Optimal Debt and Equity Values in the Presence of Chapter 7 and Chapter 11

Abstract

Explicit presence of reorganization in addition to liquidation leads to conf licts of interest between borrowers and lenders. In the first-best outcome, reorganization adds value to both parties via higher debt capacity, lower credit spreads, and improved overall firm value. If control of the ex ante reorganization timing and the ex post decision to liquidate is given to borrowers, most of the benefits are appropriated by borrowers ex post. Lenders can restore the first-best outcome by seizing this control or by the ex post transfer of control rights. Reorganization is more likely and liquidation is less likely relative to the benchmark case with liquidation only. THE U.S. BANKRUPTCY CODE, which includes a liquidation process (Chapter 7) and a reorganization process (Chapter 11), aims to resolve a number of important issues associated with a distressed firm. These issues can be classified into information asymmetry problems (e.g., quality of the firm, Heinkel and Zechner (1993)), agency problems (e.g., risk shifting, Jensen and Meckling (1976)), or coordination problems (e.g., debt of various maturities, Berglof and von Thadden (1994)). In this paper, we investigate whether there is a place for a reorganization process in the presence of costly financial distress and liquidation. These costs capture, in reduced form, the aforementioned frictions. We wish to characterize the states of a borrowing firm relative to its outstanding contractual debt obligations at different stages of financial distress assuming full information and a single issue of debt. We also seek to determine the role played by the bankruptcy code in improving the welfare of borrowers and lenders, and how its inf luence depends on the rights given to borrowers and lenders at various stages of financial distress.More precisely, we build on structural models of debt (Merton (1974), Black andCox (1976)), which allows us to determine overall firm value along with the values of equity and debt. In line with this literature, we assume that liquidation destroys part of the firm's value. We then ask the basic and yet important * Broadie and Sundaresan are from Columbia Business School. Chernov is from Columbia Business School and London Business School. We would like to thank seminar participants at Columbia, for their comments. We thank an anonymous referee for numerous comments that have significantly improved the paper. We are grateful toÖzgür Kaya for exceptional research assistance.

Asset Substitution and Debt Renegotiation

“…In particular, asset substitution does not affect the expected risk neutral growth rate of earnings. This implies that the equity holders have no direct ex post costs of implementing asset substitution and, of course, they therefore want to substitute assets to get high volatility immediately 2 Dynamic issues related to default have also been studied with a different focus than in the present paper, e.g., credit risk (e.g., Dangl and Zechner, 2004), target leverage (e.g., Ozkan, 2001;and Strebulaev, 2007), or bankruptcy law effects (e.g., Broadie et al, 2007;and Galai et al, 2007). 3 The effect of an expansion or substitution option is studied in Childs et al (2005).…”

Assessing the real value of the firm: an overview

“…Reorganization is more likely and liquidation is less likely relative to the benchmark case with liquidation only (Broadie et al, 2007). Reorganization adds value to both parties via higher debt capacity, lower credit spreads, and improved overall fi rm value.…”

Corporate Debt, Hybrid Securities, and the Effective Tax Rate

“…This implies that the ratio between the coupon C and the mark-to-market value of debt is equal to the effective interest rate (i.e., the risk-free interest rate plus the default premium). 4 For a detailed analysis of dynamic strategies, with costly debt renegotiation, see, e.g., Broadie, Chernov, and Sundaresan (2007), Christensen et al (2002), Fan and Sundaresan (2000), Fischer, Heinkel, and Zechner (1989), Galai, Raviv, and Wiener (2007), Goldstein, Ju, and Leland (2001), Hennessy and Whited (2005) and Mella-Barral (1999). 5 The quality of results does not change if, according to Leland (1994), we assume that the default sunk cost is proportional to a firm's value.…”