A Continuous-Time Analysis of Optimal Restructuring of Contracts with Costly Information Disclosure

Abstract

This paper studies the role of restructuring, as compared to the one of liquidation, in valuation of long-term debt contracts in a continuous-time model with costly information disclosure. In asset-pricing literature, Merton’s (J Finance 29:449–470, 1974) contingent-claim models have been long used for valuation of corporate securities and loans. However, since they basically assume sufficiently complete security structures in markets, the literature is not necessarily suitable for examining costly-information problems. On the other hand, in corporate-finance literature, it has been well known that agency costs (i.e., conflicts of interest among agents) distort corporate capital structure under costly-information problems. However, the effect of the distortion on valuation of securities and loans has not been explicitly studied either in theory or in practice. This paper bridges such a gap between the two literatures. This paper shows that, under a costly-information problem, corporate leverage ratios are higher when restructuring is expected to be accepted in default than otherwise. The risk of a jump to liquidation increases the default probability in short term, and decreases the probability of restructuring over time.