Strategic Debt Restructuring and Asset Substitution

31 Pages Posted: 24 Jan 2021

See all articles by Daniel Giamouridis

Daniel Giamouridis

Bank of America - Bank of America Merrill Lynch; City University London - Cass Business School - Faculty of Finance; EDHEC Risk Institute

Chara Prassa

Athens University of Economics and Business

Date Written: November 29, 2020

Abstract

This paper examines whether debt renegotiation mitigates the agency costs of asset substitution. Inspired by the studies of Mella-Barral and Perraudin (1997) and Leland (1998), we have developed an analytical continuous time model of a firm that has the option to switch to a higher risk activity and renegotiate the terms of the debt. Our model creates a trade-off between increasing firm volatility and decreasing growth rate which characterizes the potential for asset substitution. Our findings indicate that, in most cases, debt renegotiation substantially reduces agency costs of asset substitution, whereas non-renegotiable debt is optimal when equity holders have a weak bargaining position and the opportunity cost of their risk-taking incentives is high. Several testable empirical implications regarding the design of debt contracts are developed.

Keywords: Asset substitution, Debt renegotiation, Strategic contingent claims analysis

JEL Classification: G30, G32, G33

Suggested Citation

Giamouridis, Daniel and Prassa, Chara, Strategic Debt Restructuring and Asset Substitution (November 29, 2020). Available at SSRN: https://ssrn.com/abstract=3739481 or http://dx.doi.org/10.2139/ssrn.3739481

Daniel Giamouridis

Bank of America - Bank of America Merrill Lynch ( email )

United Kingdom

City University London - Cass Business School - Faculty of Finance ( email )

London, EC2Y 8HB
Great Britain

EDHEC Risk Institute ( email )

Lille
France

Chara Prassa (Contact Author)

Athens University of Economics and Business ( email )

76 Patission Street
Athens, 104 34
Greece

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