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Abstract

When firms experience financial distress, equity holders may act strategically, forcing concessions from debtholders and paying less than the originally contracted interest payments. This article incorporates strategic debt service in a standard, continuous time asset pricing model, developing simple closed-form expressions for debt and equity values. The authors find that strategic debt service can account for a substantial proportion of the premium on risky corporate debt. They analyze the efficiency implications of strategic debt service, showing that it can eliminate both direct bankruptcy costs and agency costs of debt. Copyright 1997 by American Finance Association.
... Specifically, following Fan and Sundaresan (2000) and Davydenko and Strebulaev (2007), we assume that equityholders can renegotiate the contract terms with creditors through a debt-equity swap. For robustness, we also consider another renegotiation scheme known as strategic debt service examined in Mella- Barral and Perraudin (1997) and show the main results of this paper still hold. As commonly shown in the above papers, when equityholders have the renegotiation option, the value of debt generally cannot exceed the potential liquidation value of the firm, especially when equityholders have a large bargaining power. ...
... In the literature on debt renegotiation, researchers mainly focus on the effectiveness of debt renegotiation in alleviating the debt-overhang problem; see Mella-Barral and Perraudin (1997), Fan and Sundaresan (2000), Davydenko and Strebulaev (2007), and Wong and Yu (2021). Those papers commonly show that the renegotiation channel can alleviate the debt-overhang problem. ...
... For simplicity, we first consider a debt-equity swap as the renegotiation scheme as in Fan and Sundaresan (2000) and Davydenko and Strebulaev (2007). In Section 5, we also consider another renegotiation scheme such as strategic debt service examined by Mella- Barral and Perraudin (1997) and Fan and Sundaresan (2000) as well. Specifically, at any point in time, the firm's equityholders can offer a debt-equity swap to creditors. ...
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... willingness to pay a higher rate for loans relative to bonds is different from the present value of loan cash flows (e.g., see the economic framework in Section I). Borrowers buy the implicit commitment to renegotiate loans, and the higher price the borrower pays may simply be the fair financial cost for banks to provide that commitment, as renegotiations typically involve favorable concessions to borrowers (Boot, Greenbaum, and Thakor (1993), Chemmanur and Fulghieri (1994), Mella-Barral and Perraudin (1997), Sufi (2009), Eckbo, Su, andThorburn (2022)). My replicating cash flow methodology explicitly selects market benchmarks to resemble the risk profile of frequently renegotiated loan cash flows to measure the value to the bank net of any financial concessions to the borrower. ...
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