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A Model of Firm Behaviour with Bankruptcy Costs and Imperfectly Informed Lenders

  • Pedro Rui Gil

    (Faculty of Economics, University of Oporto)

Based on Greenwald and Stiglitz (1988,1990), this work explores a simple model of microeconomic behaviour that incorporates the impact of asymmetric information in capital markets on firms’ optimal investment decision rules. Starting from a model of equity-constrained firms, where expected bankruptcy costs (reflecting each firm’s quality) imply a higher user cost of capital and, thus, a lower investment by each firm, we move to a context of adverse selection in the debt market, where banks offer a ‘one-size-fits-all’ contractual interest rate. This implies that ‘poor’ firms tend to invest more vis-à-vis ‘good’ firms, since they now take into account that higher expected default rates may not be matched by comparably higher contractual interest rates, therefore weakening the impact of bankruptcy costs on firms’ investment decisions.

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Article provided by Faculdade de Economia, Universidade de Coimbra in its journal Notas Económicas.

Volume (Year): (2005)
Issue (Month): 22 (December)
Pages: 6-22

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Handle: RePEc:gmf:journl:y:2005:i:22:p:6-22
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