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

49 Pages Posted: 5 Feb 2005

See all articles by Mark Broadie

Mark Broadie

Columbia University - Columbia Business School - Decision Risk and Operations

Mikhail Chernov

UCLA Anderson

Suresh M. Sundaresan

Columbia Business School - Finance and Economics

Date Written: July 19, 2005

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).

Keywords: Contingent Claims Approach, Default, Liquidation, Optimal Security Values, Control transfer

JEL Classification: G33, G13

Suggested Citation

Broadie, Mark and Chernov, Mikhail and Sundaresan, Suresh M., Optimal Debt and Equity Values in the Presence of Chapter 7 and Chapter 11 (July 19, 2005). Available at SSRN: https://ssrn.com/abstract=661441 or http://dx.doi.org/10.2139/ssrn.661441

Mark Broadie

Columbia University - Columbia Business School - Decision Risk and Operations ( email )

New York, NY
United States
212-854-4103 (Phone)

Mikhail Chernov (Contact Author)

UCLA Anderson ( email )

110 Westwood Plaza
Los Angeles, CA 90095-1481
United States

Suresh M. Sundaresan

Columbia Business School - Finance and Economics ( email )

3022 Broadway
New York, NY 10027
United States
212-854-4423 (Phone)
212-316-9180 (Fax)

HOME PAGE: http://www0.gsb.columbia.edu/faculty/ssundaresan/

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