Extending the Maturity of a Defaulting Debt: When it is Worthwhile!

Abstract

F. Longstaff (1990, Journal of Finance) has early pointed out that lenders have incentives to extend the maturity of the debt in case of default. He derived analytical formulae for the debtholders' net gain, the associated optimal extension period and the equity price under the assumption that the extension is decided as soon as the net gain is positive. In some cases, however, debtholders should wait for a long time to safe only a small part of their claim. This paper relaxes his assumption by introducing conditions and requirements for extension. It is claimed that the extension solution is especially valuable when the financial distress is not dramatic, when the stockholders contribute significantly, when the realization rate is time-varing and increasing or for combinations of these situations. One finally refines the extension solution by considering a supplementary monitoring process beyond default.

Keywords: Bankruptcy procedure, Extended debt

JEL Classification: G12, G32, G33