Why are downturns following high valuations of firms long and severe? 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. Firms take on more debt when they anticipate higher future industry 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. Higher anticipated liquidity can, in fact, reduce a firm’s current access to finance.
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