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

Abstract

In a contingent claims framework with a single issue of debt and full information, we show that the presence of a bankruptcy code with automatic stay, absolute priority rules, and potential debt forgiveness, can lead to significant conflicts of interest between the borrowers and lenders. In the first-best outcome, the code can add significant value to both parties by way of higher debt capacity, lower credit spreads, and improvement in the overall value of the firm. If control of the ex-ante timing of entering into bankruptcy and the ex-post decision to liquidate once the firm goes into bankruptcy is given to equity holders, most of the benefits of the code are appropriated by the equity holders at the expense of the debt holders. We show that the debt holders can restore the first-best outcome, in large measure, by seizing this control or by the ex-post transfer of control rights which allows them to decide when to liquidate the firm that has been taken to the Chapter 11 process by the equity holders. Irrespective of who is in control of the bankruptcy and liquidation decision, our model implies, based on the term structure of probabilities of default and liquidation, that firms are more likely to default on average and are less likely to liquidate on average relative to the benchmark model of Leland (1994).