Leveraged investments and agency conflicts when cash flows are mean reverting

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Journal Article
Journal of Economic Dynamics and Control, 2016, 67 pp. 1 - 21
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© 2016 Elsevier B.V.. We analyse the effect of mean-reverting cash flows on the costs of shareholder-bondholder conflicts arising from partially debt-financed investments. In a partial equilibrium setting we find that such agency costs are significantly lower under mean-reverting (MR) dynamics, when compared to the ubiquitous geometric Brownian motion (GBM). The difference is attributed to the stationarity of the MR process. In addition, through the application of a novel agency cost decomposition, we show that for a larger speed of mean reversion, agency costs are driven mainly by suboptimal timing decisions, as opposed to suboptimal financing decisions. In contrast, under the standard GBM assumption the agency costs are driven mainly by suboptimal financing decisions for large growth rates and by suboptimal timing decisions for smaller or negative growth rates.
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