Bankruptcy and Agency Costs: Their Significance to the Theory of Optimal Capital Structure

Abstract

We support and generalize our original results (1978) in light of potential impediments to a pure market solution to agency problems and potential causal links between liquidation and bankruptcy. In the case of bankruptcy costs, market impediments are easily eliminated through the inclusion of simple provisions in corporate charters and bond indentures. Further, we demonstrate that recent attempts to link liquidation costs to capital structure are without merit. If the firm is to be liquidated on the basis of a rule other than one that maximizes the total value of all the claimants, arbitrage profits arise, and informal reorganization will discipline management to follow the liquidation rule that is optimal for existing securityholders. Also, we find that the pure market solution is not readily generalizable to other classes of agency problems, particularly the risk incentive problem. However, the alternative solution of the risk incentive problem through complex financing contracting may be useful in explaining complexities in contemporary financial contracts.