Present bias: Understanding zero leverage policy and unstable capital structure

Abstract

We develop a dynamic capital structure model for a firm controlled by a present-biased entrepreneur without commitment. For sophisticated entrepreneurs, the costs associated with debt issuance act as a de facto commitment device, steering them towards a “zero-leverage strategy” due to the prohibitive costs associated with repeated debt refinancing. In contrast, naive entrepreneur fails to perceive future refinancing, this erroneous belief undermines the commitment value of debt issuance cost and leads to “unstable capital structure”. Borrower naivete provides an opening for financial intermediaries and creditors to impose increased flotation costs and elevated credit spreads. Our analysis further suggests that implementing covenants tied to financial leverage ratios alongside short-term debt obligations can serve as effective strategies to mitigate the impacts of entrepreneurial naivete.