Optimal capital structure and bankruptcy cascades

We examine two firms' strategic choices of capital structure in the presence of negative bankruptcy spillovers. The low-profitability firm(denoted by firm L) that bankrupts earlier affects the high-profitability firm(denoted by firm H). Against negative bankruptcy spillovers, firm H takes either of the two contrasting responses: decreasing leverage to prepare for operations in the worse cash flow scenario after firm L's bankruptcy or in-creasing leverage to bankrupt simultaneously with firm L. Firm H takes the simultaneous bankruptcy strategy when the tax benefits of increased debt dominate the cash flows from operations after firm L's bankruptcy. With more negative bankruptcy spillovers, a smaller profitability difference, and lower volatility, firm H is more likely to choose the simultaneous bankruptcy strategy. The simultaneous bankruptcy equilibrium shows a novel mechanism of bankruptcy cascades through firms' strategic choices of capital structure with negative bankruptcy spillovers. This mechanism can potentially explain the empirical findings of bankruptcy contagion and herding behavior for corporate financial policies