When firms experience financial distress, equity holders may act strategically, forcing concessions from debtholders and paying less than the originally‐contracted interest payments. This article incorporates strategic debt service in a standard, continuous time asset pricing model, developing simple closed‐form expressions for debt and equity values. We find that strategic debt service can account for a substantial proportion of the premium on risky corporate debt. We analyze the efficiency implications of strategic debt service, showing that it can eliminate both direct bankruptcy costs and agency costs of debt.

This article documents the fact that when debtors decide to default on their obligations too early, it is in the creditors' collective interest, as residual claimants, to make concessions prior to forcing a costly liquidation. Symmetrically, when debtors prefer to default at an inefficiently late stage, it is in the creditors' interest to propose a departure from the absolute priority rule. This article develops a continuous time pricing model of dynamic debt restructuring that reflects the crucial influence of the two counterparties' relative bargaining power. Simple and intuitive path-dependent pricing formulae are derived for equity and debt. The debt capacity as well as the evolution of the firm's capital structure throughout its existence is provided.Understanding the potential for debtors to default on their obligations is essential to lenders. Clearly, if debtors do not service promised debt payments, that is, default, creditors can use debt collection law to seize the physical assets of the firm, that is, trigger liquidation. However, debtors' default rarely coincides with liquidation. Most often the debt is reorganized, either through out-of-court arrangements or formal bankruptcy law. 1 Hence the initially agreed priority of debt on the revenues generated (or to be generated) by the firm is not respected. According to Gilson, Kose, and Lang (1990) almost half the companies in financial distress avoid liquidation through out-of-court debt restructuring.Several explanations have been given to justify the fact that creditors are complaisant: In Franks and Torous (1989) and Bebchuk and Chang (1992), debtors' ability to strategically remain in renegotiations gives them an option to delay the exit from a lengthy, hence costly, formal debt reorganization procedure. In Baird and Jackson (1988), it is management's assumed unique ability to preserve firm value that gives them such a bar-Comments by

Debt with many creditors is analyzed in a continuous-time pricing model of the levered firm in the presence of corporate taxes. We specifically allow for debtor opportunism in form of repeated strategic renegotiation offers and default threats. Dispersed creditors will only accept coupon concessions in exchange for guaranteed liquidation rights, e.g. collateral. The ex ante optimal debt contract is secured with assets which gradually become worthless as the firm approaches the preferred liquidation conditions, in order to allow for sufficient, but delayed renegotiability. Compared with singlecreditor debt, dispersed debt offers a larger debt capacity, and it is preferable ex-ante if the value of collateralizable assets is then reduced. Our model can explain credit risk premia in excess of those supported by a single creditor model with opportunistic renegotiation. Financial support for this project from the Financial Markets Group at the LSE and the hospitality of Tilburg University is gratefully acknowledged. We are grateful to seminar audiences at Aarhus, ESSEC, Groningen, LSE, Queen Mary and Westfield London, Mannheim, Odense, Rotterdam, Tilburg, Vienna, the CEPR Financial Markets Conference in Louvain-la-Neuve, and the CEPR Corporate Finance Conference in Courmayeur for helpful comments. We also wish to thank Sudipto Bhattacharya, Lara Cathart, Jon Danielsson, Darrell Duffie, Jan Ericsson, Martin Hellwig, David Webb and an anonymous referee for useful comments and advise. Any errors remain our responsibility.

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