Optimal Debt and Equity Values in the Presence of Chapter 7 and Chapter 11
by Mark Broadie of Columbia University,
Abstract: Explicit presence of a reorganization process in addition to liquidation can lead to conflicts of interest between borrowers and lenders. In the first-best outcome, the reorganization adds value to both parties via higher debt capacity, lower credit spreads, and improvement in the overall firm value. If control of the ex-ante timing of reorganization and the ex-post decision to liquidate is given to borrowers, most of the benefits of the code 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. On average, firms are more likely to default and are less likely to liquidate relative to the benchmark case with liquidation only.
Published in: Journal of Finance, Vol. 62, No. 3, (June 2007), pp. 1341-1377.