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The Dynamics of Corporate Debt forgiveness and Contract Renegotiation


  • Pierre Mella-Barral


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.

Suggested Citation

  • Pierre Mella-Barral, 1996. "The Dynamics of Corporate Debt forgiveness and Contract Renegotiation," FMG Discussion Papers dp230, Financial Markets Group.
  • Handle: RePEc:fmg:fmgdps:dp230

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    References listed on IDEAS

    1. Bergman, Yaacov Z. & Callen, Jeffrey L., 1991. "Opportunistic underinvestment in debt renegotiation and capital structure," Journal of Financial Economics, Elsevier, vol. 29(1), pages 137-171, March.
    2. Jones, E Philip & Mason, Scott P & Rosenfeld, Eric, 1984. " Contingent Claims Analysis of Corporate Capital Structures: An Empirical Investigation," Journal of Finance, American Finance Association, vol. 39(3), pages 611-625, July.
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    4. Jeffrey Sachs, 1988. "Conditionality, Debt Relief, and the Developing Country Debt Crisis," NBER Working Papers 2644, National Bureau of Economic Research, Inc.
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    7. Merton, Robert C, 1974. "On the Pricing of Corporate Debt: The Risk Structure of Interest Rates," Journal of Finance, American Finance Association, vol. 29(2), pages 449-470, May.
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    9. Longstaff, Francis A & Schwartz, Eduardo S, 1995. " A Simple Approach to Valuing Risky Fixed and Floating Rate Debt," Journal of Finance, American Finance Association, vol. 50(3), pages 789-819, July.
    10. Froot, Kenneth A, 1989. "Buybacks, Exit Bonds, and the Optimality of Debt and Liquidity Relief," International Economic Review, Department of Economics, University of Pennsylvania and Osaka University Institute of Social and Economic Research Association, vol. 30(1), pages 49-70, February.
    11. Eberhart, Allan C & Moore, William T & Roenfeldt, Rodney L, 1990. " Security Pricing and Deviations from the Absolute Priority Rule in Bankruptcy Proceedings," Journal of Finance, American Finance Association, vol. 45(5), pages 1457-1469, December.
    12. Bebchuk, Lucian Ayre & Chang, Howard F, 1992. "Bargaining and the Division of Value in Corporate Reorganization," Journal of Law, Economics, and Organization, Oxford University Press, vol. 8(2), pages 253-279, April.
    13. Fischer, Edwin O & Heinkel, Robert & Zechner, Josef, 1989. " Dynamic Capital Structure Choice: Theory and Tests," Journal of Finance, American Finance Association, vol. 44(1), pages 19-40, March.
    14. Froot, Kenneth A & Obstfeld, Maurice, 1991. "Stochastic Process Switching: Some Simple Solutions," Econometrica, Econometric Society, vol. 59(1), pages 241-250, January.
    15. Gertner, Robert & Scharfstein, David, 1991. " A Theory of Workouts and the Effects of Reorganization Law," Journal of Finance, American Finance Association, vol. 46(4), pages 1189-1222, September.
    16. Miller, Merton H, 1977. "Debt and Taxes," Journal of Finance, American Finance Association, vol. 32(2), pages 261-275, May.
    17. In Joon Kim & Krishna Ramaswamy & Suresh Sundaresan, 1993. "Does Default Risk in Coupons Affect the Valuation of Corporate Bonds?: A Contingent Claims Model," Financial Management, Financial Management Association, vol. 22(3), Fall.
    18. Oliver Hart & John Moore, 1994. "A Theory of Debt Based on the Inalienability of Human Capital," The Quarterly Journal of Economics, Oxford University Press, vol. 109(4), pages 841-879.
    19. Gilson, Stuart C. & John, Kose & Lang, Larry H. P., 1990. "Troubled debt restructurings*1: An empirical study of private reorganization of firms in default," Journal of Financial Economics, Elsevier, vol. 27(2), pages 315-353, October.
    20. Smith, Gregor W, 1991. "Solution to a Problem of Stochastic Process Switching," Econometrica, Econometric Society, vol. 59(1), pages 237-239, January.
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    Cited by:

    1. Fries, Steven & Mella-Barral, Pierre & Perraudin, William, 1997. "Optimal bank reorganization and the fair pricing of deposit guarantees," Journal of Banking & Finance, Elsevier, vol. 21(4), pages 441-468, April.
    2. Mella-Baral, Pierre & Tychon, Pierre, 1996. "Default risk in asset pricing," Discussion Papers (IRES - Institut de Recherches Economiques et Sociales) 1996021, Université catholique de Louvain, Institut de Recherches Economiques et Sociales (IRES).

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