Debt, Default, and Risk Management: Corporate Policies Under Incomplete Markets

50 Pages Posted: 30 Sep 2019

See all articles by Patrick Bolton

Patrick Bolton

Columbia Business School - Department of Economics; Centre for Economic Policy Research (CEPR); National Bureau of Economic Research (NBER); European Corporate Governance Institute (ECGI)

Neng Wang

Columbia Business School - Finance and Economics; National Bureau of Economic Research (NBER)

Jinqiang Yang

Shanghai University of Finance and Economics

Date Written: September 3, 2019

Abstract

We develop a dynamic theory of capital structure, liquidity and risk management, and payout policies for a financially constrained firm under incomplete markets. In addition to costly external equity financing, the key friction we emphasize is limited financial spanning. We show that the marginal source of external financing on a on-going basis is debt. The firm only relies on costly external equity financing or costly default, when it is near or exceeds its endogenous debt capacity. The firm may be either endogenously risk-averse or risk-loving depending on the degree of market incompleteness and its current leverage. When it is risk-averse, the firm optimally manages its risk by fully hedges its hedgeable risk so as to minimize the volatility of its leverage. When it is risk-loving, the firm gambles for resurrection by selling insurance or excessively loading up on insurance. A key prediction of our theory is that the most important determinant of future leverage is current leverage, in line with existing empirical evidence.

Keywords: leverage, capital structure, debt capacity, payouts

JEL Classification: G31, G32, G33, G35

Suggested Citation

Bolton, Patrick and Wang, Neng and Yang, Jinqiang, Debt, Default, and Risk Management: Corporate Policies Under Incomplete Markets (September 3, 2019). Columbia Business School Research Paper Forthcoming, Available at SSRN: https://ssrn.com/abstract=3460441 or http://dx.doi.org/10.2139/ssrn.3460441

Patrick Bolton

Columbia Business School - Department of Economics ( email )

420 West 118th Street
New York, NY 10027
United States

HOME PAGE: http://www0.gsb.columbia.edu/faculty/pbolton/

Centre for Economic Policy Research (CEPR)

London
United Kingdom

National Bureau of Economic Research (NBER)

1050 Massachusetts Avenue
Cambridge, MA 02138
United States

European Corporate Governance Institute (ECGI)

c/o the Royal Academies of Belgium
Rue Ducale 1 Hertogsstraat
1000 Brussels
Belgium

HOME PAGE: http://www.ecgi.org

Neng Wang (Contact Author)

Columbia Business School - Finance and Economics ( email )

3022 Broadway
New York, NY 10027
United States

National Bureau of Economic Research (NBER) ( email )

1050 Massachusetts Avenue
Cambridge, MA 02138
United States

Jinqiang Yang

Shanghai University of Finance and Economics ( email )

777 Guoding Road
Shanghai, P.R.China, AK Shanghai 200433
China

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