Debt and Input Misallocation

We investigate a class of agency costs of debt that arise because debt financing affects the firm's incentives to use inputs efficiently. A methodology for estimating this class of costs is presented and applied to a major industry, air transport. Our results are consistent with agency models that predict a decrease in efficiency as the debt increases. A part of the loss of efficiency that we identify is attributable to the greater use by levered firms of inputs that can be monitored and are collateralizable.