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Excessive Continuation and Dynamic Agency Costs of Debt

  • Décamps, Jean-Paul
  • Faure-Grimaud, Antoine

This paper analyses the incentives of the equityholders of a leveraged company to shut it down in a continuous time, stochastic environment. Keeping the firm as an ongoing concern has an option value but equity and debt holders value it differently. Equityholders' decisions exhibit excessive continuation and reduce firm's value. Using a compounbd exchange option approach, we characterise the resulting agency costs of debt, derive the "price" of these costs and analyse their dynamics. We also show how agency costs can be reduced by the design of debt and the possibility of renegotiation.

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Paper provided by Institut d'Économie Industrielle (IDEI), Toulouse in its series IDEI Working Papers with number 99.

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Date of creation: 2000
Date of revision:
Publication status: Published in European Economic Review, vol. 46, Elsevier, 2002, p. 1623-1644.
Handle: RePEc:ide:wpaper:678
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  1. Oliver Hart & John Moore, 1997. "Default and Renegotiation: A Dynamic Model of Debt," STICERD - Theoretical Economics Paper Series 321, Suntory and Toyota International Centres for Economics and Related Disciplines, LSE.
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  7. Jean-Charles Rochet & Jean-Paul DÊcamps, 1997. "A variational approach for pricing options and corporate bonds," Economic Theory, Springer;Society for the Advancement of Economic Theory (SAET), vol. 9(3), pages 557-569.
  8. Margrabe, William, 1978. "The Value of an Option to Exchange One Asset for Another," Journal of Finance, American Finance Association, vol. 33(1), pages 177-86, March.
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  12. Mello, Antonio S & Parsons, John E, 1992. " Measuring the Agency Cost of Debt," Journal of Finance, American Finance Association, vol. 47(5), pages 1887-904, December.
  13. 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.
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  15. David de Meza & Ben Lockwood, 1998. "Does Asset Ownership Always Motivate Managers? Outside Options and the Property Rights Theory of the Firm," The Quarterly Journal of Economics, Oxford University Press, vol. 113(2), pages 361-386.
  16. Jensen, Michael C. & Meckling, William H., 1976. "Theory of the firm: Managerial behavior, agency costs and ownership structure," Journal of Financial Economics, Elsevier, vol. 3(4), pages 305-360, October.
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  18. Geske, Robert, 1977. "The Valuation of Corporate Liabilities as Compound Options," Journal of Financial and Quantitative Analysis, Cambridge University Press, vol. 12(04), pages 541-552, November.
  19. Merton, Robert C., 1973. "On the pricing of corporate debt: the risk structure of interest rates," Working papers 684-73., Massachusetts Institute of Technology (MIT), Sloan School of Management.
  20. Leland, Hayne E & Toft, Klaus Bjerre, 1996. " Optimal Capital Structure, Endogenous Bankruptcy, and the Term Structure of Credit Spreads," Journal of Finance, American Finance Association, vol. 51(3), pages 987-1019, July.
  21. Mella-Barral, Pierre, 1999. "The Dynamics of Default and Debt Reorganization," Review of Financial Studies, Society for Financial Studies, vol. 12(3), pages 535-78.
  22. McDonald, Robert L & Siegel, Daniel R, 1985. "Investment and the Valuation of Firms When There Is an Option to Shut Down," International Economic Review, Department of Economics, University of Pennsylvania and Osaka University Institute of Social and Economic Research Association, vol. 26(2), pages 331-49, June.
  23. Harris, Milton & Raviv, Artur, 1991. " The Theory of Capital Structure," Journal of Finance, American Finance Association, vol. 46(1), pages 297-355, March.
  24. Anderson, Ronald W & Sundaresan, Suresh, 1996. "Design and Valuation of Debt Contracts," Review of Financial Studies, Society for Financial Studies, vol. 9(1), pages 37-68.
  25. Myers, Stewart C., 1977. "Determinants of corporate borrowing," Journal of Financial Economics, Elsevier, vol. 5(2), pages 147-175, November.
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