The Dynamics of Corporate Debt forgiveness and Contract Renegotiation
Please see the more recent version of this paper titled: The Dynamics of Default and Debt Reorganization. This paper documents the fact that in the presence of direct bankruptcy costs, prior to bankruptcy, it becomes in creditors collective interest to reduce their own contractual cash-flow claims. It analyses the pricing and efficiency implications of debt forgiveness within a fully dynamic, continuous time model. Polar cases are considered in which the balance of bargaining power in debt contract renegotiation favours either debtors or creditors. Simple closed form solutions are derived for equity and debt values, debt capacity and capital structure of the firm throughout its existence. A complete comparative analysis of the agency costs and the evolution of the firms capital structure is provided.
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