Resolution of financial distress under agency frictions |
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Affiliation: | 1. University of Zurich, Department of Banking and Finance, Center for Finance and Insurance, Andreasstrasse 15, 8050 Zurich, Switzerland;2. Bank of England, Threadneedle Street, London, EC2R 8AH, United Kingdom;1. University of Bristol, United Kingdom;2. Bank of England, United Kingdom;1. Bank of England and CEPR, UK;2. Bank of England and Centre for Macroeconomics, UK;3. Bank of England, London, UK |
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Abstract: | We introduce, in a dynamic-contracting framework with moral hazard, the possibility of recapitalization as an alternative to liquidation when a firm is distressed. This is achieved by considering a risk-averse agent and by allowing (but not requiring) the latter to inject additional capital into the firm when necessary. We show that firm recapitalization may arise in an optimal, long-term contract. As a consequence, we find that there are two mechanisms at a firm’s disposal so as to deal with financial difficulties: one corresponds to a recapitalization process, the other to a liquidation one. The choice of mechanism is based on a cost-benefit analysis. |
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