Underinvestment, Capital Structure and Strategic Debt Restructuring∗

In this paper the investment and liquidation policy of a levered firm is analyzed. The possibility of renegotiating the original debt contract is included. It is shown that the shareholders’ option to restructure the outstanding debt exacerbates Myers’ (1977) underinvestment problem. This result is due to a higher wealth transfer from the shareholders to the creditors occurring upon investment when the option to renegotiate is present. The problem can be eliminated only when all the bargaining power is given to the creditors. In such a case, the renegotiation commences at the shareholders’ bankruptcy trigger and no additional wealth transfer occurs. Moreover, it is shown the liquidation policy under partial debt financing differs from the optimal policy when the firm is all-equity financed. Even after removing the effects of the tax shield by excluding taxes, it holds that the liquidation policy is affected by the second-best investment policy, thus it occurs inefficiently early. Finally, it is shown that the presence of a positive NPV investment opportunity increases the likelihood of a strategic default when the bargaining power of shareholders is high.