One of the consequences of debt financing is its influence on the firm’s investment policy. As it is known from Myers (1977), the presence of debt in the company’s books leads to underinvestment, i.e. a situation in which some positive NPV projects are foregone. Although the impact of the agency costs of debt on the firm’s investment policy has been widely discussed in the literature in qualitative terms, relatively little has been done to analyze the magnitude of these costs. Moreover, the existing contributions yield differing predictions concerning the influence of the renegotiability of debt on the investment policy (cf. Mella-Barral and Perraudin, 1997, and Mauer and Ott, 1999). This paper uses the contingent claims approach to examine the firm’s optimal investment and liquidation policy in the presence of debt financing and the equityholders’ option to default and renegotiate the original debt contract.
The main objective of the paper is to investigate the impact of the renegotiation option, the distribution of bargaining power, and indirect bankruptcy costs on the optimal investment and liquidation policy of the firm. In particular, we are interested in the impact of those debt characteristics on the magnitude of underinvestment problem. Furthermore, the impact of a growth opportunity on the optimal bankruptcy and renegotiation timing is analyzed. In this way it can be investigated whether firms operating in sectors with significant growth opportunities are less likely to file for debt restructuring than their counterparts in more mature industries.
The motivation for this paper arises also from the ongoing debate on the differences in bankruptcy codes between the European Union (EU) and the United States, and the implications of the EU countries bankruptcy law for the firms’ operating decisions .1 Under Chapter 11 of the US bankruptcy law, financially distressed firms suspend their coupon payments and a reorganization plan including writing new debt contracts is implemented. The operations of a firm entering Chapter 11 reorganization usually remain unaffected by the negotiations process, which makes it relatively easy to remain in business if the financial restructuring is successful. In Europe, however, a distressed firm most likely goes under court administration, and its operations are suspended. As a result, the reputation of the firm deteriorates and there is a high chance that liquidation occurs.
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Underinvestment, Capital Structure and Strategic Debt Restructuring
