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Bankruptcy, Finance Constraints, and the Value of the Firm

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  • Douglas Gale
  • Piero Gottardi

Abstract

We study a competitive model in which market incompleteness implies that debt-financed firms may default in some states of nature, and default may lead to the sale of the firms' assets at fire sale prices when a finance constraint is binding. The anticipation of such "losses" alone may distort firms' investment decisions. We characterize the conditions under which fire sales occur in equilibrium, and their consequences on firms' investment decisions. We also show that endogenous financial crises may arise in this environment, with asset prices collapsing as a result of pure self-fulfilling beliefs. Finally, we examine alternative interventions to restore the efficiency of equilibria. (JEL D83, G31, G32, G33)

Suggested Citation

  • Douglas Gale & Piero Gottardi, 2011. "Bankruptcy, Finance Constraints, and the Value of the Firm," American Economic Journal: Microeconomics, American Economic Association, vol. 3(2), pages 1-37, May.
  • Handle: RePEc:aea:aejmic:v:3:y:2011:i:2:p:1-37 Note: DOI: 10.1257/mic.3.2.1
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    References listed on IDEAS

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    1. Anthony Downs, 1957. "An Economic Theory of Political Action in a Democracy," Journal of Political Economy, University of Chicago Press, vol. 65, pages 135-135.
    2. Stephen Coate, 2004. "Political Competition with Campaign Contributions and Informative Advertising," Journal of the European Economic Association, MIT Press, vol. 2(5), pages 772-804, September.
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    Cited by:

    1. Gale, Douglas & Gottardi, Piero, 2013. "Capital structure and investment dynamics with fire sales," LSE Research Online Documents on Economics 59301, London School of Economics and Political Science, LSE Library.

    More about this item

    JEL classification:

    • D83 - Microeconomics - - Information, Knowledge, and Uncertainty - - - Search; Learning; Information and Knowledge; Communication; Belief; Unawareness
    • G31 - Financial Economics - - Corporate Finance and Governance - - - Capital Budgeting; Fixed Investment and Inventory Studies
    • G32 - Financial Economics - - Corporate Finance and Governance - - - Financing Policy; Financial Risk and Risk Management; Capital and Ownership Structure; Value of Firms; Goodwill
    • G33 - Financial Economics - - Corporate Finance and Governance - - - Bankruptcy; Liquidation

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