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Rev Fin 1999; 12:535-578
© 1999 the Society for Financial Studies

Article

The dynamics of default and debt reorganization

P Mella-Barral
London School of Economics, Houghton Street, London WC2A 2AE, UK
e-mail: pmella@lse.ac.uk

Abstract

This article documents the fact that when debtors decide to default on their obligations too early, it is in the creditors' collective interest, as residual claimants, to make concessions prior to forcing a costly liquidation. Symmetrically, when debtors prefer to default at an inefficiently late stage, it is in the creditors' interest to propose a departure from the absolute priority rule. This article develops a continuous time pricing model of dynamic debt restructuring that reflects the crucial influence of the two counterparties' relative bargaining power. Simple and intuitive path-dependent pricing formulae are derived for equity and debt. The debt capacity as well as the evolution of the firm's capital structure throughout its existence is provided.


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