Interaction of the Debt Agency Problems and Optimal Capital Structure: Theory and Evidence

Does more leverage always worsen the debt agency problem? This paper presents a unified analysis that accounts for both risk-shifting and under-investment debt agency problems. For firms with positive marginal volatility of investment (defined as the change in cash flow volatility corresponding to a change of investment scale), equity holders' risk-shifting incentive will mitigate the under-investment problem. This implies that, contrary to conventional views, the total agency cost of debt does not uniformly increase with leverage. This model further predicts that, for high-growth firms in which the under-investment problem is severe, the optimal debt ratio is positively related to the marginal volatility of investment. Empirical results support this prediction.