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Pledgeability, Industry Liquidity, and Financing Cycles

Why do firms choose high debt when they anticipate high valuations, and underperform subsequently We propose a theory of financing cycles where the importance of creditors' control rights over cash flows (“pledgeability”) varies with industry liquidity. The market allows firms take on more debt when they anticipate higher future liquidity. However, both high anticipated liquidity and the resulting high debt limit their incentives to enhance pledgeability. This has prolonged adverse effects in a downturn. Because these effects are hard to contract upon, higher anticipated liquidity can also reduce a firm's current access to finance.

Author - Douglas W Diamond, Yunzhi Hu, Raghuram G Rajan
Journal - Journal of Finance

Source - https://onlinelibrary.wiley.com/doi/10.1111/jofi.12831