I show that banks place investment and borrowing restrictions on firms that are in lending relationships so that the banks can continue extracting surplus from the firms over multiple periods. This agency problem is more pronounced for firms that have larger information asymmetries with the credit market. I use the term Reverse Asset Substitution (RAS) to express this partial transfer of control that benefits debt holders at the expense of equity holders when firm is not in danger of bankruptcy. Equity holders take this agency problem along with potential bankruptcy costs of debt into account when choosing firm leverage. I find that firms enjoying perfect competition in credit supply invest 2% more in PP&E than firms facing a monopoly in credit supply by banks. RAS reduces firm growth (11% lower PP&E) and leverage (24% lower). Also, RAS reduces firm value by 23% compared to the case where bankruptcy cost is the only concern in choosing the amount of bank loan.
CITATION STYLE
Chakraborty, I. (2010). Investment and Financing under Reverse Asset Substitution. Unpublished Working Paper.
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