Journal Article

Capital Structure, Investment, and Fire Sales

Douglas Gale and Piero Gottardi

in The Review of Financial Studies

Published on behalf of Society for Financial Studies

Volume 28, issue 9, pages 2502-2533
Published in print September 2015 | ISSN: 0893-9454
Published online February 2015 | e-ISSN: 1465-7368 | DOI: https://dx.doi.org/10.1093/rfs/hhv016
Capital Structure, Investment, and Fire Sales

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  • Welfare Economics
  • Bankruptcy
  • General Equilibrium and Disequilibrium
  • Corporate Governance

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We study a dynamic general equilibrium model in which firms choose their investment level and capital structure, trading off the tax advantages of debt against the risk of costly default. Bankruptcy costs are endogenous, 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 features underinvestment and is constrained inefficient. In particular there is too little debt and default.

Keywords: D5; D6; G32; G33

Journal Article.  12737 words. 

Subjects: Welfare Economics ; Bankruptcy ; General Equilibrium and Disequilibrium ; Corporate Governance

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