Chapter 11, Private Workouts and Corporate Debt Pricing Under Asymmetric Information

Abstract

This paper studies the valuation of risky corporate debt, the firm's financing decisions and firm strategy during financial distress under asymmetric information. Using Chapter 11 as a costly state verification mechanism in a simple continuous-time setting, we characterize which firms will choose to file for the Chapter 11 Bankruptcy procedure and which will choose private workouts (in the form of strategic debt service) when the firm is in financial distress. The model predicts that firms with more intangible assets, higher book value and less information asymmetry are more likely to restructure their debt privately, and their stockholders are systematically better off. We also provide a closed-form solution to the debt pricing problem. The formula reduces to the well-known results of Merton, Black and Cox, Leland and others if the private information can be costlessly revealed.