We consider a dynamic trade-off model of a firm's capital structure with debt renegotiation. Debt holders only accept restructuring offers from equity holders backed by threats which are in the equity holders' own interest to execute. Our model shows that in a complete information model in which taxes and bankruptcy costs are the only frictions, violations of the absolute priority rule (APR) are typically optimal. The size of the bankruptcy costs and the equity holders' bargaining power affect the size of APR violations, but they have only a minor impact on the choice of capital structure.JEL classification: G32, G33, G13
In a dynamic capital structure model we study whether asset substitution implies agency costs when the firm initially takes the substitution option into account. Asset substitution affects earnings in two directions: volatility increases and growth rate decreases. We show that substitution implies agency costs if volatility increases enough. In this case, debt renegotiation to avoid substitution mitigates the ex ante costs. However, debt renegotiation decreases the equity holders' ex post costs. Thus, with a modest volatility increase, debt renegotiation allows equity holders to extract concessions from creditors albeit asset substitution was not chosen for non-renegotiable debt. Hence, debt renegotiation need not improve ex ante firm value if asset substitution is allowed for.
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