Strategic Debt Restructuring and Asset Substitution

Abstract

This paper examines whether debt renegotiation mitigates the agency costs of asset substitution. Inspired by the studies of Mella-Barral and Perraudin (1997) and Leland (1998), we have developed an analytical continuous time model of a firm that has the option to switch to a higher risk activity and renegotiate the terms of the debt. Our model creates a trade-off between increasing firm volatility and decreasing growth rate which characterizes the potential for asset substitution. Our findings indicate that, in most cases, debt renegotiation substantially reduces agency costs of asset substitution, whereas non-renegotiable debt is optimal when equity holders have a weak bargaining position and the opportunity cost of their risk-taking incentives is high. Several testable empirical implications regarding the design of debt contracts are developed.