The Impact of Bankruptcy Rules on Risky Project Choice and Skill Formation Under Credit Rationing

Abstract

The contribution of this paper is in emphasizing endogenous credit rationing in the analysis of effects of bankruptcy rules on entrepeneurs’ decisions with respect to risk-taking and ex ante skill-development. Unlike most of the literature, both the debt claim and the amount of debt financing is endogenous in our exercise. This allows us to determine the extent of credit rationing that banks use to tackle informational asymmetry. Credit rationing is non-trivial and increases the cost of capital when corporations are forced to access alternative sources of funding even when debt is a cheaper alternative. We thus solve for optimal debt-equity ratios in the capital structure of the corporation and entrepeneurs’ risk-taking. Second, we allow entrepeneurs to invest in generating skill to handle risky projects. We show that bankruptcy policies are important determinants of all these outcomes in ways that in some cases contradict the existing literature, which does not consider endogenous credit rationing.