The Role of Non-Managerial Inside Debt in Firm Risk and the Cost of Debt

ABSTRACT

This study investigates the impact of non-managerial inside debt on managerial risk-taking decisions and the cost of debt. We propose a theoretical model demonstrating that non-managerial inside debt can reduce firm risk by influencing managers’ risk-taking decisions and that non-managerial inside debt is inversely related to the firm’s cost of debt. From the proposed model, we develop an empirical hypothesis that indicates the negative relationship between non-managerial inside debt and the cost of debt. We test the hypothesis empirically and find evidence to support the model. The paper adds a novel theoretical model to the literature that shows the significance of non-managerial inside debt in firm risk-taking and capital raising.

KEYWORDS:

• Non-managerial inside debt
• business decision
• cost of debt

JEL:

• G32
• J30
• M55

Disclosure Statement

No potential conflict of interest was reported by the authors.

Supplemental data

Supplemental data for this article can be accessed online at https://doi.org/10.1080/1540496X.2023.2210717

Notes

1. Since non-managerial inside debt is a subprime loan, in other words, it represents unsecured debt claims with equal priority to other creditors, employees will suffer liquidation losses in their NMID holdings when the firm bankrupts and liquidates. The withdrawal action alleviates the liquidation loss that employees may suffer.

2. The industry distribution of the sample firms is included in the supplemental material.

3. We also employ another measure, which is the ratio of interest payment over total liabilities. The coefficient of alternative measure is still consistent with our hypothesis that non-managerial inside debt is negatively associated with the cost of debt.

4. Prior to 2003, employee deposits under the reorganization law were considered “kyoeki-saiken” (common benefit claim) and were viewed as senior debt (Dasgupta et al. 2019). The new law of 2003 placed a cap on the amount of money that could be claimed, and any excess amount would be treated the same as any other junior debt claims (Dasgupta et al. 2019). This substantially diminished the incentive for employees to deposit money into EDP. If EDP has a causal effect on the cost of debt, we expect the passage of the new law to reduce such an effect, and hence the coefficient on the interaction term (Post*Treat) should be positive.