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Bankruptcy and firm finance

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Abstract

This paper analyzes how an enforcement mechanism that resembles a court affects firm finance. The court is described by two parameters that correspond to enforcement costs and the amount of creditor/debtor protection. We provide a theoretical and quantitative characterization of the effect of these enforcement parameters on the contract loan rate, the default probability and welfare. We analyze agents’ incentive to default and pursue bankruptcy and show that when the constraints that govern these decisions bind, the enforcement parameters can have a sharply non-linear effect on finance. We also compute the welfare losses of “poor institutions” and show that they are non-trivial. The results provide guidance on when models which abstract from enforcement provide good approximations and when they do not.

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Authors and Affiliations

  1. Department of Economics, University of Illinois, 1206 S. 6th Street, Champaign, IL, 61820, USA

    Stefan Krasa & Anne P. Villamil

  2. Centro de Investigación Económica, ITAM, Ave. Camino Santa Teresa #930, Mexico D.F, 10700, Mexico

    Tridib Sharma

Authors
  1. Stefan Krasa
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  2. Tridib Sharma
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  3. Anne P. Villamil
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Correspondence to Anne P. Villamil.

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Krasa, S., Sharma, T. & Villamil, A.P. Bankruptcy and firm finance. Economic Theory 36, 239–266 (2008). https://doi.org/10.1007/s00199-007-0267-y

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  • DOI: https://doi.org/10.1007/s00199-007-0267-y

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