Underinvestment and the design of performance-sensitive debt

This paper examines the investment decision of a firm that uses performance-sensitive debt (PSD) financing. Using a real-option model of investment, we show that PSD can mitigate the well-known underinvestment problem (Myers, 1977) because of its risk-compensating nature. We also show how to design the PSD so that the underinvestment incentive is completely eliminated, thus reducing the “underinvestment” agency cost to zero. Finally, we show how to identify the optimal leverage ratio with PSD financing. Because of the complexity of the model, the results are illustrated with numerical solutions. However, the results are quite robust, and are consistent over a wide range of parameter values. The main results are (i) the “optimal” performance-sensitivity level (i.e., that eliminates underinvestment) can be significantly larger than zero, which implies that PSD is superior to the traditional fixed-coupon debt and thus provides a rationale for the use of PSD; (ii) using PSD rather than fixed-coupon financing can increase shareholder wealth by economically significant amounts; and (iii) the optimal performance-sensitivity level is an increasing function of debt level and a decreasing function of earnings growth rate and investment cost, hence firms/projects with high debt level and low earnings growth rate and investment cost are more likely to benefit from using PSD rather than the traditional fixed-coupon debt.