The Bankruptcy Decision

by Jeremy I. Bulow of the Massachusetts Institute of Technology, and
John B. Shoven of Stanford University

Autumn 1978

Abstract: This paper investigates the circumstances under which a firm will be forced into bankruptcy. The model developed can be viewed as part of a larger framework which would be necessary to address the question of optimal financial policy in a world of taxation, bankruptcy costs, investment and depreciation, uncertainty, etc. The model focuses on the conflicts of interest among various claimants to the assets and income flows of the firm (the stockholders, bondholders, and bank lenders). We derive conditions under which the necessary funds for continuation will not be forthcoming and illustrate the importance of the liquidity of the assets and the maturity structure of the debt in staving off bankruptcy. Several examples highlight the major conclusions of the paper. The conditions for bankruptcy, which have some intuitive appeal, are more complex than those appearing in the previous literature. The latter part of the paper considers merger with a healthy company as an alternative to bankruptcy. We show that the tax system has an important effect on the choice between merger and bankruptcy.

Published in: Bell Journal of Economics, Vol. 9, No. 2, (Autumn 1978), pp. 437-456.

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