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Asset Substitution and Debt Renegotiation


  • Christian Riis Flor

    Corresponding author
    1. The author is from the University of Southern Denmark. He appreciates comments from seminar participants at the University of Kaiserslautern, the University of Southern Denmark, the Symposium on Dynamic Corporate Finance and Incentives (2003), the Third World Congress of the Bachelier Finance Society (2004), the Portuguese Finance Network’s 4th Finance Conference (2006, received Best Paper Award), and the 13th Annual Meeting of the German Finance Association (2006). In particular he thanks Peter Ove Christensen, Ulrich Hege, Stefan Hirth, Holger Kraft, Jochen Lawrenz, Nikolaj Malchow-Møller, Kristian R. Miltersen, Claus Munk, Bernt Øksendal, Andrew W. Stark (editor), and an anonymous referee for helpful comments. Financial support from the Danish Research Council for Social Sciences by a grant to D-CAF is gratefully acknowledged.
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Christian Riis Flor, Department of Business and Economics, University of Southern Denmark, Campusvej 55, DK–5230 Odense M, Denmark.


Abstract:  In a dynamic capital structure model we study whether asset substitution implies agency costs when the firm initially takes the substitution option into account. Asset substitution affects earnings in two directions: volatility increases and growth rate decreases. We show that substitution implies agency costs if volatility increases enough. In this case, debt renegotiation to avoid substitution mitigates the ex ante costs. However, debt renegotiation decreases the equity holders’ ex post costs. Thus, with a modest volatility increase, debt renegotiation allows equity holders to extract concessions from creditors albeit asset substitution was not chosen for non-renegotiable debt. Hence, debt renegotiation need not improve ex ante firm value if asset substitution is allowed for.