This article examines the conflict of interest between shareholders and bondholders in a setting in which firms can renegotiate the terms of existing debt with public debtholders. In particular, we consider one of the most common types of debt restructuring: the exit‐exchange offer. Our analysis explores the relation between exit‐exchange offers and investment choice by the manager, and it concludes that managers, acting strategically on behalf of shareholders, may select inefficient investment projects in order to enhance their bargaining position vis‐a‐vis creditors. Holding the upside potential of an investment project fixed, managers/shareholders prefer projects with lower payoffs in states of bankruptcy because it induces individual bondholders to accept poorer terms in a debt‐for‐debt exit‐exchange offer, thus generating a greater residual for shareholders in states of solvency. Additionally, we show how the investment inefficiencies in our analysis depend on (i) the inability of bondholders to coordinate their actions; (ii) the ability of managers to commit to suboptimal investment projects; and (iii) the coupling of an individual bondholder's decision to tender and her decision to consent to allow the firm to strip fiduciary covenants. We suggest conditions under which a ban on coupled exit‐exchange offers—or alternatively, constraints on “debt‐for‐debt” exchanges—would be efficiency‐enhancing.

In our model, financial firms’ leverage choices and asset sales impose negative externalities on other financial firms. This means that individual firms cannot determine their optimal capitalizations in isolation, but have to take the aggregate financial sector characteristics into account. In particular, they become more aggressive when their peers are more conservative. Furthermore, financial firms over-consume liquidity in equilibrium. For some parameter regions, small parameter changes can induce large differences in the equilibrium allocation of risk. Historical experience is not necessarily a good guide as to whether the prevailing equilibrium is fragile or not.

We develop an approach to asset pricing in incomplete markets that bridges the gap between the two fundamental approaches in finance: model‐based pricing and pricing by no arbitrage. We strengthen the absence of arbtrage assumption by precluding investment opportunities whose attractiveness to a benchmark investor exceeds a specified threshold. In our framework, the attractiveness of an investment opportunity is measured by the gain‐loss ratio. We show that a restriction on the maximum gain‐loss ratio is equivalent to a restriction on the ratio of the maximum to minimum values of the pricing kernel. By limiting the maximum gainloss ratio, we can restrict the admissible set of pricing kernels, which in turn allows us to restrict the set of prices that can be assigned to assets. We illustrate our methodology by computing price bounds for call options in a Black‐Scholes economy without intermediate trading. When we vary the maximum permitted gainloss ratio, these bounds can range from the exact prices implied by a model‐based pricing approach to the loose price bounds implied by the no‐arbitrage approach.

Firms with lower leverage are not only less likely to experience financial distress but are also better positioned to acquire assets from other distressed firms. With endogenous asset sales and values, each firm’s debt choice then depends on the choices of its industry peers. With indivisible assets, otherwise-identical firms may adopt different debt policies, with some choosing highly levered operations (to take advantage of ongoing debt benefits) and others choosing more conservative policies to wait for acquisition opportunities. Our key empirical implication is that the acquisition channel can induce firms to reduce debt when assets become more redeployable.

We develop a model of a two-division firm in which the “strong” division has, on average, higher quality investment opportunities than the “weak” division. We show that, in the presence of agency and information problems, optimal effort incentives are less powerful and thus managerial effort is lower in the strong division. This leads the firm to bias its project selection policy against the strong division. The selection bias is more severe when there is a larger spread in the average quality of investment opportunities between the two divisions.

This paper explains why some firms prefer to pay dividends rather than repurchase shares. When institutional investors are relatively less taxed than individual investors, dividends induce “ownership clientele” effects. Firms paying dividends attract relatively more institutions, which have a relative advantage in detecting high firm quality and in ensuring firms are well managed. The theory is consistent with some documented regularities, specifically both the presence and stickiness of dividends, and offers novel empirical implications, e.g., a prediction that it is the tax difference between institutions and retail investors that determines dividend payments, not the absolute tax payments.