The valuation of debt and equity, reorganization boundaries, and firm's optimal dividend policies are studied in a framework where we model strategic interactions between debt holders and equity holders in a game-theoretic setting which can accommodate varying bargaining powers to the two claimants. Two formulations of reorganization are presented: debt-equity swaps and strategic debt service resulting from negotiated debt service reductions. We study the effects of bond covenants on payout policies and distinguish liquidity-induced defaults from strategic defaults. We derive optimal equity issuance and payout policies. The debt capacity of the firm and the optimal capital structure are characterized.

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In this article we construct a model in which a consumer's utility depends on the consumption history We describe a general equilibrium framework similar to Cox, Ingersoll, and Ross (1985a). A simple example is then solved in closedform in this general equilibrium setting to rationalize the observed stickiness of the consumption series relative to the fluctuations in stock market wealth. The sample paths of consumption generated from this model imply lower variability in consumption growth rates compared to those generated by models with separable utilizations. We then present a partial equilibrium model similar to Merton (1969Merton ( , 1971) and extend Merton's results on optimal consumption and portfolio rules to accommodate nonseparability in preferences. Asset pricing implications of our framework are briefly explored.The idea that a given bundle of consumption goods will provide the same level of satisfaction at any date regardless of one's past consumption experience is implicit in models that use time-separable utility functions to represent preferences. Separable utility functions have been the mainstay in much of the literature on asset pricing and optimal consumption and portfolioThe results reported in this article were first presented at the EFA meetings in Bern, Switzerland, in 1985 [see Sundaresan (1984]. Subsequently the article was presented at a number of universities and conferences. I thank the participants at those presentations for their feedback. I am especially thankful to Doug Breeden, Michael Brennan, John Cox, Chi-fu Huang, and Krishna Ramaswamy for their thoughtful comments and criticisms. I also thank Tong-sheng Sun for explaining the simulation procedure for stochastic differential equations and for his comments and suggestions. I am responsible for any remaining errors.

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