Ltd., vol. 11(03), pages 1-45, September.
    • Handle: RePEc:wsi:qjfxxx:v:11:y:2021:i:03:n:s2010139221500154
    DOI: 10.1142/S2010139221500154
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