Default Prone Bond Prices, Valuable Growth Options and the Option to Re-Organize
22 Pages Posted: 16 Jun 2010
Date Written: January 15, 2007
There is a wide body of literature in corporate finance that examines the tradeoffs between liquidation and re-organization for creditors in financially distressed firms (Kahl (2002), Hotchkiss (1995), Gertner and Scharfstein (1991)). We incorporate salient elements from this literature into a structural model of corporate bond prices. We derive the value of perpetual coupon-paying risky debt as a function of the option held by bondholders to either liquidate or to take control when a firm becomes financially distressed. Liquidation value is the depreciated value of assets in place. Firm value under bondholders is with some efficiency loss, the sum of assets in place and future growth options. We derive ex-ante values of corporate bond prices as a function of the current values of these two competing choices.
Keywords: Corporate bond pricing, contingent claim pricing, bankruptcy, growth options
JEL Classification: G12, G13, G32, G33
Suggested Citation: Suggested Citation