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Valuing Debt in a Complex Capital Structure |
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| Authors: | Timothy J Riddiough Howard E Thompson |
| Institution: | (1) Department of Urban Studies and Planning, Center for Real Estate, Massachusetts Institute of Technology, 02139 Cambridge, MA, USA;(2) Department of Finance, School of Business, University of Wisconsin-Madison, 53706 Madison, WI, USA |
| Abstract: | This article extends previous bond valuation models to account for more realistic assumptions regarding financial distress. Realized value of an individual bond under severe financial distress will reflect the expected outcome of credit-event negotiations and the relative priority listing of the security. We explicitly represent the probability rate of credit-event occurrence as a function of firm value relative to the fixed overall debt obligations of the firm. Risk premiums generated under reasonable parameter value choices fall within the range of observed bond risk premiums. Our model also provides an explanation as to why observed bond risk premia are positive after adjustment for default. |
| Keywords: | financial distress debt valuation contingent-claims pricing |
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