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Building on the trade-off between agency costs and monitoring costs, we develop a dynamic theory of optimal capital structure with financial distress and reorganization. Costly monitoring eliminates the agency friction and thus the risk of inefficient liquidation. Our key assumption is that monitoring cannot be applied instantaneously. Rather, transitions between agency and monitoring are subject to search frictions. In the optimal contract, the firm seeks a monitoring opportunity whenever it is financially distressed, i.e., when the risk of liquidation is high. If a monitoring opportunity arrives in time, the manager is dismissed, the capital structure is reorganized as in Chapter 11 bankruptcy, and the search for a new manager begins. In agency, an optimal capital structure consists of equity, long-term debt, contingent long-term debt, and a credit line with performance pricing. In financial distress, coupon payments to contingent debt are suspended but the interest rate on the credit line is stepped-up, which gives the firm simultaneously debt relief and a steep incentive to improve its financial position. An episode of distress can end with financial recovery, transition to bankruptcy reorganization, or liquidation.

Contingent Debt and Performance Pricing in an Optimal Capital Structure Model with Financial Distress and Reorganization