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Capital Structure and Investment Dynamics with Fire Sales

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  • Douglas Gale
  • Piero Gottardi

Abstract

We study a general equilibrium model in which firms choose their capital structure optimally, trading off the tax advantages of debt against the risk of costly default. The costs of default are endogenous: bankrupt firms are forced to liquidate their assets, resulting in a fire sale if there is insufficient liquidity in the market. When the corporate income tax rate is zero, the optimal capital structure is indeterminate, there are no fire sales, and the equilibrium is Pareto efficient. When the tax rate is positive, the optimal capital structure is uniquely determined, default occurs with positive probability, firms’ assets are liquidated at fire-sale prices, and the equilibrium is constrained inefficient. More precisely, firms’ investment is too low and, although the capital structure is chose optimally, in equilibrium too little debt is used. We also show that introducing more liquidity into the system can be counter-productive: although it reduces the severity of fire sales, it also reduces welfare.

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Bibliographic Info

Paper provided by European University Institute in its series Economics Working Papers with number ECO2013/09.

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Date of creation: 2013
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Handle: RePEc:eui:euiwps:eco2013/09

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Keywords: Debt; equity; capital structure; default; market liquidity; constrained inefficient; incomplete markets;

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  1. Eberly, Janice & Rebelo, Sérgio & Vincent, Nicolas, 2008. "Investment and Value: A Neoclassical Benchmark," CEPR Discussion Papers 6737, C.E.P.R. Discussion Papers.
  2. Patrick Bolton & Hui Chen & Neng Wang, 2011. "A Unified Theory of Tobin's q, Corporate Investment, Financing, and Risk Management," Journal of Finance, American Finance Association, vol. 66(5), pages 1545-1578, October.
  3. Barnea, Amir & Haugen, Robert A & Senbet, Lemma W, 1981. "An Equilibrium Analysis of Debt Financing under Costly Tax Arbitrage and Agency Problems," Journal of Finance, American Finance Association, vol. 36(3), pages 569-81, June.
  4. Jianjun Miao & PENGFEI WANG, 2010. "Credit Risk and Business Cycles," Boston University - Department of Economics - Working Papers Series WP2010-033, Boston University - Department of Economics.
  5. Fischer, Edwin O & Heinkel, Robert & Zechner, Josef, 1989. " Dynamic Capital Structure Choice: Theory and Tests," Journal of Finance, American Finance Association, vol. 44(1), pages 19-40, March.
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