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Equilibrium Defaultable Corporate Debt and Investment

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  • Hong Chen
  • Murray Zed Frank

Abstract

In dynamic capital structure models with an investor break-even condition, the firm's Bellman equation may not generate a contraction mapping, so the standard existence and uniqueness conditions do not apply. First, we provide an example showing the problem in a classical trade-off model. The firm can issue one-period defaultable debt, invest in capital and pay a dividend. If the firm cannot meet the required debt payment, it is liquidated. Second, we show how to use a dual to the original problem and a change of measure, such that existence and uniqueness can be proved. In the unique Markov-perfect equilibrium, firm decisions reflect state-dependent capital and debt targets. Our approach may be useful for other dynamic firm models that have an investor break-even condition.

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  • Hong Chen & Murray Zed Frank, 2022. "Equilibrium Defaultable Corporate Debt and Investment," Papers 2202.05885, arXiv.org.
    • Handle: RePEc:arx:papers:2202.05885
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    References listed on IDEAS

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