Investment, capital structure and agency costs with write-down equity

Abstract

We develop an investment and financing model in which a controlling shareholder holds write-down equity and extracts private benefits by diverting the firm's cash flows. The model highlights how write-down equity affects investment and financing decisions, and the aggregate agency costs arising from investment, financing, and private benefits diversion. We find that the write-down equity causes the controlling shareholder to delay investment, choose conservative debt financing, and reduce credit spreads. Additionally, under an exogenous capital structure, there exists an optimal write-down ratio that completely eliminates agency costs related to investment. An increase in the write-down ratio reduces agency costs from private benefits diversion. Conversely, under the optimal capital structure, increasing the write-down ratio increases agency costs related to financing and private benefits diversion. Thus, the write-down equity is an effective financial instrument to reduce agency conflicts between the controlling shareholder and principals (i.e., minority shareholders and debtholders), especially for firms with debt financing constraints.