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

Authors

  • MARK BROADIE,

  • MIKHAIL CHERNOV,

  • SURESH SUNDARESAN

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    • 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, European Summer Symposium in Financial Markets meetings in Gerzensee, Financial Economics and Accounting conference at University of North Carolina, HEC-Lausanne, Institute for Financial Management and Research (India), Korea Development Institute, Skinance 2005, as well as Viral Acharya, Ken Ayotte, Sergei Davydenko, Pascal Francois, Michael Genser, Dirk Hackbarth, Julien Hugonnier, Eslyn Jean-Baptiste, Hayne Leland, Erwan Morellec, Francisco Perez-Gonzalez, Matthew Rhodes-Kropf, and Michael Riordan for their comments. We thank an anonymous referee for numerous comments that have significantly improved the paper. We are grateful to Özgür Kaya for exceptional research assistance. This work was partially supported by NSF grant DMS-0410234.

Abstract

Explicit presence of reorganization in addition to liquidation leads to conflicts 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.

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