Financial Markets Group

Abstract. This article values equity and corporate debt by taking into account the fact that in practice the default point differs from the liquidation point and that it might be in the creditors ’ interest to delay liquidation. The article develops a continuous time asset pricing model of debt restructuring which explicitly considers the inalienability of human capital. The study finds that even though in general the creditors will not liquidate the firm on the incidence of default, but nevertheless would liquidate the firm prematurely relative to the first best threshold. This agency problem leads to the breakdown of the capital structure irrelevance result. 1. Theoretical Foundation The literature on the pricing of defaultable bonds started with Merton (1974) who applied the contingent claims valuation insight of Black and Scholes (1973) to the pricing of corporate bonds. He obtained closed form valuation expressions for (zero-coupon) risky bonds, by taking the lower reorganization boundary as given. Thus in his model, default occurred at maturity if the value of the firm was less than the payment promised to the bondholders. Furthermore, at maturity the compensation received by the creditors is fixe