A Theory of Credit Ceilings in a Model of Debt and Renegotiation

In: Bulletin of economic research, Band 52, Heft 3, S. 235-256

Abstract

A model is considered in which an entrepreneur uses debt to finance a risky investment project. He may in certain circumstances credibly threaten default on the loan, which is then renegotiated. However, lenders will never lend so much that default is credibly threatened in all states. There exists a 'credit ceiling' which, if binding, implies underinvestment. The paper discusses the determinants of the credit ceiling and derives some comparative statics results. For example, it is shown that the credit ceiling is raised by a mean‐preserving spread of the firm's revenues. Also, a borrower may benefit from a reduction in his bargaining power.