Endogenous Bankruptcy and Capital Structure

Abstract

In the simple setting considered in Chap. 2, the lender provided funding to the borrower in order to finance investment in a project which had a finite, known maturity of T. Accordingly, the contract between lender and borrower specified a single payment from the borrower to the lender at time T, with bankruptcy occurring when the borrower was unable to meet his contractual payment obligation. Although such an analysis is valuable for an understanding of project financing, it is much less accurate to understand firm financing. Indeed, in practice, most firms are not liquidated as their debt matures. Rather, they issue new debt and keep operating as long as they can meet their contractual payment obligations. Bankruptcy usually takes place whenever firms default on promised payments on their debt. At any point in time, equity holders can decide whether they want the firm to make the promised payments or default and trigger bankruptcy. Thus, bankruptcy is a decision made endogenously by equity holders.