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Optimal Default and Liquidation with Tangible Assets and Debt Renegotiation

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  • Goto, Makoto
  • Kijima, Masaaki
  • Suzuki, Teruyoshi
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    Abstract

    This paper proposes a new pricing model for corporate securities issued by a levered firm with the possibility of debt renegotiation. We take the structural approach that the firm's earnings follow a geometric Brownian motion with stochastic collaterals. While equity holders can default the firm for their own benefits when the earnings become insufficient to go on the firm, they may want to liquidate it by repaying the face value of debt to debt holders in order to get enough residuals, when the value of collaterals becomes sufficiently high. Unlike the existing theoretical models, the bivariate structure enables us to distinguish strategic default, liquidity default and the ordinary liquidation. It is shown that liquidity default and liquidation possibly occur without entering debt renegotiation, which makes the contribution of strategic debt service to credit spreads lower than that obtained in the previous models, irrespective of the equity holders' bargaining power. Our model resolves the inconsistency reported in recent empirical studies.

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    File URL: http://hdl.handle.net/2115/43303
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    File URL: http://eprints.lib.hokudai.ac.jp/dspace/bitstream/2115/43303/1/DPA224.pdf
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    Bibliographic Info

    Paper provided by Graduate School of Economics and Business Administration, Hokkaido University in its series Discussion paper series. A with number 224.

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    Length: 57 pages
    Date of creation: May 2010
    Date of revision:
    Handle: RePEc:hok:dpaper:224

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    Related research

    Keywords: Structural model; Debt renegotiation; Strategic debt service; Credit spread; Liquidity default; Strategic default; Liquidation; M&A; D81; G32; G33; G35;

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    1. Mella-Barral, Pierre & Perraudin, William, 1997. " Strategic Debt Service," Journal of Finance, American Finance Association, vol. 52(2), pages 531-56, June.
    2. Mella-Barral, Pierre, 1999. "The Dynamics of Default and Debt Reorganization," Review of Financial Studies, Society for Financial Studies, vol. 12(3), pages 535-78.
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