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Capital Structure and Investment Dynamics with Fire Sales

Author

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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.

Suggested Citation

  • Douglas Gale & Piero Gottardi, 2013. "Capital Structure and Investment Dynamics with Fire Sales," Economics Working Papers ECO2013/09, European University Institute.
  • Handle: RePEc:eui:euiwps:eco2013/09
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    References listed on IDEAS

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    Cited by:

    1. Daria Finocchiaro & Giovanni Lombardo & Caterina Mendicino & Philippe Weil, 2015. "Optimal inflation with corporate taxation and financial constraints," BIS Working Papers 520, Bank for International Settlements.

    More about this item

    Keywords

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

    JEL classification:

    • D5 - Microeconomics - - General Equilibrium and Disequilibrium
    • D6 - Microeconomics - - Welfare Economics
    • 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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