A Model of Optimal Corporate Bailouts - Faculty of Business and ...

Consequently, when the optimal bailout calls for intervention, the government always firesthe incumbent upon a restart, and the firm’s initial investment decision is⎧⎨ρ ∗ = IN if Π| F G=FIRE= ( R−T 1) 2− I4·c 1 ≥ 0 ,.1 ⎩OUT otherwise .A comparison of the firm’s total profits with and without government intervention yieldsthe following lemma:Lemma 3 If π ∗ 2 ( 0, 0 ) = R 2 /(4·c) − I 2 < 0, government intervention makes the firm and theincumbent manager worse off. The losses to the firm and the manager are increasing in T 1 .Without government intervention, the firm’s continuation value is zero in the reinvestmentstage if π ∗ 2 ( 0, 0 ) = R 2 /(4·c) − I 2 < 0, because the firm will choose not to reinvest. Withgovernment intervention, the firm reinvests after receiving a bailout g ∗ = I 2 − R 2 /(4·c), butits continuation value is still zero (see Theorem 1). However, the firm is worse off, becausethe government finances the bailout with taxes T 1 in the initial stage, reducing the firm’s totalprofits. (In response, the firm pays the manager a lower wage, making her worse off as well).Hence, another cost of government intervention is that it increases the tax burden on successfulfirms (and managers) without an accompanying benefit in the event of a bailout, therebydampening the incentive for the firm to invest in the initial stage.3 The Optimal Bailout (Period 0)We can now state our main result. The optimal government bailout policy, with respect to theprogram in (3), is:Theorem 2 If and only if1.R 24·c − I 2 < 0;2. I 2 ≤ 4·c − R + R24·c − 16·c 2 − 8·c·R ,⎡3. I 1 ≤4. S ≥ S ,⎢⎣R + I 2 − R24·c + R + I 2 − R24·c 2+ 8·c·R24·c − I 2 ⎤ ⎥ ⎦ 2 (16·c) , and19