Capital Structure and Investment Dynamics with Fire Sales

The financial crisis of 2007-2008 and the current sovereign debt crisis in Europe have focused attention on the macroeconomic consequences of debt financing. In this paper, we turn our attention to the use of debt finance in the corporate sector and study the generalequilibrium effects of debt finance on investment and growth. More precisely, we analyze underinvestment in equilibrium when markets are incomplete and firms use debt and equity to finance investment. At the heart of our analysis is the determination of firms’ capital structure. In the classical world of Modigliani and Miller (1958), capital structure is indeterminate. To obtain a determinate capital structure, subsequent authors appealed to frictions such as distortionary taxes, bankruptcy costs, and agency costs.1 We follow this tradition and assume the optimal capital structure balances the tax advantages of debt against the risk of costly bankruptcy. Debt has a tax advantage because it is not subject to the corporate income tax. Bankruptcy is perceived as costly because it forces the firm to sell assets at firesale prices. In equilibrium, the firm will balance the perceived costs of debt and equity in choosing the equilibrium capital structure. In our model, neither the corporate income tax nor the risk of bankruptcy represents a real burden on the representative consumer. The corporate tax revenue is returned to consumers in the form of lump sum transfers, so it has no direct effect on investors’ wealth or income. Similarly, bankruptcy results in a fire sale of assets, but this is a transfer of value from creditors to the asset buyers that has no effect on the wealth or income of the representative investor. Nonetheless, a rational, value-maximizing manager of a competitive firm will perceive the tax as a cost of using equity finance and the risk of a fire sale in