This paper studies the design and valuation of debt contracts in a general dynamic setting under uncertainty. By incorporating some insight of the recent corporate finance literature into a valuation framework, we obtain a model which seems promising for the empirical study of pricing of risky debt claims and which gives insights into the question of why certain contractual provisions are selected in some situations but not in others. The basic framework is an extensive form game determined by the terms of a debt contract and applicable bankruptcy laws. Debtholders and equityholders behave non-cooperatively. The allocation of cashflows and the firm’s reorganization boundary are determined endogenously in the perfect equilibrium in this game. Under conditions of complete information we show how to value the claims of the firm in a general dynamic setting using known techniques. Given a method of valuation we are then able to address the question of the design of optimal multiperiod debt contracts under uncertainty. The possibility of strategic debt service in our model is shown to result insignificantly higher default premia (much closer to what we observe in real world) at even small liquidation costs. When our model is used to study the design of debt contracts, we observe that cash payout rates, leverage, and tax rates are all important determinants of the optimal contractual terms of a debt contract. Higher cash payout ratio and corporate taxes tend to imply (in general) higher coupons and more sinking fund provisions. In our model, deviations from absolute priority and forced liquidations occur along the equilibrium path.
