Strategic Debt Service

Pierre Mella-Barral and William Perraudin

CEPR Financial Markets Paper from European Science Foundation Network in Financial Markets, c/o C.E.P.R, 33 Great Sutton Street, London EC1V 0DX.

Abstract: When a firm is close to bankrupcy, equity-holders may `blackmail' owners of bonds by paying less than the originally-contracted coupon payments. This paper develops simple, closed-form expressions for bond and equity values when such blackmail effects are present. Furthermore, we show that blackmail is optimal in the following sense. Without blackmail, leverage generates agency costs because value-maximizing equity-holders liquidate firms at output price levels other than the ex-ante optimum. However, if equity-holders can extract surplus from bond-holders through blackmail, they will actually choose to liquidate the firm at the ex ante optimal shut-down point.

Keywords: Debt Service; Corporate Bonds; Agency Costs (search for similar items in EconPapers)
Date: 1993-10
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Journal Article: Strategic Debt Service (1997)
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