Firm Investment and the Composition of Debt

This paper analyzes optimal debt structure when firms simultaneously choose the size of the project to be financed (investment), and the composition of debt between intermediated debt (bank loans) and arm's length debt (bonds). The key distinction between the two forms of debt is that, when liquidation looms, intermediated debt is easier to restructure. Absent deadweight losses in liquidation, debt structure is irrelevant to the investment choices of the entrepreneur. With liquidation losses, I show that investment is financed by a combination of bank and market finance so long as 1) banks have higher intermediation costs than markets and 2) internal resources of entrepreneurs are sufficiently small. The share of bank finance in total investment then depends non-monotonically on internal resources: firms with very limited internal resources are increasingly reliant on bank finance to expand investment, while medium-sized firms reduce the contribution of bank finance as their internal resources increase. The model's predictions finds support in cross-sectional data on the debt structure of US manufacturing firms.