Asset Substitution, Debt Overhang, and Optimal Capital Structure

This article uses a contingent-claims valuation method to compare debt financing, investment, and risk choices of a firm adopting the second-best strategy with those of a firm adopting the first-best strategy. The former bears the agency costs, as conjectured by Jensen and Meckling (1976) and Myers (1977), because it chooses suboptimal investment timing and risk levels, while the latter is able to avoid them. For plausible parameter values, we find that the second-best firm that takes on more debt will under-invest and bear excessive risk. We also find that the agency costs of debt are 15.8% of the first-best firm value, which is higher than that found by Leland (1998) and Mauer and Sarkar (2005).