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Capital structure and investment dynamics with fire sales

Gale, Douglas and Gottardi, Piero (2013) Capital structure and investment dynamics with fire sales. SRC Discussion Paper (No 7). Systemic Risk Centre, The London School of Economics and Political Science, London, UK.

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Abstract

We study a general equilibrium model in which firms choose their capital structure optimally, trading off the tax advantages of debt against the risk of costly default. The costs of default are endogenous: bankrupt firms are forced to liquidate their assets, resulting in a fire sale if there is insufficient liquidity in the market. When the corporate income tax rate is zero, the optimal capital structure is indeterminate, there are no fire sales, and the equilibrium is Pareto efficient. When the tax rate is positive, the optimal capital structure is uniquely determined, default occurs with positive probability, firms’ assets are liquidated at fire-sale prices, and the equilibrium is constrained inefficient. More precisely, firms’ investment is too low and, although the capital structure is chosen optimally, in equilibrium too little debt is used. We also show that introducing more liquidity into the system can be counter-productive: although it reduces the severity of fire sales, it also reduces welfare.

Item Type: Monograph (Discussion Paper)
Official URL: http://www.systemicrisk.ac.uk/
Additional Information: © 2014 Systemic Risk Centre, The London School of Economics and Political Science
Divisions: Systemic Risk Centre
Subjects: H Social Sciences > HG Finance
Sets: Research centres and groups > Systemic Risk Centre
Date Deposited: 29 Aug 2014 11:56
Last Modified: 08 Oct 2019 23:26
Projects: ES/K002309/1
Funders: Economic and Social Research Council
URI: http://eprints.lse.ac.uk/id/eprint/59301

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