Capital structure, investment, and fire sales

Douglas Gale (douglas.gale@nyu.edu) and Piero Gottardi

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

Abstract: We study a dynamic general equilibrium model in which firms choose their investment level and their capital structure, trading off the tax advantages of debt against the risk of costly default. The costs of bankruptcy are endogenously determined, as bankrupt firms are forced to liquidate their assets, resulting in a fire sale if the market is illiquid. When the corporate income tax rate is positive, firms have a unique optimal capital structure. In equilibrium firms default with positive probability and their assets are liquidated at fire-sale prices. The equilibrium not only features underinvestment but is also constrained inefficient. In particular there is too little debt and too little default.

Keywords: Debt; equity; capital structure; default; market liquidity; constrained inefficiency; incomplete markets (search for similar items in EconPapers)
JEL-codes: D5 D6 G32 G33 (search for similar items in EconPapers)
Pages: 83 pages
Date: 2014-11-04
New Economics Papers: this item is included in nep-dge
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Citations: View citations in EconPapers (1)

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Related works:
Journal Article: Capital Structure, Investment, and Fire Sales (2015)
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Persistent link: https://EconPapers.repec.org/RePEc:ehl:lserod:60958

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