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Pierre Mella-Barral
Edhec Business School
mella@edhec.edu
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Overview
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Notice:
Does not assume asymmetric information.
Trading occurs continuously in perfect and frictionless markets.
Management acts in debtors interest.
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Model
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Model
I
Assumption
1. At entry, (x0 ) > (x0 ) (otherwise already in liquidation).
2. The functions (x) and (x) have a single crossing point,
3. the corresponding state, x , is smaller than x0 .
Ph.D. in Finance Corporate Finance (Part 1)
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Model
A representation of the set-up is as follows:
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(x)
Z
(xs ) e s ds | x = x .
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Debt contract:
C ( ; C (x) )
Pre-liquidation
cash flows
Ph.D. in Finance Corporate Finance (Part 1)
Post-liquidation
cash flows
Topic 7 Dynamic Debt Renegotiation
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D(xt | ) = (xt )
+ (x D ) C (x D ) (x D ) +
C (x D )
P(xt x D )
where
Z
P(xt x D ) =
t
I
e (Tx D t) ft (Tx D )d Tx D .
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whereas
Debtors ex-post optimal (second-best) default trigger level,
x D , consists of balancing
a pre-default rent, (x) , against
an alternative post-default rent, (x) C (x).
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Consequently,
such that
There exists a unique level of debt service obligations, ,
x equals x D .
This, for any given liquidation sharing rule, C (x), such as the
APR. Hence with the APR, there exists a unique level of
borrowings for which debtors optimal decision is not ill-timed.
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I
I
Renegotiation is pareto-optimal.
There are two dimensions to it:
1. Leverage (as we have just see);
2. Bargaining power (who internalizes the surplus to be gained in
reorganizations).
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[ D(xt | ) + C (xt | ) ]
First Best
Second Best
(with x )
(with x D )
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Debt Renegotiation
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inf {x }.
0t
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C (xt , xt ) ,
(xt ) C
D (xt , xt ) .
(xt ) C
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Readings
Mella-Barral, P., and W.R.M. Perraudin, 1997, Strategic Debt
Service, Journal of Finance 52, 531-556.
Mella-Barral, P., (1999) The Dynamics of Default and Debt
Reorganization, Review of Financial Studies, Vol. 12, No. 3,
pp 535-578.
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