Dynamic Optimal Restructuring Policies Under Debt Renegotiation with Positive Externalities

Abstract

This paper develops a debt renegotiation model with positive externalities by using Nash bargaining game and explores dynamic optimal downward debt restructure policies in financial distress. A novel feature of our model is the positive externalities, which imply that liquidation threat offered by the shareholders for renegotiation does not bring about any losses for both creditors and shareholders, and that the two parties always benefit from the debt renegotiation. We derive the closed-form expressions for optimal restructure policies. Moreover, we provide theoretical support for the advantages of debt renegotiation with positive externalites since it not only increases firms' value but also dramatically alleviates and even fully eliminates the inefficiency arising from asset substitution. In addition, our model may explain the violation of the absolute priority rule for firms in financial distress. Finally, we discover that firms with a relatively lower risk and larger leverage ratio are more easier to proceed to debt renegotiation, which are documented by empirical evidences.

Keywords: Debt renegotiation; Positive externalities; Dynamic capital structure; Asset substitution

JEL Classification: G13, G31, G32