Optimal Capital Structure and Bankruptcy Choice: Dynamic Bargaining vs Liquidation

Optimal Capital Structure and Bankruptcy Choice: Dynamic Bargaining vs Liquidation

By
Samuel Antill, Steven Grenadier
Journal of Financial Economics. July
2019, Vol. 133, Issue 1, Pages 198-224

We model a firm’s optimal capital structure decision in a framework in which it may later choose to enter either Chapter 11 reorganization or Chapter 7 liquidation. Creditors anticipate equityholders’ ex-post reorganization incentives and pricethem into the ex-ante credit spreads. Using a realistic dynamic bargaining model of reorganization, we show that the off-equilibrium threat of costly renegotiation can lead to lower leverage, even with liquidation in equilibrium. If reorganization is less efficient than liquidation, the added option of reorganization can actually make equityholders worse off ex-ante, even when they liquidate on the equilibrium path.