DP2504 | Excessive continuation and Dynamic Agency Costs of Debt

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This paper analyses the incentives of the equityholders of a leveraged company to shut it down in a continuous time, stochastic environment. Keeping the firm as an ongoing concern has an option value but equity and debt holders value it differently. Equity holders' decisions exhibit excessive continuation and reduce the firm's value. Using a compound exchange option approach, we characterize the resulting agency costs of debt, derive the ?price? of these costs and analyse their dynamics. We also show how agency costs can be reduced by the design of debt and the possibility of renegotiation.