Capital structure and investment dynamics with fire sales

Douglas Gale () and Piero Gottardi

LSE Research Online Documents on Economics from London School of Economics and Political Science, LSE Library

Abstract: We study a general equilibrium model in which firms choose their capital structure optimally, trading off the tax advantages of debt against the risk of costly default. The costs of default are endogenous: bankrupt firms are forced to liquidate their assets, resulting in a fire sale if there is insufficient liquidity in the market. When the corporate income tax rate is zero, the optimal capital structure is indeterminate, there are no fire sales, and the equilibrium is Pareto efficient. When the tax rate is positive, the optimal capital structure is uniquely determined, default occurs with positive probability, firms’ assets are liquidated at fire-sale prices, and the equilibrium is constrained inefficient. More precisely, firms’ investment is too low and, although the capital structure is chosen optimally, in equilibrium too little debt is used. We also show that introducing more liquidity into the system can be counter-productive: although it reduces the severity of fire sales, it also reduces welfare.

Keywords: debt; equity; capital structure; default; market liquidity; constrained inefficient; incomplete markets (search for similar items in EconPapers)
JEL-codes: D50 D60 G32 G33 (search for similar items in EconPapers)
Pages: 41 pages
Date: 2013-11-22
New Economics Papers: this item is included in nep-cta and nep-dge
References: View references in EconPapers View complete reference list from CitEc
Citations: View citations in EconPapers (3)

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http://eprints.lse.ac.uk/59301/ Open access version. (application/pdf)

Related works:
Working Paper: Capital Structure and Investment Dynamics with Fire Sales (2013)
Working Paper: Capital Structure and Investment Dynamics with Fire Sales (2013)
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Persistent link: https://EconPapers.repec.org/RePEc:ehl:lserod:59301

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