Default, debt maturity, and investment dynamics

This paper studies the optimal maturity structure of debt in a neo-classical investment model with financial frictions. External financing is costly because firms have limited liability, and default entails deadweight output losses. Firms operate long-dated assets, and may thus want to issue long-term debt in order to mitigate liquidity risk. However, lack of commitment on the firms' part makes long-term debt issuance costly, relative to short-term debt. In theory, the optimal maturity structure of debt should trade off these two forces. In numerical calibrations of the model, however, lack of commitment often dominates. Optimal borrowing policies often involve maturity shortening, either by letting outstanding long-term debt roll off, or by foregoing investment and using resources to repurchase outstanding debt at discount prices. The results suggests that the agency costs associated with long-term debt issuance are large, and that maturity adjusmtent can substantially alter investment dynamics.