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 equity holders’ ex-post reorganization incentives and price them 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 equity holders worse off ex-ante, even when they liquidate on the equilibrium path.
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