Abstract:
Weaker creditor rights can increase credit costs and thus prompt firms to reduce debt and investment. Yet, they can reduce distress costs and thus allow firms to increase leverage and eliminate risk-reducing but unprofitable investments. We hypothesize that firm size influences the effect of creditor rights on credit costs and distress costs and thus which effect dominates. Weaker creditor rights should have a negative effect for small firms but a positive effect for large firms. Using a German bankruptcy reform, we find support for our hypothesis. Our findings reconcile mixed evidence and have important implications for optimal bankruptcy design.
