Design and Valuation of Debt Contracts

Ronald W Anderson and Suresh Sandaresan

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: This paper studies the design and valuation of debt contracts in a general dynamic setting under uncertainty. By incorporating some insights of the recent corporate finance literature into a valuation framework, we obtain a model which seems promising for the empirical study of pricing of risky debt claims, and which gives insights into the question of why certain contractual provisions are selected in some situations but not in others. The basic framework is an extensive form game determined by the terms of a debt contract and applicable bankruptcy laws. Debtholders and equityholders behave non-cooperatively. The allocation of cashflows and the firm's reorganization boundary are determined endogenously in the perfect equilibrium in this game. Under conditions of complete information we show how to value the claims of the firm in a general dynamic setting using known techniques. Given a method of valuation we are then able to address the question of the design of optimal multi- period debt contracts under uncertainty. The possibility of strategic debt service in our model is shown to result in significantly higher default premia (much closer to what we observe in the real world) at even small liquidation costs. When our model is used to study the design of debt contracts, we observe that cash pay-out rates, leverage, and tax rates are all important determinants of the optimal contractual terms of a debt contract. Higher cash pay-out ratios and corporate taxes tend to

Keywords: Security Design; Contingent Claims; Financial Distress (search for similar items in EconPapers)
Date: 1994-04
References: Add references at CitEc
Citations:

There are no downloads for this item, see the EconPapers FAQ for hints about obtaining it.

Related works:
This item may be available elsewhere in EconPapers: Search for items with the same title.

Export reference: BibTeX RIS (EndNote, ProCite, RefMan) HTML/Text

Persistent link: https://EconPapers.repec.org/RePEc:cpr:ceprfm:0048

Ordering information: This working paper can be ordered from

The price is 4.00 pounds or 8.00 dollars per paper.

Access Statistics for this paper

More papers in 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.
Bibliographic data for series maintained by ().