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Capital structure, investment, and fire sales

Gale, Douglas and Gottardi, Piero (2014) Capital structure, investment, and fire sales. Systemic Risk Centre Discussion Papers (23). Systemic Risk Centre, The London School of Economics and Political Science, London, UK.

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We study a dynamic general equilibrium model in which firms choose their investment level and their capital structure, trading off the tax advantages of debt against the risk of costly default. The costs of bankruptcy are endogenously determined, as bankrupt firms are forced to liquidate their assets, resulting in a fire sale if the market is illiquid. When the corporate income tax rate is positive, firms have a unique optimal capital structure. In equilibrium firms default with positive probability and their assets are liquidated at fire-sale prices. The equilibrium not only features underinvestment but is also constrained inefficient. In particular there is too little debt and too little default.

Item Type: Monograph (Discussion Paper)
Official URL:
Additional Information: © 2014 The Authors
Divisions: Systemic Risk Centre
Subjects: H Social Sciences > HG Finance
JEL classification: D - Microeconomics > D5 - General Equilibrium and Disequilibrium
D - Microeconomics > D6 - Welfare Economics
G - Financial Economics > G3 - Corporate Finance and Governance > G32 - Financing Policy; Financial Risk and Risk Management; Capital and Ownership Structure
G - Financial Economics > G3 - Corporate Finance and Governance > G33 - Bankruptcy; Liquidation
Date Deposited: 16 Feb 2015 15:19
Last Modified: 24 Nov 2022 15:27
Projects: ES/K002309/1
Funders: Economic and Social Research Council

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