This paper shows that shareholders' option to renegotiate debt in a period of financial distress exacerbates Myers' (1977) underinvestment problem at the time of the firm's expansion. This result is a consequence of a higher wealth transfer from shareholders to creditors occurring upon investment in the presence of the option to renegotiate. This additional underinvestment is eliminated by granting creditors the entire bargaining power. In such a case, renegotiation commences at shareholders' bankruptcy trigger so no additional wealth transfer occurs. In addition to deriving the firm's policies, we provide results on the values of corporate claims, the agency cost of debt, and the optimal capital structure. Empirically, we predict, among others, a lower sensitivity of capital investment to shocks to Tobin's q and cash flow for firms financed with renegotiable debt, and a negative effect of debt renegotiability on the relationship between growth opportunities and systematic risk as well as leverage.
NOTICE: this is the author’s version of a work that was accepted for publication in Journal of Corporate Finance . Changes resulting from the publishing process, such as peer review, editing, corrections, structural formatting, and other quality control mechanisms may not be reflected in this document. Changes may have been made to this work since it was submitted for publication. A definitive version was subsequently published in Journal of Corporate Finance, [16, 5, (2010)] DOI 10.1016/j.jcorpfin.2010.06.010