Optimal capital structure and simultaneous bankruptcy of firms in corporate networks

We examine two firms’ strategic choices of capital structure in the presence of negative bankruptcy spillovers. The low-profitability firm (denoted by firm L) that bankrupts earlier affects the high-profitability firm (denoted by firm H). Against negative bankruptcy spillovers, firm H takes either of the two contrasting responses: decreasing leverage to prepare for operations after firm L’s bankruptcy or increasing leverage to bankrupt simultaneously with firm L. Firm H prefers simultaneous bankruptcy when the tax benefits of increased debt dominate the cash flows from operations after firm L’s bankruptcy. With more negative bankruptcy spillovers, a smaller profitability difference, and lower volatility, firm H is more likely to choose simultaneous bankruptcy. The simultaneous bankruptcy equilibrium shows a novel mechanism in which firms’ strategic capital structure choices cause simultaneous bankruptcy of firms in corporate networks. This mechanism can explain empirical findings of chains of bankruptcies and herding behavior for corporate financial policies in corporate networks.