K.U.Leuven - Departement toegepaste economische wetenschappen
DTEW Research Report 0110 pages:1-65
We model the entrepreneurial firm's choice of debt finance, allowing for debt renegotiations in the event of financial distress. We differentiate two sources of debt finance, bank debt and trade credit, by the implicit equity stake that lenders hold in the borrowing firm. Lenders with a large implicit equity stake, such as suppliers, may adopt a more lenient liquidation policy for their debtors, but then set a higher price for their credit. Entrepreneurs, who have private information about their probability of financial distress, borrow exclusively from lenders with a small implicit equity stake, such as banks, only when the price advantage of bank debt outweighs the cost of a stricter enforcement of liquidation rights. Entrepreneurs who prefer the lenient liquidation policy adopted by suppliers contract only partial bank finance in order to avoid a potential default against the bank later on. We show that the fraction of debt that consists of bank loans depends upon the cash flow in the bad state, the value attributed to control rights and the initial wealth and risk aversion of the entrepreneur.