DESIGN AND VALUATION OF DEBT CONTRACTS

This article studies the design and valuation of debt contracts in a g eneral dynamic setting under uncertainty. We incorporate some insights of the recent corporate finance literature into a valuation framework . The basic framework is an extensive form game determined by the term s of a debt contract and applicable bankruptcy laws. Debtholders and e quityholders behave noncooperatively, The firm's reorganization bounda ry is determined endogenously. Strategic debt service results In signi ficantly higher default premia at even small liquidation costs. Deviat ions from absolute priority, and forced liquidations occur along the e quilibrium path. The design tends to stress higher coupons and sinking funds when firms have a higher cash payout ratio.